Policy makers are currently facing a dilemma. Government and corporate debt-to-GDP ratios had already risen to excessive levels after the Great Financial Crisis of 2008, and they´ve now exploded even higher during the COVID pandemic. Even consumer balance sheets, which had been recovering until this year, have exploded once again.
Policy makers are currently staring at two wildly opposing choices: save more or spend more (i.e. austerity or expenditure).
In the last macro edition of The Lykeion, we detailed a range of austerity measures, including taxation, that could be implemented in an attempt to pay the bills and balance budgets. We labelled this the path of pain because it requires considerable sacrifice on the parts of governments, corporates and households. We also highlighted how, independently of the level, austerity measures will likely prove insufficient given the total amount of indebtedness in the system right now.
In this edition, we look at potential fiscal expenditure measures in which we might print our way to prosperity. We label this the path of pleasure, as it promises far fewer sacrifices, and guarantees elected politicians more popular support.
The path of pleasure changes the rule of the game as it elevates governments to the top of the economic hierarchy, in which deficit spending, including debt jubilees and universal basic income, seek to redress imbalances (like income inequality or over-indebtedness) and stimulate the areas that monetary policy cannot reach. It is a world rooted in Keynesian Economics and taken to an extreme by Modern Monetary Theory (MMT).
For traditional economists, soaring debt levels are a problem. Realistically though, massive debt levels, like the current ones, can never be repaid by simple measures of austerity alone. Take the example of Greece. It has debts of $370 billion, which is about $33,000 debt for each of its 10.7 million people, but annual GDP per capita is $24,000. That cannot be repaid in a single lifetime.
Through Austerity, the small savings at the national level can lead to excessive hardship at the individual level. When there’s lots of pain for very little gain, a policy will quickly fall out of favor and policy makers are likely to be voted out of office. This was the experience in Greece that saw a left-wing coalition (Syriza) take power in 2015 during the Greek debt crisis. Beyond being unpopular, austerity is also ineffective given the size of the problem. With austerity out of the way, here comes deficit spending.
The idea that deficit spending (the amount by which government spending exceeds revenue) should be used to stimulate demand during times of economic weakness is hardly new. John Maynard Keynes, a British economist during the Great Depression, argued that inadequate aggregate demand led to longer than needed periods of higher than expected unemployment. Keynes suggested that a government’s fiscal policy should be used to stimulate demand and offset an economic downturn, shortening the collective economic pain that a society needs to endure.
Many Keynesian policies were adopted in the post-Depression and post-WWII eras, but then started to lose momentum after the stagflation of the 1970’s. This period saw the rise of the monetarists, like Milton Friedman who favored controlling the money supply (monetary response) over Keynes’ taxing and spending (fiscal response), whilst labor was expected to reach full employment through (lower) wage flexibility.
Over the last few decades, however, in addition to controlling the money supply, many governments have tended to also spend (or save less) during times of plenty, so that they were weakened going into times of famine (recession).
MMT believes, however, that there should be no spending limits for a country with sovereignty over its own currency. Spending during times of plenty should not leave that country in a weakened position.
But what is MMT and why is it gaining momentum?
There is no single definition of Modern Monetary Theory (MMT), but it frames the broader discussion on fiscal and monetary expenditure because it outlines an unconstrained model of spending for a country which has sovereignty over its own currency (which is a central pillar of MMT). Modern Monetary Theory focuses primarily on the efforts of the fiscal authority (government), whilst the role of the monetary authority (central banks) is to facilitate these efforts. Again, the government is elevated to the top of the economic hierarchy. So, what does it mean to have sovereignty over its own currency?
A country who has sovereignty over its own currency:
The government is the issuer of the currency. The corporate and household sectors are the users of that currency. This distinction between an issuer and a user of a currency is central to MMT. A country with sovereignty over its currency can issue as much currency as it chooses, whilst a household or company is only using that currency.
