Modern Monetary Theory (MMT), is becoming all the rage now among progressive economic thinkers. The simplest way to explain MMT is that sovereigns like the US, Japan and UK, who issue in their own currency can never default, hence deficits mean absolutely nothing in the short run, and maybe even in the long run. On the other hand, for the 19 members of the European Union who have willingly ceded their monetary sovereignty to the ECB, deficits do matter since they cannot print their way out of their troubles, unless the ECB does it for them.
Using the language of Stephanie Kelton’s new book “the Deficit Myth”, Uncle Sam is a money issuer, while the nations of the European Union are money users, and therein lies the difference. In countries like the US, Japan and UK, more deficits mean more money in bank reserves, which means lower, not higher interest rates. Interest rates in these countries are a policy variable, set by their Central Banks at whatever levels they want to. In countries like Greece, Italy and the like, more deficits, if they were allowed, would mean interest rates and spreads as set by the market, and can only be set by the Central Bank if it was blissfully ignorant of the distortions it creates across the member economies.
I do not agree with all the tenets of MMT, just like I do not agree with all the tenets of “New-Keynesian” economics that is the doctrine of the day at the Fed, or even the Friedmannian “monetarist” school, which was the doctrine of the Fed almost half a century ago. But it does seem that with no perfect theory that has worked in preventing bubbles and busts, the money makers in Washington today are being pulled in the direction of what MMT says. So as open minded investors, it behooves us to imagine – if the Fed actually embraced MMT, reluctantly maybe, what does it possibly mean for markets? If anything, I would likely argue, it is massive fiscal stimulus in the guise of a monetary policy, which is hard to argue with. I cannot help but wonder whether this stimulus has something to do with, for example, Hertz (HTZ) filing to issue new stock this week even as it declares bankruptcy; or a company such as Nikola (NKLA) reaching a market cap of almost twenty five billion dollars with a handful of employees and no revenue (Source: Bloomberg).
But before we go into the broader implications for the market, it is important to note that the basis of MMT is the following foundational assumption: the Federal government does not need the people’s money via taxes or via borrowing; it first prints money and gives it to the people so that it can use the money to keep account. Kelton calls this the “STAB” model, i.e. spending comes before taxes and borrowing. This is different from what classical economics teaches us, where taxes and borrowing has to come before spending. Since it has monopoly issuance power for the currency, the Fed uses this monopoly to put the money in circulation, and takes it out by taxation, or converts it to a future liability by borrowing. Taxation is then a way to balance who gets to keep it and when, and borrowing is a way to give people a way to move today’s money into the future. So the government, under MMT, does two things: it makes a “horizontal” transformation by re-distributing money, and a “vertical” transformation across time from savers to borrowers, or vice versa.
This is all a massively oversimplified description, but I believe that it summarizes in practical terms how MMT works. Which brings us to the main risk of MMT as described by its proponents. Most MMT economists would say that the main risk to MMT is that the irresponsible sovereign prints more money than is needed to keep the game going, leading to excessive money in the “wrong” places. This excess spending would result in inflation, and eventually bring down the standard of living if growth in the economy is not keeping up pace. Most MMT economists, however, also don’t count financial asset price inflation as part of inflation; it matters little if your inflation metric is CPI, PPI, the GDP deflator or what not. If asset prices are not in the inflation metric, then “voila”, one can print an infinite amount of money as a sovereign, and since there is no inflation, presumably there is no harm done.
But experience tells us that when too much money goes into financial asset markets, they become more vulnerable to crashes. When the market crash eventually happens, the Fed steps in again, to…print more money, i.e. to pump asset prices back up. And the cycle continues, because the Fed can always print more money. And yes, sharp rises in asset prices also eventually result in inequality between the rich and the poor since the rich are typically the ones who predominantly own financial assets, but this is not a forum to discuss social matters.
We do know that as long as the price of goods does not rise by too much, those who spend their money to buy these goods don’t complain much, and as long as financial asset prices don’t fall much, those with assets don’t complain much. But if financial asset prices fall sharply and goods prices rise a lot, everyone complains, forcing the hand of the government and the Fed. Which is why we have the Fed now underwriting direct purchases of corporate bonds, and soon, as in Japan, equities. As my former colleague Mohamed El-Erian has beautifully written in his book, they are “The Only Game in Town”, and they know it. The sooner investors realize that the Fed has unlimited power to create bank reserves and extend credit against the reserves to itself buy assets and force others to buy assets, the sooner they will realize that fighting the Fed when it comes to asset prices is a foolish game.
So that’s where we are today. Yet again, the Fed has saved the world, by buying assets when people panicked and sold them. The Fed has taken the elements of MMT and opened up the money spigot and credit window wide open, albeit the main beneficiaries so far have been owners of capital. Asset prices are again close to all-time records. There are no signs of inflation (again, because asset prices are not in the CPI), so for now all appears to look good. The Fed does not control the economy, but it does control financial markets. Classical economic thinking that does not have financial markets as a key element of their theory are just as outdated as Newtonian mechanics in the quantum world.
For US based investors, the directives seem to be clear for now: (1) Buy every dip in stocks, (2) Don’t worry about inflation, (3) Spend like your life depended on it. On the other hand, in countries where the sovereigns do not have the ability to print in their own currency, or those pegged to a foreign currency, or those who borrow a lot in foreign currency, the lessons are exactly opposite: (1) Do not buy the dip unless you are sure there are fundamental economic reasons to do so, (2) Do worry a lot about inflation, (3) Save like your life depended on it. And yes, I mean this for the Greeks, the Italians and all the others who are at the mercy of an ECB that has consistently failed in delivering on its promises.
Putting these themes together, it appears that investors and market participants alike might be well-served, at least for the time being, to consider over-weighting US stocks over Europe and Emerging Markets, over-weighting US Treasuries over bonds of countries who cannot issue in their own currency, and generally betting on sectors, like retailers, that will likely benefit from a return to spending in the US once the COVID-19 shock wears off.
At some point, it is likely the Fed will backtrack from its blanket support of markets, but until then, it is time to crawl out from under the rock and carefully participate in the next melt-up in US markets. Europe, unfortunately, is a completely different story.