TS Lombard with the note:
In a recent podcast, the influential MMTer Stephanie Kelton claimed victory in the debate about fiscal policy, suggesting the US Congress was now taking her advice. Other commentators also sense a “regime shift” in macro policy, claiming we have reached the end of the Neoliberal era. While these declarations are premature–both in the US but especially in other parts of the world–there has long been a certain inevitability to MMT’s success. The idea that fiscal policy must take over from monetary policy has been increasingly obvious for years, especially given the perversity of the macro policy mix we have had since the Global Financial Crisis. Nominal bond yields at 700-year lows were a clear signal something had gone wrong. As we explained in a previous Macro Picture, policy-stabilization efforts have been retracting the long historical “supercycle”, with the recent era of secular stagnation putting the authorities back where they were in the 1930s. Not to take anything away from MMTers, but there has been a degree of “endogeneity” to their success. We can also place the policy supercycle into a series of macro-financial-political regimes since the late-19th century, the“three phases of Capitalism”. While some pundits were surprised there wasn’t a “regime change” after the 2008-crash, there was no clear alternative to neoliberalism.
Today, MMT provides the “software” for a new paradigm. Mainstream economists love to point out “there is nothing new in MMT”. When interest rates are zero, all MMT’s big macro claims should be uncontroversial even for traditionalists–monetary policy will struggle to reflate the economy, bond and “money” financing are equivalent (so QE is meaningless), there is no “crowding out”, and fiscal policy must take over. But the mainstream had forgotten this analysis and has spent the last decade assumingthe zero-rate environment would be temporary. Not only has MMT always been on the right side of these debates (which makes Kelton a sort of modern day Milton Friedman), but, thanks to the COVID-19 response, MMT now has unambiguous evidence to show fiscal policy is highly effective (with no serious side effects). While MMTcan provide the intellectual rationale for a new form of Capitalism (Capitalism 4.0), it is going to take more than the creation of new fiscal/monetary policy space to get there. It will be crucial to monitor what happens to other institutions and broader political trends in the years ahead. Will there be a Reagan/Thatcher for Kelton’s Friedman? While some commentators believe President Biden has already adopted this role in the US–proving more radical than anyone could have imagined before he entered office–the situation in the rest of the world is murkier (especially in jurisdictions that are less amenable to MMT-style thinking).
The big thing about the macro-financial supercycles is that they ultimately sow the seeds of their own destruction. Overly powerful trade unions played this role in the“mixed economy” of the 1970s, while unsustainable debt expansions destabilized Capitalism 3.0. A pivot to “full MMT” could suffer a similar fate, by giving elected politicians too much responsibility for inflation. MMT analysis is sound when interest rates are zero but we should also expect activist fiscal policy to create a tendency for inflation and interest rates to rise. Some investors (particularly those who remember the 1970s) believe this “time inconsistency” problem will inevitably lead to stagflation and financial repression. Back in the 1970s, when fiscal deficits were often“unfunded”, the authorities had to fight inflation by any means other than raising interest rates–which led to serial policy errors. It is possible MMT will set us downa similar path. But because secular inflation trends remain weak and labour-market institutions are totally different to the 1970s, such an “endgame” could be many years–perhaps even decades–away. More important, the influence of MMT is still (mainly) confined to fiscal policy rather than monetary policy. If central banks retain their independent, a “romance”with MMT (rather than a full marriage) would be a positive development, both for finance and the real economy. We certainly face a more sensible policy mix (and perhaps even a less toxic political situation) than during the Capitalism 3.0 era.
Last summer, after Stephanie Kelton published her influential book “the Deficit Myth”, I told TSLombard clients it could be the most influential economics volume in a generation. This view wasn’t based on MMT’s underlying analysis, which had been in the public domain for a number of years, but rather the timeliness of the message combined with MsKelton’s natural ability to distil complex ideas into an appealing public narrative.Pretty soon, even sports celebrities and rap musicians were expressing their appreciation for MMT ideas. As a public-facing economist, Kelton is reminiscent of Milton Friedman, or rather an“anti-Freidman” given she holds an entirely opposite macro-political philosophy. But, while MMT has gained momentum with the publication of The Deficit Myth, this is a revolution in macroeconomics that has looked inevitable for some time. Even before COVID-19,we had identified a long “supercycle” in macro policy, showing how–over the last century–the pendulum had swung several times between extreme fiscal and monetary dominance, with the world again primed for another fundamental regime switch.
The “supercycle” turns
We can trace the policy supercycle from the end of World War I, which saw the rigid Gold Standard replaced with the more flexible Gold Exchange Standard. Until then, the monetary system significantly constrained what policymakers could do. Sure, financial panics were frequent, but there was no sustained monetary expansion (beyond the discovery of new gold supplies, such as New World gold in the 1500s). Inflation was effectively white noise. This changed in the 1920s, when the authorities–particularly on the monetary side–gained significantly more discretion. (As the BIS puts it, the global credit system became“more elastic”.) The consequences of this new regime were profound, with the authorities in the US (and in some other countries) inflating an unprecedented credit bubble, which burst spectacularly in 1929.While monetary policy was dominant in the 1920s, by the mid-1930s it was clear that it had no solution for a serious Depression. This is when Alvin Hansen’sidea of secular stagnation first appeared, together with the metaphor of monetary policy“ pushing on a string”. The authorities could pull the string to drag inflation lower, but they couldn’t push on it to reflate a chronically weak economy. Fiscal policy had to take over–which is what happened during/after WWII.
