The big question about Modern Monetary Theory everyone is missing

Economists are in the midst of one of the periodic debate flare-ups over Modern Monetary Theory. On the pro-MMT side we have economists like Stephanie Kelton and Randall Wray, while on the other we have the odd bedfellows of The New York Times' Paul Krugman and the People's Policy Project's Matt Bruenig.

This intricate debate is about the main merits of MMT, an economic school of thought which has received wide attention for its dismissal of the need for taxes to pay for new spending. However, there is an important question which has to this point not been raised. The MMT advocates say that inflation should be controlled through fiscal policy, instead of monetary policy conducted by the central bank as is current practice. In other words, if prices start rising, we can keep them in line by raising taxes.

But does that actually work?

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First, a quick bit of background. As economists Arjun Jayadev and J.W. Mason write, at bottom MMT isn't all that different from traditional lefty Keynesianism when it comes to macroeconomic management. During times of recession and economic slack, a state borrowing in its own currency has unlimited capacity to spend, because printing money or borrowing (backed if necessary by the central bank printing and buying government debt) to spend on public works and so on will not cause inflation so long as there are unemployed workers and idle capital stock (that is, factories and such). That's how to solve recessions either as a Keynesian or an MMTer. But if there is full employment, both sides agree taxes are needed for new programs — to fund them for the former, or to stave off inflation for the latter.

Now, it should be noted that MMT's style of argumentation seems to have dented the brainless pro-austerity mindset that dominates much of elite discourse, which is very much to its credit. However, that doesn't bear on the theoretical issues at hand.

With that covered, on to taxes and inflation. One important perspective is that of institutionalist economist John Kenneth Galbraith, who argued that taxes alone were insufficient for controlling inflation, based on his personal experience as the head of the U.S. Office of Price Administration (an agency that regulated American prices from 1941-47) in the Second World War.

By 1941-42, war spending had stoked the American economy red-hot. Yet the Roosevelt administration badly wanted to avoid the unpopular high inflation of the First World War — which was unfair and may have even damaged the war economy. High taxes were imposed, but so were strict rationing and price controls, so the absolute maximum of war materiel could be wrung out of the economy in an egalitarian and efficient manner.

Galbraith explained his wartime experience (which convinced him to drop his previous contrary conviction) in an episode of his documentary series The Age of Uncertainty:

After some experimenting, Galbraith's Office of Price Administration worked extremely well. Production exploded from 1939 to 1943 by 131 percent, but price increases were held to a modest rise of 21 percent. This was practically the inverse of World War I, when production rose only 25 percent but prices accelerated by 77 percent.

Galbraith later developed his price views in his book A Theory of Price Control. His basic argument was that with large firms and high unionization, big swathes of the economy had partly escaped from market competition. The way tax-side inflation control is supposed to work is through supply and demand. Since taxation will leave buyers with less money in their pockets to spend, market competition will force suppliers to cut prices and workers to accept lower wages. But if markets have become dominated by a few big firms, then business can resist this pressure, because buyers have nowhere else to go. And if labor markets have been heavily unionized (not the case now, but it was from the 1930s-70s), then big unions will be able to resist wage cuts as well.

On the other hand, big firms and big unions are much more amenable to government price regulations. In a market with thousands of sellers and buyers, it is nearly impossible for the regulator to keep an eye on everything. A family farmer selling eggs to a willing individual at an illegally high price will almost certainly get away with it. But big companies and big unions are much easier to monitor, because of their centralized structure — effectively administering the price regulation themselves across a big chunk of the economy.

Now, Galbraith would not argue that taxes can never cut inflation (after all, during the Great Depression prices fell steadily), but instead that it would require a lot of unemployment and take a long time. A good test of this prediction came in the late 1970s, when inflation was at its postwar peak. Galbraith argued for a return to price controls, but conservative "monetarists" like Milton Friedman argued that the problem could be solved by resetting expectations — a credible signal from the central bank, in the form of a steep hike in interest rates, and inflation would come down quickly and easily.

The Fed tried Friedman's policy, but it turned out Galbraith was right. The Fed hiked interest rates to an eyewatering 20 percent, creating the worst recession since the Great Depression up to that time. But inflation only came down very slowly — partly through Keynesian-style spending effects, but partly by badly damaging the labor movement, which cut unionization. In effect, inflation control came at the expense of full employment and organized labor more broadly.

There are also institutional factors to consider. One reason inflation control is delegated to the central bank is that it can work quickly, adjusting interest rates in response to economic conditions several times per year. Congress works extremely slowly at the best of times, and control is usually split between the two parties. The Fed may have performed poorly over the last decade, but do we really want Mitch McConnell having to sign off on inflation policy?

Of course, today things are very different than they were in the 1970s. We no longer have big unions in most of the economy, and with the persistent economic weakness of the Great Recession, which still has not been totally fixed either in the U.S. or in Europe, inflation seems like a distant concern. On the contrary, the major inflation problem since 2008 has been that it is too low.

On the other hand, markets have become much more monopolized than they were in the 1970s. And if Democrats take power in 2020, and push through a stimulative Green New Deal and lots of pro-union policy, it's not out of the question that inflation control again will again be a live policy concern soon. It's worth straightening out how that should happen before prices start coming up.