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The problem with the “Modern Monetary Theory”

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04/12/2019 | 10:04am EDT

IMF Managing Director Christine Lagarde warned on Thursday against the "temptation" of "Modern Monetary Theory", a concept that is gaining some traction among certain political and financial circles. It is a rather attractive theory… but a flawed one.

"We do not think that the modern monetary theory is actually the panacea," Christine Lagarde said at the International Monetary Fund's spring meeting in Washington.

This doctrine, also called MMT, was first mentioned in the 1990s. It considers that high sovereign debt is not such a problem, especially for countries that can borrow in their own currency such as the United States or Japan. The absence of inflation in recent years in major economies has given renewed interest to this theory by some economists and politicians on the left, such as New York elected official Alexandria Ocasio-Cortez.

They believe that all money is ultimately created by the State, which prints it and puts it into circulation. Therefore, the government can never be short of money because it can always create more money. So, this means that the sole role of fiscal policy and the issuance of government bonds would be to ensure financial balance in the economy and avoid inflationary pressures.

No free lunch

But Christine Lagarde pointed out that while this theory can work for a short period of time for countries experiencing deflation, but once inflation picks up, this becomes a problem. Indeed, if the government had the option of adopting spending programs without worrying about funding, this would probably end up badly. Let’s take the example of Venezuela, where the government can use public funds without restriction. In 2018, inflation was around 1,000,000%. Money is worth so little there that it is used by artisans to make sculptures that they can sell, as it is worth more this way than as actual cash. There are other examples, such as Zimbawe.

Gita Gopinath, the IMF’s chief economist, echoes Christine Lagarde’s sentiment: “Fiscal policy is a very important part of the tool kit for policy makers. That said, there is no free lunch. There are limits to how much countries can spend.”

Romain Fournier
© MarketScreener.com 2019
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