As the US House of Representatives has shifted to the left with the freshman class of progressive Democrats, the US is increasingly debating a new form of economic policy that is likely to become a centre of attention of UK politics, once a Labour government with Prime Minister Jeremy Corbyn is in power (just kidding...or maybe not?): Modern Monetary Theory (MMT). For investors who want to understand the potential future direction of monetary policy in the US and other western countries after non-traditional policies like quantitative easing have reached their limits, it is well worth spending time to understand this theory.
Modern Monetary Theory traces its roots back to the early 20th century writings of Georg Friedrich Knapp and Alfred Mitchell-Innes and can be understood as an evolution of Keynesian economics. The basic premise is that unlike in an economy based on the gold standard, money is not a physical commodity and unlike in standard monetary theory, money is not a medium of exchange, but a standardised form of credit (an “IOU”).
Because in a world of fiat currencies, the government has the unique privilege of seignorage (i.e. the right to create money) government deficits are fundamentally different from private debt. While private debt is indeed debt, a government that runs a deficit issues one form of government debt (bonds and bills) in exchange for another form of government debt (IOUs commonly referred to as cash). Because nobody can borrow back their own debt, what is called “government debt” shows up as additional wealth on the balance sheets of investors, while on the government’s balance sheet it appears as a transformation of one liability into another, but not as a new liability.
This view has two important consequences for fiscal and monetary policy:
Government deficits are not an expression of rising indebtedness of the public sector but simply an expression of rising wealth in the private sector. So instead of saying that the US deficit rises from $800bn to $1tn, the correct statement is that private wealth has increased from $800bn to $1tn. Higher deficits thus become desirable in order to stimulate the economy. The most recent tax reforms in the US have certainly increased private wealth by creating larger corporate profits and larger household incomes at the expense of higher government deficits. According to MMT this is a desired outcome of increased deficits.
Because the government simply engages in an accounting transformation of its own debt, there is never an explicit need to reduce debt through higher tax income. The more a government increases its deficit, the more private wealth will increase. In traditional monetary theory, the assumption is that this debt will eventually have to be repaid through higher taxes that raise government revenues, but in MMT these chickens may never come home to roost.
One can see why politicians, particularly on the left, like this theory because it seemingly provides them with a licence to (almost) unlimited deficit spending. What if interest rates rise in response to higher deficits? Just borrow more to pay for the higher interest cost. What if interest rates rise so fast that we enter an accelerating spiral that may cause hyperinflation? Just look at Japan, where the central bank has kept interest rates at zero in order to keep interest costs from spiralling out of control. What if rising government debt crowds out the demand for corporate debt and leads to higher interest rates on corporate debt? The central bank could lower interest rates or buy corporate debt and mortgages to reduce the debt burden for private borrowers, as it has done in Japan and in the US.
Critics of MMT argue that central banks and governments are not good at allocating resources efficiently, but if unemployment rises, one could just introduce a job guarantee for every working age citizen or a universal basic income. Financing it would be easy, since deficits could just be expanded and then financed with money created by the central bank. Of course, this hypothetical world would require policy coordination between the government and the central bank and would effectively abolish central bank independence, but we forget that under the “real bills doctrine” a similar coordination between central banks and governments existed from the 1920s to the 1940s. And after all, central bank independence can easily be abolished by an act of Parliament if needed…
On the political left this theory is often oversimplified to the slogan that “deficits don’t matter”, but MMT economists argue that deficits do matter eventually, but the level at which they matter may be much higher than we think. Stephanie Kelton recently argued that while deficits do matter, the risk of rising inflation increases only once the economy runs at full capacity and there is full employment. Until then, the risk of keeping deficits low is that the economy lacks the vital sources of income and profits. Looking back at the reaction to the Eurozone debt crisis and the last couple of years in the UK, many left-leaning economists would argue that austerity policies were responsible for slower growth and higher unemployment in Europe and the UK compared to the US (where no austerity measures were enacted). In essence, MMT economists argue that as long as inflation expectations remain well anchored, deficit spending can continue indefinitely.
The crucial question then is how will inflation expectations react to ever increasing deficit spending. If inflation expectations rise slowly as deficits and government indebtedness increases, then central banks have sufficient time to reign in inflation threats with higher interest rates. However, as someone who subscribes to the complex dynamic systems view of financial markets, I am aware that financial markets typically do not react linearly to an increasing stimulus. Instead, there are phase transitions where nothing happens for a very long time and then, boom! All of a sudden, the system explodes and accelerates in one direction or another without prior warning. In this world, deficit spending works very well for many years until suddenly trust in the government disappears and inflation skyrockets. Students of the history of money will know that hyperinflationary periods materialise often within months and without warning, or in reaction to one seemingly innocuous policy move.
This is why I am so sceptical about MMT. I learned from history and my study of financial markets as complex dynamic systems that MMT is putting the entire economy of a country on a path where one mistake by politicians can throw the country into a multi-year depression. And if we should have learned one thing from history then it is that politicians make economic policy mistakes all the time.