We Are All Modern Monetary Theorists Now
As a consequence of loose monetary policy with a fiat currency, the United States is rapidly descending into an economic reality of Modern Monetary Theory, or MMT. While MMT (also known as Chartalism) is typically associated with its Keynesian predecessor and the policies of the Left, new developments reveal that both parties are responsible for the slip into a brave new economic world.
Essentially, there are four preconditions in Modern Monetary Theory:
1) Money enters the economy through government spending, as the total amount of money is constrained not by gold but by the total output of the national economy;
2) Government spending is speculative as it prints as much money as it needs to control production and, as a byproduct, employment, and spending beyond productive capacity leads to inflation;
3) Taxes do not pay for expenditures but are instead a way to throttle private sector demand; and
4) The government is the issuer of the currency, sovereign governments that issue their own currency are never insolvent, so debts essentially don’t matter.
I would submit we now meet those preconditions. With the Federal Reserve’s bond-buying program, beginning with Quantitative Easing “QE1″ in November 2008, the US government is the de facto issuer of currency, as the Fed can, for the most part, purchase Treasury Bonds at will. The Federal Reserve is currently purchasing 61% of Bonds at auction, quickly approaching its 70% self-imposed limit, which was relaxed from 35% in 2010.
When 40 cents of every dollar spent is borrowed, the US government is running record trillion dollar deficits, borrowing $4 billion per day to pay for massive spending. As a result, the federal government has no other option but to flood the market with low-rate Treasury Bonds. Basically, our monetary policy is being used to pay for unfunded fiscal policy.
The Fed has recently announced it will keeping its low interest rates to combat unemployment, and continue its bond-buying program, spending $85 billion per month on Treasury bonds and mortgage-backed securities. As a result, banks are posting large quarterly profits as new money, tripling the monetary base since 2008, enters the economy.
With this newfound ability of the Federal Reserve to issue currency, the next constraint on spending is the Congress. But when the dedicated priority of one party is tax reduction to stimulate production, and the other party’s is increased spending to fight unemployment, there are no real constraints. Neither party holds spending in check. MMT is already happening.
Consider the message stressed by Louisiana Governor Bobby Jindal last week, and repeated by Representative Paul Ryan, that Republicans must move away from “austerity” and embrace a ”pro-growth” focus. Paul Ryan actually said Republicans should ”prevent and preempt austerity so we can get back to growth.” But what are pro-growth policies, if not stimulative?
To further illustrate this, consider last week when the House voted to raise the debt ceiling, guaranteeing another fight in three months, where expectations of a debt reduction deal remain low. Or consider that the last manufactured crisis, the fiscal cliff, came with $74 billion of hidden pork barrel spending. Or consider how Defense hawks on the Right began to squawk when GDP unexpectedly retracted 0.1% in the 4th quarter of 2012 due to a plunge in Defense Spending. More government spending, they portend, will fuel the economy. Just let them pick the sectors.
In the short term, we collectively abandon our concerns for debt, as we get larger government at a discounted interest rate, which only encourages further spending. Unlike the rest of the industrialized world, devaluing faster than we are, we don’t worry about imposing taxes or austerity measures to fight our debt, because, as the theory goes, we can acquire as much debt as can be paid back with interest.
And even if we have 10% inflation, as long as wages inflate 11%, we are fine. And while that’s a good theory, it’s just that: a theory. Even John Maynard Keynes, the forerunner to MMT acknowledges the deleterious effects of slow inflation:
“By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some.”
So what are the risks of injecting money into the economy? First, inflation is a concern, and while core inflation has not been high, commodities have inflated irregularly while savings and investments have been – ahem – confiscated through negative real interest rates. Acknowledging that stimulus creates bubbles of artificial speculation and malinvestment, the combination of low rates and monetary stimulus has created a Bond Bubble, with inflation hidden on the central banks’ balance sheets. Also, while productivity (measured in output per “man-hour”) is rising, and GDP is not, we risk stagflation last experienced in the 1970s when we officially left the gold standard.
Second, our loose monetary policy leads to increased income inequality. When the Federal Reserve buys Treasury Bonds, new money enters the system at the banks, which works its way through the financial system, to the productive sectors of our society, and, supposedly, to the service sectors. This new money results in weakened purchasing power of the Dollar, which results in higher prices. Therefore, prices rise faster than wages for those not “at the top.”
Third, our debt has a drag on our economic output. Putting our debt in perspective, Carmen Reinhart and Ken Rogoff, the authors of This Time It’s Different (2009), conducted an empirical study of 22 global economic crises and found that when government debt-to-GDP ratio rises above 90%, it lowers the future potential GDP of a country by at least 1%, and begets a slow-growth, high unemployment economy. As a reminder, the US ended 2012 with 103.8% debt-to-GDP.
Still, many believe debt accumulation is of little concern. This past week, Nobel Prize-winning economist Paul Krugman said, “Don’t worry about these deficit things for the time being; they’re non-issues.” But as fellow guest CFR’s Richard Haass responded to Krugman, “You’re right until the day you’re wrong, and that’s a bad day.”
With limited power to combat the Federal Reserve, the supposed deficit hawks should stop dabbling in Keynesian spending, and set a limit based on Hauser’s Law to keep spending/GDP less than 19.5%, equal to the maximum amount of revenue that can be extracted through taxation; otherwise, deficits are guaranteed. Only then can we begin to address our long-term debt.