How Did Modern Monetary Theory Develop?

A Collection of Commonly Used Modern Currencies

The idea of money and currency has existed since the dawn of civilization more than 5,000 years ago. Early currencies were somewhat crude and mainly just involved using standardized weights to determine the value of certain commodities. The ancient Lydians were the first people to use coins as a form of currency and as store of value, which was a major step toward money as it is known today. After the Lydians, silver became the type of metal most people used to mint coins, but gold was always the reserve and what “backed” the money. Even after paper money became the norm in the modern period, gold still backed most economies and was convertible in paper currency, and vice versa, in many countries into the twentieth century. But gold as the standard backing a national currency officially ended when American President Richard Nixon terminated the Bretton Woods financial regime in 1971. From that point forward, historians and economists, as well as laypeople, have repeatedly asked: what is the value of money?

Since modern economies are no longer backed by gold, questions concerning what currency represents and how it has value have led to some diverging and interesting theories. Most economists agree that modern economies operate under the idea of a “fiat currency,” which simply means that a currency has value because the government minting and printing the money says so. By the 1980s a group of the world’s leading economists, led by Randall Wray among others, began advocating a theory known as “Modern Monetary Theory” or “Neo-Chartalism” that would help explain the post-gold economic order.

Modern Monetary Theory is complex, yet at the same time somewhat simple, as it argues several clear points: money’s value comes from the sovereign power that prints it; the sovereign can create money through printing, which is then needed by the citizens to pay taxes; the currency can “float” when it is not fixed to an exchange rate or commodity such as gold; and default is nearly impossible, but inflation can be a problem. The origins of these ideas date back to the early twentieth century and were later influenced by notable economist John M. Keynes, who argued that state spending, higher consumption, and low interest rates were needed to keep unemployment low. In the 1980s, economists would take a number of Keynesian economic ideas and modify them to produce what is today known as Modern Monetary Theory.

Chartalism, Keynes, and the Origins of Modern Monetary Theory

John Maynard Keynes in 1933

Modern Monetary Theory can be traced back to an early twentieth century idea known as “chartalism.” German economist Georg Friedrich Knapp first articulated chartalism in papers and finally his 1924 book The State Theory of Money as the idea that fiat money has value because it is needed to pay taxes. [1] Outside of economist circles, chartalism did not gain much traction because gold was still being used by most nations to back their currencies. But the world wars changed the world’s economic order and how the leaders of nations would come to view the concept of money.

There was no more influential economist in the twentieth century than Englishman John Maynard Keynes (1883-1946). Keynes wrote extensively, taught, invested in numerous enterprises, and worked with the leaders of Britain and the United States to develop the post-World War II Bretton Woods economic system. Keynes’ influence on post-war economics is extensive that his name is often used as an adjective – “Keynesian” – to describe government economic policies that he advocated. He wrote about those ideas extensively, but they are perhaps best described in his 1930 book Treatise on Money and his 1936 book General Theory of Employment, Interest, and Money.

Keynes mentioned the term “chartalism” on his works, but expanded on the basic idea to include the government’s role in interest rates, employment, and consumption. Arguing that low interest and unemployment rates were the key to a strong economy, Keynes believed that government spending should be encouraged if need be and that tying a currency to a metal was an archaic idea. Keynes argued that “when employment increases, aggregate real income is increased.” [2] Perhaps more importantly, Keynes further wrote that low levels of employment were the result of higher amounts of consumption (spending) by the people of a particular country. [3]

Many of these ideas were advocated by Knapp and other early Chartalists, but Keynes took things a step further by reasoning that governments should play a more active role in the controlling and lowering of interest rates.

“The short-term rate of interest is easily controlled by the monetary authority, both because it is not difficult to produce a conviction that its policy will not greatly change in the very near future, and also because the possible loss is small compared with the running yield (unless it is approaching vanishing point). But the long-term rate may be more recalcitrant when once it has fallen to a level which, on the basis of past experience and present expectations of future monetary policy, is considered ‘unsafe’ by representative opinion.” [4]

In a somewhat ironic historical turn, although Keynes was theoretically opposed to tying a nation’s currency to the value of gold, he was one of the key architects of the Bretton Woods system, which essentially was the world’s attempt to revive the gold standard. Keynes would have preferred not using gold to determine currency exchange rates, but relented due to political pressure. [5] The Bretton Woods system would continue the use of gold as a determination of the value of money, but the foundations for Modern Monetary Theory had poured.

