‘Miserable’ Myths

It’s now widely (if begrudgingly) accepted that many developed nations are engaged in a version of Modern Monetary Theory. The pandemic forced the issue.

For more than a decade, policymakers, economists, and analysts, persisted in the exceedingly ridiculous notion that all a central bank needs to do in order to escape charges of debt monetization is i) insert a middleman between itself and its bond-issuing sovereign, and ii) insist that at some undefined future date, the balance sheet expansion engendered by the purchases will be unwound.

A central bank that buys trillions of its own government’s debt from an intermediary is engaged in “accommodative monetary policy” which, while potentially risky for a laundry list of reasons, is academically acceptable and, if not exactly “embraced” by everyone steeped in the debate, won’t get you ostracized or disinvited from dinner parties. Debt monetization, on the other hand, is taboo. Suggesting it should be implemented as public policy risks being brought up on charges of heresy in the court of budget rectitude, not to mention excommunicated from academic circles where the maintenance of orthodoxy is seen as important despite the fact that economics is most assuredly not a hard science.

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None of this is to say that Modern Monetary Theory is advisable (or even feasible) for every nation. In the same vein, economics is more or less scientific/deterministic depending on a given country’s place in the world and current circumstances. For example, Recep Erdogan drives Turkey to the brink of a currency crisis at regular intervals by failing to acknowledge that, for a variety of obvious reasons, his country does not belong to the club of nations that can afford to be cavalier with monetary policy.

But for the US (and also to greater or lesser degrees for the UK, Japan, Europe, Australia, New Zealand, Sweden, etc.), the notion that the government is constrained in its capacity to spend on behalf of the economic welfare of its citizens is only true to a point. Absent an unacceptable rise in inflation, that constraint doesn’t actually exist.

What we’ve learned in the post-financial crisis world, is that while placing a middleman (primary dealers) between central banks and governments issuing bonds gives everyone implausible deniability when it comes to charges of debt monetization, it also dooms the entire enterprise to failure if the liquidity doesn’t end up in the real economy.

Commenting Sunday on the prospect of central bank digital currencies, Nordea’s Andreas Steno Larsen referenced recent remarks by Lael Brainard.

“The no-bulls&%t translation of [her] speech is basically that the Fed is looking into giving each and every American an account at the Fed, which could pave the way for actual ‘People’s QE’ when the next crisis makes it necessary to increase the money supply markedly in an attempt to prop up inflation while keeping unemployment down”, Steno Larsen wrote, adding that,

It may not be such a bad idea compared to decade-long (or even eternal) asset purchases. After all, we have gathered fairly decent empirical evidence that asset QE only shows up in higher house, equity, bond, and gold prices, which is not exactly the kind of inflation that the Fed is truly after (at least officially).

“Fairly decent” is a generous way to describe the “evidence” — I’d call it virtually irrefutable. Preserving the charade by leaving a middleman between central banks and the government bonds they’re buying isn’t just superfluous, it’s deleterious in the extreme, especially given the extent to which asset price inflation serves to perpetuate inequality.

I always use the same language to describe this. The transmission mechanism through which monetary largesse acts on financial asset prices is orders of magnitude more efficient than the channels through which those same policies act on the real economy.

The black line (figure below) dropped precipitously during the last two recessions as asset prices reacted to massive busts. It recovered its pre-recession levels more rapidly following the GFC than it did after the dot-com collapse. You can see a blip lower on the right-hand side representing Q1 2020. This time around, it will likely recover in no time flat — probably within two quarters given the record-fast recovery in financial asset prices.

This is what Steno Larsen means, and one way to short-circuit it is to simply drop the charade and have the central bank buy debt directly from the issuing government — overt debt monetization.

Critics shriek at the notion, and many will point to their own criticism of the post-financial crisis monetary policy regime as evidence that they are being genuine. And yet, when pressed to reconcile the rather glaring disparity between, on one hand, their criticism of QE for the extent to which it exacerbated inequality and failed to produce robust outcomes in the real economy, and, on the other, the rather self-evident fact that removing the middleman and ushering in overt debt monetization would fix that problem assuming lawmakers direct the funds to public works projects (for example), those critics refuse to engage. Or at least refuse to engage honestly.

Instead, they’ll fall back on i) the Venezuela straw man (i.e., hyperinflation), ii) the same misinformation about debt and deficits in advanced economies that’s been foisted on the American public for decades, or some combination of both.

One of the most pernicious aspects of this mind warp, is the extent to which false statements are trotted out not just as truth, but as immutable laws whose fundamental veracity can be established by reference to common sense. In fact, however, common sense often dictates precisely the opposite.

Consider, for example, the following exchange between Bloomberg’s Brian Chappatta and Lacy Hunt:

Brian Chappatta: The Treasury is issuing a record amount of debt and the Fed’s balance sheet has grown by $3 trillion. Has this changed your thinking at all around the interplay between debt, growth and inflation?

Lacy Hunt: The measures taken to ameliorate the recession, in terms of trying to help people in distress, while they’re popular and humane, they’ve resulted in a massive increase in the debt overhang. The pandemic will eventually go away, but the debt will remain. It’s been my view that over-indebtedness ebbs economic growth. Debt is a double-edged sword: It’s increasing current spending in exchange for a decline in future spending unless it generates an income stream to repay principal and interest.

With apologies to Lacy, that’s a lie. He’s essentially conflating private debt (e.g., how you would think about your own household balance sheet) with that of the US government. And given Lacy’s curriculum vitae, it is impossible to call it anything other than that. He knows better. So, he’s simply perpetuating a myth. And the fact that he surely means no harm doesn’t really ameliorate the situation.

