Modern monetary theory (MMT) has been around for a while. However, it has gained significant attention over the last couple of weeks as countries realise the need for large fiscal stimulus. It is, therefore, important to explain what MMT is, how it is relevant and what it means for us.

But before we explain MMT, let us first revisit some issues of macroeconomics; the central issue is of deficit. As we know, governments are largely run on deficits and this deficit is largely financed by borrowings.

Government borrowings have the potential to increase interest rates, and that, in an economy, savings are fixed and therefore, more money lent to government would result in lesser capital available for private sector.

Therefore, it is argued that higher government deficits ‘crowd out’ investments. Moreover, there are cases where governments have defaulted on their borrowings.

The crux of MMT is that as long as a country has its own currency, it can print as much money as needed and therefore, the sovereign has negligible risk of default. It is precisely this reason why the interest rate on government securities is usually considered as risk – free rate.

Therefore, it may be intuitive to believe that MMT means that a government can run a high deficit or that, there is no constraint on just how much it can spend.

However, that is not true as MMT acknowledges the risks associated with financing of government spending through printing of currency in the form of inflation.

Therefore, inflation (or the prospects of higher inflation) in future is the constraint on government that would discipline it from excessively expanding the deficit.

Moreover, going by MMT’s description, there is always a possibility that a mismatch between labor and capital demand could be corrected by government spending to maintain full employment without inflationary pressure.

Economist Keynes argued for an increase in spending to combat recessions. MMT proposes to finance such spending by simply printing currency.

The kind of fiscal packages being announced by countries such as the US and UK suggest the possibility of financing a bulk of them through printing of currencies. However, an important point here in the form of an addendum is that it is not just inflation that acts as a constraint on fiscal deficits.

Balance of payments and movements in exchange rates also depend on the size of fiscal deficit and therefore, higher deficits can have consequences for deterioration in balance of payments and induce volatility in exchange rates.

The key point that many MMT proponents highlight is the accuracy with which it allows us to look at real constraints in a fiat-based monetary system (a currency issued by a sovereign government is termed as fiat).

That is, for an economy to grow, either the household, or the private sector or the public sector must expand its balance sheet. This expansion in balance sheet cannot happen in the event of a government maintaining a budget surplus as it is effectively taking monetary resources away from the citizens.

Therefore, a deficit becomes a necessity to ensure savings with households and corporates.

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