The Emperor’s New Clothes? The Thread Count on Modern Monetary Theory - Grattan Institute

Times of crisis bring the need for new ideas. With governments struggling to grapple with a confluence of health, economic and environmental shocks, people are looking for answers. Enter the interest in modern monetary theory (MMT), a niche theory about fiscal and monetary policy that had largely been confined to small groups in finance and academia.

Before the pandemic, MMT managed to recruit some popular US politicians to its ranks in Bernie Sanders and Alexandria Ocasio-Cortez, as well as making a dent in Wall St. In Australia, SBS The Feed featured an MMT economist and made the case for never paying back the government debt. So, just how tight is the weave on this new fashion item?

One of the fascinating ideas behind MMT is that it flips the standard chain of events that occurs in fiscal spending. We normally think that the government must first issue debt and then spend the money it has raised. Just like a household, the government must borrow in order to spend. MMT claims that in reality the government spends first and then collects taxes afterwards. It proposes that issuing debt to make up for a shortfall in tax collection is not necessary – debt is only a mechanism that assists the central bank in keeping interest rates at target. Advocates claim that once the financial constraint on the government budget has been lifted, a range of policies become financially feasible. In particular, that the government should always make up any shortfall in aggregate demand with fiscal spending (and temper an overheating economy with taxation).

The simplicity of the MMT view is obscured by its esoteric roots. Money creation, central bank operations and the banking sector are not well understood. There is a long history of economists, central bankers, finance workers and others pointing out that the textbook models do not describe reality. These have been the few, not the many. MMT exists within this diverse, but thinly populated, tradition. Communicating the ideas behind MMT usually requires educating the reader first. Once equipped with a basic understanding of how banking operations take place, we can then scrutinise MMT.[1]

The core aim of a central bank is usually price stability – low and steady inflation around 2-3 per cent (depending on the country) – alongside helping to achieve full employment. To achieve price stability, the central bank targets inflation by setting the overnight interest rate that commercial banks charge each other to borrow and lend. Banks lend to each other to manage their liquidity. When a business makes a large payment, the funds may be transferred from one bank to another. Banks settle transactions with each other using ‘reserves’ held in exchange settlement (ES) accounts at the central bank.

The central bank controls how much reserves are in the system as a whole and adjusts this daily through ‘open market operations’.[2] As the sole issuer of currency, the central bank creates these reserves out of thin air as it deems fit. Managing the level of reserves in the system is a crucial part of setting the interest rate.  

The government also holds an account at the central bank that it uses for a range of things like paying government employees or receiving taxes. This account is counted separately to the balances of the ES accounts that banks hold. Government transactions with households and businesses are conducted via the banking sector, and so involve the transfer of central bank reserves between the ES accounts of banks and the government account at the central bank. A business pays taxes – their deposit account at a commercial bank is reduced, the ES account of that same bank is reduced and the government account at the central bank is increased.  

Armed with a superficial understanding of modern banking, we can return to analysing the claims of MMT. As mentioned, MMT flips the standard sequence of fiscal spending. MMT claims that the government can spend first and worry about the financing later. It is best to consider this first as a description, and second as a proposition.

As a description of reality, its validity rests on one simple question. If the government asks the central bank to transfer an arbitrarily large amount of money to households or businesses, will it do it? The answer: no. Independent central banks have not allowed a government’s account to go negative without bound.[3] Doing so would allow the government to create reserves as it pleases with no promise to pay them back. With this simple constraint in place, the standard logic wins out and the government must act like a household and borrow first before spending. (Although, note that the government can freely issue debt, so management of the budget is quite different to that of a household.) By borrowing through debt, rather than issuing money through creating reserves, the government commits to paying the money back in the future.

A central pillar of modern central banking relies on this constraint. If the government can spend as much as it wants, it would be tempted to engage in ‘outright monetary financing’ – printing money to fund government expenditure – to any end it desires.[4] In the past, this has lead to devastating hyperinflation. Enforcing that this does not happen is precisely why central banks are independent from politics.

So what about MMT as a proposition, not a description? MMT advocates agree that unbridled monetary financing will create inflation and even hyperinflation. MMT is instead proposed as a technique of inflation targeting by ensuring the economy is always at, but never above or below, full capacity. This uses fiscal spending and taxation as the instrument for inflation targeting instead of interest rates.

Critics might say that this reduces MMT to money printing and counter-cyclical fiscal policy, neither of which are new ideas. A deeper question is asking how this arrangement would be implemented? Hyperinflation is usually caused by opportunistic politicians thinking that they had found a free lunch, and so never backing off when inflation starts to rise. The current institutional arrangement prevents that happening.

So what does MMT offer to bind the hands of politicians? It has not been spelled out clearly. What they propose is a big risk without a formal institutional structure to keep prices stable.

There appears to be some crucial threads missing in MMT. As a description, it misses the mark, and as a proposition, it falls short on details about implementation. It might be time for MMT advocates to break out the cotton and start darning. They may come up with a technicolour dreamcoat rather than becoming the Emperor’s new clothes.


  • For a full treatment, see either of two articles published by the Bank of England in 2014 and RBA in 2018 on how the banking sector issues money. A further RBA piece from 2019 will tell you how monetary policy is implemented through the RBA’s interactions with the banking sector.
  • This can involve complicated transactions, but in simple terms the central bank buys (or sells) government bonds from (to) the commercial banks to increase (or decrease) the level of reserves.
  • The Bank of England has stepped into this territory during the pandemic, but it firmly reiterates the conventional view.
  • MMT advocates may claim that it is not equivalent to outright monetary financing, but an understanding of the banking sector does not change the fact that paying for government expenditure by directly increasing the money supply is just that. You cannot dress the wolf up in sheep’s clothing.
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