Whenever there’s an economic ideology that is gaining traction, I try to keep an open mind about it and stay abreast. I’ve noticed throughout history that when the dominant economic ideology of the day changes, their effects are typically felt over years and decades. After all it was Lord Keynes who wrote that:
‘The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.’
That is why it’s important to keep track of ideas and the narratives surrounding them. Modern Monetary Theory (MMT) is this new idea in town, and it is very likely to stay and form a cornerstone in policy-making.
I brought it up in an earlier post (If there’s one thing to know soon, it’s MMT) back in November 2018, and received a number of responses (some were unpleasant tweets and emails accusing me of lacking a professional economics background). The reason for writing about it 19 months ago wasn’t to pretend that I’m an economics expert or profess how to run macroeconomic policy, but to simply point out that the conditions were ripe for this economic ideology to take root.
I finished that 2018 post with the following:
‘While MMT hasn’t taken root entirely among all politicians and policy-makers, there is a very high probability that it could go mainstream in economic decision making when growth conditions deteriorate in the future (like during a US recession).
This could cause a paradigm shift among investors and market observers…
Macro investing is about identifying and anticipating the shifts in dominant narratives held by the majority of market participants, and understanding what that means for asset markets once those shifts happen.
If and when MMT takes hold in policy-making circles and becomes the dominant philosophy in guiding governments’ modus operandi, investors will need to prepare for the realisation that governments may ignore fiscal restraints, or adopt a combination of unorthodox monetary policies (outright monetisation of debt anyone?) to fulfill their policy aims.’
We all know what happened since then.
The COVID-19 pandemic this year has accelerated shifts in the economic policy-realm. It has caused every government to do whatever they can to prevent their economies from collapsing. It has forced fiscally-conservative countries such as Germany to abandon her traditional stance, and numerous emerging markets to engage in Quantitative Easing (QE) for their first time.
Budget deficits no longer matter as much, but rather, the focus is on governments to do more. Like it or not, we’re living in an MMT-world.
As market participants, it is time that we educate ourselves about MMT. These days, there are more material available on the subject, but Stephanie Kelton’s new book ‘The Deficit Myth‘ is an easy read for anyone interested to get started.
I’ll present the summary of Kelton’s argument in the first part of this post, and offer some of my thoughts in the second half. If you’re already familiar with MMT, skip to the second portion (My take on MMT). This post will be fairly long.
But before I begin, I would like to mention the following:
- I’m not an economist, and certainly do not pretend to be an expert in economic policy-making.
- I’m not an expert in MMT, and can be wrong about my take and views.
- I’ve avoided jargons as much as possible. Material on MMT out there can be pretty wonky and technical.
- I’m approaching this topic as a student of the markets seeking to understand the reality of this complex world that we live in.
- I’m approaching this topic from the perspective of a market participant seeking a better chance of protecting and growing the capital entrusted to me.
- Hence, I will be focusing more on the implications rather than the general concept or idea of MMT (that is for economists and policymakers to debate).
It is also vital to note that MMT is an evolving set of ideas and various proponents tend to differ on the details occasionally. Nothing listed in this post is exhaustive. It is best to keep an open mind at this juncture.
Additionally, if you’re interested in taking a deeper dive into the subject, I’ve listed some sources at the end of this post for further reference.
MMT is a macroeconomic theory that describes the practical uses of fiat currency as a public monopoly from an issuing authority (i.e. central banks). MMT proponents argue that a sovereign spending in its own issued currency cannot be forced into involuntary defaults. ‘Fiscal sustainability’ doesn’t apply to these entities, and hence, deficits do not matter as much as traditionally thought.
These sovereign entities are said to have ‘monetary sovereignty‘.
The way to understand this school of thought is to look at government’s finances differently from how you normally understand a household’s finances.
A national currency is a public good that is provided by a sovereign (the issuer). Everyone else within the economic system are users of the public good. This means that the users can run out of the public good (currency), while the issuer can always create it because it does not need it.
