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How MMT Differs from Mainstream Macroeconomics: Steady-State Interest Rate Dynamics

Many critics of Modern Monetary Theory have a difficult time understanding exactly where it differs from the consensus of mainstream macroeconomics, which for the sake of precision, I define here as the macroeconomics taught in universities and practiced by central banks and the IMF. This confusion stems from the fact mainstream macroeconomists believe with incredible conviction that certain basic underlying assumptions are so obviously undeniable that MMT's points of distinction are rarely discussed with enough nuance to allow a proper understanding of the claims being made. Until such points of distinction are made clear, conversations about the comparative merits of the two approaches will continue to be unproductive. One of the most important differences, which I will explain in this short article, is the effect of nominal interest rates being held at a particular level (or in a given range) for an extended period of time, or steady-state interest rate dynamics.

To understand why steady-state interest rate dynamics matter, let's briefly recap what happens when the government spends. When a nation's treasury is not using one of the many workarounds at its disposal, current institutional arrangements customarily encourage or explicitly require the treasury to have a positive balance in its reserve account at the nation's central bank when it spends (or at least to eliminate any overdraft by the end of the day). When the treasury's balance is inadequate, it sells bonds in exchange for central bank reserves. Subsequently, only one of two things can happen. Either the central bank will do nothing, in which case the rate of interest on treasury bonds (the "risk-free rate") will rise, or it will accommodate the additional government spending by buying the bonds from the private sector, preventing the risk-free rate from rising. Both MMT and mainstream economists agree that a risk-free rate that remains high for an extended period of time (the "high-for-long steady-state") creates severe harms that are difficult to remedy, although they disagree on the exact nature of those harms. In contrast, when it comes to the harms resulting from a risk-free rate that remains low for an extended period of time (the "low-for-long steady-state"), MMT and mainstream economists agree about the nature of some of those harms but disagree about the severity and treatability of those harms.

No One Wants the High-For-Long Steady-State

Both groups of economists agree that a high-for-long steady-state is undesirable, albeit for different reasons. Mainstream economists believe that high interest rates depress aggregate demand by stifling or crowding out private sector borrowing and risk causing a recession. MMT economists believe that high interest rates have–at best–an inconsistent effect on aggregate demand because of the interest income channel and various points of inefficiency in the transmission process, as I have explained previously. However, MMT economists emphasize that high interest rates can enhance inequality, particularly as public debt increases, since high-yielding treasury bonds are essentially "basic income for people who [already] have money." Because each groups believes that the harms it recognizes from the high-for-long steady-state are severe and untreatable, neither group believes the high-for-long steady-state is desirable, although they prescribe different remedies for treating these ill-effects. MMT economists believe that the proper remedy for the high-for-long steady state is for the central bank to lower the risk-free rate by buying treasury bonds to accommodate government spending, while mainstream economists believe that–while some amount of central bank accommodation is appropriate in certain contexts–if government debt ever approaches some threshold (77% of GDP according to the World Bank, 60% of GDP according to Eurozone rules) they believe the government should reduce its debt to allow the risk-free rate to fall without central bank accommodation.

At the other end of the spectrum, if the central bank is very accommodative, it can push the risk-free rate to zero, and once the risk-free at zero, it can keep it at zero. Keeping the nominal risk-free rate at zero for an extended period of time is a steady-state interest rate policy called ZIRP (zero interest rate policy). Mainstream economists and MMT economists have very different hypotheses regarding the impact of ZIRP.

Mainstream Economists Don't Want ZIRP

Mainstream economists believe that ZIRP is inadvisable for one of two reasons. Either they think that having the risk-free rate pegged at zero leads to some combination of increased consumer prices, asset bubbles, and financial instability (i) while the "natural", "neutral", or "equilibrium" rate of interest ("r-star") is significantly above zero, or they think that having the risk-free rate pegged at zero leads to some combination of increased consumer prices, asset bubbles, and financial instability (ii) even if r-star is at zero.

For an example of how ZIRP and its accompanying central bank bond purchases allegedly lead to higher consumer prices according to mainstream theory, read this short passage from Chapter 4 of Olivier Blanchard's book Fiscal Policy Under Low Interest Rates:

The relevant argument is based on the nature of the liabilities issued by central banks to pay for the purchases of bonds. If these liabilities had been non-interest paying money, be it non-interest paying reserves or currency, then this would have led to a large increase in the non-interest paying monetary stock, with the potential, if this increase was not undone later, to create high inflation down the road. (This is indeed how hyperinflations have always started)....US M1 has been multiplied by 4 since the beginning of 2020. Under the old quantity theory (which assumed money did not pay interest), and ignoring real output growth, this increase would eventually lead to the price level being multiplied by 4 as well. If the adjustment happened over 10 years, this would imply an annual inflation rate of 15%, reason enough to worry.

