Critiquing Modern Monetary Theory: When Mainstream Economists Use Misesian Arguments

Modern Monetary Theory (MMT) has been causing quite a stir in the field of economics for some time now. It’s gathered traction in academic and political circles, ruffling the feathers of both those that believe the central bank should be using monetary policy to smoothen the business cycle and those that believe there should be a free market in money. There have been numerous critiques of MMT from both sides, but in this article, I would like to point out an interesting and perhaps useful for those who see Böhm-Bawerk’s capital theory and its relation to money as integral to a holistic theory of economics.

The orthodox economists, and even New Keynesians, have been attacking MMT from multiple angles, but use the methods and reasoning the same as Hayek did when addressing Keynes’ points about “socializing investment.” This shows how the mainstream is not as far off from those that consider themselves supporters of laissez-faire. I’ll point out a few of these arguments and responses from different sources below.

The first thing to notice is that the mainstream economists defend the notion of the Wicksellian “natural rate” of interest from MMTers, who deny its importance or even existence, maintaining that market rates can and should be pegged to zero. None other than Paul Krugman explains it in an exchange with Stephanie Kelton, an economist and supporter of MMT:

First, she suggests that the neutral or natural interest rate – which is defined as the interest rate consistent with full employment given everything else – does not exist. What does she mean by that? I think she means that it’s hard to determine, or maybe that it’s unstable, which are defensible claims. However, the analysis I’ve presented does not depend on the natural rate being either easily estimated or stable over time.

 All we need is that the central bank is able to move rates and that these rates affect overall spending. What purpose does claiming that the natural rate is a meaningless concept serve? It looks to me like sophistry – word games intended to confuse what should be a simple issue. Maybe that’s uncharitable, but I truly don’t see the point otherwise.”

Anyone familiar with Ludwig von Mises’ Human Action will recognize the natural rate of interest concept that relates to how intertemporal coordination is maintained by market rates of interest meeting this natural rate. Another orthodox figure further explained to an MMT supporter, “I will use ‘natural rate’ to mean ‘the rate of interest which arises when loanable funds/capital markets clear’. The natural interest rate is an equilibrium price.” 

The natural rate is where the demand for loanable funds, or investment, meets the supply of savings. To MMTers, the natural rate is of no significance, and therefore they are unable to acknowledge the problem in perpetually low-interest rates. Orthodox economists tend to find lower nominal interest rates  (by the Fed) inappropriate with an economy at full employment due to the Fisher effect: not so with MMTers. Thus, both groups find the relation between the natural rate and market rate(s) of interest to be a useful construct, even if they disagree on the precise mechanisms at play with a given monetary institutional arrangement. This is somewhat common ground between economists and Austrians who find themselves at odds with MMT on a few other things as well. But there have been many more fierce debates between those that are more aligned with Krugman’s position and the MMTers. 

On the subreddit r/BadEconomics (composed of mainstream academics), a conversation between both camps eroded into a sloppy debate recently full of ad hominems and supposed straw man arguments. However, a few remarks were made by the mainstream side that should be of interest to Austrians. I’ll list them below:

MMT argues that money is non-neutral. If money is non-neutral the government can peg interest rates to zero. We know – both empirically and through super intuitive theory – that money is non-neutral. Friedman (1968) goes over why you can’t peg interest rates at zero as higher rates manifest themselves through the Fisher Effect. High-interest rates tend to coincide with high inflation (Mishkin 1992).

 Money is shortrun non-neutral but long-run neutral. MMT is suggesting we can continuously fund real government expenditures via money printing which can’t actually occur in the long run due to money non-neutrality.

I’ll summarize here from what I can gather from each side:

  • MMT: Short-run non-neutrality of money; Long-run non-neutrality of money.
  • Mainstream: Short-run non-neutrality of money; Long-run neutrality of money.
  • Austrian: Short-run non-neutrality of money; Long-run non-neutrality of money.

On the surface, it seems like MMT and Austrians agree on money’s effects on the economy, but I will argue in short that both of them mean different things when they claim that money is not neutral in the long run. Austrians (and even some classical economists to an extent) claim that money has real effects on employment, production, and fiscal matters, even in the long -run. From their business cycle theory, they protest any claim that states an increase in the money supply to fund deficits, among other reasons, cannot create any long-term benefits, and will actually redistribute real capital and resources into the hands of those who are benefited through relative price and Cantillon effects. But this is precisely the opposite of the MMTers, who claim that the non-neutrality of money in the long-run can fund government programs and other initiatives that will improve long-term job-growth, output, and prosperity. This is what Kelton purports when she responded to Krugman:

He then goes on to say that “by crowding out investment,” deficit spending “will somewhat reduce long-term economic growth.”