The conventional thinking is that the issuer taxes and borrows before spending (T A B – S), and ‘public money’ does not exist. Governments must come up with the money before they can spend, and that is why taxation and borrowing occurs.
On the other hand, MMT argues that the issuer spends first before taxing and borrowing (S T A B). The issuer doesn’t need the public’s money – it spends its issued currency into existence. Users need the issuer’s money, and they have to earn it via producing the goods and services that the economy needs.
Government deficits therefore should not be looked at in the same light as a household’s balance sheet. MMT argues that policy focus shouldn’t be on balancing government budgets (or fretting over debt levels) but rather on maximising the potential economic output by leveraging on the issuer’s (sovereign) monopoly over its currency. Thus, governments should maximise their spending powers to fulfill their responsibilities such as solving unemployment and providing necessary welfare.
Governments do not need to balance their books. If they’re overtly concerned about their budgets, the real economy will lack the collective savings and wealth needed for economic development and prosperity. Kelton’s economic equation provided in her book is simply:
Government financial balance + Nongovernment financial balance = Zero
However, MMT proponents don’t believe that governments spending power is unlimited. The key constrain, according to them, is real-world inflation. Government spending is constrained by it because there are only so many workers or factories and commodities available (finite resources).
If governments do not need our money, why the need for taxes?
In her book, Kelton mentioned her encounter with an early proponent of MMT, the financier Warren Mosler. He explained to Kelton that since the government doesn’t want the public’s dollars, it wants only to provision itself.
Governments exist to get people working and producing things for the government and the economy. Taxes are imposed to create a demand for the government’s currency, and users have to produce to earn it.
As quoted from her book:
‘Mosler had a beautiful beachfront property with a swimming pool and all the luxuries of life anyone could hope to enjoy. He also had a family that included two young kids. To illustrate his point, he told me a story about the time he sat his kids down and told them he wanted them to do their part to help keep the place clean and habitable. He wanted the yard mowed, beds made, dishes done, cars washed, and so on. To compensate them for their time, he offered to pay them for their labor. Three of his business cards if they made their beds. Five for doing the dishes. Ten for washing a car and twenty-five for tending to the yard work. Days turned into weeks, and the house became increasingly uninhabitable. The grass grew knee high. Dishes piled up in the sink, and the cars were covered in sand and salt from the ocean breeze. “Why aren’t you doing any work?” Mosler asked the kids. “I told you I would pay you some of my business cards to pitch in around here.” “D-a-a-a-a-ad,” the kids intoned. “Why would we work for your business cards? They’re not worth anything!”
That’s when Mosler had his epiphany. The kids hadn’t done any chores because they didn’t need his cards. So, he told the kids he wasn’t requiring them to do any work at all. All he wanted was a payment of thirty of his business cards, each month. Failure to pay would result in a loss of privileges. No more TV, use of the swimming pool, or trips to the mall. It was a stroke of genius. Mosler had imposed a “tax” that could only be paid using his own monogrammed paper. Now the cards were worth something.
Within hours, the kids were scurrying around, tidying up their bedrooms, the kitchen, and the yard. What was once considered a worthless rectangular calling card was suddenly perceived as a valuable token. But why? How did Mosler get the kids to do all that work without forcing them to do any chores? Simple. He put them in a situation where they needed to earn his “currency” to stay out of trouble. Each time the kids did some work, they got a receipt (some business cards) for the task they had performed. At the end of the month, the kids returned the cards to their father. As Mosler explained, he didn’t actually need to collect his own cards back from the kids. “What would I want with my own tokens?” he asked. He had already gotten what he really wanted out of the deal—a tidy house! So why did he bother taxing the cards away from the kids? Why didn’t he let them hold on to them as souvenirs? The reason was simple: Mosler collected the cards so the kids would need to earn them again next month. He had invented a virtuous provisioning system! Virtuous in this case means that it keeps repeating.
