Wealth Management: Market Perspective – Modern monetary theory
Kevin Gardiner, Global Investment Strategist, Wealth Management
Monetary cynicism could backfire
“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…” - Keynes, The General Theory
We've spent much of the last decade arguing that economists worry too much about many things, such as debt, demography and deflation. But there is something we think they worry too little about: does monetary policy need to be so generous?
We are hearing about another proposed innovation that makes us nervous on this account. Something called Modern Monetary Theory (MMT) is being taken seriously by economists and central banks - as well as a couple of would-be Democrat candidates for the White House.
MMT is not in fact a modern idea, nor - unfortunately - is it a theoretical one. It has been put into practice all too often.
MMT: a money-financed fiscal boost
If a government decides something must be done to boost the economy, what are the options?
- Try to change the level of activity in the
economy with its own spending and taxation
plans (fiscal policy).
- Try to manipulate interest rates, and/or
the quantity of credit or money, and/or the
exchange rate (monetary policy);
- Do both.
(This assumes the government has some monetary autonomy or sovereignty. The US has the luxury of being able to both print its own currency and borrow in it. But members of a currency union, for example, or small countries dependent on overseas funding, may have little control over their interest rates and exchange rates.)
If they spend more, but also raise taxes, the budget stays balanced and net demand doesn't change much (it probably rises a little: some of the taxes would have been saved).
If they spend more (or cut taxes) and pay for it by borrowing (issuing bonds) from the public, then fiscal policy is said to be expansionary, and will boost net demand as long as the funds borrowed were not already earmarked for other projects. If they spend more and pay for it instead by creating money, or if they spend more and cut interest rates to offset any 'crowding out', they are using both fiscal and monetary policy.
MMT does both: it combines monetary and fiscal stimulus in the shape of money-backed public spending. The monetary component, however, differs from other recent 'unconventional' monetary tools like quantitative easing (QE).
The money created by QE sits on bank balance sheets: it may or may not leak into wider circulation, and in turn may or may not support private spending. By contrast, the government's own spending is the focal point of MMT, and is backed directly by creating new circulating money - cutting out the middlemen. Arguably it might be better named 'Modern Fiscal Theory'. (Some less kind alternatives have also been suggested: Professor Ken Rogoff has referred to 'Modern Monetary Nonsense', and the phrase 'Magic Money Tree' might spring to mind had it not already been appropriated elsewhere.)
MMT could have a big impact. It doesn't have to, because if people see the money-backed spending as a substitute for projects they otherwise would have done themselves, then total spending might not rise. But generally, if the government is able to procure what it wants, and does so without causing people to take offsetting action of some sort or squeezing private finances, it could deliver directly a big increase in demand.
The man behind the curtain
Ultimately, money is a bit of a confidence trick: it has no intrinsic worth, but has value because people see it as acceptable tender, and as largely fixed in supply (or at least, as not growing dramatically and arbitrarily).
Policies which loudly proclaim a big increase in its supply might undermine that confidence, and lead to money losing some of its value (that is, to inflation). As a result, the potency of MMT could be a bit like that of the Wizard of Oz: pretty impressive, until it is revealed that the loud voice, thunderflashes and confetti come from a rather ordinary bloke behind the curtain.
Then, instead of the new money-backed demand being translated into wizard gains in output and employment, and perhaps some small increase in inflation, it might instead be transformed wholly into inflation and, if big enough, threaten monetary collapse.
We do not know where that revealing moment is. It may be some way away, particularly if there is a lot of free capacity in the economy, which can then absorb the extra government procurement without leaving less output available for other buyers. But it may not be.
Keynes talked about tackling unemployment by burying banknotes and letting people bid for the right to dig them up. But they would only do so if they felt that the notes would still be worth something. In the 1930s, with unemployment high and communication slow, their worth might not be questioned. But when there is little slack in the economy, and everyone knows what is happening, such blatant monetary cynicism might undermine faith in the currency.
Taking such a risk is not something to be entertained lightly. There are no instances of societies imploding because of low inflation, but monetary collapse is a killer. And we're saying nothing about the bigger government.
Why take this risk now?
It is not clear what question this potentially alarming policy might be trying to answer.
Admittedly, global growth has been slowing for two years, and US and EU inflation rates are slightly below target. There is concern over rising inequality. There is also unease (in Europe) over negative nominal interest rates and their associated distortions (most visibly, those elevated bond prices), and some worry about what central banks might be able to do if an economic emergency were to arrive with interest rate policy already dialled up to eleven, as it were.
These arguments are unconvincing. As noted above, there are few reasons for seeing this slowdown as especially sinister. Meanwhile, unemployment in Western economies is historically low, not high.
Inequality may not be best targeted with a monetary blunderbuss. Nor is it clear that MMT would assist in normalising interest rates. Maybe MMT could help if a genuine economic emergency were to arise - a point made by the IMF's Christine Lagarde - and were to do so with interest rates still at today's levels. But why introduce it now?
Mission creep and hubris
The popularity of MMT reflects mission creep in the central banking debate. Many economists, believing growth to be disappointing, fretting that inflation is a few tenths of a percentage point below target, and emboldened by central banks' success in saving the world in 2008-09, want policymakers to try harder.
But inflation targets do not exist because we want more of it: small arbitrary targets were the only way of squeezing chronically high expectations out of the system. A bit more inflation is not a good thing in itself, and the idea it can somehow be fine-tuned is hubristic. Paul Volcker - the Fed Chairman who did so much to restore US monetary credibility in the early 1980s, and whose death sadly has been announced as we write - said in 2018:
“… even if it were desirable, the tools of monetary and fiscal policy simply don't permit that degree of precision… The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking.”
Our 'muddle-through' scenario has worked well for a decade now, but wholesale adoption of MMT (or, here in the UK, 'people's QE') might be a risk too far. It could yet snatch defeat from the jaws of victory in the fight against inflation - the investor's most determined long-term enemy.
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In this Market Perspective:
- Keeping an open mind
- Modern monetary theory (current page)
- US elections and portfolios
- Economy and markets: background
- Important information
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