The US, the UK and Japan all have sovereignty over their currency. Member states of the Eurozone do not (which is a root cause of the debt issues that regularly besets the region). Greece is unable to print euros for itself, whilst the Bank of England can choose to print pounds. Countries with large external debts in a foreign currency (e.g. a South American country with large dollar-denominated debts) also don’t have sovereignty over their currency. If a country has US dollar-denominated debts, then those debts will become harder to pay back if the dollar starts to strengthen. The country has no control over the strength of the US dollar (apart from trying to intervene in the forex markets)
MMT argues that current economic thinking has got it “the wrong way around” and will fail to realize the true potential of an economy. It argues that:
If spending can be separated from taxing and borrowing (all spending can be met by issuing more money instead of being financed by taxes or borrowing), then governments with sovereignty over their own currency can offset liabilities such as government debt, student debt and pension shortfalls in their entirety, whilst manufacturing full employment (e.g. the creation of more public sector employees, financed via the issuance of additional currency) in which everyone has a worthwhile job. It sounds very persuasive.
By spending first, and printing money to pay down the “debts” later, MMT attempts to solve the problem that is traditionally classified as “too much debt”. In other words, debts in the same currency should not exist if we can print money to pay it down, so there’s no need to spend time accounting for it.
“But if you’ve made your peace, then the devils are really angels, freeing you from the earth. It’s just a matter of how you look at it, that’s all. So don’t worry, okay?”
Jacob’s Ladder, 1990
MMT academics believe that inflation still is the constraint, but in the absence of it, governments can continue spending to encourage, for instance, full employment indefinitely.
Modern Monetary Theorists would argue that unless we see inflation, we have not achieved an economy’s full potential, and so we should continue to fund growth through deficit spending, independently of the rate of unemployment. This “disregard” for the rate of unemployment means that MMT does not accept that there is a non-accelerating inflationary rate of unemployment (NAIRU) in which a percentage of the population will always be unemployed, which opposed the Monetarists approach of trying to calculate NAIRU and as the economy approaches it, they would tighten policy in order to control inflation.
Given the more aggressive approach towards stimulating the economy, it is key for MMT to be able to manage inflation growth. Analogously, the current approach is based on a lower “speed limit” that the vehicle of fiscal spending can reach, because we do not sufficiently trust our brakes. MMT increases the speed limits, which bears the responsibility of better brakes.
So how will governments ensure we do not run into hyper-inflation? Well, under MMT, governments will try to control inflation via taxation. Basically, once we see price inflation, the government would target businesses and households with tax hikes so there’s less money available to spend, slowing down the rate of inflation.
The inflation argument against MMT is frequently presented, and rightfully so. Ultimately, MMT is still quite theoretical, and the idea of central institutions being successful at controlling inflation is a hypothetical scenario that we struggle to digest given their track-record in fighting deflation.
That being said, besides the inflation counter-argument, we believe that proponents of MMT have omitted or forgotten a more menacing threat: MMT forces us to live in world of central planning, which destroys incentives in an economy, and prohibits the forces of competition and capitalism to boost innovation and, hence growth. MMT implies a move towards a more controlled economy, something that in past experiments has not worked well. But let’s break this down, step by step. What are the main problems with Modern Monetary Theory?
Money is not wealth. Printing money doesn’t equate to printing wealth. We work to create wealth, which happens to be denominated in a currency. Prosperity is a ‘condition of wealth.’ All of these imply effort, innovation and productivity on the part of people, either individually or collectively, rather than simple financial wizardry.
Printing a currency (QE, MMT) actually tends to devalue the existing wealth denominated in that currency (through inflation). This means that, by printing money to finance fiscal spending, which in turn funds the parts of society who need income support, we’re diluting the overall level of wealth of a nation rather than redistributing wealth from the haves to the have nots. Indiscriminate spending risks to undermine society as a whole if not properly managed. Ultimately, through MMT you’re trusting your Government that it will be able to chemically manage the economy so that inflation doesn’t get out of hand.
