This is how MMT could work

I am not a fan of Modern Monetary Theory (MMT). Nevertheless, it is becoming gradually more popular amongst politicians and mainstream economists. That is no surprise given that MMT promises politicians that they can run deficits for much longer than we currently think without causing inflation or a debt crisis. For small countries, this is clearly ahistorical, as I have argued before. Countries that have run large deficits for too long eventually were abandoned by bond investors and faced either a currency devaluation that triggered inflation and/or a dramatic rise in the cost of debt through higher real interest rates. The former could be observed in Latin American countries throughout the 1980s and 1990s, the latter in Greece in 2011.

However, if you are the United States, you have a distinctive advantage. Because your currency is the world’s reserve currency, the demand for your debt is always there, both from domestic investors as well as foreigners. Furthermore, because all commodities are priced in Dollars, you don’t get a massive spike in inflation the moment your currency weakens. Yes, commodity prices rise if the Dollar weakens and yes, foreign investors can reduce their purchases of Treasuries, but the impact of such developments is much smaller for the United States compared to other countries. 

And this means that as long as the Dollar remains the world’s reserve currency, the United States can probably get away with massive deficits and an MMT-inspired policy of reckless deficit spending. And as I have argued before, there is no replacement for the Dollar as the world’s reserve currency in sight. The Chinese Renminbi is probably several decades away from becoming competitive with the Dollar, let alone replacing it as the international currency of choice.

In a sense, the United States is already embarking on massive deficit spending. The Covid-19 pandemic has obviously increased the projected budget deficit for 2020 and the Congressional Budget Office estimates that in 2020 the US budget deficit will reach 16%, then shrink to 8.6% in 2021 and then fluctuate between 4% and 5% per year for the rest of the decade with no deficit reduction in sight. Note that the consensus amongst economists is currently even more pessimistic with US budget deficits expected to surpass 10% in 2021 as well. Whatever the exact numbers are going to be, the United States is inflating its debt at a rapid speed and is on track to reaching Italian-style debt levels within a decade. But if Italy can get away with these kinds of debt levels (and Japan with far more debt than that), then the United States easily can do so as well.

Projected budget deficit of the United States

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Source: Congressional Budget Office.

In fact, the deficit spending of the Americans opens a doorway for excessive deficit spending to be successfully implemented by other countries. The UK, Germany, France, etc. can’t just run deficits to their heart’s delight without risking being punished for it by investors. But as long as these countries run deficits that are smaller than the US deficit and as long as their debt/GDP-ratios and other metrics remain better than the metrics of the United States, they can count on enough demand for their government debt to avoid a debt crisis or a significant devaluation of their currency vs. the Dollar. 

Regulations for banks, insurance companies, and pension funds guarantee that there will always be some residual domestic demand for government bonds no matter how unfavourable the terms are. Just look at Swiss government bonds which have had negative yields for maturities up to 30 years and more for years now. Yet, the Swiss government had no problem finding buyers for these bonds because compared to other countries the debt levels of Switzerland are much, much lower. 

And the same mechanism is likely to hold for other countries as well. France may have massive debt and deficits, but as long as France has slightly better fundamentals than the United States it will find international investors who are willing to purchase their bonds to get that little bit of extra security (I know that word sounds misplaced when we talk about French government finances, but that’s what it is). It is a race to the bottom where other countries can be the one-eyed amongst the blind as long as they manage to have somewhat better fundamentals than the United States.

In fact, countries that don’t participate in that race to the bottom and refuse to run large deficits may get into trouble. A country with solid government finances and little debt might become so popular that its currency will appreciate significantly vs. the Dollar. For Germany that is less of a problem, because it is part of the Eurozone and the Euro will be assessed based on the situation in the Eurozone overall. So, Germany can run low deficits without risking an appreciation of the Euro (and thus significant headwinds for its exporters) because it has France, Italy, Greece, and other countries in the Eurozone that have massive debt. In this sense, Germany’s economy is benefitting from the recklessness of its neighbours in the Eurozone.

But what about countries like Switzerland and to a lesser extent Sweden? Both countries have low debt, low deficits (if not a surplus), and an economy that relies heavily on exports. As long as these countries insist on solid government finances, they will face massive pressures on their home currencies to revalue, which will significantly harm economic growth and prosperity.

Which brings us to an awkward conclusion: In a world where the United States embarks on endless deficit spending, the countries that have sound finances risk becoming the losers, while the countries with bigger (but not too big) deficits may be the winners. It truly is a world turned upside down.

But…

But, for this world to exist, countries around the globe have to coordinate their actions. This does not mean that there needs to be a conspiracy amongst politicians or central bankers to run deficits that are large but not so large as to outpace the United States and risk a debt crisis. All it needs is for US politicians and central banks to be reliable. 

If the US government is projected to run a deficit of x% the next year and it then runs a deficit that is x% or larger, the other countries can each on their own create policies that run deficits of x% - 1%, for example. No conspiracy or coordination between countries is needed. All that is needed is that the United States does its job and does what it says it will do.

But if the United States should unexpectedly cut its deficits, this house of cards may quickly collapse. If the United States is expected to run a deficit of x% the next year, but then has a deficit of just half that, the other countries that try to run a deficit in the shadow of the United States suddenly will be exposed as deficit sinners and risk a massive currency devaluation sending them into a currency crisis. So, let’s all hope the United States government will not suddenly become frugal and stop spending money it doesn’t have, because in this strange new world of eternal deficits, should it come to pass, this is when the crises may start.