Earlier this month, longtime bond bull Lacy Hunt waded into the MMT debate and it’s fair to say his assessment was some semblance of scathing.
“In historical cases of money printing, the countries were not the reserve currency of the world, as the U.S. is today”, Hunt wrote, in Hoisington Investment’s quarterly outlook report. “Thus, the entire global system could be destabilized in very short order if this were to occur.”
Needless to say, Hunt is not alone in suggesting that MMT is probably a bad idea or at least something that shouldn’t be allowed to escape the lab, run down the hill into the village and become actual policy.
What’s interesting about this debate is that while you’ll find no shortage of dour assessments with regard to the assumed catastrophic consequences of adopting MMT, what’s in short supply are trenchant explanations for why, exactly, the theory is flawed.
Jeff Gundlach, for instance, famously called MMT a “crackpot” idea last month during one of his rambling webcasts. Jeff’s subsequent effort to explain exactly why MMT is misguided fell a bit flat, though, when the DoubleLine boss bungled what he called “an old riddle” about three guys, an innkeeper and a bellhop. (And yes, that is just as funny as it sounds)
Other efforts to rebut MMT are similarly tainted by what amount to ad hominem attacks.
People have a hard time coming to terms with theories which ostensibly promise a “free lunch”. The knee-jerk assumption is that those theories must be inherently flawed. MMT advocates would likely tell you that the “free lunch” characterization is itself inaccurate – that lazily tossing out the term “free lunch” is indicative of efforts to undercut the theory by misapplying generic derision.
In my opinion, critics of MMT risk falling into the same trap as those who continue to insist (sometimes to the detriment of their P/L) that there are “limits” to what can and can’t be done in terms of accommodative monetary policy.
In a way, the post-crisis experiment in accommodation has made everyone a hard-money advocate. “This is unsustainable”, is a common refrain, as are shrill warnings about the purported “intrinsic” absurdity of large-scale asset purchases and arm’s-length deficit financing. Everyone seems to have bought into the notion that it “shouldn’t” work and these policies are somehow an affront to nature.
But it’s critical that you can separate things that are “absurd” in a comedic sense, from things that are “absurd” in the sense that they literally cannot work by virtue of forces that are beyond our control. Allow me a brief pseudo-digression in that regard.
There is, unquestionably, something amusing about the idea of printing an IOU denominated in a currency you also print and selling it to yourself with no middleman. With apologies to anyone who might be offended by my dumbing things down to that lowest common denominator, that is a giggle-inducing concept. Here is the full passage from the Hoisington quarterly outlook report mentioned above:
Under existing statutes, Fed liabilities, which they can create without limits, are not permitted to be used to pay U.S. government expenditures. As such, the Fed’s liabilities are not legal tender. They can only purchase a limited class of assets, such as U.S. Treasury and federal agency securities, from the banks, who in turn hold the proceeds in a reserve account at one of the Federal Reserve banks. There is currently, however, a real live proposal to make the Fed’s liabilities legal tender from this sale so that the Fed can directly fund the expenditures of the federal government – this is MMT – and it would require a change in law, i.e. a rewrite of the Federal Reserve Act.
This is not a theoretical exercise. Harvard Professor Kenneth Rogoff, writing in ProjectSyndicate.org (March 4, 2019), states “A number of leading U.S. progressives, who may well be in power after the 2020 elections, advocate using the Fed’s balance sheet as a cash cow to fund expansive new social programs, especially in view of current low inflation and interest rates.” How would MMT be implemented and what would be the economic implications? The process would be something like this: The Treasury would issue zero maturity and zero interest rate liabilities to the Fed, who in turn, would increase the Treasury’s balances at the Federal Reserve Banks. The Treasury, in turn, could spend these deposits directly to pay for programs, personnel, etc. Thus, the Fed, which is part of the government, would be funding its parent with a worthless IOU. In historical cases of money printing, the countries were not the reserve currency of the world, as the U.S. is today. Thus, the entire global system could be destabilized in very short order if this were to occur.
That analysis (accidentally) underscores the notion that MMT naysayers are conflating man-made constructs with natural laws.
