October 30, 2020

Speed Read:

• In the last few decades, monetary policy has been widely seen as the most effective tool for managing the economy. However, this assumption is now being called into question.

• Enter Modern Monetary Theory (MMT), a new way of thinking about government spending. Crucially, its swelling supporters argue that fiscal policy should be the primary tool for macroeconomic growth and stability.

• Whether investors agree with MMT or not is irrelevant. The world is steadily moving toward the adoption of its ideas.

It always takes a trauma to shake up economic thinking. The Great Depression set policy on a far different path, ushering in a Keynesian era where governments used budgets to fine-tune growth and inflation. That orthodoxy came crashing down in the raging inflation of the 1970s.

From there, central bankers emerged as the leading macroeconomic managers. Of course, interest rates were their weapon of choice.  Fed Chairman Paul Volcker, with his towering presence and cigar-smoking press conferences, oversaw a boost in borrowing costs to 20 percent in the 1980s. The cult of the central banker was born.

Alan Greenspan, who led the Fed from 1987 – 2006, took it to a whole new level. Dubbed the “maestro”, he developed an impenetrable linguistic style, clearly indulging — even enjoying — his oracular aloofness. At one point, Greenspan could have stuck a licked finger in the air to convince the public of the economy’s direction.

Monetary policymakers were more like modern-day rock stars. And for good reason. They had routed the inflation enemy. In the US, inflation averaged around 5 percent through the 1970s. Then, it steadily melted. In other developed nations, it has been broadly a similar story.

Central bankers were not shy about celebrating their victory. In the mid-2000s, they would boast of having achieved a “great moderation”: economic and inflation variability had been tamed. Few disagreed that monetary policy was the most effective tool for managing the economy.

Yet all that changed after 2008’s global financial crisis. To fight the downturn, central banks pursued unbridled monetary expansion. Over USD $16 trillion was added to their collective balance sheets. Plenty of voices warned that inflation would come roaring back. It didn’t. Today’s levels of inflation are still lower than a decade ago.

In fact, central bankers have consistently fell short of their inflation and growth targets. The President of the European Central Bank put it plainly in 2014: “deflation is the ogre that now must be fought decisively”.

All of which brings us to today. Globally, almost USD $12 trillion in monetary and fiscal support has been pumped into the economy to fight the impact of Covid-19, leading to soaring budget deficits and public sector debt in all major economies. Have governments done too much? Apparently not. The world has been stuck with inflation stubbornly below official targets and bond yields at new lows.

With this backdrop, it is no surprise that a global policy debate has been sparked. Why does recent experience seem to totally refute standard macroeconomic theory? And what, pray tell, is the right policy mix for the times?

Enter Modern Monetary Theory (MMT), a new way of thinking that has electrified the policy atmosphere. Its prescriptions are so potent and alluring that it seems to pass directly into the bloodstream. At least that’s how this author felt upon spending the last three months wading through a mélange of white papers, academic literature and, not to be forgotten, online blogs and debates best characterized as a few degrees below collegial. It is a very controversial topic. And it may be the first economic theory that has quickly mobilized a band of politically engaged bloggers — with religious fervor no less — to spread the gospel.  

MMT For Dummies

But what exactly is MMT? Fortunately, a new best-selling book, The Deficit Myth (2020), provides a clear exegesis. Its author, Stephanie Kelton, also happens to be MMT’s most mediagenic expert. Her words — both in print and person — have the arc of well-thrown darts.

She also has deep experience in Washington (which she recalls with less than flattering observations). When Bernie Sanders ran for the Democratic nomination, Kelton became his chief economic adviser. Before that, she served as chief economist on the Senate Budget Committee. Her work builds on a theory that began to take shape in the 1990s when academics began publishing new research that challenged traditional thinking. 

Kelton’s first chapter gets right to the point and — as if to lean in conspiratorially — reveals its central doctrine:

“The truth is the federal government is nothing like a household or a private business. That’s because Uncle Sam has something the rest of us don’t — the power to issue the US dollar. Uncle Sam doesn’t need to come up with dollars before he can spend … Uncle Sam will never go broke. When governments try to manage their budgets like households, they miss out on the opportunity to harness the power of their sovereign currencies to substantially improve life for their people.”

At its core, MMT argues that almost everyone has the economy backward. Conventional wisdom holds that government and household budgets are alike. Governments tax in order to fund their expenditures, in the same way that households have income and spending.

MMT refutes this. Households are “currency users” that must earn money before spending it. Governments, at least those that control their own money, are “currency issuers”. The government then, which is the source of all dollars, spends first and taxes later. When it funds programs, it literally spends money into existence, injecting cash into the economy. The order of operations is key: government spending comes before tax and borrowing, not after.

Got all that? Good. Because it is a crucial point. What follows is that the usual fears about the federal government being able to repay national debts aren’t important. Instead, the constraint on government spending is inflation. We will know government spending has gone too far when prices start rising too much. The real limit, MMTers argue, is the capacity of the economy — employees, materials and so on.  