Modern Monetary Theory

The Federal Reserve Bank in New York, New York

After the Bretton Woods system ended in 1971, most of the industrialized nations’ currencies went from being fixed or “pegged” to gold to the “floating” currency regime that exists today. The value of the U.S. dollar, yen, euro, Canadian dollar, and Australian dollar were valued in terms of their demand domestically and in international markets, which brought forth a new economic reality that left many people struggling to understand.

By the 1980s a new wave of economists, led by Randall Wray, Paul McCulley, and Stephanie Kelton among others, began to interrupt the post-Bretton Woods world economy through a chartalist and post-Keynesian lens in what became known as “Neo-Chartalism,” but is now known more commonly as “Modern Monetary” or Modern Money Theory” or MMT. The MMT theory/philosophy consciously “builds on the insights” of Keynes, Knapp, and other early twentieth century chartalist economists. [6] The core concept of this philosophy is that governments that mint and print their own money, and do not peg it to another currency or commodity, can never be insolvent. These currencies are what is described as “sovereign currencies” because they derive their value from the sovereign governments that print them.

MMT furthers Knapp’s earlier argument that the tax system is what gives value to a fiat money system. The sovereign currency is needed to pay taxes, which in turn creates a demand for the currency. [7] The idea of sovereign currency was directly influenced by Knapp, but other elements of MMT are clearly taken from Keynesian economics.

Low interest rates were one of the linchpins of Keynes’ ideas and they are in MMT as well. The theory holds that low interest rates drive investment and keep money circulating throughout the economy in a process known as “velocity.” Keynes, as well as MMT proponents, believe that central banks should play a direct role in keeping interest rates low through a variety of measures, including money printing, quantitative easing, and purchasing bonds. [8]

MMT adherents also follow Keynes with the idea that not only should the central government play a role in keeping unemployment low, but that low unemployment is more important than controlling inflation. Spending increases consumption, which in turn creates more jobs and higher incomes. [9] Although inflation may be the result of more government spending and lower interest rates, low unemployment and higher wages means that the population will be able to better withstand the price increases. Wray has admitted that inflation is certainly a potential problem of following MMT policies, but he points out that cases of truly economic crippling “hyper inflation” are extremely rare throughout history. The cases of Weimar Germany, America during the American Revolution, and Zimbabwe are the three best known cases, which Wray notes were all accompanied by extreme political instability and general bureaucratic incompetence. [10]

Conclusion

In the midst of the collapse of the Bretton Woods financial system, economists, bankers, financiers, and government leaders scrambled to understand their new economic reality. One of the primary theories that developed was Modern Monetary Theory, which was heavily influenced by chartalist and Keynesian economic theories of the early twentieth century. MMT gradually became the leading economic theory of the industrialized world, although not all economists are necessarily on board.

A notable and influential group of economists led by James Rickards believe that MMT policies could be the death knell of the modern economies by creating unending cycles of deflation and inflation and that gold still has a place in modern economics. Another emerging group of economists believe that MMT places too much emphasis on the idea of money and that the concept of credit has all but replaced money in many countries.

References

  1. Polillo, Simone. “Money, Moral Authority, and the Politics of Creditworthiness.” American Sociological Review 76 (2011) p. 439
  2. Keynes, John Maynard. The General Theory of Employment, Interest, and Money. (Ware, United Kingdom: Wordsworth, 2017), p. 28
  3. Keynes, p. 91
  4. Keynes, p. 176
  5. Conway, Ed. The Summit: Bretton Woods, 1944: J.M. Keynes and the Reshaping of the Global Economy. (London: Pegasus Books, 2014), p. 124
  6. Wray, L. Randall. Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems. Second Edition. (London: Palgrave Macmillan, 2015), p. 1
  7. Wray, pgs. 49-54
  8. Fontana, Giueseppe. “The Role of Money and Interest Rates in the Theory of Monetary Policy: An Attempt at Perspective.” History of Economic Ideas 19 (2011) pgs. 123-5
  9. Wray, p. 23
  10. Wray, pgs. 258-62