(passage following ellipses from footnote 4; emphasis added). In other words, according to Blanchard, accommodative monetary policy, in which the central bank issues non-interest bearing reserves to pay for bonds, would result in increases to the price level that are directly proportional to the percentage of new reserves issued over some lagged period.

John Kitchen and Menzi Chinn make a similar argument in their 2012 paper "Financing US Debt: Is There Enough Money in the World - and at What Cost?", in which increased central bank holdings of treasury securities are assumed to increase inflation and exchange rate depreciation on a 1-to-1 basis.

The final scenario presented here considers the general effects from sustained higher growth of Federal Reserve holdings of Treasuries – an illustration of a partial ‘monetization of the debt’. The scenario is based on examining the general pressures that would arise from sustained higher growth of Federal holdings of US Treasury securities over time, and the implications for inflation, interest rates and the international position and flows as examined in the other scenarios of this analysis. It uses standard restrictive ‘monetarist’ relationships: first, a sustained increase in the rate of growth of the Federal Reserve balance sheet (increase in monetary base growth) by 1% per year relative to the base case passes through one-for-one to the money supply, and one-for-one to inflation being higher by 1% per year. Second, the higher inflation rate passes through to nominal interest rates one-for-one, and the exchange value of the dollar declines by an additional 1% per year relative to the base case, maintaining relative parity relationships. For purposes of the monetary policy rule, the target inflation rate also increases by 1%.

(emphasis added).

For an example of the claim of financial instability under accommodative interest rates, see the following excerpt from a report by the Czech National Bank:

If the real interest rate (the monetary policy rate adjusted for inflation) is below the natural rate of interest, monetary policy is considered to be accommodative; if the real interest rate is above the natural rate of interest, monetary policy is considered to be restrictive...[H]ighly accommodative monetary policy after the GFC has led to a prolonged period of low interest rates. On the one hand, such an environment may improve the current financial conditions, but on the other hand it may create and increase future financial vulnerabilities. In the short term, favorable financial conditions can increase the resilience of the financial system via better access to cheaper funding and improved borrower creditworthiness, supporting bank capital and reducing non-performing loans...Nevertheless, a prolonged period of low interest rates may offset this effect in the medium to long run by depressing the profitability of financial institutions and consequently reducing their capitalization and solvency. Heightened financial vulnerabilities may amplify adverse shocks and pose risks to financial stability if accompanied by weakened resilience of the financial system.

(emphasis added).

The report goes on to list the following financial instability risks that it predicts accommodative policy causes: excessive credit growth and leverage, mispriced risk, excessive maturity mismatch and market liquidity, misaligned incentives and moral hazard, and high interconnectedness and exposure. However, even if r-star is low, meaning there is less inflation risk from having low nominal rates, mainstream economists still believe there is still a risk of financial instability. According to mainstream economic theory, if r-star is low, then nominal rates will also be low. As the Bank of Canada explains:

The neutral rate can also have important implications for financial stability. For example, a neutral rate that is lower now compared to the past could encourage excessive risk taking by institutional investors if return expectations were slow to adjust to the new reality. Such behaviour might undermine financial stability in the economy.

The Federal Reserve Bank of San Francisco echoes these remarks:

A less studied, but equally important issue is the potential deleterious effects of low r-star for financial stability. A world characterized by very low, and at times negative, interest rates could have adverse long-term consequences for financial sector profitability and increase incentives to reach for yield. This could contribute to a buildup of excessive risk-taking and leverage, pushing asset prices to high levels and perhaps resulting in increased risk to the financial system as a whole.

Finally, the Federal Reserve Bank of Cleveland has similarly argued that "the potential for financial vulnerabilities to build up in a low-equilibrium-interest-rate (r-star) environment is elevated, all else equal." The consensus view among mainstream economists is therefore that central bank accommodation and the low-for-long steady state are both harmful, meaning the central bank must actively adjust interest rates.

