MMT spikes interest rates – triggers asset price bubbles that crash the economy

3.2.1 Financial markets, the complex of interest rates, and asset prices

Government is likely to face significant financial market blowback if financial markets believe it is engaging in excessive money issue. In particular, long-term interest rates will tend to rise if financial market participants anticipate risks of future financial turmoil or higher future inflation. Current financial market conditions are affected by expectations about the future, which means the future is always already here and in the present. Consequently, inflationary bias in MMT's reliance on money-financed deficits will creep into present financial market conditions long before full employment.

It is sometimes claimed that government can set the long-term bond interest rate, just as it sets the short-term money market interest rate. The argument is government can buy or sell long-term bonds to set the long-term interest rate in the same way as it does for the short-term rate. However, if private agents deem the bond rate too low given inflation expectations created by money-financed deficits, the government bond market will shrivel, in the sense of fewer private agents being willing to buy government bonds. More importantly, bond market repression does not prevent interest rates rising in private credit markets, and they may even overshoot owing to unfavorable expectations caused by money-financed fiscal policy. Consequently, the combination of money-financed deficits and bond market repression can disrupt private credit flows, and thereby disrupt economic activity. Furthermore, owing to expectations, those disruption effects can emerge in advance of full employment. However, once again, such effects are absent in MMT because it ignores expectations and treats private credit markets as irrelevant.

Increases in the money supply can also potentially cause asset price bubbles. That is because some of the money injected into the circular flow of expenditure and income leaks into the financial circuit via the process of saving (Palley 1998), where it is directed to bidding up asset prices. Bubbles are unstable and subject to abrupt crashes owing to changes in sentiment and expectations. When they crash they can cause major economic disruption, as illustrated by the global financial crisis of 2008. Bubbles can also develop independently of full employment. Those features give policymakers good reason to prevent them, which constrains policy. For instance, bond-financing of deficits may be preferable to money-financing to the extent that bond-financing is less likely to promote financial market bubbles. However, bond-financing raises its own concerns with adverse interest rate effects and debt sustainability. Such considerations are absent in MMT's analysis because it is silent on asset price formation, the effect of asset prices, and the impact of budget deficits on asset prices.

Interestingly, the effect of budget deficits on credit and asset markets will likely depend on current conditions and expectations of future outcomes, with expectations being influenced by the nature of the policy regime. That type of effect illustrates the importance of the Lucas (1976) critique for understanding financial market responses to deficit-financed fiscal policy. Such concerns with the bond market's reaction and psychology were also central in Keynes's critique of Lerner's functional finance view and its assertion that money-financed spending could effortlessly solve the Keynesian macroeconomic problem (Aspromourgos 2014). However, such effects are again absent in MMT, which explains why MMT fails to recognize them.