There is much more to MMT. For example, Kelton proposes a federal jobs-guarantee program that would function as an automatic stabilizer. When the economy tanks, more people enter the program, and spending increases. When the economy improves, people move on to better jobs in the private sector and spending shrinks.

Crucially, she also urges the demotion of monetary policy. “The best they can do to promote employment is to try to establish financial conditions that will give rise to borrowing or spending,” Kelton says. Instead, we should “elevate fiscal policy as the primary tool for macroeconomic stabilization” (if that wasn’t clear already). 

If your jaw has not already dropped to the floor on all this, stay with us (and, hey, don’t shoot the messenger). The basic assumption of MMT is seductively simple: governments should not budget like households because they can simply create their own money.

What follows is that currency-issuing governments could spend as much as they need to provide full employment and other social goods. After all, the federal government never “runs out” of money. Kelton pokes fun at all the government theatrics about budget constraints and fiscal cliffs which she says are used to justify defunding social programs.

What’s more, Kelton argues that the US economy has operated most of the time, if not always, below potential output. Chronic excess capacity implies that we can, and should, imagine an entirely new approach to fiscal spending.

This is next level thinking. A free lunch awaits if the economy has un-tapped resources that could raise aggregate demand. The policy potential is near limitless. Kelton imagines a lofty and near-utopian world where millions of people have access to improved healthcare, advanced education, better pensions and world-beating infrastructure.

MMT and New Realities 

Back at sea level, the Forstrong investment team has engaged in much spirited debate over all this (all the while keeping the room’s temperature just right). Actively seeking information or views that are different from our own — and updating our beliefs when the evidence suggests we should — is hardwired into our investment process. Neither task is easy.

But why should investors care about economic theory? Admittedly, much of it is useless and has zero application in the real world. And the role of the money manager is not to prescribe government policy.

Yet, we must anticipate policy trends and their impact on financial markets.

To be sure, the idea of MMT leads to many questions. Most importantly, can governments rein in deficits in a timely manner when inflation starts to rise? How would this work in practice and how reliable are future predictions of inflation? What’s more, politicians generally, to put the most charitable spin on it, do not have a good track record of reining in spending and cutting programs.

The fact is MMT is an untested theory. It has never been tried anywhere. Therefore, how can it be debunked?

But the other reality is that MMT arrives at a ripe time. An enormous appetite exists for new solutions to the issues facing modern economies. The rolling crises of the last two decades have shaken the public’s trust in established ways of thinking. Disinflation is still well-entrenched and growth, even before mass lockdowns, has been persistently weak. MMT provides support for a new policy approach.

Looking back, a new theory was destined to surface in this environment. MMT fits the times. And, while Kelton’s prescriptions have not yet been widely adopted, we are edging closer: look no further than the ongoing convergence of monetary and fiscal policy, where central banks play a passive role by buying up as much government debt as needed. MMT may not be here, but the world is steadily moving toward adopting its ideas.

Investment Implications

The last decade was characterized by slow growth, deleveraging, dis-inflation and skittish investor sentiment from 2008. With tepid inflation and scarce growth, investors aggressively paid up for assets not tied to broad economic growth: disruptors, bonds and US technology stocks. The problem is that these assets now trade at a large premium, also quickly pricing in their advantage in a Covid-19 world.

But what could change this situation? Growth — and even a little inflation. Investors should not lose sight that fiscal thrusts pack a bigger punch than the monetary variety. Money is channeled directly to households or businesses. Conversely, central banks can only inject more spending power into the economy via an indirect channel: the cost of money.

Looking ahead, there is broad enthusiasm around the world for more deficit spending. The spending driven by Covid is a mere trailer for a coming era of fiscal largesse. In the US, Trump is promising more tax cuts if he wins. Biden has outlined a USD $3.5 trillion stimulus package. Across the Atlantic, the Eurozone’s previous fiscal caution (led by Germany’s inflation-phobia) has decisively turned. Crucially, they have taken a big step in the direction of more coordinated EU fiscal policy. EU-backed bonds are here. Even in Japan, Yoshihide Suga, Japan’s prime minister, has implied there’s no hard limit to how much his government can borrow.

It’s difficult to imagine with the backdrop of a pandemic, but we are at the beginning of the end of the deflationary era. New investment leadership will emerge. Cyclicals and value, nearly left for dead by most investors, are starting to show life. The US stock market — long seen as the safest house in the neighborhood — is starting to falter relative to other countries (particularly those that do well when global growth is higher). This is the first crisis where Emerging Asian markets have outperformed their Western counterparts.

The period from 2008 – 2020 will come to be viewed as one of monetary fidgeting, scarcity … and of sobriety. “Austerity,” Kelton writes, “is a failure of the imagination.” Dang. You could just sit and let that line marinate in your head for hours.

And whether investors agree with MMT or not is irrelevant. Even a few days before a historic US election with an unknown outcome, the policy trajectory has already been set in favor of fiscal spending. The bar is finally open.