For most of the last 40 years, the United States, like most developed economies, has suffered from a lack of demand for goods and services. This has contributed to a steady slide in inflation. More importantly, it has indirectly triggered recessions by funneling money towards assets, feeding bubbles which have inevitably burst. A lack of aggregate demand has also slowed the recovery from those downturns, inflicting hardship on millions of workers and small business owners.
The causes of this lack of demand are not hard to deduce. Nor is it difficult to see how to remedy the problem, via changes in the tax code, exchange rate policy and government spending. However, these changes require tough political decisions and we seem to live in a democracy which has run to populist seed, preventing us from confronting problems in a mature way.
In the absence of such mature decisions, politicians have reached out for easy solutions. Modern Monetary Theory (or MMT for short), is a set of ideas that has come into prominence in recent years, appearing to provide just such an answer by promoting the idea that budget deficits can largely be expanded without consequences.
However, there is a problem with MMT. It essentially exploits the trust that people place in fiat currency and the financial assets denominated in them – namely, the idea that a dollar is a safe and reliable store of value. The more successful MMT is in pushing the economy towards full employment, the more likely it is that that trust will be undermined and eventually broken. Moreover, trust in money is much like trust in marital fidelity – once lost, it is exceedingly hard to regain.
We have today, without acknowledging it, already embarked on the MMT experiment. That makes it particularly important that we understand the nature of our macroeconomic difficulties, and the problem with using the opium of MMT to treat the injury of insufficient demand.
The long drift down in inflation
The formative years of my economics education were the early 1980s when economics, as a profession, was obsessed with inflation. Long a minor problem, it exploded in the 1970s, sparked by oil price spikes and fueled by surging demand from baby-boomers establishing households and loose monetary policy from over-indulgent central banks. The year-over-year CPI inflation rate soared, even in the midst of a deep recession, to 12.2% by the end of 1974, retreated, and then climbed again to a modern-day record of 14.6% in the spring of 1980.
The disruption caused by inflation gave a strong platform to monetarist economists, such as Milton Friedman, who argued that inflation was the result of too much government spending and too little discipline in controlling the growth of the money supply. It led to a political swing to the right, in the election of Ronald Reagan, and empowered the Federal Reserve, under the leadership of Paul Volker, to raise interest rates and tighten the growth in the money supply to reduce inflation.
Inflation did fall, particularly during and following the deep recession of 1982. However, even after the economy had regained its health, inflation continued to drift down, declining both during and following the recessions of 1990-91, 2001 and 2007-2009. Moreover, after each of those recessions, the recovery in economic activity was remarkably sluggish, causing many to wonder why demand wasn’t strong enough to produce faster recoveries or prevent this steady decline in inflation.
The lack of aggregate demand: Understanding the Causes
With the benefit of hindsight, the reasons for insufficient demand are clear enough. To see them, a good place to start is with the plumbing diagram that graces the opening pages of most introductory macroeconomics textbooks.
An economy that produces $100 in output of goods and services will also produce $100 in income that can be used to buy them. This is the wages paid to workers, rents paid to landlords and the dividends and interest payments paid to owners and lenders for their contribution to the production of that output.
Some of this great river of income leaks out of the system, of course. Some gets spent on imports, or is saved, or is taxed by governments. However, this lost demand is offset by other demand, from foreigners buying our exports, businesses investing in new plant and equipment and governments spending both on on-going operations and building new infrastructure. In a balanced system, this extra demand equals the amount that leaked out of the system. However, since the mid-1980s, the economy has frequently struggled with inadequate demand.
One part of the problem has been a too-high U.S. dollar which has contributed to chronic trade deficits. Indeed, since 1980, the U.S. has had an average trade deficit of 2.6% of GDP and has failed to run a trade surplus in even one year. If we are buying substantially more of everyone else’s stuff than they are buying of ours, we are, right away, liable to see insufficient demand for the goods and services we produce.
However, a second major cause has been rising income inequality. According to data compiled by Thomas Piketty and Emmanuel Saez, from 1951 to 1981, the share of income received by the top 10% of households was remarkably steady, averaging about 34% of the total. However, since then it has soared, exceeding 50% for the first time in at least a century in both 2017 and 2018.
The reason this is such a potent macro-economic issue is that better-off households tend to spend much less of their income on goods and services. Indeed, in 2019, according to the Consumer Expenditure Survey, the richest 10% of households spent just 64% of their after-tax income and saved the rest. The other 90% of households, on average, spent 99% of their income, many of them, of course, borrowing to finance spending. The steady growth in the income share of the richest households has contributed, simultaneously, to strong and rising demand for financial assets and lackluster demand for goods and services.
As an important aside, this can also, of course, partly explain some of the surges in asset prices in recent decades which have occasionally ended in tears, as in the case of the tech bubble that ended in 2000 or the housing bubble that ended in 2007. Nor has this trend come to an end. Indeed, since the mid-1980s, the growth in asset prices has very consistently outpaced the growth in consumer prices. Consequently, the ratio of the value of U.S. financial assets to U.S. GDP has risen from an average of 2.6 times between 1951 and 1985 to roughly 5.5 times today.
 The best-known proponent of Modern Monetary Theory, Stephanie Kelton, outlines these ideas in “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy”, June 2020.
 See “Income Inequality in the United States, 1913-1998”, by Thomas Piketty and Emmanuel Saez, Quarterly Journal of Economics, 118(1), 2003, with data updated to 2018 on the website of Emmanuel Saez. Income is defined as pre-tax income including capital gains and excluding government transfers. While measuring the absolute degree of income inequality does depend, to some extent, on which definition of income is used, the broad trend of sharply rising inequality since the 1980s is present in all reasonable definitions.