Mosler used this story to illustrate some basic principles about the way sovereign currency issuers actually fund themselves. Taxes are there to create a demand for government currency. The government can define the currency in terms of its own unique unit of account—a dollar, a yen, a pound, a peso—and then give value to its own otherwise worthless paper by requiring it in payment of taxes or other obligations. As Mosler jokes, “Taxes turn litter into currency.” At the end of the day, a currency-issuing government wants something real, not something monetary. It’s not our tax money the government wants. It’s our time. To get us to produce things for the state, the government invents taxes or other kinds of payment obligations.’
Kelton offered four main reasons why taxation is important: (i) for a government to provision itself, (ii) for a government to regulate spending power to control inflation, (iii) for policy-makers to alter the distribution of wealth and income, and (iv) for a government to encourage or discourage certain behaviours.
If governments do not need the public’s money, why do they issue debt securities?
Shouldn’t governments just spend directly in its own issued currency instead of issuing its own debt? That was a question that popped out in my head when studying MMT.
Kelton argues that sovereign bonds are just a choice offered by governments to offer people a different kind of government money (one that pays interest).
‘To buy some of those interest-bearing dollars from the government, you first need the government’s currency. We might call the former “yellow dollars” and the latter “green dollars.” When the government spends more than it taxes away from us, we say that the government has run a fiscal deficit. That deficit increases the supply of green dollars. For more than a hundred years, the government has chosen to sell U.S. Treasuries in an amount equal to its deficit spending. So, if the government spends $5 trillion but only taxes $4 trillion away, it will sell $1 trillion worth of U.S. Treasuries. What we call government borrowing is nothing more than Uncle Sam allowing people to transform green dollars into interest-bearing yellow dollars.’
Because users need the currency, and not the other way round, users need government debt securities. These debt securities are just another form of currency (the public good) that can be saved or held for later use that are circulated within the financial system.
Fiscal policy should be maximised to fulfill governments’ responsibilities
Since governments with monetary sovereignty are only constrained by inflation, proponents of MMT believe that these governments should maxmise their fiscal space to fulfill their mandated objectives. These include solving unemployment (launching job programmes and guarantees) and providing social welfare needs such as healthcare spending. The key message here is that such debt-financed spending doesn’t crowd out private investment.
Kelton proposed that:
‘When it comes to creating those jobs, we think it’s important to recognize that the federal government is not in the best position to identify the community’s most pressing needs. The people who live and work in the community are. That’s why we recommend that government agencies work with community partners to assess and catalogue unmet needs so that jobs can be tailored to meet the needs of the community. Together, states and municipalities would work with their community partners to create a repository of work projects.’
Depending on where the economy is in its cycle, people can transition from either public sector jobs to private sector jobs or the other way round.
Kelton also dived into the complex topic of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) in her book (for those of you who wanted to know) and how policy-makers should approach it.
‘Instead of relying on the concept of a NAIRU to try to figure out when the economy is approaching its productive limit, MMT urges us to think about slack more broadly.’
To control inflation, fiscal policy is the main tool
In the MMT-worldview, fiscal policy is the leading tool for controlling inflation. Taxation policies and government debt sales could be tweaked and adjusted accordingly as inflation trends between what policy-makers are comfortable or uncomfortable with.
As Kelton explains:
‘Transferring the economic steering wheel to the fiscal authority means relying on democratically elected members of Congress to relax the purse strings when bigger deficits can help support the economy and then tighten them back up as the economy reaches its full employment speed limit. This is the essence of the functional finance approach that was pioneered by Abba P. Lerner in the 1940s. Instead of obsessing over deficits and trying to force the budget into balance, Lerner wanted lawmakers to write a budget that would keep the economy in balance at full employment.
MMT draws inspiration from Lerner’s work but with the caveat that we need to do more than simply ask Congress to take over the steering wheel from the Federal Reserve. We need to offer some guiding principles to help lawmakers wield this power responsibly and in ways that serve the broader public good. For that, we’ll need to establish some new guardrails. And we’ll need to provide lawmakers with clearly marked speed limits, a dashboard of indicators, and a driverless feature that takes over much of the steering. That way, fiscal policy can serve as a powerful stabilizing force even when our politics are at their most dysfunctional.’
