Is modern monetary theory and the saviour of the economy or a pathway to economic damnation?
The following article is authored by two investment luminaries from Epoch Investment Partners: William W. Priest, CFA — Executive Chairman, Co-CIO and Portfolio Manager Kevin Hebner, PhD — Managing Director, Global Investment Strategist. The article explores modern monetary theory and whether it’s the saviour of the economy or a pathway to economic damnation.
Proponents of modern monetary theory (MMT) assert that governments can and should fund their spending simply by printing money. From their perspective there is no limit to government debt issuance, provided two conditions are met:
- The country controls its own printing presses and currency
- Inflation remains benign.
Under these circumstances, MMT acolytes envisage a complete convergence of fiscal and monetary policy, which should be used to finance ‘mission-oriented spending goals’.
A key implication of MMT is that, once COVID-19 is finally brought under control, there will be no debt ‘hangover’ and no painful period of austerity. Moreover, we can keep spending and racking up deficits until the unemployment rate falls back to 4% and the output gap has closed.
That sounds awfully enticing, like we’ve finally discovered the philosopher’s stone and are now capable of transforming lead into gold. And it’s easy to see why MMT has become so popular with politicians. What ambitious government wouldn’t want to dodge difficult macro trade-offs and be freed from binding financial constraints?
“We have let our imaginations become far too limited, and it’s holding us back:… There are limits. However, the limits are not in our government’s ability to spend money, or in the deficit, but in inflationary pressures and resources within the real economy. MMT distinguishes the real limits from the delusional and unnecessary self-imposed constraints.”
— Stephanie Kelton, “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy,” June 2020
Before this year’s crisis, this perspective was viewed as quite arcane and eccentric, but it’s important for investors to understand because, while not yet explicitly acknowledged by policymakers, we already live in an MMT world.
Almost to the dollar, the Fed has monetised the unexpected US Treasury issuance resulting from COVID-19. Further, the Fed has adopted a yield curve control policy (so far just implicit, but likely to be made explicit during the next year or two) and is constantly badgering the Trump administration to increase fiscal spending.
One consequence is that MMT expectations have been a key driver of the equity market’s resilience over the last six months. Moreover, investors remain confident that any economic weakness over coming quarters, possibly due to a second wave, will be met with additional fiscal stimulus and an immediate 1:1 ramp up of QE purchases by the Fed.
“Unfortunately, because of the crisis, we have actually taken a number of steps which are heading into new territory—and so we’ve done some version of MMT to some extent to deal with this crisis.”
— Robert Kaplan, President of the Dallas Reserve Bank, June 15, 2020
Monetary policy does not operate in a political vacuum and MMT advocates are well represented on both sides of the aisle, with the pandemic creating a natural catalyst for ambitious fiscal policies to be embraced. For example, Joe Biden has campaigned on promises of greater public spending on education, health care, the environment and infrastructure, while President Trump is calling for additional fiscal stimulus and yet another round of tax cuts.
Whoever wins on November 3, we can be confident in predicting more deficits, more debt, and more monetisation, which raises the question of when the bill will come due and who will pay for it. Given this year’s extraordinary and unprecedented policy response, the consensus view has evolved and now conjectures the answer is nobody, so that we can keep enjoying this proverbial ‘free lunch’ ad infinitum. Could it really be that simple?
Managing inflation risks: the critical challenge
MMT advocates, such as Kelton, do acknowledge one practical limit on their spending plans, acceding that every economy has a ‘speed limit’ where the output gap is closed, the labour market becomes too tight and inflation begins to accelerate. From there, MMT bravely assumes that the inflationary consequences of fiscal policies can be forecasted accurately and that, well before the economy reaches the inflation tipping point, our wise and benevolent policymakers will proactively hike taxes, by the exact right amount and at the exact right time, to pull us back from the brink.
