The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy

Crowding out refers to the conventional economic theory that government deficits harm private investment by forcing the government to compete with private borrowers for a limited pool of savings. According to this theory, when the government runs deficits and borrows money, it reduces the supply of available funds in the market, driving up interest rates and making it more difficult for businesses to secure funding for their projects. Kelton argues that this theory fundamentally misunderstands how modern monetary systems operate, as government deficits actually increase the total amount of savings in the private sector rather than depleting them. She demonstrates that for countries with monetary sovereignty, crowding out is impossible because government spending creates the very funds that private actors later use to purchase government bonds.

The deficit myth refers to the widespread but incorrect belief that federal deficits are inherently harmful to the economy and must be avoided. This misconception leads policymakers and the public to view government spending through the lens of household budgets, falsely assuming the federal government can run out of money. The term encompasses several related misconceptions about government finance, including ideas that deficits burden future generations, that government must tax or borrow to spend, and that deficits indicate fiscal irresponsibility.

A fiat currency is money that a government issues and declares as legal tender, but which is not backed by a physical commodity like gold. In modern economies, fiat currencies derive their value from government authority and public confidence rather than from precious metals or other physical assets. The US dollar is a fiat currency, which gives the federal government, as its issuer, unique powers and capabilities that ordinary currency users do not have.

A government’s ability to influence a country’s economy by strategically taxing its citizens and spending money is called fiscal policy. Modulating the levels of taxation and spending is typically done in accordance with specific aims, such as increasing employment or lowering inflation. Kelton challenges traditional assumptions about fiscal policy by reframing the relationship between taxes and government spending: Rather than seeing the former as funding the latter, modern monetary theory argues that taxes serve to create demand for currency, manage inflation, and address wealth inequality, while spending—which occurs before, or even independently of tax revenues—should be directed to social gaps such as healthcare and educational access.

Functional finance is an economic framework developed by economist Abba Lerner that evaluates fiscal policy based on its real-world outcomes rather than arbitrary financial targets. This approach judges policies by their effects on employment, inflation, and economic equality, not by their impact on the federal deficit. Functional finance forms a theoretical foundation for modern monetary theory, emphasizing that government financial decisions should focus on achieving concrete economic goals rather than maintaining specific budget numbers.

The Great Recession refers to the severe economic downturn that occurred from 2007 to 2009, marking the worst financial crisis since the Great Depression. This period began with the collapse of the US housing market and evolved into a global financial crisis that cost millions of Americans their jobs, homes, and savings. Kelton uses this period to illustrate how deficit fears led to an inadequate government response, resulting in a slower recovery and unnecessary economic hardship.

Inflation is a continuous rise in the general price level of goods and services in an economy. Kelton describes how various government agencies measure inflation through different indices, such as the Consumer Price Index and Personal Consumption Expenditure, which track changes in the cost of typical baskets of goods and services. In The Deficit Myth, inflation serves as the true indicator of government overspending, rather than deficit levels. The author argues that inflation can occur through various mechanisms, including “cost-push” factors like resource shortages or wage increases, and “demand-pull” factors when spending exceeds the economy’s productive capacity.

An issuer refers to a government that creates and controls its own currency. In The Deficit Myth, Kelton identifies the federal government as the sole legal issuer of US dollars, with the power to create currency through the Treasury Department and Federal Reserve. This status gives the government unique financial capabilities that other economic actors lack, including the ability to spend without first collecting revenue.

Modern monetary theory is an economic framework that examines how monetarily sovereign governments function in economies with fiat currencies. MMT argues that such governments cannot run out of money they issue, and their spending is constrained by real resources and inflation rather than by tax revenue or borrowing capacity. This theory challenges conventional economic wisdom about deficits, debt, and government spending, proposing that fiscal policy should focus on maintaining full employment and price stability rather than balanced budgets.

Monetary sovereignty describes a nation’s complete control over its currency system. According to Kelton, this requires three elements: the exclusive right to issue the national currency, freedom from promises to convert the currency into something scarce (like gold), and the practice of only borrowing in the nation’s own currency. Countries with monetary sovereignty, such as the United States, Japan, and the United Kingdom, have greater financial flexibility than those without it.

NAIRU (Non-Accelerating Inflation Rate of Unemployment) represents the theoretical unemployment rate below which inflation begins to accelerate. In The Deficit Myth, Kelton criticizes the Federal Reserve’s reliance on this concept to guide monetary policy, noting that their NAIRU estimates have consistently proven incorrect. She explains that this concept leads policymakers to intentionally maintain a certain level of unemployment to prevent inflation, effectively using human suffering as an inflation control tool. The author argues that this approach is both morally problematic and economically unnecessary, as demonstrated by periods when unemployment fell below predicted NAIRU levels without triggering accelerating inflation.

PAYGO (Pay-As-You-Go) is a congressional budgeting rule that requires new spending to be offset by either spending cuts or tax increases. In The Deficit Myth, Kelton identifies this as a self-imposed constraint that makes it more difficult for Congress to implement new programs or expand existing ones. She argues that this rule reflects and reinforces the misunderstanding of federal spending capacity.

A pegged currency is one whose value is fixed to another currency, typically the US dollar, or to a commodity like gold. Countries that peg their currencies surrender significant monetary sovereignty because they must maintain sufficient reserves of the anchor currency to defend the peg, often requiring them to prioritize this goal over domestic economic needs. Kelton argues that currency pegs can worsen a nation’s economic position over time, as their private sectors may become increasingly dependent on borrowing in the currency they’re pegged to, further reducing their monetary sovereignty and policy flexibility.

The power of the purse refers to Congress’s constitutional authority to tax and spend, determining how federal money is allocated. This authority gives Congress significant control over national priorities and policies through spending decisions. According to MMT, this power is more extensive than traditionally understood because the federal government, unlike state and local governments or households, can create the currency needed to fund its priorities.

S(TAB) (Spending, then Taxing And Borrowing) represents Kelton’s explanation of how government finance actually operates. This sequence indicates that government spending comes first, creating the money that the private sector can then use to pay taxes or buy government bonds. Kelton presents this as the correct understanding of government finance, in contrast to the conventional TABS model.

(TAB)S (Taxing And Borrowing, then Spending) represents the conventional understanding of government finance that Kelton challenges. This model suggests that the government must first collect taxes or borrow money before it can spend, similar to how a household must obtain money before making purchases. Kelton argues that this misunderstands the fundamental nature of government finance.