As for monetary policy, authorities will use it to assist fiscal policies and priorities. For example, interest rates can be fixed low to allow the financing of government deficits when it is the time for more fiscal spending.
To end the summary off, here is a flow diagram from Brian McIndoe that illustrates the MMT view of money flow:
Also, do remember that MMT only applies to governments with monetary sovereignty (countries that spend, tax and borrow in their own issued currency). Countries that borrow heavily in currencies that they do not issue (non-monetary sovereign economies) do experience the side effects of rampant fiscal spending (like the crowding-out effect).
My take on MMT
To be frank, I was appalled when I first encountered MMT (AKA Magic Money Tree in some circles).
But after taking a step back to examine my own biases and tracing MMT’s lineage and the history of soft-currency economics, I’m much more neutral about it these days. I simply try my best to look at it from an empiricist standpoint.
Based of observations, the descriptive part of MMT makes sense. Sovereign governments spending in its own issued currency can never be forced into involuntary defaults. They also have the power to keep interest rates low according to whatever their policy requirements are. It largely explains why countries like Japan can see its public debt burden grow to levels that alarm foreign observers (in Japan’s case, it helps that the deficits are mostly internally funded by domestic savings, which makes it more sustainable).
During the Second World War, the U.S. had to budget for an enormous amount of wartime spending to finance the Allied war effort. Overall debt levels and budget deficits as percentages of GDP were at record levels during the 1940s, as shown in charts here from hedge fund Bridgewater Associates (see Bridgewater’s Ray Dalio’s post – The Mechanics of the War Economy).
In fact, soaring national debt levels alarmed observers in the 1940s as well. Frank Dickson, an economist from the University of Illinois, wrote a popular op-ed in 1944 arguing that the only the U.S. could survive economically was to default on its $200 billion of war-time debt. Dickson warned that ‘a whole generation would spend their entire careers working to pay off the national debt.‘
However, there wasn’t any defaults, and in fact, the U.S. government was never forced to repay at the aggregate level. The U.S. economy simply grew out of it (when the rate of nominal growth is higher then the nominal interest rate), and refinancing took place along the way. This dynamic certainly doesn’t apply to a corporation or a household or an individual, as correctly described by MMT.
My issues with MMT are with the practical side of things, or what MMT debaters call the ‘prescriptive‘ part of MMT.
MMT proponents propose that governments should eliminate unemployment by undertaking major job creation initiatives, and that this should be done as automatically as possible (perhaps after legislation). By doing so, this lowers the odds of such programmes being shelved by politicians over electoral cycles. These programmes will come with minimum wage policies so as to set the floor on the price of labour, particularly during economic slowdowns.
Like Neo-Keynesians, proponents of MMT cite the historical example of U.S. President Franklin Roosevelt’s New Deal in the 1930s following the Great Depression.
I understand that Professor Kelton has suggested that government consultations with the private sector and local communities will be launched to understand what and where the needs are; and these set of constant initiatives will form the bedrock of guaranteed employment programmes. However, I remain sceptical of the efficiency of these programmes, the administrative and the execution process. It’s unclear if shifting resources from the private sector to the public sector could make society better off.
From a political and social standpoint, consultations have to be thought through and calibrated wisely, because the decision-making progress is top-down in nature.
Jobs could be created, but the viability of these programmes also depends on the skillsets of the employed. The evolution and nature of how people adapt and change their skillsets are typically micro-level in nature and influenced by the price signals of the free market. Afterall, the intention of these programmes is to provide the unemployed with a means to income but only for a temporary period of time before they can rejoin the private sector.
Incentives are a big part of capitalism, and economic systems are complex and adaptive. Changing a portion could lead to unexpected consequences. How would the risk-taking behaviour of people on government-guaranteed employment change? How would productivity on a macro level change?