Unfortunately, there are a multitude of ways this could go wrong including:
- Reasonable people could disagree on the size of the output gap and the risk of inflation accelerating, especially given there is no one, universally agreed upon model of the economy
- Given that policy lags are famously long and variable, it is easy to misjudge and either hike taxes by too little, thereby allowing inflation to soar, or too aggressively, and with that inducing a severe recession
- Partisan differences could well come into play, providing incentives to delay policy tightening, especially if there is a pet project under consideration or an election on the horizon.
Moreover, the historical track record of countercyclical tax policy should provide us with little to no confidence that this would work. Rather, it is more likely that bond markets would take fright as they see the fiasco unfolding, pushing the economy into a painful and prolonged recession. The role of bond vigilantes is especially critical, and perilous, given the record-high levels of government and corporate debt that already exist and would assuredly become even more extreme in an MMT world.
A short, medium and long-term view on inflation
Regardless of our skepticism and apprehension, MMT is already in play, which means investors need to understand its implications and risks. As Kelton emphasizes, “Managing the inflation risk is the critical challenge. More than any other economic approach MMT places inflation at the center of the debate.” Given that entirely appropriate frame of reference, we now provide three different perspectives on the inflation outlook.
Starting with the short term, the pandemic has accelerated the digitisation of the economy. All five digital trends are inherently disinflationary, but so far, we only have anecdotal evidence regarding telehealth, e-fitness, work from home and ed-tech.
Fortunately, the fifth example, e-commerce has been around for much longer, so that we now have hard data on its disinflationary impact (Figure 1). Of the 18 different categories represented in the overall Digital Price Index, all but two (groceries and flowers & related gifts) have exhibited negative price trends since the series’ inception in 2014. By contrast, the conventional Consumer Price Index has risen by 10% during this period[1].
Next, turning to the medium term, there has been a clear decline in inflation over the last four decades (Figure 2). Moreover, forward-looking metrics tell the same story, with inflation expected to remain benign for the foreseeable future, with only a small probability of a breakout above and beyond 2%.
While there are a number of factors behind this secular trend, including demographics, globalisation and the success of inflation-targeting central banks, we believe the most important reason is the rising prominence of digital technologies that, as discussed above, are inherently and profoundly disinflationary.
Figures one and two help us to understand why MMT has become the new orthodoxy, embraced by policymakers and politicians from both sides of the aisle. Rising inflation is the Achilles heel of MMT, but it has been tame for decades now, and our base case features benign inflation, lower for longer interest rates and an enduring world of yield starvation.
That said, it strikes us as ahistorical and dangerously naïve for policymakers to willfully dismiss the risk of an inflationary spike. Taking a longer-term perspective, it is clear that inflation shocks are a regular, if infrequent, occurrence (Figure 3). Moreover, in such a scenario, the damage inflicted on an economy that has followed the tenets of MMT and maxed out on debt would be severe indeed.
Conclusion and investment implications
While not yet explicitly acknowledged by policy makers, we already live in an MMT world. One consequence is that expectations of government debt monetisation have been a key driver of the equity market’s resilience over the last six months. Moreover, investors remain confident that any economic weakness over coming quarters will be met with additional fiscal largess and an immediate 1:1 ramp up of QE purchases by the Fed.
Moreover, we can be confident that, regardless of who wins on November 3, there will be more deficits, more debt and more monetisation by the Fed.
Rising inflation is the Achilles heel of MMT, but it has been tame for decades now, partially because of the rising prominence of digital technologies which are inherently and profoundly disinflationary. Consequently, our base case features benign inflation, lower for longer interest rates and a continued world of yield starvation.
There are numerous implications for investors, but we will just conclude with two here.
First, turbo charged by lower for longer interest rates, we expect long duration digital platforms to comprise the vast majority of S&P 500 market cap by the end of the decade, with tech, health care and communications the most promising sectors.
Second, in a world of yield starvation, with central banks holding policy rates at or close to zero for the foreseeable future, the best — really, the only — alternative for investors who seek income is a diversified portfolio of high-quality equities paying attractive, growing dividends supported by underlying, growing cash flow.
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