MMT Economists Think the Fear of ZIRP is Vastly Overstated

On the other hand, MMT economists believe that a government that spends more than it taxes under ZIRP could be functional and healthy for three reasons. First, MMT economists question the strength of the empirical claims made by mainstream economists about how ZIRP could lead to increased consumer prices, asset bubbles, and financial instability. Second, MMT economists believe there are very simple policies that a government could use to prevent those problems from occurring. Third, even if r-star is real, it is also malleable.

With regards to inflation, the monetarist quantity-theory-of-money relationships that Blanchard and Kitchen & Chinn rely upon in the above excerpts have serious theoretical and empirical flaws that I have discussed previously. In short, their theory ignores heterogeneity in the propensity to spend, the elasticity of supply, and the overall weakness of the exchange-rate pass-through effect. Similarly, the evidence that low rates cause inflation is weak according to several peer reviewed studies. In addition, the mainstream models ignore the fact that there are several things the government can do to reduce upward pressure on the price level or equitably reduce aggregate demand, not all of which require increasing the risk-free rate or reducing spending. Finally, the mainstream strategy of raising rates to fight inflation ignores the inflationary effect of currency selection in developing economies.

With regards to asset bubbles and financial instability, MMT economists find the empirical evidence behind mainstream claims to be lacking, even according to mainstream analysis. For example, the Bank of International Settlements' Committee on the Global Financial System published a paper that found there was:

little systematic correlation between interest rates and measures of bank soundness and risk-taking. Banks have increased asset durations and shifted more loans into the housing sector since the GFC, but have not exhibited signs of more exuberant reaching for yield. Even where interest rates have fallen to very low levels, aggregate measures of bank soundness have not deteriorated to a marked extent, including in Europe and Japan.

Similarly, when discussing the impact of low interest rates on private sector balance sheets, ECB President Mario Draghi pointed out in 2015 that low interest rates can lead to greater financial stability by decreasing interest burdens on households and firms.

[I]n a debt overhang environment it is not clear that accommodative monetary policy is inimical to balance sheet repair. In many countries low interest rates have in fact helped stabilise debt dynamics via reduced interest rate burdens, and thereby facilitated balance sheet adjustment. The interest spending-to-GDP ratio of euro area governments has declined on average by 0.4 p.p. of GDP between 2012 and 2014. Similarly, the debt burden of households and firms has fallen and reduced bank funding costs have contributed positively to retained earnings, which accelerates the deleveraging of bank balance sheets.

In addition, studies by mainstream economists that have looked for evidence of bank risk-taking under ZIRP have found an incredibly small effect. One IMF working paper found that a 2% interest rate cut increases the risk of the typical bank loan by .057 on a scale of 0-5, which is not only insignificant on its own but insignificant compared to the standard deviation of 0.85 on that same risk scale.

In contrast, the claim that high rates will deter the type speculative investing that creates asset bubbles and leads to financial instability is somewhat naive. As I have written previously, the story that "investors who are starved for profits have no choice but to make investments they know are risky," is but the first chapter of an incomplete, one-sided framing. There are three chapters to this story, involving not only investors, but also investment banks and firms.

The second chapter of the story is "firms who are being undercut by government bonds have to lie to investors about how profitable their companies are." If the government is promising a risk-free 9% and your business wants to raise money, the only way you can do so is by promising 10%. Even if you believe the market can distinguish between firms that can actually deliver on this promised return, it assumes the market has correct information, which might not be the case, since 11% of U.S. firms fraudulently misrepresent their financial statements. The empirical evidence suggests that firms do lie to get loans that they cannot pay back during periods of high rates, since the rate of default on business loans is higher in a high interest-rate environment. Additionally, widespread fraud during positive real interest rate environments was a major cause of both the Stock Market Crash of 1929 and the Great Financial Crisis.

The third chapter of the story is "financial advisors who are shielded from financial loss have an incentive to mislead their clients about the risks of investments." The employees of investment banks made huge money in commissions and sales of risky assets leading up to the 2008 recession. Their companies were bailed out by the government, and none of them went to jail for fraud. They are the ones guiding the decision-making, and there is no risk to them, other than the risk that they might be scolded in a Congressional hearing. Also, we need to consider the rates of return that speculative investors are actually hoping to get. According to American Banker's Asset Securitization Report, the average rate of return on investment-grade (safe, allegedly) CDOs in 2001 was 16.5%, ranging from 14.1% to 18.6%. So, from the perspective of the investment bankers, they had a zero-risk investment that paid up to 18.6%, so they invested with wild abandon. The existence of a 10% or even 15% Treasury wouldn’t deter investing in these products. One might ask, “What if Treasuries had paid more than the CDOs? What if they had paid 25%? Would that deter speculation?” Maybe, but given that CDO sellers lied about the safety of their products when rates were moderate, there is no reason to believe they wouldn't lie about being able to create a safe return greater than 25% when faced with intense competition from Treasuries. Either way, this would create the high-for-long scenario which both MMT and mainstream economists view as undesirable.

