Why 'Modern Monetary Theory' won't work for South Africa

A 'new' economic school of thought has emerged and gained mass popularity over the recent years. Modern Monetary Theory (MMT), seeks to challenge the mainstream consensus across the economic spectrum. What exactly is MMT and could it work to address South Africa's economic woes?

For starters, MMT recognises that the South African government is the sole issuer of the Rand, and consequently has a monopoly on the domestic currency. This statement is consistent for most countries, especially in the developed world.

Credit creation

The problem with this assumption is that it fails to account for Rands that are created in the shadows. Banks create money out of thin air through the process of credit creation.

This means that banks have no constraints as to how much money they can create, in theory. In the real world, they have certain constraints on credit creation, such as customer's creditworthiness, regulatory requirements, etc.

Entities in the shadow banking system create and destroy Rands out of thin air, off-balance sheet, leaving central banks in the dark of what's really going on.

One of the ways entities create or destroy money in the shadows is through the repo market. Repo is a repurchase agreement between two or more entities. There are two types of repo transactions: Bilateral and Tri-party repo. Ryan Miller thoroughly explains how the repo market works in one of his articles.

In the repurchase agreement, Entity A borrows money from Entity B, and pledges collateral to Entity B until the end of the secured loan. Once Entity A repays the loan, it repurchases its collateral from Entity B. From the perspective of Entity A, it's in a repurchase agreement (repo). From the perspective of Entity B, they are in a reverse repurchase agreement (RRP).

Rands that are constantly created or destroyed in the repo market on a daily basis, are not accurately captured in the money supply metrics. This is because a great number of these transactions take place unregulated. What’s more fascinating is that repo balances are frequently used in real life economic activities.

For instance, a corporation could access repo to get funding in order to buy materials for their daily operations. This 'repo money' is never captured in the money supply metrics, which tells us that the central bank cannot accurately quantify the entire money supply.

If the almighty South African Reserve Bank, a government entity, cannot accurately measure how many Rands actually exist, that tells you that it does not have a monopoly on the rand, as MMT claims.

This isn't unique to South Africa alone. It is consistent throughout the entire global economy. Money is being created in the shadows, unregulated, and very hard to accurately measure, because most of this type of money-creation takes place off-balance sheet.

Raising taxes to combat inflation

The second point that MMT assumes is that government, with its sovereign power and ostensibly infinite knowledge, spends money into existence first, and then taxes individuals after it has spent.

In other words, government funds their expenditures with newly created currency, expanding the money supply, and then taxing individuals which destroys the money supply. See Buddy Wells' article on how MMT works from a balance sheet perspective.

There is a  problem with this assumption. MMT proponents claim that if inflation gets out of control, we can simply raise taxes to combat inflation. Let's look at some empirical evidence to see if raising taxes to appropriately fight inflation will work.

This chart tells us everything about the flaws of this MMT story. The government could raise tax rates as high as they want, however it doesn't necessarily mean that individuals will pay more because of those increased rates. The inflation genie could go out of control and raising taxes would do little to put that genie back in the bottle.

If we look at it from a political perspective, raising taxes to combat inflation would be impossible. A great number of the new generation of young people are constantly demanding 'free stuff' from politicians. People are eager to vote for a political party that offers the most 'free' goodies. Spending increases gets you re-elected. Spending cuts get you kicked out of office.

When you carefully consider the political atmosphere we're in, I'd assume that it's very naïve to believe that raising taxes is possible in the first place.

Government spending

The last point is MMT's dubious claim that government can spend money effectively and increase economic growth. This could not be further from the truth.

Without getting political, let's take an empirical approach to this claim, by comparing government spending with economic growth, not just in South Africa, but across the globe.

These charts illustrate a conspicuous negative correlation between government debt and economic growth. When government takes on more debt to spend money, it drains the free market of capital that it would otherwise use to produce goods and services efficiently.

When government spends money, it is mainly spent on unproductive purposes, like social programmes, entitlements, etc. This type of spending doesn't generate an income stream to service debt, therefore it is unproductive debt, impeding economic growth.

We can further observe this phenomenon by looking at the marginal revenue product of debt (MRPD) from developed economies like Japan, the United States, and the Eurozone.

Source: Hoisington.com

Looking at the chart above, US$1 of debt produces only US$0.25 of GDP. In plain terms, for every US$1 that government spends, it only generates a quarter of a dollar in revenue.

As government grows bigger in size, and undertakes more debt, the lower the debt multiplier. Dr Lacy Hunt frequently talks about the negative effects of government debt on economic growth.

In conclusion

Many world-class studies have proven that government spending leads to lower economic growth, yet MMT fails to acknowledge this indisputable truth.

The point is not to attack MMT or its proponents. Early adopters of MMT like Warren Mosler and Stephanie Kelton are very insightful thinkers. The problem with MMT is that it fails to account for the actual functioning of the monetary system, as well as the more obvious problems with government spending.

This article was first published on BBrief 24 November 2021.

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