Policy Research in Macroeconomics

Is Modern Monetary Theory suited for the EMU?

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In 2020, governments all over Europe and beyond enacted unprecedented fiscal stimulus to keep their economies afloat amidst the pandemic. By the end of the year, a country like France will have engaged or guaranteed at least EUR 300 billion, the equivalent of four years of income tax receipts. Institutions of the European Union (EU) also rightly stepped up to the challenge.

Of particular importance has been the response of the European Central Bank (ECB) which launched several bond-purchasing programmes of a total value of EUR 1.85 trillion (the equivalent of the yearly economic production of a country like Italy) to absorb the rising public debt on its balance sheet. By purchasing bonds in exchange of so-called ‘central bank money’, the ECB notably allowed governments with higher debt servicing and refinancing costs to benefit from its own credibility as lender of last resort.

Should the public debt sitting on central banks’ balance sheet be considered a burden or an unfortunate tab that a country can get away with? This is basically the question that Stephanie Kelton, one of the leading progressive voices in American academia, raises in her book ‘The Deficit Myth’ (2020) (John Murray Press). Kelton’s book, which is meant to serve as a manifesto for the ‘Modern Monetary Theory’ (MMT), primarily considers the nexus between fiscal and monetary policy in the specific context of the United States. In the wake of the Covid-19 pandemic, Kelton’s ‘deficit myth’ has, however, gained traction in the EU with some policymakers referring to MMT as a way to ‘cancel’ public debt.

In this review, I first attempt to draw light to the main claims of the MMT advocates. I then consider MMT’s claims in the specific context of the Economic and Monetary Union with a specific focus on the challenges facing Euro area governments amidst the Covid-19 pandemic. I finally consider which lessons may be drawn from ‘The Deficit Myth’ by European progressive forces in their quest to drive structural change of the framework of the Economic and Monetary Union.

A misnomer rightly debunking misconceived views on fiscal policy

As Kelton herself acknowledges (2010), Modern Monetary Theory is a ‘misnomer’. MMT is indeed not a theoretical but rather a descriptive approach, which largely builds on the work of 1930’s-40’s economists such as Knapp, Keynes, and Lerner. MMT also primarily focuses on the role of fiscal policy in achieving macroeconomic objectives  – such as full employment, low inflation, and lower inequalities – with monetary policy arrangements rather supporting these goals in the background.

In The Deficit Myth, Kelton’s argument relies on the following three main claims:

  1. There are neither financial nor monetary constraints for monetary sovereign countries. Kelton primarily focuses on the United States as a country issuing fiat money (i.e. a government-issued currency not backed by a physical commodity, such as gold) in a floating exchange rate regime where its currency is internationally accepted. In this context, governments can never default. Instead, they can just create money by having the central bank credit the accounts of banks holding public bonds. Accordingly, governments don’t need taxes or borrowing to fund their expenditures.
  2. Fiscal policy should help balance the economy, not the budget. Kelton rightly rejects the widespread view of state’s finances approximating that of private households. This is where the influence of Lerner’s ‘functional finance’ work (1943) is most visible: borrowing, like taxes, is not there to fund public expenditures, but to resolve well-targeted objectives in the economy, including achieving full employment, controlling inflation, or altering the distribution of income. Efficiency should hence be considered against the objective of achieving policymakers’ goals (e.g. restructuring income distribution for fiscal policy) rather than correcting market failures. In that spirit, Kelton proposes introducing a federal job guarantee scheme, which would create a market for jobs linked to building a care economy.
  3. The real constraint is not deficit, but inflation. Kelton clearly acknowledges that whereas a deficit may not be a constraint on government expenditure, inflation is one that needs be taken seriously. More specifically, productive resources are the real constraint as demand-pull inflation will kick in when aggregate demand is higher than productive capacity. Inflation, she argues, should then be dealt with by raising taxes or cutting spending to reduce the money available in the hands of the tax payer. The federal job scheme would supposedly also help reduce inflationary pressures by stopping companies from bidding up wages to attract workers to join.