Even if there were some latent risk of financial instability due to low interest rates, reducing that risk is possible even under the most uncontroversial frameworks. The BIS paper mentioned previously concludes by stating that "the first line of defence by prudential authorities should be to continue to build resilience in the financial system by encouraging adequate capital, liquidity, and risk management." Similarly, in Draghi's speech, he points out that accommodative monetary policy can occur simultaneously with "both de-risking and de-leveraging of bank balance sheets" through the use of "Comprehensive Assessment of bank balance sheets, which included an asset quality review of unprecedented depth and breadth." Simply enforcing loan-to-value ratios (as recommended by the Reserve Bank of New Zealand's Fang Yao) or restricting bank leverage (as outlined by the ECB's Alejandro Van der Ghote) could create financial stability without raising interest rates. MMT economist Nathan Tankus has also written a detailed framework for creating banking regulation designed to enhance stability, and MMT co-founder Warren Mosler has written a detailed set of proposals for enhancing the stability of the banking system.

Finally, there is reason to believe that price and stability concerns resulting from the risk-free rate being lower than r-star will be short lived. This is because r-star itself is not fixed but reacts to monetary policy. According to one BIS Working Paper by Phurichai Rungcharoenkitkul and Fabian Winkler, "the central bank initially believes correctly that r-star remains constant. But as it eases policy, the private sector reacts by revising down its perception of r-star, pushing the relevant natural rate for the economy lower. This creates demand headwinds, which the central bank then attributes partly to a decline in r-star, not realising the endogenous impact of its own policy action." In other words, macroeconomic policy can lower r-star. Because r-star is in part a reflection of household's propensity to consume, policies that promote household saving or slow bank lending would lower r-star. This would imply that the differential between the risk-free rate and r-star can be closed not only by raising the risk-free rate, but also by lowering r-star, which could be accomplished by increasing household saving and slowing bank lending with the various proposals mentioned above.

The Difference in Theory Matters

The different empirical assumptions made by mainstream and MMT economists lead to vastly different tolerances of government spending. According to mainstream theory, if spending is high, either there will be inflation and financial instability because interest rates are low, or there will be crowding out and depressed aggregate demand because interest rates are high. They could try to hit the magical r-star rate number in which there is neither inflation nor depressed demand, but according to mainstream economists, not only is this difficult, but the risk of harm from an incorrect interest rate increases as government debt rises–as Blanchard would put it, "Lower debt implies a smaller adverse effect of a given interest rate increase on debt dynamics". Blanchard goes on to suggest that if governments want to completely eliminate the risk of a sustained increase in interest rates leading to a "debt explosion," they may need to reduce the debt-to-GDP ratio to "as low as 7%." For these reasons, mainstream economists conclude that it is best to keep government spending balanced or low, except in emergencies or recessions.

For example, in Kitchen & Chinn's paper, they imply in their conclusion that because central bank purchases of government debt would inevitably cause inflation and because the rest of the world is unwilling to hold government debt, measures must be taken to reduce the deficit by changing the trajectory of tax revenues and spending– they write:

Ultimately, measures that reduce the deficit by changing the trajectory of tax revenues and spending, particularly in the latter years of the horizon we consider and beyond, would mitigate concerns about the financing of the US budget and current account deficits. In the absence of such actions, it is unlikely that the [rest of the world] would finance our needs at the terms that are currently being projected, and American policy makers will become less and less the masters of our own economic fortunes.

Consider Blanchard's and Kitchen & Chinn's models. When Paul Krugman defends mainstream economists' failure to realize that (a) Social Security is not at risk of running out of money, (b) bond vigilantes will not force higher interest rates, (c) foreign investors will not prevent the United States from running budget deficits, and (d) the United States could never end up like Greece, by tweeting "we let our gut feelings override what our own models were telling us," I do not know what he means or which models he is referring to. The mainstream framework very clear. If debt is not kept low, to prevent adverse outcomes, interest rates must rise, which will cause a different set of adverse outcomes.