I can’t help to wonder: could these guaranteed employment programmes distort the nature of free market capitalism?
Another concern is the actual reactions of the users of a system who remain unconvinced of the MMT ideology and proposal. I believe that money as a concept relies on network effects for it to exist, which is something observed from history. It isn’t really clear how taxation policies solely justifies money among users.
What happens if users start to question the notion of the scarcity of money (the public good) or even doubt the sanctity of the value of money? How would they behave from an economic and financial standpoint? How would they work and go about their lives?
When it comes to investment finance, there could be second-order and even third-order consequences when investors and Wall Street start to question their assumptions of risk-free rates. This is because the risk-free rate (i.e. U.S. Treasury bond yields) is used to assess and price various sorts of publicly-traded assets like credits and equities.
Should the MMT perspective – how the issuer (monetary sovereign) have total control of risk-free rates without any adverse consequences while monetising deficits – take hold, how will investors price and view risk to their capital? How would this affect how their demand for these private sector securities?
Gazing into the Crystal Ball
As traders/investors, we’ll have to approach things from the practical reality of what is likely to happen rather than what we think should happen. Leave the judgment and debates about what is right or wrong to economic historians.
George Soros said it best when he wrote:
‘Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited.’
Recognise the trend…
MMT offers the concept of money creation as an infinite resource that can be directed for the public good, in contrast to the neo-liberalist scarcity concept that all of us are familiar and have grown up with.
In the current socioeconomic environment of wealth and income disparity and a polarised political climate, I think that it is highly likely that MMT is entering adoption phase. My fear is that it will probably be abused. Opportunistic politicians will adopt it in a religious manner to appeal and appease to their electorate – you’ll be hearing a lot of it in the months and years ahead.
The following are some implications I see:
First implication: The blurring of divisions between fiscal & monetary policies
MMT proponents call for government authorities to control inflation via the fiscal lever toolkit, while monetary policy is used flexibly to coordinate the government’s response. This is in effect, blurring the division between fiscal and monetary policy realms.
As Kelton explained:
‘Because it has monetary sovereignty, the U.S. has many options when it comes to borrowing and managing its interest rate. It could exert rigid control of the short-term interest rate but allow financial markets to have some influence on longer-term borrowing costs. That’s how it works in the U.S. today. Or, it could take control of longer-term borrowing costs, the way it did during and immediately after World War II or the way the Bank of Japan (BOJ) does it today. It could even dispense with Treasuries altogether, which would make it all but impossible for anyone to tell a crowding-out story based on the argument that government borrowing is what drives interest rates higher. The point is, deficits pose no inherent crowding-out risk. The loanable funds theory is simply wrong. Fiscal deficits—with or without bond sales—do not mean an inevitable increase in interest rates.’
Central banks have to do their utmost to ensure the financial plumbing continues smoothly in such a world (if they aren’t already in today’s markets). This could be controversial in liberal democratic countries given constitutional considerations of central banks and their perceived independence. For autocratic countries, this may not mean as much as the independence of monetary policy-makers is usually doubted.
If we take a look at the minutes of the U.S. Federal Open Market Committee’s (FOMC) recent June meeting, it revealed that some form of a yield-caps/targets or yield curve control policy was discussed. Fed members discussed pros and cons to the policy, and noted the Australian experience (the Reserve Bank of Australia’s current targeting of its three-year government bond yield) as the most relevant for the U.S. in current circumstances.
‘These participants noted that, even if market participants currently expect the federal funds rate to remain at its ELB through the medium term, the introduction of an effective YCT policy could help prevent those expectations from changing prematurely—as happened during the previous recovery—or that the size of a large-scale asset purchase program, which also poses risks to central bank independence, could be reduced by an effective YCT policy.’
The U.S. Treasury curve has not moved much since the release of the minutes, and it remains to be seen how the twenty-first century’s Fed’s yield curve policy will be rolled out.