Essentially, Kelton promotes the use of fiscal policy to address macroeconomic issues and to “shift away from the current reliance on central banks to deliver on the twin goals of full employment and price stability”. In this regard, the ‘Deficit Myth’ has the merits of trying to identify general rules to rewrite monetary and fiscal theory in an extremely complex and diverse global economy, also marked by a background environment of ‘radical uncertainty’. To that extent, what may be valid points for the specific situation of the US and other “monetary sovereign countries” may only really apply to a handful of countries.

Assessing the validity of MMT for these countries would go beyond the scope of this paper. Rather, we seek here to lay down some thoughts on the extent to which this perspective may also help draw relevant lessons for the Euro area. In that regard, Kelton’s critique of the neo-classical logic according to which “every penny spent should first be raised” echoes the critique of numerous scholars having pointed to the design flaws of an EMU largely built upon such principles (Eichengreen & Temin 2010).

With the benefit of hindsight, we now know that the ‘institutional reflex’ with which EU institutions first responded to the Great Recession negatively affected EU welfare structures, triggered a ‘popular pushback’ and eventually lead to a recalibration of EU’s economic governance strategy (Hemerijck and Huguenot-Noel, 2021). Yet the MMT’s approach is not only helpful to help us shed light on the aftermath of the sovereign debt crisis in the EU. It is also particularly instructive for the developments recently observed in the EU’s response to the Covid-19 pandemic.

ECB’s ‘bazooka’ as Modern Monetary Policy in action

The EU’s response to the pandemic constitutes a sea-change in economic and monetary governance to the extent that it was described as “Modern Monetary Theory in action” (Bofinger 2020). As we know, EU member states made a giant step in agreeing to issue common debt to fund expenditures to address and recover from the pandemic through a mix of grants and loans. EU institutions also agreed to temporarily relax EU fiscal, state aid, and competition rules.

The ECB’s response to this crisis proved indeed much faster than during the Great Recession. Thus, the ECB reacted to widening spreads by initially announcing a package with three main pillars: (i) support of bank liquidity and lending by offering more favourable conditions for long-term refinancing operations (LTROs); (ii) an expansion of targeted LTROs; (iii) an expansion of asset purchases (’quantitative easing’). As the pandemic impact widened and initial action fell short to convince financial markets, the ECB launched the Pandemic Emergency Purchase Programme (PEPP) on 18 March 2020 (its ‘bazooka’). The PEPP represented a further intensification of the quantitative easing programme with a foreseen envelope of €750 billion for the year, bringing the ECB’s bond-buying programme to a total of EUR 1.35 trillion, with possibility of expansion. On 10 December 2020, the ECB decided to increase the size of the PEPP by €500bn to €1,850bn. The programme will now at least be active until the end of March 2022. 

Most importantly, the ECB’s action went a considerable way in resolving the immediate threat of self-fulfilling prophecies stemming from ever higher interest rates demanded by international creditors on financial markets. Thus, spreads declined markedly after the launch of the PEPP, and its positive impact continues to be felt up until the present. A good example is Portugal’s 10-year bond yield which in November 2020 fell, for the first time, below zero.

As of December 2020, a substantial and increasing amount of government debt was sitting on both the ECB’s and the Fed’s balance sheet. Yet, as the new waves of the pandemic may lead the cash accumulated to continue to grow on both sides, profound differences exist in terms of institutional design and political economy constraints facing the Fed and the ECB. These differences provide for fundamentally different exit strategies. In the US context, the back-up of the US Treasury and the confidence in the dollar basically allow the Fed to keep government debt more or less permanently on its balance sheets.

