Much ado about Modern Monetary Theory

AS governments worldwide dig deep to fund Covid-19 support, the alternative macroeconomic approach known as "modern monetary theory" (MMT) has captured the public imagination - particularly in economies such as the United States.

In its most beguiling form, the theory suggests governments can increase money supply and manage the resulting risk of inflation through other means such as taxation.

In the spirit of challenging orthodoxies, not least after last year's record fiscal spending, one might be forgiven for asking: Can Singapore draw any inspiration from this idea?

Yet a closer look suggests that even if there is a case to be made for MMT in the right circumstances - and this remains a large "if" - the theory's relevance to Singapore is necessarily limited, due to its very premises.

How is MMT meant to work?

"The broad argument behind MMT is that deficit financing will not have negative repercussions when there is excess slack in the economy," said Ramkishen S. Rajan, Yong Pung How Professor at the Lee Kuan Yew School of Public Policy in the National University of Singapore (NUS).

With excess slack - that is, no inflationary pressures - central banks can simply finance deficits with infusions of liquidity. Interest costs can also be kept low to encourage private sector spending, he added.

Why can't Singapore do this?

Massive increases in domestic liquidity would cause significant currency depreciation. This might be acceptable in larger economies with flexible exchange rates but is incompatible with Singapore's exchange-rate-based policy, said Prof Rajan.

MMT is more applicable to economies that control the domestic quantity or price of money - that is, interest rates - and where most of the debt is domestically held, he said. "It seems less applicable to a country like Singapore where the central bank controls the external value of money, i.e. the trade weighted exchange rate."

Nanyang Technological University associate professor Yip Sau Leung, meanwhile, said MMT is off the table for Singapore due to the established economic concept of the "impossible trinity".

Causal logic dictates that an economy can only effectively feature two out of these three elements: free capital mobility, an independent exchange rate policy, and an independent monetary policy.

If a country sets a higher interest rate than the world rate, for example, capital would flow in and push the currency up. The central bank would either have to impose capital controls, or give up its ability to set the exchange rate.

"For a large economy like the US, they want independent monetary policy," said Prof Yip. Their economy is driven largely by consumption and investment, with a relatively small role for exports and imports: "If they want to stimulate the economy, they increase the money supply or reduce interest rates.

"Singapore is different. We are a small, open economy - most of our consumption and investment is imported. If you stimulate consumption, you stimulate imports. But we want to stimulate our own production, which is exports.

"Because Singapore wants to be a global financial centre, we have to allow for free capital mobility."

Of the remaining two, Singapore chooses to control the exchange rate "because the effect of exchange rates on our output and inflation is more important".

Since Singapore has chosen free capital mobility and independent exchange rate policy, it follows that it has "to let the market decide money supply and interest rates".

What about other economies?

Even economies whose currencies are recognised as being among the world's reserve currencies may not be able to implement MMT, said OCBC economist Howie Lee.

"In fact, I don't expect MMT to work outside of the top three economies - US, eurozone, China - if at all."

"Economies outside of these three, especially in Asia and other developing markets, are prone to capital outflows when debt spirals out of hand."

This would cause a sharp depreciation, driving up import costs and sending the economy into hyperinflation, he added.

What about deficit financing in general?

One obvious obstacle to even considering deficit financing - under MMT or otherwise - is that the Constitution prevents the Singapore government from running a deficit over its term of office, as Singapore Management University (SMU) professor Chow Hwee Kwan pointed out.

"Another practical constraint to MMT lies in Singapore's dependence on foreign investment, which means that it can ill afford to lose the confidence of investors," she added.

SMU senior lecturer Huynh Bao Tan said: "Given how connected Singapore is to world trades and international financial systems, the types of government spending and fiscal practices that MMT advocates may mean excessive volatility in Singapore's currency and prices that are difficult to control."

He also highlighted another practical risk: "The role of expectations is important in economics, particularly when it comes to investors' perception of a government's fiscal prospects."

MMT gives fiscal policy a primary role in managing the economy and setting the overall economic agenda. But investor confidence in a country's fiscal soundness - which affects how they view a country's sovereign debts - is a "crucial consideration that cannot be taken as a given, constant parameter", he said.

If it ain't broke...

If nothing else, the discourse over MMT has, in a sense, "shifted the global and emerging economy debate away from being too fiscally hawkish", said NUS's Prof Rajan. It has suggested that there may be scope for significant deficit-financed fiscal expansion, at least in periods of low interest rates and significant idle capacity.

"This is quite a major intellectual shift from just a decade ago when the focus, even with the recession induced by the Global Financial Crisis, was about ensuring fiscal sustainability and there being strict limits to the size of public debts and deficits."

Nonetheless, the central MMT argument - that governments are not faced with financial constraints, only resource constraints - is likely to be seen as too radical, he added.

Despite the fiscal challenges posed by Covid-19, there is still insufficient impetus for economies to turn to something as heterodox and unproven as MMT, said OCBC's Mr Lee.

"There is too much at stake - jobs, livelihoods, political and social stability - to attempt an untested MMT theory on any present economy, much less a well-oiled economy like Singapore," he said. "It is not so much fiscal prudence that is holding back MMT, but the complete change of mindset required."