Back in the Second World War, the Fed implemented a rate cap regime (series of caps across the curve):
From my point of view, it’s only a matter of time before a yield target or yield curve control is adopted. Momentum for it is building, and policy-makers have been increasing their communications about the topic to build awareness and credibility within the public and private sector. The MMT worldview necessitates such policies for monetary sovereigns embarking on deficit-financed spending.
Second implication: More government institutions & controls
To governments and MMT-inspired bureaucrats will probably resort to using educational means and restriction measures to implement their objectives. MMT may be introduced to the broader public via and education curriculum, while laws have to be in place to facilitate the implementation of MMT-inspired objectives.
While debt securities need not be issued according to the MMT worldview, they are viewed as an extension of the public good (currency) issued by the sovereign. With this in mind, fiscal authorities have to ensure that the various entities and individuals (other than the central bank purchasing these debt securities) continue to use these securities within the system.
There could be new legislation requiring ‘patriotic duty‘: individuals or investment institutions (e.g. pension funds) have to purchase government bonds, gradually creating a culture of such a practice. In fact, this has been happening in Japan for decades now, with a vast majority of Japanese sovereign debt purchased by their national pension funds by mandate.
A variety of monetary controls or forms of capital controls could be introduced in countries engaging in MMT-inspired policies and programmes (although I’m less sure of this point). In such a dystopian reality, there is potential for the universe of cryptocurrencies to flourish, as wealthy individuals, fearing the repercussions of government controls or unconvinced by their policies, seek to protect their assets from the control of governments.
The converse is also true. If the vast majority are convinced that MMT works and their fears of a destruction in monetary values are misplaced, it will deliver the coup de grâce to alternative currencies and traditional ‘stores of wealth’.
Third implication: The transition to State Capitalism
MMT shifts the focus from the private sector to the public sector’s targeted central control of the allocation of resources.
By pushing for the government’s permanent presence in economic management, it is obvious that the allocation of resources will increasingly be done by the state, as the private sector assesses supply and demand conditions in both the resource and labour markets at various points of the business cycle.
More bureaucrats and administrators will be seen dictating economic policy, which for better or worse, could discourage entrepreneurship if taken too far (where do governments draw the line?). This means that we’re likely to see a transition from the current economic system to State Capitalism.
Investors have to watch the political sphere and assess political trends closer than ever. Economic policies are likely to be decided by the flavour of the season, or whatever themes of the day that is deemed to be most politically-correct and palatable by the general public. Opportunistic politicians will ride on this trend, or fear getting booted out by voters.
As Kelton mentioned (my emphasis in bold):
‘MMT isn’t a blank check. It doesn’t grant us carte blanche when it comes to funding new programs. And it’s not a plot to grow the size of government. As an analytical framework, MMT is about identifying the untapped potential in our economy, what we call our fiscal space. If there are millions of people looking for paid work and our economy has the capacity to produce more goods and services without raising prices, then we have the fiscal space to bring those resources into productive employment. How we choose to utilize that fiscal space is a political matter, and here MMT can be used to defend policies that are traditionally more liberal (e.g., Medicare for all, free college, or middle-class tax cuts) or more conservative (e.g., military spending or corporate tax cuts).’
What are the current flavour of the seasons? Here’s a few for you.
In the U.S.:
Investors have to adapt to this new realm of State Capitalism, and re-look their playbook and strategies. Figuring out how governments mobilise and utilise economic resources is what I have in mind, and it will be key for seeking out returns to thrive in the years ahead.
As Bridgewater’s Bob Prince said in a recent interview, it’s all about ‘following the money‘.
Books / Papers / Articles:
The Deficit Myth – Stephanie Kelton
Modern Money Theory – L. Randall Wray
Modern Money Theory 101 – L. Randall Wray & Éric Tymoigne
What is MMT & Why is AOC so Enamored With It? – Brian McIndoe
The Mechanics of the War Economy – Raymond Dalio
Videos / Podcasts: