Why Labour shouldn’t rule out Modern Monetary Theory

Jonathan Reynolds, in his LabourList article on Modern Monetary Theory, is right to say that this subject would attract only a small audience, but a small audience is often the most well-informed. It’s therefore vital to correct the facts on a concept that Jonathan describes as “deeply flawed and a dangerous distraction for people on the left”.

“Advocates of MMT claim that governments with sovereign currencies like the UK can simply spend whatever they like, and taxes only exist to deliver other public policy goals, like controlling inflation or reducing inequality. Aside from the valid concern that printing additional money nearly always leads to higher inflation, outside exceptional circumstances like the global financial crisis, currencies need to maintain value to trade internationally,” writes Labour frontbencher Jonathan Reynolds.

I was one of the first, if not the first, to advocate directing quantitative easing (QE) towards the real economy in modern times. I have never advocated “spending whatever you like”. The only person who advocated QE while using taxation to reduce inequality was Milton Friedman in an essay of 1948. He proposed that all money be created by government rather than by high street banks. In other words, nationalisation of the money supply. That is so left-wing that Chris Williamson should put this guy’s face on his T-shirt. As for the idea of taxes being used to control inflation, this was proposed by Simon Wren-Lewis in a chapter of John McDonnell’s book. It’s not a consensus, but simply an idea.

For those who have an understanding of monetary theory, I will try to elaborate the main issues. It’s important to understand what we mean by “circulation” in monetary theory. If an economy needs £10m of money, then we only need to print £1m because each bank note will be used ten times. The “circulation” would be x10. Hence £1m printed equals £10m in quantity.

Following the banking crisis, there was a lack of demand in the economy and the circulation slowed down. Rather than each bank note being used ten times, they were used only five times. If the circulation falls by half, then it is necessary to double the printing of notes in order to achieve the same quantity of money. So £2m printed, at a circulation of five, makes a quantity of £10m, the correct amount. QE didn’t increase the quantity of money – it corrected the quantity of money.

QE was spent on government bonds, and the sellers of those bonds spent the proceeds in the stock market, which lifted shares but didn’t cause companies to invest, so that money did not circulate beyond the financial markets. If the newly-created money was spent building roads and bridges, it would have had inflationary pressure because wages tend to get spent, and so circulate in the economy.

Simon Wren-Lewis proposed that the state create money but if inflation builds then taxation should be used to reduced the amount of money in circulation. I think this is faulty because it is using a tool at the circulation stage rather than the creation stage, which seems difficult to control and will have a very long lag. The existing tool of interest rates is proven effective at influencing whether people borrow or save, which is the moment that money is created.

If government decided to print £4bn of money to build roads, then the Bank of England would calculate how much this would add to inflation and would adjust interest rates accordingly. In effect, this is an indirect form of taxation: those with large debts would pay a little more in interest rates, while government gets £4bn that it doesn’t have to pay back.

Only a fool would suggest rushing into printing money for government spending on a large scale. A good and gradual start might be to fund the National Investment Bank with a £4bn deposit straight from the Treasury, bypassing the need for the Bank of England to raise the money on the bond markets. This avoids adding £4bn to our national debt. If all goes well, this cautious approach could be expanded.

Having the state create money rather than high street banks does not debase anything if the quantity of money is correct. Nor is there any reputational issue, to which Jonathan alludes – as long as the quantity of money is correct. Nobody knowledgeable is proposing that inflation should be ignored.

The shadow Treasury team need to apply themselves to fully understanding the concept before they dismiss it. MMT simply offers better value for state funding with positive knock-on effects for the private economy. To rule this out without making a proper effort to understand it would be a wasted opportunity.