On Modern Monetary Theory and Some Odd Twists and Turns in the Evolution of Macroeconomics

Jörg Bibow | October 16, 2018

Mainstream neoclassical economics is hooked on the idea of individual worker-savers as prime movers in capitalist market economies. As workers, individuals choose how much to work, determining the economy’s output; as savers, they determine how much of that output takes the shape of the economy’s capital investment. With banks as conduits channeling saving flows into investment, firms churn inputs into outputs that match worker-savers’ tastes. In this way, the neoclassical world gets shaped by what rational intertemporal utility-maximizing worker-savers wish it to be.

In its most fanciful version – erected on supposedly sound micro foundations and known as “real business cycle theory” (RBC) – the neoclassical fantasy world of intertemporally optimizing worker-savers is subject to exogenous shocks to tastes and technology. Random technology shocks may be either positive or negative, and as Edward Prescott—acclaimed RBC founding father, together with Fynn Kydland—famously explained, negative technology shocks arise whenever there is a traffic jam on some bridge (see Romer 2016). That’s truly creative: Imagine a couple of dancers receiving the Nobel prize in medicine for wildly hopping around a coconut tree while peeing on a rotten banana and screaming voodoo until they are blue in the face. Unlikely to happen in medicine, you might say, but in economics voodoo routines and hallucinations of this kind can still earn you a pseudo-Nobel prize properly known as “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.”

There also exists a “New Keynesian” variety of mainstream neoclassical economics that accepts the RBC framework as its core but adds some “frictions” to the modeled worker-saver paradise that hinder continuous and smooth full-employment equilibrium. Both camps share a common modeling technique (or speak the same language) known as “Dynamic Stochastic General Equilibrium” (DSGE) methodology. The only thing “Keynesian” about the New Keynesian variety is that it provides a rationale for government stabilization policies.

Hardcore (“New Classical”) RBC proponents interpret the Great Depression as a worker-saver mass movement into the world of leisure. By contrast, New Keynesians offer an apology for why market economies might take their time in returning to full employment. Regaining full employment may then be accelerated by government intervention, preferably to be enacted by an independent central bank – with central bank independence being re-interpreted as “rules rather than discretion” in another extraordinarily muddled piece of obscurantism by said RBC-duo Kydland and Prescott (1977) (see Bibow 2001).

Needless to say, and obvious to any serious economist, the worker-saver fantasy world depicted in DSGE models has little in common with capitalism as we know it on this planet. In fact, modern mainstream macroeconomics has completely unlearned the “Keynesian revolution” and essentially turned macroeconomics into an especially shoddy version of microeconomics.

Keynes identified two key flaws in the mainstream neoclassical economics of his time. The first was a fallacy of composition regarding the working of the labor market: while the individual worker may price themselves into employment by accepting a lower wage, workers in the aggregate can only price the macroeconomy into debt deflation by going down that route. Keynes observed that the only reliable expansionary effect of a falling wage level arises through competitiveness gains and net exports. Writing at a time when the world was engaging in “beggar-thy-neighbor” competitive devaluations, that seemed hardly a promising strategy to rely on.

The second flaw Keynes identified concerns the neoclassical capital market supposedly channeling worker-savers’ saving flows into investment, with banks collecting loanable funds as deposits which they then lend out to investing firms. Keynes exposes a fatal neoclassical confusion between money and saving (Bibow 2009). In capitalism nothing much happens without money, so it’s money first, then saving – if money can make James Meade’s (1975) investment dog smile and wag its tail. In Keynes’s vision of capitalism, entrepreneurial investors and their financiers emerge as the prime movers, while worker-savers are largely relegated to a more passive role. They, too, try to optimize – but under the macroeconomic constraint posed by the level of effective demand.

Interestingly, Schumpeter’s vision of capitalism is quite similar to Keynes’s, with entrepreneurial-investors driving the never-ending process of “creative destruction” and banks acting as “ephor” (gatekeepers) of capitalist development. Schumpeter, too, understood the money-first principle and saw banks as money producers rather than loanable funds conduits. Minsky stood on both giants’ shoulders, elaborating on the central role of finance in capitalism and the endogenous emergence of financial fragility as the driving force behind boom-bust cycles. However, Minsky clearly leaned towards the Englishman rather than the Austrian regarding the role of government as a player in its own right potentially stabilizing the macro economy.

It was Abba Lerner (1943, 1944), who pushed Keynes’s macroeconomic insights to its logical conclusion with regard to fiscal policy. Lerner’s “functional finance” approach proposes that the government, not facing the usual monetary constraints that can hold back private actors, should let its budgetary position passively adapt to whatever may be required to achieve macroeconomic equilibrium.

Keynes responded to Lerner’s functional finance as a “splendid idea” but had reservations as far as putting it into practice was concerned: “functional finance is an idea and not a policy; part of one’s apparatus of thought but not, except highly diluted under considerable clothing of qualification, an apparatus of action. Economists have to try to be very careful, I think, to distinguish the two.”

It is here that “Modern Monetary Theory” (MMT) comes into the picture. As a recent conference held in New York City made clear, MMT is a call for action. It is a program to alert policymakers and the public that decisions about, for instance, infrastructure, the environment, or progressive social programs are nothing but political choices within the fiscal powers of sovereign states.