Do you have faith in the ability of governments to allocate capital efficiently? One of the notions which MMT seeks to dispel is that governments crowd out the private sector. As a ‘matter of accounting’:
Government Balance + Private Sector Balance + Foreign Sector Balance = Zero
One sector’s deficit is another sector’s surplus. Not all dollars, however, have equal potential. A government deficit may be exactly equal to a private sector surplus in notional value, but are both parties equally good at allocating capital, and hence, promoting growth and prosperity? Here is an extremely simplified example.
Which is likely to have the best outcome? The notional value is the same, but most people would expect the private sector to be more efficient at allocating the capital (obviously there’s a multitude of caveats, but money can have significantly different outcomes depending upon who is wielding it). MMT argues that fiscal deficits increase our wealth and collective savings, rather than creating a borrowing (debt) requirement that puts the government in competition with other potential borrowers (households and corporates, for instance). The issue, however, is not the potential for crowding out of the private sector by excessive government deficits, but the potential for misallocating capital. MMT forces you to agree that the Government is a better capital allocator than the private sector.
Economists love an output gap, in which variables such as aggregate demand may fall below the potential of the economy. Many of them believe that governments should use debt (or deficits) to stimulate demand back to an economy’s full potential. Rarely considered is the possibility that the prior level of demand was in excess of its natural level.
Whilst it is almost impossible to calculate the natural level of an economy, we could argue that if demand has been fueled by debt (e.g. UK and US), then households have been consuming beyond their organic means, via leverage. Is the output gap therefore the result of too little demand today, or excessive debt-fueled demand of the past?
Let’s imagine that the nuclear US family consists of two adults and two children, in a two thousand square foot home, with two cars and two vacations per year. We’ll call this the natural level of demand. If the family uses excessive debt to buy a three thousand square foot home, three cars and three holidays, this family would be living beyond their means. Extend this across a whole nation, aggregate demand is excessive (or unnatural). If there is a credit shock (2008), the family might retrench back to a smaller house and fewer cars. We now have an output gap.
Policy makers could step in with support to drive demand back up the previous unnatural levels, but living standards are relative and not absolute. Policy makers can stimulate demand back to a three thousand square foot house, three cars and three vacations, but the desire for improved living standards will fuel the quest for a four thousand square foot house, four cars and four vacations, just to keep the customer satisfied.
Many developed economies are currently battling a plateau in the rate of change of the standard of living because consumers have used debt to keep that (unsustainable) rate of change on an upward trajectory. If you decide to decrease the level of leverage used to stimulate the growth in standards of living, then it is normal that the rate of change turns.
Is a world without murder optimal for society? The initial answer would appear to be ‘yes’. Ok, now back to economics. Does full employment equate to optimal employment? Full employment is an honorable intention as much as it is to want a world without murder.
What does an acceptable murder rate have to do with full employment? They both correlate with government oppression.
A society today with a murder rate of zero is most likely to be an Orwellian society with few freedoms and high levels of oppression, in which the state controls every aspect of our existence to eliminate murder. An unfortunate side effect of a free and open society is that some people are ‘free’ to commit murder. We have traded an acceptable murder rate in exchange for a free society.
Full employment is a similar trade-off. Full employment comes with a certain amount of financial repression if the government, or central planners, are deciding which jobs should be created or protected (the USSR had full employment). This is not positive for a free capitalist system. Some may consider this tradeoff, for full employment, to be acceptable.
In order to reduce unemployment to zero, capital needs to be diverted from other productive means, potentially leading to a chronic misallocation effect. MMT would argue that more money is always available to offset a misallocation, but in order to offset that misallocation, as we discussed earlier, we’ll be diluting the overall level of wealth through inflation, unless the government is successful in controlling it.