The binding constraints some MMT critics implicitly claim exist, do not actually exist. All of this is, in one way or another, subject to our own laws and regulations. We can, in fact, issue IOUs to ourselves and use the funds we created to “purchase” those IOUs for whatever we want to use them for. You might think that’s distasteful, but the bad optics emanate entirely from our own misgivings about something that sounds silly, not from immutable truths enshrined in Newtonian physics.
Similarly, there is no such thing as “the market”. At a basic level, the idea of an “invisible hand” is nonsense. If you want to see the work of a real “invisible hand”, take a look at gravity – that’s an invisible hand. If I drop a bowling ball off the balcony, it’s going to hit the ground. Economics isn’t physics and a failure to recognize our own role in markets is a blind spot that very often leads to spurious conclusions. Here’s what I wrote in early December, for instance, when inversions in the 2s5s and 3s5s had some investors panicked:
…it’s entirely possible that the end-of-cycle trade is being pulled forward by traders themselves, who are looking at the curve and forgetting about their own role in shaping it.
Remember: there is no such thing as “the yield curve” outside of traders (carbon-based or otherwise). The bond market is something that exists because we made it up. Last time I checked, the Genesis creation story doesn’t have God creating the yield curve on any of his “working” days.
The point is, what you’re seeing when you look at the yield curve is you or else the actions of some algo you created to trade fixed income.
Not all of the above is strictly relevant to the MMT discussion (that’s why I called it a “digression”), but, I would argue, an overriding penchant for pretending as though there are natural laws governing man-made economic/market constructs is at the heart of many MMT critiques.
For instance, imagine a scenario where Japan simply cancels all the JGBs the Bank of Japan owns. Where is it written in stone that the yen has to collapse in that scenario? It might, but it might not, too (pardon the bad grammar). Here’s another passage from the Hoisington report, describing what Hunt says would happen were MMT put into action in the US:
There would be no real increase in services or money since very little time would lapse before people realized increasing inflation was not increasing real purchasing power. If the government responded by issuing more central bank legal tender, the inflationary process would become self-perpetuating, and as was the case in numerous historical instances this would lead to hyper-inflation. Moreover, the central bank would have no capability of reducing the money supply. All they could offer would be the zero maturity, zero interest liabilities of the government, but there would be no buyers. This would mean that hyper-inflation would be difficult to stop.
Note how many references there are in that paragraph to “would”. Everything is couched in terms of inevitability. But I’ll ask you again: Why is that inevitable? Show me where, in a physics textbook, you can find immutable laws that dictate the mechanics of this. If you can’t do that, then the cold, hard reality of this situation is that these dour prognostications are merely speculation based on (also somewhat subjective) assessments of the causes of historical instances of hyper-inflation.
Read Wall Street’s take on MMT so far
None of this is to pick on Lacy Hunt, of course. Rather, the point is simply to say that dire predictions about what it would mean if MMT were implemented aren’t hard to come by and they generally take the same form.
We’ve documented various MMT critiques in these page over the past two months and we also brought you a more constructive take, by way of a two-part “practitioner’s guide” penned by Kevin Muir, former Head of Equity Derivatives at RBC Dominion, now of EastWest Investment Management.
Part one of that two-part series elicited the following comment from Stephanie Kelton herself:
I had a similar experience after first encountering @wbmosler and then going down the rabbit hole to see if it all checked out. Great when others have the same intellectual curiosity.
The Macro Tourist Presents: A Practitioner’s Guide To MMT https://t.co/KCztQiWMtD
— Stephanie Kelton (@StephanieKelton) April 24, 2019
With all of that in mind, we wanted to highlight an interview with Lacy Hunt which comes courtesy of Erik Townsend’s MacroVoices podcast.
As regular readers are aware, Erik lands a lot of great guests and the discussions are always topical and timely.
Hunt’s comments on MMT (excerpted above) were highlighted by Bloomberg earlier this month and his remarks to Townsend help put things into perspective by placing the MMT discussion in the context of the broader debate about what’s next at a time when the world is awash in debt and policymakers have, by some accounts, reached the limits.
Below, find selected excerpts from the transcript as well as the full interview.
Erik: Okay, if I can just briefly summarize all of this to make sure that I have your view correct, you’re basically saying that here we go again. We’ve tried to solve a problem of too much debt with more debt. And, just as you can solve a heroin junkie’s withdrawal addiction by giving him more heroin, that works in the very short term but eventually it just makes the problem worse.
