Modern Monetary Theory (MMT)

Simply put, MMT is the idea that for a country that issues government debt in its own currency budget deficits don’t matter.   The government can simply print more money if it wants to spend more than it collects in taxes.

Although the theory has been around for a while (the first Google result I got was a critical opinion piece from almost a decade ago), it’s been revived recently by “progressive” Democrats arguing for dramatically increasing social welfare spending.  For them, the answer to the question “What about the Federal deficit?,”  is “MMT,” the government can always issue more debt/print more money.

MMT reminds me a bit of Modern Portfolio Theory (MPT), which was crafted in the 1970s and “proved” that the wild gyrations going on in world stock markets in the late 1960s and the first half of the 1970s were impossible.

 

Four issues come to mind:

–20th century economic history–the UK, Greece, Italy, Korea, Thailand, Malaysia, lots of Latin America…   demonstrates that really bad things happen once government debt gets to the level where investors begin to suspect they won’t be repaid in full.

This has already happened three times in the US: during the Carter administration, when Washington was forced to issue Treasury bonds denominated in foreign currency; during the government debt crisis of 1987, which caused a bond market collapse that triggered, in turn, the Black Monday stock market swoon a few months later; and during the Great Bond Massacre of 1993-94.

In other words, as with MPT, the briefest glance outside through an ivory tower window would show the theory doesn’t describe reality very well

–the traditional case for gold–and, lately, for cryptocurrencies–is to hedge against the government tendency to repay debt in inflation-debased currency.  In other words, every investor’s checklist includes guarding against print-more-money governments

–excessive spending today is conventionally (and correctly, in my view) seen as leaving today’s banquet check to be picked up by one’s children or grandchildren.  In the contemporary cautionary tale of Japan, the tab in question has included massive loss of national wealth, a sharp drop in living standards and economic stagnation for a third of a century.  No wonder Japanese Millennials have a hard time dealing with their elders.

Why would the US be different?  Why are Millennial legislators, of all people, advocating this strategy?

–conventional wisdom is that the first indication that a government is losing its creditworthiness is that foreigners stop buying.  This is arguably not a big deal, since foreigners come and go; locals typically make up the heart of the market.  During the US bond market crisis of 1987, however, the biggest domestic bond market participants staged the buyers strike.  Something very similar happened in 1993-94.  I don’t see any reason to believe that the culture of the “bond vigilante” has disappeared.  So, in my opinion, the negative reaction to a policy of constant deficit spending in the US is likely to be severe and to come very quickly.

should the US dollar be strong or weak?

This is the question President Trump purportedly called his adviser, Michael Flynn, to ask at 3am one recent morning.  Flynn, to his credit, said he didn’t know.

Perhaps the genesis of the inquiry is the odd position Mr. Trump has put himself in of criticizing Germany (and by implication the EU as a whole) for damaging the US by having a currency that’s too strong while berating China for damaging us by doing the opposite.

It may also be economists’ comments that the Republican Congressional proposal to introduce a value added tax on imports could trigger a sharp appreciation in the dollar, thereby making exports from the US that much less attractive.

What is the best strategy for the US?

First of all, we should recognize that there’s no generally accepted economic framework that deals with currency.  There are lots of theories for particular aspects of currency relationships, but no one go-to theory.

Also, the US is in the unusual position of being the only universally accepted reserve currency, making the US is in effect the banker to the world.  So rules that apply rigorously to others may not, for good or ill, hold so firmly for us.

 

In 30+ years of dealing with foreign currencies as an equity investor, I think the issue can be summed up in practical terms to the question:  “If this country were a person, would I feel comfortable lending money to him?”

The factors that have meant the most to me are:  political stability, the rule of law, growth-oriented government policies, no excessive government debt, prudent government spending, and no restrictions on being able to repatriate my funds.  All other things being equal, mild appreciation of the foreign currency would be nice.  But I would trade that away in a nanosecond for assurance I wouldn’t have a currency loss.

All this implies that the value of a country’s currency isn’t determined by a deliberate currency policy.  Instead, it’s the result of overall conditions for doing business in that place, and of the effectiveness of government in providing a backdrop conducive for corporations to locate there.

One instructive recent example of what not to do:  massive government-engineered currency depreciation has been the cornerstone of Abenomics in Japan.  The main results so far have been to revive the fortunes of near-obsolete manufacturers, while retarding innovation and inducing an epic fall in the standard of living of ordinary citizens.

My advice for Mr. Trump?   Press forward on tax reform and infrastructure spending.  Establish meaningful vocational training to replace the VA-like stuff we have now.  Don’t try to weaken the dollar; that’s a recipe for disaster.

 

how do tariffs affect selling prices?

The purpose of tariffs on imported goods is to discourage their use and to encourage the development of domestic substitutes.  It sounds good in theory but may not work in practice.

A recent example of the latter is the imposition of tariffs by the Obama administration on truck tires imported from China.  The tariffs made the Chinese tires affected noncompetitive in the US.  But US tire makers regarded this market as not lucrative enough for them to enter.  So trucking companies began to import more expensive tires made in Thailand.  Economists estimated at the time that because the tariffs raised the cost of doing business for truckers it lowered their profits and overall cost the country about 3,000 jobs.  And then, of course, China retaliated by placing an import duty on poultry source in the US, hurting that industry as well.

The key points:

–tariffs raise the cost of doing business for the industries affected.  That extra cost must either be absorbed by the buyer of imported materials or passed on to the customer.  Theory says that if the end product is unique, the burden will be mostly borne by the end user;  if it’s a commodity, the importing company will have to absorb most of the extra expense.  An interesting case in this regard is toys.  Most of the toys bought in the US are made in China.  A tariff on run-of-the-mill imported toys (which probably means 90% of them) would mostly raise the price to consumers, in my view.

–tariffs may not promote domestic industry, and may do significant net damage, as the truck tire example shows.

–in addition, decades of protection against foreign competition did little to protect US carmakers from the long-term threat of imports.  On the contrary, Washington’s protective umbrella shielded shoddy manufacturing and lack of innovation that ultimately ended with two of Detroit’s Big Three declaring bankruptcy.  To be sure, government action forced foreign carmakers to establish manufacturing operations in the US.  However, the sad case of General Motors, which controlled 40% of the US cara market at one time, makes it hard to argue, I think, that government protection of domestic industry against foreign competition is the best thing to do.

 

interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.

 

At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.

 

More on Monday.