MMT In Practice
While MMT may seem like a purely theoretical construct, it should be recognized that many governments, including the U.S. government, are effectively already putting MMT into practice.
After years of fiscal restraint, Congress passed the Tax Act of 2017, even when the economy was close to full employment, leading to a sharp widening of the Federal deficit in 2018. This year has, of course, seen a much more significant increase in the deficit in reaction to the social distancing recession with the federal debt rising from 79% of GDP this time last year to likely over 105% of GDP next year.
The Federal Reserve, while ostensibly engaging in QE to hold long-term interest rates in check has, in practice been monetizing the debt, ensuring that, at least for now, the federal government can run a huge deficit, financed at very low interest rates. Indeed, since the start of the year, while the federal government has added an astonishing $3.7 trillion to the federal government debt, the Federal Reserve has increased their Treasury holdings by almost $2.1 trillion, financing more than half of the additional debt.
It should be noted that since all the profits earned by the Federal Reserve on its portfolio are paid to the Treasury, this is essentially an interest free loan. It should also be noted that to achieve this increase in assets, the Fed has also permitted an enormous increase in its reserves, which has, in turn, led to a huge surge in the money supply, with M2 growing by more than $3 trillion, or 21% since the start of the year.
The Problem With MMT
The danger, of course, is that this could all end very badly. For as long as inflation remains low, there seems little cost to this massive increase in the money supply or in total financial assets.
However, the problem is that each dollar of the money stock, and indeed of financial assets in general is, essentially, a coupon, entitling the bearer to some share of the goods and services produced by the U.S. economy. If I have money in a bank account or a mutual fund, I didn’t accumulate it just to look at the pretty numbers. I assume that, at a time of my choosing, I can cash in these assets for some goods and services.
The danger in the rapid expansion of these financial assets, which MMT would only accelerate, is that there could easily come a time when the holders of those coupons begin to notice how many more coupons are floating around, and begin to worry that they won’t be able to redeem them for as many goods and services as they thought. This could cause more people to try to convert these coupons into assets of more security.
Holders of small cap growth stocks might decide that large-cap value stocks or bonds were a safer bet. Holders of long-term bonds might worry about an inevitable rise in interest rates and seek greater security in cash. And holders of cash might decide that real assets such as real estate or commodities or even foreign currencies managed in a more responsible manner would be a better bet. If, of course, this were to cause rising commodity prices, rising money velocity or a falling dollar, it would add to the inflation problem. It is also not clear that the government would have the intestinal fortitude to raise taxes in this environment, as MMT would recommend, or have any clue how much to raise them to restore faith in the currency and financial assets.
Moreover, there is no reason to believe that this would all happen gently. If investors and consumers suddenly began to expect higher inflation, interest rates could rise sharply both because of an increase in expected inflation and uncertainty about how much that inflation could be in the future. Many of the economies of Latin America provide a contemporary and stark warning about what can happen to an economy when people lose faith in its money.
It should be emphasized that there is nothing imminent or inevitable about this outcome. Inflation is very unlikely to spiral higher 2020 or 2021 in an economy of still high unemployment. Moreover, responsible fiscal and monetary policy in the aftermath of the 2020 elections should probably still be able to alleviate the situation.
However, for investors, it is important to consider how to protect themselves if such policies are not adopted and we find ourselves, within a few years, in new paradigm, where, in sharp contrast to the last few decades, inflation trends up and many financial asset prices trend down.
David Kelly is chief global strategist at JPMorgan Funds.