17 Jul 2019
A narrative to take markets higher
In June 2016 we wrote a light-hearted article called “Solving Japan's Financial Problems”. In it we proposed that Japan's Reserve Bank, which at the time owned over a quarter of the Japan government’s debt, should just write it off. What little income it was earning was going to the Reserve Bank, the maker of money, that had no need for it. The only consequence would be the risk of inflation, but Japan was, and still is, struggling with deflation. The Japanese government would then be unencumbered by its debt problem and be able to borrow more and spend it on infrastructure, providing much needed stimulus to its economy and potentially pulling it out of deflation woes. Simple!
And apparently, we weren't the only ones thinking about this. Policy and business circles are increasingly talking these days about an economic theory called Modern Monetary Theory (MMT).
MMT is being discussed for one main reason. It provides a rationale for government spending despite high levels of debt, a problem that most of the largest economies of the world are encumbered with. In countries with sovereignty over their currency MMT argues that, rather than using interest rates to regulate employment and inflation, it can be regulated by spending and taxes. It is sort of an extreme version of Keynesian economics, asserting that interest rate changes have no discernible effect on an economy’s aggregate demand. The risk-free (government) interest rate can therefore be set at zero so the level of debt a government holds becomes irrelevant. Nice!
There are a fair number of MMT critics. Former US Treasury Secretary, Larry Summers, has called it “voodoo economics”. Warren Buffet is "no fan" of MMT either. However, MMT also has a few high-profile supporters. Ray Dalio, the highest paid hedge fund manager in the world last year, is a backer of the philosophy behind MMT. He recently noted that MMT can be used to redirect stimulus from those who own financial assets to those who don’t, helping to reduce the wealth inequalities that are part of the current rise of populism. “Quantitative Easing (QE) and interest rate cuts help the top earners more than the bottom (because they help drive up asset prices, helping those who already own a lot of assets). Those levers do not target the money to the things that would be good investments like education, infrastructure, and R&D.”
We do not profess to have more economic firepower that these experts to be able to determine who is correct. What interests us about MMT is the potential for it to push markets higher.
Most of the world’s largest economies are in a bind, fighting high government debt levels, deficits and the threat of debt defaults and deflation. MMT must be a very palatable option for consideration by our world’s law makers. Why not use free money to build much-needed roads, bridges and hospitals, while at the same time reducing wealth inequality and stimulating the economy? Especially when the alternative option requires the almost impossible task of reining in spending and paying down debt.
QE is sort of a watered-down application of MMT. The difference is governments technically must pay their reserve banks back one day. Now that governments have got the QE habit, it will be easier for them to move onto a purer substance with a bigger hit. In our opinion, QE will be used until high inflation ceases to permit it. MMT makes it easier for them to do that, or even one better.
Whether MMT is a workable theory or not, it is likely to be ultimately misused in practice. Too much of a good thing never works out well, and it is likely that inflation will not be kept in control under this approach because governments will not introduce unpopular higher levels of tax quickly enough. Basic human nature will result in too much money being printed, and this will result in high inflation.
Dalio acknowledges this weakness. “The big risk of this approach arises from the risks of putting the power to create and allocate money, credit, and spending in the hands of politically elected policy makers”. This is also probably the reason why Buffet is no fan.
But inflation appears to be some way off. In the interim, MMT can be used to describe the current situation and justify the monetization of government debt, and further fiscal spending while lowering interest rates at the same time. What this long bull market lacks to date is a euphoric melt-up based on a “this time is different” narrative. Perhaps we have it.