This follows directly from his model, and these are the arguments I disputed in my most recent reply. Our differences derive from our different analytical frameworks: Mainstream Keynesian versus MMT.

It would make sense that several politicians would find MMT to be a worthy concept in terms of potentially financing government programs they support. But coming back to the point about money’s effect on real variables, it seems that while the mainstream and Austrians differ on the long-run effects of increases in the money supply, they both agree that the kind of pecuniary benefits MMTers support with an increase in deficits through total debt monetization is not viable. I found it extremely telling, and very amusing, to see this comment from someone in the debate who supports the Federal Reserve’s monetary policy in response to an MMTer:

I don’t know what else to call “printing money makes us richer”. What’s a better label?

This point can be related to Austrian capital theory, which has influenced the debate to some extent, but not substantial. That same commenter made several related points about one of the overlooked faults of modern monetary theory. There are constraints on the policies which MMTers are attempting to put forth in academia. These constraints are related to real factors:

There are a finite amount of real resources that can be used to invest in projects or spend in consumption. This could mean money in a traditional savings and loan bank, a bond mutual fund, a pension fund, etc.

If you think that there are not real resources being moved around in capital markets then you reject basically all economics at a fundamental level.

If you do not think that real resources are moved around in the market this implies that financial markets have an infinite amount of resources to go around to fund any project we want. This is not the case.

Other similar point made:

There is a real resource constraint — if you use real resources to build a factory, those are resources not available to make a chocolate cake. If all output is consumed, there’s nothing left over to use for investment. At full employment, this constraint binds and is what determines real interest rates. Everyone agrees on this point.

For the mainstream, the benchmark model is the real model that would hold at full employment. Keynesian effects enter through the deviations from this model. For MMTers, the benchmark model is a nominal model, where actual quantities of money are sitting around in different places in the model, and the government can act on those quantities. That’s why the discussion of “loanable funds” is so confusing. The mainstream is thinking about the real constraint, while MMTers are thinking about the nominal balances.

I agree with their points completely, especially when one of them ironically uses the phrase many Austrians wield against these very individuals, “if you think otherwise then you think markets are able to create goods out of thin air.” However, the argument does not go far enough, particularly when it’s stated, “Of course, in recessions when we have underutilized resources, there is less if any competition between the private sector and government. But we’re not always in a recession.”

To add to their stance, it is important to remember some of the most important points of capital theory. First, capital is heterogeneous and multi-specific. This means not just any pieces of capital or labor can “fit” together, they must be complementary to one another in a given production process. Each factor of production has an opportunity cost, especially the less specific it is. Many factors have several uses, making it more versatile in production and it’s demand more elastic. If a given production method is found to be unprofitable, then the capital used can be reallocated to another industry or sector which needs it. But this comes with a cost, when capital is reallocated, it must often be changed, restructured, or formatted to adjust in a new factory or firm. There are therefore transaction and transportation costs involved when resources are allocated to new places by changes in monetary policy.

 This is what Austrians mean when they say money is a “loose joint” in the system. When there is malinvestment, resources are wasted because they are often very specific and cannot be inserted into another production process, making it idle. The MMT position completely ignores this aspect of money.

Second, interest rates influence the value and supply of capital. If interest rates rise (fall), then the price of capital tends to fall (rise), but this process can be reversed if the interest rates don’t reflect the time preferences of individuals. This is a point that MMTers miss, and is related to Austrian business cycle theory. Labor is also affected by these policies since it must be complementary to capital used in specific processes that are affected by them. Otherwise, workers must be retrained to be properly absorbed back into the labor market in accordance with a given capital structure that changes when prices, interest rates, or government spending and taxation change. And with MMT, there would be high rates of volatility in these variables.

Modern monetary theorists, therefore, ignore the capital structure entirely, insisting that increases in the supply of money can only have positive externalities. The mainstream, while aware of real resource constraints and interest rate effects on real activity, can only flirt with the Austrian position when critiquing MMT. Although the mainstream often ignores aspects of Austrian theory, some of the strongest intuitive arguments against MMT come from the lessons taught by the heterodox Mises and Hayek.

Further Readings

Michael Hoffman
Michael Hoffman is the author of Monetary Kaleidics: Reflections on Money Illusion and the War on Cash.