Similarly, in his comparison of MMT to UK Labour's fiscal sustainability rule, economist Simon Wren-Lewis claims that "There is only one way that public spending for given taxes could be higher in an MMT world [in which interest rates are pegged at zero] compared to Labour’s fiscal rule, and that is if inflation was not controlled at all." The obvious implication here is that the only way for the government to keep inflation low while spending is high is to raise interest rates. Therefore, according to Wren-Lewis, unless the government is prepared to harm the economy by raising interest rates, it must limit its spending. Interestingly, Wren-Lewis is at least latently aware that prices are not only reflections of rates but are also affected by market power, writing "there are other government measures that make markets work better. The most obvious example is to reduce monopoly power, which reduces prices and increases the quantity traded in that market," but chooses to exclude these dynamics in his models. However, despite being fully aware that policies other than fiscal adjustment and rate hikes are feasible, Wren-Lewis chooses to advance a framework that implies that the only way to prevent inflation is by subtracting net financial assets from the private sector (by reducing government spending) or by giving free money to rich people (by raising interest rates). This active, political choice by Wren-Lewis and most other mainstream economists is why MMT economists sometimes accuse many so-called "progressive" economists of following neoliberalism.

Mainstream economics is built upon this political choice. In contrast, MMT (rather than being political itself) is merely a rejection mainstream economists' own political choices. According to MMT, if government spending is high, regardless of whether the risk-free rate is high, there will only be inflation and financial instability if the government does nothing encourage household saving, increase supply, enforce antitrust laws, regulate banking, or any of the other recommendations made by MMT or other non-neoliberal economists ("structural policies"). Furthermore, if these structural policies are strong enough, there is no reason for that high government spending balanced or low, even outside of emergencies or recessions. What follows are two incredibly stripped-down conceptual equations meant solely to illustrate the difference in the two approaches. First, the mainstream equation:

Inflation = deficit - risk-free rate

Financial stability = balance sheet health + risk-free rate

And now, the MMT equation:

Inflation = additional spending by currency issuer - non-tax inflation management policies

Financial stability = balance sheet health - risk-free rate + banking regulation

Mainstream models and policy discussions do not usually incorporate the potential impact of structural policies. In contrast, in addition to reversing the sign on the effect of the risk-free rate, MMT policy discussions elevate structural policies to the forefront of analysis. Because mainstream economists do not consider structural policies and assume that a heightened risk-free rate is necessary for preventing inflation and strengthening financial stability, their models effectively assume that currency-issuing governments have similar budget constraints as private firms or households have. For example, on February 7, 2022 economist Jason Furman shared a slide from a class he was teaching. It was labeled "The costs of debt" and listed the following:

  1. Needs to be repaid, shifting a burden to future generations.

  2. Can crowd out private investment (and increase foreign borrowing), reducing future GDP (or incomes after repaying foreigners).

  3. Can increase the chance of a fiscal crisis.

  4. Can reduce the political and economic scope to respond to unexpected downturns or crises.

All of this is technically true, but only if you assume that the central bank should not and will not accommodate government spending by buying the treasury's bonds because the risk of incorrectly setting the interest rate is too great. In contrast to Jason Furman's claims about the costs of debt, the MMT economists emphasize that because (1) pegging interest rates at zero causes neither inflation nor financial instability inherently; (2) the natural rate of interest is malleable; and (3) inflation and financial instability can be addressed through non-tax policies and banking regulation, there is rarely any need for a currency-issuing government to make spending reduction or debt reduction its top priority (how I personally define the "MMT Lens"). As I've cited above, some mainstream economists (including Mario Draghi, Fang Yao, and Alejandro Van Der Ghote) are aware of or agree with some of the empirical and theoretical claims that support the MMT lens, but to my knowledge, only MMT combines all of these insights into a single framework in a way that allows one to explicitly reject the Economics 101 language that implies the necessity of (and usually leads to) balanced national budgets. MMT economists' choice to reject empirically-denied, neoliberal shortcuts is why they come to different policy recommendations than mainstream economists, but mainstream economists' utter incredulity towards the MMT Lens prevents them seeing MMT as anything other than an intellectually dishonest preference for unlimited government spending. Unless mainstream economists and MMT economists place the empirical evidence for or against the claims of the MMT Lens at the forefront of their debates, no discourse between them will ever have any value.


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