More Musings on Modern Monetary Theory

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Written by Dean Baker   
Monday, 09 April 2012 16:15

I had several people ask me in comments or e-mails whether I agreed with Modern Monetary Theory (MMT) that the government doesn't need to raise taxes to pay for spending or whether I agreed with Paul Krugman that it does. I won’t claim to know exactly Paul Krugman’s view on the topic, but let me reframe the issue somewhat in a way that may cause people to see differently what is in dispute.

I think that all MMTers believe that the government cannot literally spend without limits. In other words, we can push the economy to the point where inflation is a real problem. The MMT answer is to raise taxes to prevent inflation from getting out of control.

Now suppose we are in the world where we have pushed the economy to the point where inflation is a problem and we decide we want the government to spend more money on some great project. At that point, it would seem that MMTers would have to agree that we need tax increases to offset the impact of government spending in boosting the economy.

We don’t literally need the tax increases to pay for the spending. The Fed could simply create more money to finance the spending. However if we don’t want the spending to be inflationary, then it must be offset by a tax increase.

I think the difference between the MMTers and Krugman is largely on the frequency with which they believe that the economy is up against its capacity constraints so that inflation is a real issue. I don’t want to put words in Krugman’s blog, but my guess is that he believes that the U.S. economy is typically operating near its capacity, so that the story of needing tax increases to offset spending would in general apply.

The current situation is an exception in this respect. Krugman has been as loud and clear as possible about the need for spending to boost demand in the current context, without any offsetting increase in taxes.

For my part, I think the cases where the economy has been near its constraints have been the exception. I think the economy was arguably facing supply constraints at the end of the 90s when the unemployment rate fell to a 4.0 percent year-round average in 2000.

I don’t think we hit supply constraints at any point in the following decade, which is why I could not get all that upset about the Bush tax cuts. It was not a good idea from the standpoint of either economics or equity to focus tax breaks on high income taxpayers, but if we had the same spending policy in the years 2001-2007 without the tax breaks I think the recovery would have been weaker and unemployment would have been higher. In other words, the tax breaks were better than no tax breaks, but had they been structured to be more progressive, they would have provided more boost to the economy. And, spending on infrastructure, education, and research and development would have been even better.

So I don’t know if this puts me in the MMT camp on this one, but I think the differences between Krugman and the MMTers may not be as large as some have claimed. Or at least they may take a different form.

Tags: inflation | mmt | taxes