We’re coming, now, into, by the end of this year, that next slowdown where the Fed will very quickly be forced to go back to the zero-bound with the Fed funds rate. We’ll probably have to explore alternative, unconventional means of easing.
And this puts us back in a situation where, as you say, we’re not facing the conspiracy blogger scenario of the whole world blows up, but rather what we are facing is maybe the entire developed world kind of looks like Japan has looked for the last 20 or 30 years, which is extremely weak economic conditions because the country has been burdened with just too much debt.
And it sounds like you’re saying that the whole developed world takes on those symptoms and conditions. But, just as Japan has not blown up completely, the rest of the world doesn’t blow up. We just get stuck in a situation where the entire economy is slave to excessive debt.
Is that a fair summary of your views?
Dr. Hunt: I think it is a fair summary. And I think it is correct with historical analysis. The great David Hume, who is known as the father of the enlightenment, a tremendous thinker – Adam Smith, who was mentored by Hume said he was the greatest intellect of all – wrote a paper in 1752 called “Of Public [Credit]” which is on the internet. You can read it and it’s well worth reading.
And Hume looked at all of these cases of extremely over-indebted economies up until the point that he wrote the paper. He looked at the Mesopotamian and Roman Empires and a number of much smaller cases that have entirely been forgotten.
This is what he said toward the end of the paper: When a state has mortgaged all of its future revenues, the state lapses into tranquility, languor, and impotence.
So that’s the pattern. That’s the long slow grind downward. This has led me to develop an interest rate theorem that i think is very useful. And it surprises a lot of folks.
My interest rate theorem is that government debt accelerations lead to lower, not higher long-term government yields. And when the debt levels are already high, and there is an acceleration in debt-financed activity, there’s a transitory gain in economic activity but it doesn’t last very long. And then the economy weakens.
And when the economy weakens, then the inflation rate moves lower. And when the marginal revenue product of debt declines as it does today, it pulls the velocity of money down, which results in additional downward pressure on GDP growth. So the pattern is toward lower rates.
If you do a little simple exercise and graph the long government yields in Europe versus the government debt to GDP ratio – just put them on a graph, one on the left axis, one on the right – government debt to GDP, the government bond yield on the other. Do the same thing for Europe, do the same thing for China, and do the same thing for the US.
[From the Hoisington quarterly]
And what do you see? In all cases, the government debt to GDP ratio is rising substantially and the bond yield is declining. There is a negative correlation, not a positive correlation.
Japan is more pronounced, because they have been in this debt cycle longer than all the rest. We’re just in various stages of lag behind them. And that’s the course.
So there is a transitory gain. For example, the big surge in deficit spending last year, it produced an acceleration in GDP growth in the second quarter, a little bit in the third quarter. But, by the end of the year, it was really hard to identify.
And I think that that’s the case. The benefit from debt-financed activity is very fleeting. There is a benefit, but it does not last very long.
That’s what we’ve seen in Japan in numerous cases and what we’ve seen in Europe in many cases. And I think we’re going to start seeing now in China, when the big surge in debt that they’ve engineered this year really doesn’t produce the results that it has in the past. Because we’re further along the diminishing returns curve.
Erik: Let’s focus on that diminishing returns curve, because you said earlier that you expect the Fed, because of economic conditions, to have to take us back to the zero-bound. You said, because of this diminishing returns curve, it’s likely that they will have to do some kind of unconventional policy action.
But you said quantitative easing really hasn’t been that effective. And, of course, it is diminishing in its efficacy the bigger the balance sheet gets.
So what do you think comes next, if it’s not quantitative easing? Is it outright debt monetization? Or is it something else?
Dr. Hunt: Well, there are some folks out there, mainly the modern monetary theorists, that want to make the liabilities of the Federal Reserve legal tender. In other words, allow the Fed’s balance sheet to sort of operate as a cash cow and to pay for the Treasuries bills.
The Federal Reserve does not have that authority at present. The [Federal Reserve] 1937 Act, the principal author was Senator Carter Glass of Virginia, who also wrote the Glass-Steagall Act, did not intend to give them that authority. He consulted with Irving Fisher of Yale and other great monetary thinkers of the time, and they did not give the Fed that authority.