The extreme confidence in monetary policy of the 1920s was eventually replaced with an excessive faith in fiscal policy. Central banks were subservient to governments after WW2 and interest rates were relegated to the role of supporting the public debt. It isn’t surprising this policy mix would eventually lead to the inverse of what happened in the 1920s–with inflation replacing deflation as the dominant problem. Eventually, of course, fiscal policy would become just as ineffective as monetary policy had been in the 1930s. Keynesian economics had no answer for 1970s stagflation. What works better against high inflation? Monetary policy. So the1980s produced another regime change in policy, with monetary tools gaining traction, taming inflation and then completely taking over. Governments made their central banks independent, to lock in this new disinflationary era, with fiscal policy relegated to an untrustworthy secondary role (at best). Though the regime of monetary dominance was remarkably successful until the 2000s, it became clear that stimulating the economy via debt accumulation created severe underlying (often latent) imbalances–by the mid-2010s, secular stagnation was back.
Investors have a tendency to see the world through the prism of macrostabilization tools, but the relative importance offiscal and monetary policy–together with the underlying macro environment in which they operate–is jointly determined with the broader political climate. In recent years, several academic studies and influential books have analysed macro policy as part of a sequence of deep macro-financial “regimes”, identifying three main phases of Capitalism:
(i) the pre-World War I era, which combined the Gold Standard with “corporatism”
(ii) The “mixed economy” that followed World War II (the “Golden Age”);
(iii) Post-1980s “Neoliberalism”, which gained traction with Reagan, Thatcher etc.
Traditionally, political-economy analysis assumed exogenous events–such as the oil shocks in the 1970s–caused the world to switch between these three regimes. But a fascinating recent paper by Dafermos, Gabor and Michell (2020) suggests something deeper has been going on. Channelling Hyman Minsky, they argue that the capitalist system is fundamentally unstable, which forces the authorities to design institutions and “thwarting mechanisms” to try to manage and ultimately reduce this instability. In line with other recent work–such as Blyth and Matthijs,(2017)–the configuration of these institutions ultimately depends on the balance of power between different “interests”, especially labour versus capital (see Table 1). When labour is dominant, we end up with institutions designed to ensure full employment. When capital is in charge, the focus is on keeping inflation low. But the whole system is reflexive–institutions affect economic outcomes and economic outcomes, in turn, alter the balance of power.
In the Dafermos et al model, the supercycle arises because the effectiveness of the “thwarting mechanism” (‘customs, institutions or policy interventions’) needed to restrain capitalism naturally diminishes over time, as economic agents learn to game the system. There is an“endogenous erosion” of their potency, which eventually produces a tipping point. In the 1970s, for example, powerful trade unions–necessary to ensure full employment–eventually undermined the wage-price setting process. In the 2000s, the power of the financial sector eroded financial regulation and created dangerous macro imbalances. The system experiences a systemic crisis once the thwarting mechanisms are no longer sufficient to constrain the dynamics of the business cycle. At that point, there is a power struggle, which eventually produces new institutions and an alternative policy regime.
This reconfiguration of thwarting mechanisms reshapes the supercycle, hardwiring powerful macro ideas into new policy regimes.
Defermos et al create a “macrofinancial stability index”, which they use to identify four phases ofthe supercycle: expansion, maturity, crisis and genesis (Chart 8). During the expansion phase, newly introduced thwarting mechanisms are highly effective, delivering strong economic growth and broad social/financial stability. Short-term recessions occasionally disrupt activity but thwarting mechanisms prevent a systemic crisis.Eventually, however, economic agents learn how to adapt to the new institutional environment, innovating to increase their profits. This reduces the effectiveness of thwarting mechanisms. Further, when the authorities introduce mechanisms to reduce one source of instability, they might create new problems–for example cutting interest rates to alleviate a recession might create inflation or encourage private debt. And once the effectiveness of these mechanisms starts to decline, the supercycle enters its maturity phase. Economic growth might continue but the macro-financial stability of the system diminishes. The next recession will lead to a more serious crisis, triggering wider social instability.
Have we reached the tipping point?
Back in 2009, there were lots of commentators warning about a“crisis for capitalism”. Some thought the banking crash would trigger widespread social tensions, forcing a new regime (“Capitalism 4.0”).While there were political strains throughout the 2010s–populism, Brexit,Trump, euroscepticismetc.–the full “regime change” never happened. Instead, governments adopted austerity and central banks tried QE, pushing the old system to even greater extremes and widening wealth/income inequalities. Part of the problem was a collective lack of imagination–nobody could imagine a serious alternative to Capitalism 3.0 (“neoliberalism”). In part, this was because the subprime crisis came as a total shock to the establishment, breaking the Great Moderation, a long period of uninterrupted growth and prosperity. The response to COVID-19 has been radically different. Today, there is a broader feeling that the old “system” is broken and no expectation that the situation will improve with a laissez-faire government attitudes. The popularity of MMT is also significant–for the first time in a generation we have a clear alternative to neoliberal economics. While MMT enthusiasts say they are merely offering a “tool”to understand the economy, it is clear MMT is the blueprint for an entirely different institutional “software” and–ultimately–a way to shift the balance of power from“capital” to“labour”.
The full note is well worth your time.