I was asked this question yesterday:
Can you please say a word about the effect MMT might have on the exchange rate – a potential “currency crisis” is a convenient bogeyman for opponents to raise.
This was my reply:
This is a common concern, often raised precisely because it sounds alarming and yet remains vague.
MMT does not deny that exchange rates matter. What it challenges is the idea that a government using its monetary and fiscal capacity responsibly is somehow inviting a currency crisis.
The exchange rate is influenced by many things: relative inflation, interest-rate differentials, trade balances, geopolitical risk, speculation, and confidence in institutions. Fiscal policy is only one part of that picture. There is no automatic link between government spending and currency collapse.
A genuine currency crisis usually arises when a country:
- Borrows heavily in a foreign currency it cannot issue.
- Runs persistent trade deficits without domestic productive capacity, or
- Pegs its exchange rate and then loses reserves trying to defend it.
MMT explicitly warns against all three.
In fact, MMT-style policy can strengthen currency resilience if spending is directed toward expanding domestic capacity: energy security, housing, food supply, transport, skills and productivity, as it suggests to be appropriate policy measures. That action reduces import dependence, which is one of the biggest sources of exchange-rate vulnerability.
What opponents often imply is that markets will “punish” governments for abandoning austerity. But markets react to inflation risk and external balance, not to whether a government understands its own monetary system. Countries like Japan show that high public debt does not automatically produce currency collapse when institutions are credible and policy is coherent.
So the real safeguard is not pretending we are financially constrained. It is:
- Spending well.
- Taxing appropriately.
- Managing inflation, and
- Investing in the real economy.
A currency crisis is not triggered by honesty about money; it is triggered by ignoring real resources and external constraints. MMT is unusual in making this clear. It does not create risk. It is explicit bout how to manage it.
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FX does need to be addressed by those (ie. us) proposing radically different fiscal and monetary policy frameworks.
“In theory, practice and theory are the same; in practice they are not”. (Yogi Berra, I think). I basically agree that there’s no reason for a collapse in GBP, although a modest devaluation would make sense and, perhap, be welcome. The problem is that the UK runs a large trade deficit and is highly reliant on foreign investment which tends to be “flighty”. Whatever the wisdom of a new framework, not all will agree so we must expect (or at least be prepared for) capital flight and speculative selling of GBP.
Ultimately, a currency’s value depends on the quality of its economy which should improve…. but getting from “here to there” is the challenge.
I would note that in 1992, the chaotic withdrawal from the ERM saw a big sell off in GBP but, at that lower level, the economy thrived and the currency recovered all of its losses over the following years.
Much to agree with
But where does the Sterling go? My understanding of MMT is that once Sterling is created either by Government daily spending, or licensed banks making loans, it only disappears by paying tax or paying off loans, or can temporarily disappear for a few years by being locked up in Gilts.
So lets say Amazon (who must have a large holding of Sterling from so many sales in the UK) decides to no longer invest in a new warehouse inside Britain, and instead decides to convert the Sterling into Dollars so Jeff can make another rocket. He needs though to find someone with Dollars prepared to swap them for his Sterling, and once they do that, the Sterling still exists and still can only be used in the UK.
I can understand the notion of capital flight when Gold was allegedly backing Sterling – it could literally mean buying Gold from the BoE and shipping it out, but now that Sterling is fiat, it only has value in terms of what it can purchase in the UK doesn’t it?
And as long as the Government doesn’t make the same mistake as happened on Black Wednesday and lets any speculative selling of Sterling naturally drop the value of Sterling on FX markets, then the speculators will be wiped out and the UK will have a temporary shock of import inflation perhaps (assuming my understanding is correct)?
This is a good line of reasoning, and you are close to the core of it. Let me tighten it up and correct a couple of points.
First, you are right about where sterling comes from and where it goes. Sterling is created by:
• government spending, and
• bank lending.
It is destroyed by:
• taxation, and
• loan repayment.
Gilts do not make sterling disappear; they swap one form of sterling asset for another (reserves for bonds). So the money still exists.
Now take your Amazon example. If Amazon earns sterling in the UK and decides not to invest here, it has only three basic options:
1. spend it in the UK,
2. hold it in sterling assets (cash, deposits, gilts), or
3. exchange it for another currency.
In case (3), you are exactly right: someone else must want the sterling. Sterling does not vanish. It changes hands. The UK as a whole cannot “lose” sterling abroad. What changes is who holds it.
So what does “capital flight” mean in a fiat system? It does not mean money leaving the country. It means:
• foreigners holding fewer UK assets, and
• UK residents holding more foreign assets.
That portfolio shift can move the exchange rate, but not drain sterling from the UK economy.
Your point about gold is crucial. Under a gold standard, capital flight could literally empty the vaults. Under fiat money, it cannot. The constraint is not solvency; it is the exchange rate and inflation.
And here you are again broadly right. If sterling falls, the effect is:
• higher import prices,
• possible short-term inflation,
• redistribution between importers and exporters.
It is not national bankruptcy.
Black Wednesday mattered because the UK was trying to defend an arbitrary peg. If the government allows the exchange rate to float, speculators do not “win” in the long run; they just change the price at which trade occurs. The cost is a real one (import inflation), but it is manageable and often temporary.
So the correct framing is this:
• Sterling never leaves the UK system.
• What moves is ownership and price.
• The real risk is inflation from imports, not running out of money.
• Policy choices (energy strategy, domestic capacity, capital controls if needed) determine how painful that adjustment is.
Once you see this, a lot of the fear language around “capital flight” dissolves. It is not magic. It is accounting plus power plus policy choice.
There’s an extensive YouTube interview of Richard Werner who talks about this at length in the case of Japan in the 90’s and 00’s where excessive credit creation by banks caused a real estate bubble but didn’t devalue the Yen against the dollar.
Thanks Richard, another excellent post in your growing series responding to FAQs. The currency crisis is a bogeyman I haven’t felt well equipped to respond to, this fills the void precisely and succinctly.
An FAQ section would make a useful addition to your site.
I am looking at that…