So-called ‘Modern Monetary Theory’ – or MMT – has attracted plenty of attention of late, but Franklin Templeton Investments’ Sonal Desai warns it is not the magic cure that its fans claim it to be.
MMT has gone from being an obscure argument that was once confined to the blogosphere and a handful of universities to the topic of the moment in economic and political circles, winning itself a number of champions who believe the US should embark on its radical principles.
However, it remains difficult to pin down exactly what MMT is. At heart, it is a heterodox macroeconomic theory that is rooted in the belief that a country with its own currency does not have to worry about accumulating too much debt because it can always print more money to pay interest.
Desai, who is Franklin Templeton’s fixed income chief investment officer, pointed out that the theory has attracted “scathing criticism from an array of heavy hitters”, including former US Treasury secretary Larry Summers, former International Monetary Fund chief economist Ken Rogoff, Nobel Laureate Paul Krugman and Stanford University’s John Cochrane.
Modern Monetary Theory’s lineage
Source: Adapted by Bloomberg Businessweek from Macroeconomics, published by Red Globe Press
According to Desai, the main tenets of MMT are: 1) the government has a monopoly over the issuance of national currency; 2) unlike households or companies, the government does not have a budget constraint; it can never run out of money to spend because it can print money; and 3) the only limit to the government’s spending power kicks in when it generates excessive inflation.
“I think of MMT as a shape-shifter; it presents itself as a set of sensible principles then morphs into dangerous policy ideas – which is why so many prominent economists now sound alarmed, rather than dismissive,” he added.
Proponents of MMT argue that government should set public spending and taxes to generate maximum employment and stable, moderate inflation. This, of course, is a view shared by many orthodox economists: if a government runs a significant budget deficit to invest in education, infrastructure and research & development, it can boost long-term growth so the debt it accumulates in the process will not be a problem.
“But here is the shape-shifting: for MMT, public debt does not matter – at all,” Desai said.
MMT’s advocates argue that Japan teaches a very important lesson and not one of warning. The country’s public debt is 240 per cent of its GDP yet Japan has no meaningful inflation, creating an example that MMT proponents believe could be worth following by the US.
Over the past 15 years, advanced economies (with the exception of Germany) have seen their public debt-to-GDP ratios increase sharply without the influence of MMT. Desai pointed out that large stocks of debt need to be rolled over and new deficits need to be financed, meaning a larger supply of government bonds and even more government spending to pay interest on that debt.
Although the cost of debt has been held down by quantitative easing in the years since the global financial crisis, the chief investment officer argued that this is an anomaly and pointed out that interest payments on public debt are expected to climb higher as interest rates go up.
“MMT advocates would say that does not matter either. You can let the deficit expand further and issue even more bonds. If investors’ appetite for government bonds weakens, you can have the central bank step in to finance the deficit,” Desai said.
“That way, MMT can be used to justify any additional government spending. Universal free education and healthcare, a guaranteed income even for those unwilling to work, etc. They no longer need to be financed by higher taxes. They can be financed by issuing more debt, possibly supported by central bank bond purchases. After all, the government can never run out of money to spend – it can print it.”
Source: International Monetary Fund’s World Economic Outlook, as at Oct 2018
Of course, MMT argues that the above is only valid if it does not cause inflation. Examples such as Venezuela suggest that governments should avoid spending “with abandon” if they want inflation to remain in check but supporters of MMT often argue that the US is different because it can print US dollars – which are the global reserve currency and the rest of the world will always want more.
Desai, however, pointed out that the US was not always the global reserve currency and only assumed this role after decades of growth-boosting, responsible policies made it the stable currency of the world’s strongest economy. A dramatic shift in policy could see the rest of the world could change its preferences to other reserve currencies.
The CIO also takes issue with the belief that the only potential risk of excessive government spending is demand-driven inflation, because “then the only limit to public spending becomes a politician’s imagination on how to spend more money”.
This standpoint ignores the fact that budget constraints forces governments to think hard on where money will be best spent and underestimates the damage that excessive government spending can do to incentives and resource allocation.
“This is where MMT becomes dangerous,” he continued. “By arguing that the government does not have a budget constraint, MMT becomes intellectual fuel for populism.”
Desai noted that politicians in the US and Europe have increasingly being offering easy fixes and painless solutions to quite big issues, such as leave the EU (Brexit); persuading the EU to let them spend more money including on a ‘citizenship income’ (Italy) and keeping out foreign workers or having the government provide free healthcare and education for all (the US).
“Fear of adverse consequences has dissipated together with respect for the experts,” he added.
“QE did not fuel inflation and Brexit did not trigger a recession, so who says we can’t have universal basic income and print our way to prosperity? There is no appetite to discuss difficult trade-offs and to accept that success in a more competitive global economy requires hard policy choices and structural reforms to boost innovation and productivity.”
US interest rate payments and public debt
Source: Bureau of Economic Analysis, Federal Reserve Bank of St Louis
But this is creating two sets of risks that are relevant to both citizens and investors.
First, an unwillingness to address hard choices on education, infrastructure and public spending could undermine the long-term growth potential of advanced economies. “This would have direct implications for financial assets’ performance and it would heighten the geopolitical tensions that have already become a greater source of market volatility,” Desai said.
Secondly, the risk that something goes “badly wrong” rises exponentially as politicians and voters become complacent and ready to embrace out-of-the-box policies. This heightens the risk of events such as a major sovereign debt crisis, a new financial crisis, a surge in inflation or a prolonged slump in a major economy.
“That’s why as investors we should worry about the rise of Modern Magical Thinking—just as Cochrane, Summers, Rogoff and Krugman do,” Desai warned.