MMT’s theoretical roots reach back to Keynes, Lerner, and a less well-known German political economist with the name of Georg Friedrich Knapp (1905). The latter is known for his “state theory of money” (or: “chartalism”) emphasizing that money is a creature of the state rather than a convenient market invention to reduce transaction costs.

MMT features the money-first principle: the state has to first issue its money, either by literally spending it into existence or by having its central bank purchase (“monetize”) assets, for taxpayers to then send it back to the treasury as taxes. Seen in this way, taxes do not “finance” government spending. Rather, they are a means to contain inflation depending on the economy’s real resource constraints (as made clear in Keynes’s [1940] “How to pay for the war”). Similarly, government bond issuance – supposedly collecting loanable funds from worker-savers – is not a means to “finance” government spending either, but an instrument to manage interest rates (as Keynes made clear in his reflections on monetary policy and debt management during WWII).

These insights into modern money and state power are inconvenient from the perspective of those who favor a small state and unfettered finance (i.e., the powers of wealth). It is therefore somewhat ironic to see that the current U.S. government has embraced MMT with much enthusiasm.

Recall that the Republicans in Congress opposed the “Obama stimulus” in 2009 when a second Great Depression was looming. Recall also that in 2011 a Republican Congress engineered a grossly premature turn to fiscal austerity that pummeled the still shaky recovery and forced the Federal Reserve into extended monetary overdrive. Officially, both acts of folly were made in the name of “fiscal responsibility.” But Republican Senate leader Mitch McConnell made it public that his primary ambition was to wreck the Obama presidency and limit it to one term. Attempting to sabotage his black president and unnecessarily putting the economy and the well-being of his American compatriots in jeopardy did not make him a traitor, as one would think, but a Republican hero masterminding plenty more dirty work on behalf of his subversive party rather than the nation.

And here we are today. Imagine a populist takeover of the nation by a gang of ruthless kleptocrats. Confronting a society botched with income and wealth inequalities similar in degree to the time before the Great Depression, they go about filling their own pockets by squandering tax cuts on the super-rich without paying any attention to the budgetary consequences. Fiscal responsibility was yesterday. Today is self-indulgence without fiscal worries of any tomorrow.

Ironically, certain conservative economists had remarkably clear foresight of modern developments under conservative government. James Buchanan’s vision of public policy was inspired by little else but fears of plundering kleptocrats. Milton Friedman favored fixed rules for public policy precisely because he feared discretion in the hands of incompetent and/or corrupt policymakers. It is difficult to deny today that they had a point.

Today’s political realities probably also play a part in explaining why there is significant popular interest in MMT at the other end of the political spectrum. The speech in NYC by Stephanie Kelton titled “Mainstreaming MMT” highlighted that MMT has indeed made important inroads into public life, the media, and academia (excluding the neoclassical economics mainstream of course). Participants and activists present at the NYC conference were equally enthusiastic about conceiving an active role for the state for progressive causes – unhindered by “sound finance” myths.

One can rest assured that conservatives will rediscover their love for fiscal responsibility as soon as they lose their reach to the public purse. Crying “socialism” whenever responsible fiscal action on behalf of society gets discussed, they will once again demand nothing but “sound finance.” It would be a shame if, for a third time in a row, a government inheriting Republican fiscal wreckage declared “sound finance” as their policy priority. Instead, the next government might be well advised to set out and prove Buchanan and Friedman wrong by showing that honest, responsible, and competent “government of the people, by the people, for the people” is actually possible.

Sadly, kleptocrats’ imaginative powers never reach beyond their own pockets. Imagine a government that really cares about the environment, good infrastructure, and a healthy and well-educated society, a government that understands these political choices are possible here and now – if only we as a society went for it.


Bibow, J. (2009). Keynes on Monetary Policy, Finance and Uncertainty: Liquidity Preference Theory and the Global Financial Crisis, Routledge.

Bibow, J. (2001). Reflections on the Current Fashion for Central Bank Independence, Working Paper No. 334, Levy Economics Institute of Bard College. Updated here: (2004). Cambridge Journal of Economics, Vol. 28, No. 4, pp. 549-576

Keynes, J.M. (1940). How to Pay for the War: A Radical Plan for the Chancellor of the Exchequer, Macmillan.

Knapp, G.F. (1905). Staatliche Theorie des Geldes, Munich and Leipzig, Duncker & Humblot.

Lerner, A.P. (1943). Functional Finance and the Federal Debt, Social Research.

Lerner, A.P. (1944). The Economics of Control, Macmillan.

Meade, J.E. (1975). The Keynesian revolution, in M. Keynes ed. Essays on John Maynard Keynes, Cambridge, Cambridge University Press.

Romer, P. (2016) The Trouble with Macroeconomics, Commons Memorial Lecture of the Omicron Delta Epsilon Society delivered on January 5, 2016, New York University, manuscript, September 14.

Kydland, F.E. and Prescott, E.C. (1977). Rules Rather Than Discretion: The Inconsistency of Optimal Plans, Journal of Political Economy, vol. 85, issue 3, 473-91.


One Response to “On Modern Monetary Theory and Some Odd Twists and Turns in the Evolution of Macroeconomics”

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  1. Comment by Mario Tonveronachi — October 17, 2018 at 4:23 am   Reply

    A wonderful narrative and a very good point for the US. Applying MMT to peripheral countries would add further problems given the present international institutional setup.

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