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Recent Fed Actions Bring New Seriousness to Modern Monetary Theory

Chris Gaetano
Published Date:
Apr 15, 2020
The U.S. Federal Reserve over the past few weeks has been pumping trillions of dollars into the economy to prop up sagging markets, which the New York Times said have effectively been magicked into existence, lending new credibility to the once obscure idea known as modern monetary theory, which takes the term 'fiat currency' extremely literally.

Modern monetary theory is essentially the idea that, because money is nothing more than a social agreement between people and ultimately does not stand for anything real, a country that controls its own currency can never go broke, and so deficits don't matter. Proponents say that the typical way people think about government spending (it has a certain amount of money, and if it decides to buy something, it spends that money or, if it can't entirely afford it, it goes into debt, which then must be paid off with future earnings) is not the way things are actually done. Instead, they say, government does the exact opposite. The government decides it wants to buy something. It passes a budget resolution authorizing it. Then it instructs the Federal Reserve to simply create the necessary money needed to make the purchase. This is similar to how a bank, through the issuance of new loans, essentially creates money from whole cloth. This is why it is called fiat currency, as it is produced by fiat, rather than a commodity currency, which is linked to the supply of a physical commodity like gold.

The Times said that this is, in fact, pretty much exactly what the Federal Reserve has been doing with its various programs over the last few weeks. Beyond actions directly undertaken by the central bank, the Times notes that the federal government, through the CARES Act and other legislation, has sharply increased public debt, but that since the Fed has committed to buying this debt, the deficit has far more room to grow without adverse consequences. This is because, by law, bond proceeds are sent to the U.S. Treasury, which includes the Treasury bonds that it issued itself. This means the Treasury, when it pays off this debt, will be sending money to the Fed, which by law will then move most of this money back to the Treasury. It is effectively as if it never issued the bond in the first place, according to proponents.

This fiat currency does risk hyperinflation, however, as the amount of money grows faster than the goods and services available to spend it on. Modern Monetary Theory proponents point to taxation as one potential lever to control inflation, as this would effectively shrink the money supply to meet the current economy.

In the past, however, this idea has drawn major condemnation from prominent financial players. A diverse array of critics, ranging from liberal economist Paul Krugman to Federal Reserve Chair Jerome Powell to BlackRock CEO Larry Fink, have all panned the idea, with Fink himself recently saying it was "garbage."

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