The story is fundamentally different in the EMU context. While now guaranteed until March 2022, the government bond purchasing programmes launched by the ECB remain temporary in nature. This means that, even if spreads were credibly limited, countries like Italy or Greece will still face high and rising debt ratios. In this context, risks are real that the fear of having to pay back soaring debts once rules are re-established may lead some countries to enact more cautious recovery plans than they would need.

As many of MMT advocates refer to it as a fiscal policy approach benefiting from central bank unconditional support, it is also useful to take a closer look at the opportunities and limits of the MMT’s approach of monetary policy for the specific context of the EMU.

Moving away from technical monetarism

Kelton’s The Deficit Myth undeniably has the merit of bringing back the instrumental role that fiscal policy can – and in fact should – play in achieving macroeconomic objectives citizens actually care about. In the same vein, another major contribution of MMT is the rejection of technical monetarism, which basically sets the view that governments should keep the money largely steady and price stability be some sort of a totem for which objectives as legitimate as full employment should be politically sacrificed.

A modern criticism of the neoclassical paradigm is particularly relevant in the light of the original EMU institutional design. From the years following the adoption of the Maastricht Treaty to those of the Great Recession, EMU rules and their interpretation undeniably reflected the zeitgeist in which the Treaties were signed which coincided with the supply-side revolution in economics. The launch of the common currency indeed not only coincided with lower policy autonomy at the national level, as it restricted national capacity for currency devaluation and capital movements control. The ‘central’, EU level was also deprived from any capacity for macroeconomic management.

Thus, the ‘no bail out’ clause enshrined in the EU Treaties prevented member states from the possibility of addressing shocks by means of EU solidarity. Meanwhile, the monetarist design of the ECB and its focus on keeping inflation (well-)below the 2% target was often achieved at the expense of high levels of unemployment. To that extent, pre-‘whatever it takes’ ECB monetary policy did represent a case example in Kelton’s criticism of a theory promoting precisely this approach, namely: the non-accelerating inflationary rate of unemployment (NAIRU).

Equally, Kelton is also right to highlight that the lack of inflation and risks of deflation have been more of an issue in recent years than the one of an inflation spiral unfolding. And rightly so. Already before the pandemic, the world economy was facing persisting deflationary pressures, notably linked to ageing population, a weakening of the bargaining power of trade unions, and large excesses in private savings. And while large amounts of money have been injected into the economy to respond both to the pandemic and the resulting lockdown, historical comparisons suggest that such types of massive liquidity injections in the economy did not necessarily translate into uncontrollable inflation spirals (Bofinger 2020).

In light of the global macroeconomic environment, scholars have highlighted the benefits in the ECB engaging, in response to the pandemic, in at least some kind of temporary monetary financing (Blanchard and Jean Pisani-Ferry 2020). Yet, as with any short-term remedy, monetary financing also comes with some long-term side-effects that will need be mitigated. After about three decades of focusing on maintaining (successfully) inflation at low level, it is now particularly interesting to seek to understand the conditions under which a shift in the ECB’s strategy may prove both desirable and politically feasible.  We therefore look at what the externalities of monetary financing may be, the extent to which MMT considers how to deal with them, and what lessons this implies for EMU reform.

Keeping inflation, financial stability and inequality in sight

Before making any argument about what EMU issues MMT does not address, one should first acknowledge that The Deficit Myth is a book primarily looking at the situation of the United States and largely dedicated to an American audience. To be sure, there is only so much that monetary financing in an MMT fashion can teach us in how to deal with the problems facing the Euro area. Yet, given the universal claims made by Kelton in some parts of the book (starting from its title) and, above all, its reception in some national contexts as a kind of new ‘general theory’ in the making, it is surely fair to address some of the apparent limits standing in the way of MMT in fostering the kind of paradigmatic change it aspires to trigger.  