“Distortion in the cost of credit is the not-so-remote cause of the raging fires at which the Federal Reserve continues to train its gushing liquidity hoses. But the firemen are also the arsonists. It was the Fed’s suppression of borrowing costs, and its predictable willingness to cut short Wall Street’s occasional selling squalls, that compromised the U.S. economy’s financial integrity”
The prevalence of Quantitative Easing (QE) and the renewed interest in Yield Curve Control (YCC) has obscured the fact that these are unorthodox policies which have distorted the value of capital. QE is where a central bank purchases a specific monthly amount of assets (such as bonds). YCC is where a central bank purchases bonds in order to maintain a specific level of yield.
Interest rates and bond yields are mechanisms that help price discovery and the efficient allocation of capital. If I can borrow money for free, I might be frivolous with that money. If I can only borrow money at an annual rate of 10%, I’m going to use that money wisely.
If the fiscal authorities continue to suppress the market’s ability to price capital through bolder initiatives like MMT, then capital becomes less dynamic if it is constantly controlled by the central planners. Wealth creation (innovation) stagnates and if you devalue wealth, you undermine its creation. Stimulus would then be locked in an ever-expanding cycle in order to replace the loss of wealth creation.
The problem for the fiscal expenditure model (whether it is debt-fueled Keynesianism or the money manufacturing via MMT) is that it becomes a never-ending (infinite) stimulus in order to keep expectations in the changes of living standards on that upward trajectory. This is why households and then corporates have binged on debt in the past. MMT simply allows an economy to continue to rely on external financing (in this case, through fiscal spending) instead of finding ways to become internally competitive. If QE might have already set the stage for an economic depression, MMT will ensure that this will be the case and most likely with a multiplier effect.
If you stopped expanding (never mind removing) the stimulus, it would be profoundly deflationary because the productive capacity we have today has been inflated to a level that is far in excess of the natural or organic rate of demand, creating an imbalance of too much supply for too little (real or natural) demand.
In the current scenario, money printing would be fixing the problem of lower demand that should never have existed in the first place, because demand is simply trending towards its more natural level.
Policy makers would need to embark on round after round of stimulus, as they’ve been doing, directly or indirectly, rightly or not, since the Greenspan era. There would be no end in sight, apart from chronic inflation should the government mismanage the economy (which, to us, is quite likely to happen).
The MMT ‘solution’ for controlling inflation – taxation – would see living standards collapse and deflation quickly follow, because it would attack the very parts of the economic framework that had become bloated under MMT. This means that MMT doesn’t really change anything as it is likely to be faced with the same (but bigger and scarier) ghosts that we’re currently facing, but without having an answer for them either. MMT would again need to re-invent even more unconventional measures to plug the output gap. It would be never-ending.
Policy makers who favor the fiscal expenditure packages proposed by MMT believe they can control inflation. But policy makers who favored the monetary path thought that they could control deflation (something that was only partially true and very expensive for all but asset owners). If inflation gives way to hyperinflation, then the attempts to tax consumption back to manageable levels are likely to lead to deflation, although we can’t really know. What we do know is that MMT is aligned with how central banks and governments have decided to progressively respond to the problem of chronic lack of demand; it simply is a more extreme version of what we’ve seen to date.
The problem with these answers offered by monetary leaders and politicians is that they’re not solving the real problem (little demand) because the only way to solve it would be to, in our view:
Given that we can’t forecast the latter, we can only speculate on the former. The adjustment needed is incredibly painful on a social, political and economic level, which is why no one is incentivized to face reality. Everyone is aligned in kicking the can down the road.
And, whilst we keep on doing that, we’ll avoid facing the much needed adjustment at the expense of increasing the size of the problem. What we need to remember, though, is that we’re paying current demand with future demand, and the more we spend now, the less we’ll have in the future to spend.
And so, who will ultimately pick up the bill? Probably our kids, or their kids, depending on how long we can keep the charade in place.