The exchange (below) is from an interview between Dissent magazine and MMT patron saint Stephanie Kelton, whose bestseller “The Deficit Myth” could scarcely have been released at a more opportune time. Read it, then re-read Hunt’s remarks to Chappatta.

Dissent: Why isn’t the fact that the U.S. government is going to accrue trillions of dollars of debt a burden on future generations?

Kelton: The deficit hawks try to convince us that at some point, it has to be paid back, and that the bill is going to fall on the rest of us. That’s not the case at all. Calling this thing the national debt is a big problem. What’s really happening is that the government is basically making some of its payments with interest-bearing dollars. We call those dollars U.S. Treasuries. Unfortunately, we call the entire stockpile of these financial instruments the national debt. And the word “debt” creates all sorts of unnecessary anxiety in people. It reminds people of their credit card debt, their car payment, their student loan debt, their mortgage, and they say, “Well, debt can be dangerous. I don’t want to be in debt. I don’t want too much debt. My country is in debt, so that’s bad.”

There isn’t any question about who is “right” in this situation. Hint: It’s not Lacy.

The purported “debate” between Kelton and those who claim Modern Monetary Theory is a “dangerous” fantasy, isn’t really a debate. That’s another mind warp. Kelton describes how the system literally works and what things actually are. It’s a real-life, economic version of the famous “red pill, blue pill” decision from The Matrix.

Her critics, on the other hand, generally describe what they imagine will be the end result if too many people wake up to those realities. That’s a key distinction.

Note how I described the standard reaction of those critics above. Invariably, they will correctly identify the problems with QE, but then, when confronted with the prospect that Modern Monetary Theory addresses those problems head on, they either refuse to engage or resort to straw men arguments and/or misinformation.

With that in mind, below find Hunt correctly identifying the problem, but then, when asked by Chappatta whether Modern Monetary Theory might correct it, resorting to questionable tactics:

Hunt: When the Fed initiated QE1, QE2 and QE3, folks said those policies were very inflationary. There is a liquidity effect of what the Fed is doing, and the liquidity effect can be very powerful over the short term. But ultimately the increase in the money supply did not follow through after the rounds of Fed purchases of government securities because the banks couldn’t utilize the reserves, they didn’t have the capital base to make the loans, they had to charge a risk premium in an environment in which the risk premium was rising very dramatically and the borrowers couldn’t pay the risk premium. There was no secondary follow-through in terms of money supply growth, and the velocity of money fell and the growth rate fell back after a transitory rise. And I don’t really see this as any different.

Keep in mind, when the Fed comes in barrels open like this, the program initially looks successful because it unblocks what problems existed in the markets. But it’s the job of the economist to understand the unintended consequences. When the Fed comes in and they have this tremendous success, which gives the appearance that the inflation process is starting, they thwart a couple of important mechanisms that make the free enterprise system work: creative destruction and moral hazard. The first-round effects of the Fed look effective, and they’re widely hailed, but they make the economy even more overleveraged than it was before and credit is allocated to those who are not really in a position to generate economic growth from it. We’ve seen numerous similar programs in Japan and Europe and it looks like the central bank has the capability to do whatever it takes. They certainly have the ability to calm and reliquify markets, but those actions then compound the underlying problem, which is the extreme over-indebtedness. You get a transitory boost, you get a liquidity effect, but that liquidity effect runs out very quickly.

Chappatta: I want to ask you about the rise of Modern Monetary Theory within economics, and some proposals to have the Fed give money directly to individuals. 

Hunt: The great risk is that we become dissatisfied with the way things are, and either de jure or de facto, the Federal Reserve’s liabilities are made legal tender. 

The Federal Reserve as it’s constituted today can lend but it cannot spend. Now, they’ve done some things that are different from what the Federal Reserve Act said under the exigent circumstances clauses, but so far they’re lending. They’re not directly funding the expenditures of the government in any meaningful way. But there are folks who want to use the Fed’s liabilities for that purpose.

There are folks who want to make the Fed’s liabilities legal tender. Now, if that happens, then the inflation rate would take off. However, in very short order, everyone would be totally miserable because no one would want to hold money. You would trigger  Gresham’s Law – people would only want to hold commodities they can consume and commodities that can be traded for others. 

I’ve assessed that claim from Hunt (that “everyone would be totally miserable”) in these pages before, only back then, I had a sense of humor about it because the world wasn’t suffering from the worst public health crisis in a century, and 22 million Americans hadn’t just lost their jobs.

Suffice to say I’ve lost my sense of humor with Lacy’s “miserable” thesis. Everybody’s already miserable. 30 million Americans didn’t have enough to eat late last month. People are (quite literally) rioting in the streets.

In acknowledgement of my own shortcomings when it comes to engaging in constructive dialogue once I’ve lost my sense of humor about something, I’ll just give the last word to Kelton and let readers draw their own conclusions.

Dissent: In your book, you claim that misplaced emphasis on the fiscal deficit covers up other deficits that we should be really concerned about. What do you mean by that? 

Kelton: Today, there is a yearning to return to normal. But what did normal, before the pandemic, look like? Several trillion dollars of needed repairs in our crumbling infrastructure. Normal was 87 million Americans who either didn’t have health insurance or were underinsured. Normal was 500,000 medical-related bankruptcies every single year in this country. Normal was 40 million people living in poverty. Normal was millions of people who aren’t prepared for retirement; who can’t afford to send their kids to school or can’t pay back their student loan debt. Normal was 40 percent of families not having $400 set aside to handle an unexpected financial emergency. Normal was a great city like Flint, Michigan, not having safe water. These are the deficits that matter. Those are the kinds of shortfalls that I wish that we were all worried about.

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