The first issue on which one would have wished The Deficit Myth to cast further light relates to how to deal with inflation risks. As we highlighted above, most analysts agree that chances of inflation hitting EU economies for a sustained period are rather low. Yet this does not mean that these risks are inexistant. As the editorial board of The Economist (2020) put it: “Covid-19 pandemic has shown the value of preparing for rare but devastating events. The return of inflation should be no exception.” What if, then, a ‘demand-pull’ inflation spiral did unleash as a result of EU’s bazooka in more than a temporary rebound? What if ‘cost-push inflation’ was triggered by other long-term trends, be it deglobalization or demographic ageing (Goodhart and Pradhan, 2020) or by extreme events such as a new catastrophe induced by climate change or a new conflict in the Middle East?

Unfortunately, Kelton’s suggested response to potential inflation risks is rather poorly developed in The Deficit Myth. Kelton’s argument largely relies on a general assumption that inflation may be addressed more effectively from the fiscal side than from the monetary side. This assumption does, however, appear as fairly naïve. As the Great Recession has shown, ‘internal devaluation’ strategies, usually associated with spending cuts, lower wages and labour market flexibilization, are not only more perceivable (and hence politically contentious) than interest rates hikes.

This strategy also risks proving less effective in calming down inflationary expectations, potentially costing precious time for policymakers seeking ways to preserve the value of their currency. A final cause for concern is redistributive since addressing inflation through tax hikes or spending cuts (especially) has been shown to be particularly detrimental to those relying the most on public assistance.

The second issue which The Deficit Myth falls short in addressing is linked to the negative externalities associated with a situation of permanently low interest rates. Undesirable side-effects may include financial stability as well as issues of a more redistributive nature. While MMT surely helps revive the role of fiscal policy in macroeconomic stabilization, the role that monetary policy can play in this area seems overly downplayed.

With the benefit of hindsight, we now know that the decades of cheap money following the launch of the EMU, combined with rules restricting the scope for industrial policy, contributed to the emergence of credit booms, excessive private expenditures, and the building of current account imbalances in some EU member states. Low interest rates can also disincentivize policymakers from making the kind of long-term reforms that help improve the productivity of their economy. As shocks hit, these trends can in turn expose countries to risks of capital flight and create immense socioeconomic challenges especially in those countries where years of neglect and underfunding undermined institutional capacity.

The challenges facing the Eurozone today – propelling the transition towards climate neutrality, tackling inequality – may well be different from yesterday. In the medium to long run, overburdening monetary policy with issues of a more fiscal nature could however largely constrain its capacity to help trigger the kind of change it aspires to propel. Not only is cheap money artificially keeping zombie firms alive, preventing the emergence of more sustainable business models. As we know, the latest exercises of quantitative easing also lead to a major rise in the value of financial assets, far from reflecting developments in the real economy.

There are risks that the status quo further exacerbates the gap between asset-rich and asset-poor individuals as well as countries. Finally, going forward, a continued focus on the sole purchase of government bonds is unlikely to help the ECB address deflationary pressures and may well delay its transition towards an often advocated objective of ‘greening’ its balance sheet.

All in all, MMT may well not be the response to all the problems faced by the Euro area. But, provided that is of any significance in considering the direction for EMU reform (a thesis which previous sections have confirmed), one should also be aware of the shortcomings inherent in this theory. In other words, limiting central banks’ role to pursuing the sole mission of ensuring very low interest rates and accepting permanent monetary financing could risk reducing monetary policy to a position where it would be “totally dominated by fiscal policy”, as Vítor Constâncio, a former Vice-President of the European Central Bank rightly stressed. Accordingly, addressing this issue should start with aiming to find the right mix between monetary and fiscal policies.

Progressive economics in the EMU today

What is then the way forward for EMU reform from a progressive perspective in the wake of the Covid-19 pandemic? While many European economies find themselves dealing with the second wave, options for the recovery are already on the table ranging from ‘back to business as usual’ to government debt being simply ‘cancelled’ from the ECB’s balance sheets. In this conclusion, I consider these options and suggest what I believe should be the priorities of an agenda for structural reform of the EMU agenda which European progressives should be uniting behind.

