Modern Monetary Theory has drawn attention from the public as well as in academic circles, but why the fuss? Why is MMT more relevant than ever and why do some economists talk about MMT as if it were the holy grail while others strongly reject it? What is MMT? Is it already implemented in practice?Should you care as an investor? And what are the portfolio consequences of a full-blown MMT regime? We try to answer the frequently asked questions in this piece. Enjoy!
Q1:Why the fuss?
Since the great financial crisis, central bankers have eased credit into financial markets while private savings continuously increase. No tool seems to do the job when it comes to boosting the economy just enough to make inflation climb to the 2 percent goal that most advanced economies aim for. Even though the Fed, Bank of England, ECB, and Bank of Japan all have been aggressive in their asset purchasing programs, the for-ever-low-inflation is a ruthless opponent who stands strong against central bankers and claims that no amount of money is high enough to make him tap the floor as long as private savings increase.
Central bankers are furthermore limited by a sort of effective lower bound not too far from zero when setting the policy rate as too negative policy rates may carry negative spillovers. German saving tendencies started to increase as soon as yields breached the zero-mark. Do simple savers simply increase savings if yields turn negative? It makes sense from a back-of-the-envelope approach to saving but it is the exact opposite of what central bankers try to obtain with NIRP. So why not allow the government to spend an unlimited amount of money until we reach maximum employment and inflation starts to accelerate?That is exactly what MMT fans are proposing.
Q2: What is MMT?
MMT claims that a sovereign government can issue as much money as needed to finance expenditures issued in its own currency. As such, a sovereign government is essentially not financially constrained in the way the government budget constraint identity from Economics 101 would have us believe. The goal of MMT is maximum employment which really is the cornerstone of the theory: A government that controls its own currency can reach full employment by offering job guarantee to everyone willing to work, and thus create jobs through public spending without the need to worry about the deficit that follows. The government can simply fund fiscal operations by issuing liabilities that the central bank buys back by increasing the money base instead of lending in the market. Free lunch.
This almost sounds too good to be true – what is the catch? There is no catch as long as inflation is kept under control, but low unemployment and a warm printing press smells a tad inflationary. Inflation rises when skills and capacity are scarce, and when this happens the government should cut down on public spending and raise taxes. This is really the other cornerstone of MMT: By raising taxes the government creates demand for its currency because holding the currency is the only way private agents can pay their taxes.
Q3: IS MMT the holy grail?
MMT claims that if there is still unutilized capacity in the real economy such that inflation is under control, we should not worry about increasing debt. If the inflation rate increases the government should raise taxes to offset private consumption and take off the steam of inflationary pressure. This is probably right, but our biggest concern is that it fails to pass a reality test. Would you rather trust a central banker or a politician with tightening financial conditions / stimulus when needed? Probably neither, but it is still more likely that a central banker will do so than a politician with an election at the horizon. MMT has yet to pass a reality test, and we remain (very) unconvinced that it actually ever will.
Q4: Is there something about MMT that could raise a concern?
According to MMT advocates, the power of the printing press should not solely rely on unelected central bankers. Instead, this privilege should be by order of elected officials to ensure that it is used in the public interest. The pro is that elected officials are held accountable at the next election where the people can punish “incompetent” politicians, but this is also exactly the con.
Giving this kind of power to elected officials and hoping that they use it for the greater good might be too much to hope for. Economic growth booms in election years which really is the elephant in the room – most politicians’ purpose is to remain in office and it is common knowledge that they stand stronger in exit polls if they a) boost the economy, and b) give away free money in election years. As such, the most obvious shortcoming of MMT is the misalignment of incentives of those who will print money and do politics.
Q5: Is the US doing MMT in practice already?
The answer to whether the Fed is already doing MMT, intentionally or not, is currently a no. The Congressional Budget Office projects a staggering $2.3 trillion deficit on the budget balance in 2021, but a huge deficit is not per se MMT but rather the leftover of a large fiscal stimulus package like the $1.9 trillion relief proposal outlined by the Biden administration last month.
