Brian Easton asks whether Modern Monetary Theory is a new way of thinking about the economy or just an old way, that was problematic in the past, dressed up to appear novel?

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

As a student, I sat with one finger on Keynes’ The General Theory of Employment, Interest and Money and another on Alvin Hansen’s Guide to Keynes. Keynes can be a superb stylist with pages of brilliant quotes, but he can be very difficult. In part this was because The General Theory was so pioneering, so innovative, that Keynes was struggling to explain. He was trying to establish a whole new way to think about the economy. Today we call it ‘macroeconomics’, a term not invented until 1933.

By coincidence at the same time as I was struggling with The General Theory, I was involved with forecasting the macroeconomy at the NZ Institute of Economic Research. It used a Keynesian theoretical framework but was working with a quite different economy from the one in the book. It was open with exports and imports and so it behaved quite differently from the closed economy of The General Theory. Of course Keynes knew about open economies but he was puzzling over why you could get mass unemployment in a closed economy – presumably he was thinking of the whole world. The clash between the two experiences gave me a considerable insight into the strengths and weaknesses of Keynesian economics.

At that time there was no ‘monetarism’, which sees itself as a critique of Keynesianism despite adopting much of its framework. Certainly, many of monetarism’s elements existed earlier, but the term was not coined until 1968. That meant I was following its development before it became fully fleshed out, which gave me some insights and some scepticism about it.

For instance, it was built around a notion of a quantity of money as if the notion of ‘money’ was well defined. You get this in statements like ‘The Reserve Bank should target the quantity of money’. To which it would reply, ‘which quantity of money?’ for there are many different definitions of money in a modern economy with cryptic names such as M0, M1, M2, M3 and DCE. Their measures do not correlate very well. Famously, the Bank of England economist Charles Goodhart articulated ‘Goodhart’s Law’, which says when targeting a particular monetary variable, the relationship between that variable and the rest of the economy changes, thereby frustrating the targeting.

As I recall it, when the Reserve Bank was first given its independence, there was talk of it targeting the quantity of money, but at that time the various measures of money were all over the place because of the monetary liberalisation of the time. So the RBNZ never adopted money targeting and instead operates through interest rates – something which the early monetarists denied was possible. Certainly the RBNZ Monetary Policy Committee looks at the various measures of credit in assessing the economy when it makes its decisions, but that is not targeting them any more than it is targeting any of the host of the other economic variables it looks at.

In the 86 years since the publication of The General Theory there have been a host of developments in the Keynesian framework, including by economists who are at the monetarist end of the spectrum. The variety gets quite bewildering.

A recent one has been Modern Monetary Theory (MMT) which is popular among those who are not economists but largely dismissed by the economics profession. When I looked at it, I found it sounded eerily like the account of the economy I learned about in The General Theory and was subject to all its strengths and weaknesses. ‘Modern’ appears to be a misnomer (unless 86-year-olds are ‘modern’).

In particular the theory describes a closed economy without exports and imports, ignoring that while a country may control its own currency, holders of the currency may want to exchange their domestic currency for foreign currency. New Zealanders don’t want just New Zealand dollars but they also want American dollars to pay for imports of goods and services.

Some versions of MMT model introduce an external sector by claiming that a floating exchange rate regime resolves the theory’s limitations. It does not because such a regime has capital flows which foul up internal monetary arrangements. Indeed, in the short term capital flows drive the exchange rate more than the current account of goods and services. (I made a similar mistake when I first studied Keynesian economics; so did the Treasury in its 1984 post-election briefing.)

It is possible to think of MMT not as a theory of the economy, so much as a policy prescription of how to manage the economy. In particular it rejects the Austrian policies which focus on austerity, often at the expense of public wellbeing. But so do may economists who are not support MMT. In fact Austerianism is losing any popularity it had – even within the policy community.

There is a kernel of truth in the MMT description, although it is not original. Once one gets over the notion that there is a particular thing called money – and that there is a special quantity of it one should target – macroeconomic policy should be concerned about getting the right monetary conditions.

That last phrase is simpler than the task it sets. Economies – especially open economies – are much more complex than the theories which are taught at the elementary level, although those theories need to be mastered as a foundation for tackling the complex issues. The complexity is the reason why the Reserve Bank has a Monetary Policy Committee rather than just operating a rigid rule. And why it sometimes makes mistakes ...

It would make bigger mistakes if it were to use incomplete theories like Modern Monetary Theory.

The column is taking a holiday until the end of January.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.