Today, a popular option among many EU policymakers seems to be driven by an unfortunate desire to getting back to business as usual. How would this translate into policymaking? If a majority supports this view also at the EU level, the rules of the Stability and Growth Pact and the Fiscal Compact will be re-established as they were, as soon as the pandemic starts to be under control. The European Central Bank may also decide to get back to its capital key and gradually stop buying the debt of governments lacking an investment grade status (such as Greece, currently hard hit by the second wave). At the national level, some policymakers are already calling for the need to balance budgets, “as every responsible household would do”, belying MMT’s lessons. New committees have already been set up, headed by fiscal hawks already hinting at possible ways to achieve this through cuts in social programmes.

As we know from the sovereign debt crisis, a mere focus on fiscal consolidation would not only be socially harmful but also likely prove ineffective, and may trigger further undesirable side-effects for all EMU members, including in the form of a slower recovery. To be sure, a major risk facing Euro area economies today is indeed one linked of too little (EU and national) money reaching the real economy too late (see e.g. Darvas 2020). Efforts should therefore first focus on mitigating the risk of subdued fiscal support.

A second option currently flying high is a proposal, particularly in vogue in France and Italy, to get rid of public debt all in all, through its cancellation on the ECB’s balance sheet. While the pandemic highlighted the possibility of the ECB ‘absorbing’ vast amounts of debt on its balance sheet, the argument goes, public debt should now be simply ‘cancelled’ at least for the stock of state bonds resulting from the shock induced by the Covid-19 pandemic. In this context, MMT is often being referred to as evidence (if not an undeniable proof) that deficit is not only a myth but printing cash also a magic trick.

In a different fashion, other commentators have advocated for the EU to consider the kind of joint borrowing enacted by EU institutions through the pandemic-related debt to be ringfenced with no date for future repayment (see e.g. Soros 2020), an option previously experimented by large countries e.g. after war episodes. Hurdles here, however, are also particularly high. As highlighted in previous sections, there are first legal constraints as public debt monetization is explicitly forbidden in EU Treaties. Besides, economic analysts also pointed to the fact that governments being the shareholders of central bank money, these would ultimately lose in dividends what they would earn through such cancellation (Pisani-Ferry 2020).

Are progressive voices in the EU therefore to be deemed to accept an unsatisfactory status quo on the basis of legal and economic barriers? A long-term orientated perspective certainly invites us to clearly respond in the negative, as the new macroeconomic reality, but also our cognitive understanding of causal mechanisms, and our normative aspirations regarding the role of economic and monetary coordination of the EU, have dramatically evolved in recent years. To be sure, EU rules will need to be changed and many proposals have been made in this regard, stemming from the transformation of fiscal rules into fiscal ‘standards’ (Blanchard et all. 2020) to comprehensive proposals on how to revise the monetary-fiscal policy mix (Bartsch et all. 2020).

Yet the short-term answer forces us to also address a question of a more political nature: Would debt cancellation really provide the most suitable alternative to the ‘back to business as usual’ narrative? For governments borrowing at negative interest rates from financial markets today, cancelling government debt from the ECB’s balance sheet could in fact provide little additionality. Indeed, as was repeatedly stressed in recent months, in a context where interest rates are expected to remain below growth rates, debt rollovers, that is the issuance of debt without a later increase in taxes, may well be feasible – and, practically, “have no fiscal cost” (Blanchard 2020).

The case for not considering debt cancellation as the most progressive alternative to the status quo ex ante is not only economic. It is also linked to democratic legitimacy. Debt cuts are decisions having a major redistributive impact and both economists and political analysts will generally agree that it would be unreasonable for decisions of such a political nature to be left to a non-elected institution.

