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A government that prints its own currency can never go bust, or so runs an increasingly influential mantra. The U.S. or UK could never default like Greece or Argentina, right? Wrong. A string of countries, including big ones like Brazil and Russia, has defaulted in their own currencies and not just in times of war.
The idea has gained ground – advocates call it modern monetary theory (MMT) – that the government creates money (or government bonds, a virtual substitute) therefore it can always pay its bills. Fears of debt sustainability should be the last of anyone's worries. Obsessing over the deficit is unnecessary. It is no more than an accounting identity, the counterpart of saving by the private sector, or by ever-obliging foreigners.
Indeed, deficit spending is the government's duty, at least during a downturn, since it is the only real source of economic stimulus, or so the theory goes.
It's understandable that frustrated progressives in the U.S., including some of the new crop of Democrats in the House, have turned to this idea.
Even the International Monetary Fund (in its 2017 Article IV consultation) agrees that the U.S. would benefit from more spending on public goods, financed by higher taxes, and more redistribution to even up people's life chances. Instead, political outcomes lead to lower taxes and fail to yield solutions to well-known issues such as growing Social Security and healthcare costs, never mind more existential 21st century challenges.
A permanent stimulus program would certainly face obstacles. The MMT vision of a free-spending public sector unshackled from the budget constraint contrasts miserably with the chill reality of a federal government shut down for most of January.
Yet assuming away the political hurdles, a more relaxed attitude to borrowing seems an attractive prescription for the U.S. Surely demand for US government debt, like its money, could never be put in question? Not so.
The US dollar has few rivals for now as a store of value and global medium of exchange. But buyers of U.S. dollars are after all investors. The attributes that back the dollar, including the credibility of the U.S. government and the Federal Reserve and its price stability mandate, can slowly crumble. Unlimited economic stimulus would eventually lead to a crisis of confidence in the U.S. dollar.
Reserve currencies come and go. Bad money chases out good.
From the macro point of view, when a country runs large deficits, it adds to demand, crowds out lending to the private sector and typically pushes up interest rates. When deficits are financed by irreversible money creation, it leads to excess growth in the money supply and eventually inflation, vitiating incentives to save, invest and grow the economy. MMTers admit inflation is a constraint but believe the government can rein in spending to head it off.
The 10 years since the crisis have witnessed all kinds of economic policy experiments. The Fed's response to the global financial crisis applied radical textbook ideas to actual policymaking for the first time to avert the risk of debt deflation. Governments ran huge deficits at the bottom of the economic cycle without sparking the inflation some economists wrongly predicted.
But this experience does not back the idea of unlimited deficits or monetary financing of governments in good times and bad times alike.
Spare also a thought for the rest of the world.
Massive stimulus in the U.S. would initially lead to higher interest rates and push up the value of the U.S. dollar, and would have major spillovers for emerging markets and dollar borrowers around the world. The likely sequel, with a slumping dollar shunned by the rest of the world, would be no less disruptive.
—Charles Seville is the senior director and co-head of Americas sovereign ratings at Fitch Ratings.