Meanwhile, the Fed has put all horses into the race in reaction to the global pandemic with large-scale asset purchase programs mainly in US Treasury bonds and mortgage-backed securities to support fiscal stimulus and ease financial conditions. With the asset purchases, the Fed has brought its balance sheet to $7.59 trillion in the 8th week of the year compared to $4.17 trillion last year. This aggressive boost of the money supply in financial systems looks a bit like MMT, not least as the Fed bought MORE bonds than what was issued in parts of 2020 – but there is no such thing as free lunch at the Fed. QE is not MMT, but simply the Fed taking on long-term liabilities in exchange for short-term liabilities to support their forward guidance practice and keep interest rates low.
Is the US budget office going to raise taxes in the aftermath of the crisis or will Powell step in and offer the alternative of exchanging the maturing bonds for new almost perpetual bonds with maturity so long that we can simply forget about them because economic growth and inflation easily erode the so-so-close-to-zero-interest-rate bonds whose object is to finance the old so-close-to-zero-interest-rate bonds that mature?
The current (almost) perpetual QE and accordingly yuge public deficits smell of MMT, but it is not MMT on paper but rather some kind of pseudo-similar regime that the Fed could opt to “end” if inflation runs hot in Q2.
Q6: How do central banks position themselves towards MMT?
In the beginning of the year The Financial Times surveyed the biggest investors in the British bond market about their thoughts on the BoE’s asset purchasing program. BoE promises investors that its QE program is designed to reach its 2 percent inflation target, but investors have little faith that the bank works independently of the government’s financial needs and at the same time the BoE has failed to influence inflation expectations, which raise questions whether the BoE essentially is moving towards an MMT era.
BoJ has been subject to this kind of talk since they gave birth to the QQE regime. The communication strategy of the central government of Japan feeds into the narrative of Japan being the largest lab experiment of MMT yet to be seen, when the central government in 2012 vowed to implement three policy pillars of bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment. As Chart 6 shows, the relationship between the money supply and the long run interest rate is strongly negatively correlated, just as we would expect. But Japan has not succeeded with raising inflation rates and in January 2021 the inflation rate was once again negative with -0.58 percent. MMTers point to the missing acceleration in inflation upon the extensive Japanese monetary financing as the raison d’être for MMT. Meanwhile conservative market participants speculate on how Japan is going to pay back the close to ¥1750 quadrillion public debt, BoJ owns around ¥540 trillion of government bonds and struggles to raise inflation, which makes MMT supporters cheer for their case though Chairman Kuroda dismisses it.
Central banks will never call current setups MMT-like since they will argue that raising the monetary base is solely a necessity to raise inflation (a bit MMT-like) and that they would obviously want to keep the inflation target as a central bank objective and not a political objective.
Q7: What would be the market repercussions of full-blown MMT?
We argue that a full-blown MMT is most likely to happen in the US since the theory is only relevant to countries that control their own floating currency and raise taxes and debt in their own currency. As mentioned – what we observe today may be the first steps of a full-blown MMT laboratory experiment in the world’s leading economy, but we are still some steps away from an actual MMT regime.
If Powell or Yellen were ever to admit to MMT, instant market repercussions would likely be driving toward a fear of inflation. If a state promises to spend perpetually until an inflation target is reached, wouldn’t that be more inflationary than a central bank asset swapping in eternity until an inflation target is reached? After all, fiscal policy is probably more potent than monetary policy at the current juncture.
We find it likely that interest rates INCREASE should the MMT-mania go bananas, but so far US authorities are only playing an MMT-like play swelling it in a cocktail of a huge fiscal deficit and QE. This is only inflationary, IF mechanisms are in place that ensure that the printed USDs reach the real economy. Currently that is the case via direct transfers and credit programs. Inflation is accordingly coming in Q2.