The political dimension of public debt cancellation leads us to a consideration of a more strategic nature specific to the EMU context. What many consider being institutional ‘barriers’ today are there for a reason. A reason of a historical nature. Institutions indeed usually reflect hard fought compromises found between antagonistic forces, at a moment in time. Monetary policy in the EMU context has the specificity of dealing with multiple sovereign fiscal authorities, all coming with their own national specificities and economic cultures. To be sure, both the monetarist design of the EMU, and the EU’s overall institutional framework, have been shown to provide a more favourable environment to some “coordinated market economies” (Germany, The Netherlands), compared, e.g. to their Southern neighbors (Hall 2014).

Yet, recent developments also show that the EMU design is an ever evolving beast, likely to always trigger national resistance in some parts of the EU. Thus, whereas the ECB’s reluctance to actively help close spreads at the beginning of the pandemic was heavily criticized in countries like Italy, recent challenges by the German Constitutional Court suggest that frustration with low-yield savings and concerns over risks of return of inflationary pressures still hold sway in countries attached to a more monetarist appreciation of the role of the ECB. As we have shown above, revising EU fiscal and monetary rules is increasingly needed. Yet one should also keep well in mind that, in order to drive forward what remains today, by global standards, the most comprehensive form of regional economic integration, and a major pillar to the European peace project, reform proposals also need to integrate a wider context than a mere national one.

The bottom line is: new compromises must be found – and in fact are currently being struck in the current critical juncture for E(M)U integration. In a few years times, there are reasons to believe that what the EU leaders achieved this Summer through the creation of an embryo of fiscal capacity for the EU level will be considered as an essential step in improving economic and monetary coordination in the EU. The EU’s EUR 750 billion recovery fund, which includes both grants and loans funded by common borrowing, does constitute a historic breakthrough for the EU.

Undeniably, some concerns remain on the macroeconomic relevance, the timing and overall direction of travel of EU support. Accordingly, active and united engagement of European progressive forces will be needed to ensure, among other things, that Next Generation EU money will be allocated in way which advances progress towards the Sustainable Development Goals. Equally, the SURE programme launched in the midst of the pandemic will need to be transformed into a fully-fledged European unemployment reinsurance scheme (Andor, 2020), akin to Kelton’s federal job guarantee proposal.

Finally, deficit and debts are instruments and should therefore no longer be taken as objectives per se. To remedy this, a critical step will be to strike a new EU compromise on the purpose of EU fiscal policy and what should be a desirable fiscal stance in today’s low rate environment. Building on this, rules of the Stability and Growth Pact should be revised to assess fiscal sustainability in all the complexity that different national contexts require, while allowing EU governments to further invest in green and digital infrastructure, and, above all, in their greatest productive force: people.

In The Deficit Myth, Stephanie Kelton’s main insight is essentially that economic instruments should remain means to pursue political end goals. It is true of fiscal policy and of monetary policy. Today, major debates remain as to the extent to which the Modern Monetary Theory she advocates for in the US may apply to the EU’s context. But the novelty of the latter argument should not blind us to what is certainly the most decisive reminder of the MMT approach, namely that fiscal policy can and should be used as a force for short-term stabilisation, long-term development, resource allocation and distribution, and employment maximisation. Accordingly, a main take-away from this book should be to get priorities right and acknowledge that no decision may be more critical for the EMU today than developing fiscal capacity at EU level in a way which matches the productivity capacity of its members.

Assuredly, convincing sceptics and sealing broad-based coalitions will require precious political capital to be invested smartly. A way to do this is to ensure that the sharing of fiscal capacity at EU level has a clear purpose, well-defined objectives, and is effectively spent, thereby showcasing why it may be here to stay.

In short, the main policy implication of Kelton’s Modern Monetary Theory should be to make EU’s common fiscal capacity work. This approach will surely have more value than raising the flag of an obscure, risky, and, in fact, unnecessary government debt cancellation by the ECB.

Robin Huguenot-Noël is a PhD researcher at the European University Institute (EUI), Florence. He previously served as an advisor to the UK Treasury and the German development cooperation agency (GIZ). Contact: [email protected]


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