The Fed can only use its balance sheet to buy a select group of assets from the banks, government, and agency securities – and then those proceeds have to be held at the Federal Reserve bank. So the money supply is equal to the monetary base and the money multiplier, which is endogenous and which the Fed does not control.
And, regardless of what you have heard – and there was once a statement, which was eventually corrected, from Ben Bernanke that in quantitative easing the Fed was printing money – but the Fed does not have that capacity. It doesn’t have the mechanism or the tools to print money. For them to be able to print money you would have to rewrite the Federal Reserve Act.
Now you could go down that route. But what would happen in that case is in very, very short order we would get hyperinflation. Because the aggregate demand curve would shift upwards, the money multiplier would no longer be relevant, and prices would rise as fast as the increase in the money supply and eventually faster.
And something called Gresham’s Law would take effect. The bad money would chase out the good money. People would not be willing to exchange money for commodities, return to barter. There would be massive inefficiencies.
In the old days, when countries made the central banks’ liabilities legal tender, we of course had many smaller producers. Maybe somebody produced eggs and someone else produced milk and someone else baked bread, and you could then barter.
But, today, we all have specialized skills. It would be hard to barter specialized skills. And, of course, we have the mass merchandiser that couldn’t operate with a barter system.
Also in the past, when the Federal Reserve’s liabilities were made legal tender, those currencies were not the reserve currency of the world. So if we were to do that, it would quickly destabilize the global monetary system.
That’s the siren song, and some people are advocating it. But if we were to make the Fed’s liabilities legal tender, in very short order nearly 100% of our people would be miserable, absolutely miserable.
Erik: So let’s assume that your scenario plays out. The economy worsens through the rest of 2019. We go into the election year of 2020 in either recession conditions or rapidly approaching recession conditions. It’s not looking very good for the incumbent party.
Suddenly we end up with President Bernie Sanders, Vice President Alexandria Ocasio-Cortez, and they appoint Professor Stephanie Kelton as the new Federal Reserve Chairman. Stephanie Kelton, of course, is one of the major proponents of modern monetary theory – the view that it’s perfectly okay for the government to create as much money as necessary as long as there is not an immediate inflation risk.
Obviously, that’s an extreme hypothetical. I don’t know that we would ever get there. But for sake of argument, let’s assume that there is a pivot in social mood to where suddenly more government spending – things like universal basic income, using modern monetary theory to pay for more social spending, forgiveness of student debt, maybe even government subsidized free university tuition – those kinds of things that the political left has begun to focus on sort of come true in terms of those people coming into power.
What does that do to your outlook for fixed incomes? Because, obviously, those would be very inflationary conditions.
Dr. Hunt: Well, if you make the Fed’s liabilities legal tender, then all bets are off. And the inflation rate would begin to rise rapidly and that would require a different investment strategy. There is no question about that.
But if there is an attempt made to rewrite the Federal Reserve Act, you’re going to have a little bit of time because it would have to go to the House and the Senate. They would have to pass compatible bills and go to the President.
Under the right political circumstances, they could do that. But, even in the best of circumstances, the process would take a little time. And so that would give investment managers an opportunity to reposition their portfolios.
I might also add that the leadership of the Federal Reserve would have to be changed. That could be done as well. But all these things would take time. It couldn’t be done overnight, because the Fed does not have the current capacity.
Now you might do something like this: You might say, well, we’ll have an announcement from the Fed that they will increase the balance sheet – if the deficit is going to be $2 trillion or $3 trillion, they’ll increase the Fed’s balance to $3 trillion.
But we already really tried that in 2012 and 2013. The increase in the Fed’s balance sheet in those two years equaled the budget deficit. But, you see, in that particular case, existing under the Federal Reserve Act, the money supply is still equal to the base times little m, the money multiplier.
So you would have the Fed buy the government’s securities. But the banks would not be able to employ it unless they had the capital to utilize the excess reserves, which was the same problem that constrained the banks from turning the balance sheet into an acceleration in money supply growth.
So when we had quantitative easing, the Fed’s balance sheet quadrupled but the money multiplier dropped from 9 to 3. And the rate of growth in money supply did not accelerate.
The only thing that would really be different would be if there was a concerted effort to make the Fed’s liabilities legal tender. And my read is that that requires a rewrite of the Federal Reserve Act and also some other companion legislation as well.
It could be done under the right political circumstances. But ,as for the time being, it cannot be done.