“There are decades where nothing happens; and there are weeks where decades happen.” ― Vladimir Lenin
“There is nothing so permanent as a temporary government program.” ― Milton Friedman
What an eventful few weeks!
- Prime Minister of the United Kingdom, Boris Johnson, suspended Parliament for five weeks in the run up to the Brexit decision in an attempt to hijack proceedings and has now been found by the Supreme Court to have acted “unlawfully”.
- An aerial attack took place on Saudi Aramco’s facilities at Abqaiq and temporarily took out more than 5 million barrels a day of crude oil production ― representing roughly the equivalent of 5 per cent of global oil supply. The price of oil spiked by almost 20 per cent on the news but has fall back to levels prior to the attack following assurances from the Saudi Arabian government to quickly ramp up production.
- The We Company, purveyors of the WeWork brand of office space, has seen its prospective IPO unceremoniously unravel, culminating with the board room coup by Masayoshi Son-led Softbank and the ousting of co-founder and CEO Adam Neumann.
- Overnight borrowing rates in the repurchase or repo market, where traders do short-term deals to swap Treasuries for cash, suddenly rose to 10 per cent, up from their normal levels of 2-2.5 per cent. (Something we touched upon in January.)
- And most recently, Speaker of the House of Representatives, Nancy Pelosi, announced that the House will proceed with an “official” impeachment against President Trump.
All of this is unfortunate; none of it feels unusual anymore and maybe explains why the S&P 500 is barely 2 per cent from all-time highs.
On to this week’s update.
Modern Monetary Theory
The course of markets is unpredictable, crooked as the corrupt, companies rising and falling by whim and chance, bated by politicians, manipulated by greed, taken hold of by the unscrupulous, rattled by rogues, addled by analysts.
This has all been true since there have been markets. It still holds true today. The reality, however, has not discouraged attempts to chart the motions of prices and model the behaviour of markets as if these were matters of physics, like gravity and the coming and goings of the tides. New business models, novel algorithms, ‘structured’ products and twists on age-old policies have been unveiled at different points in history to mark the start of a new era, in which the course of markets might be made predictable, investment returns consistent and the behaviour of market participants that would be ruled not by fear and greed but by reason and rationality. The goals are always lofty, and their fate always the same.
The current incarnation of these less-than-illustrious elixirs being promoted is Modern Monetary Theory (or MMT in more common parlance). In this week’s piece, we take a much overdue look at MMT.
Before going on to the specifics of MMT, however, a few fundamental concepts are summarised so that the conclusions drawn are coherent.
Private vs Public Asset Creation
Private asset creation, including money is less susceptible, on a system-wide basis, to miscalculation and misallocation than government led asset creation, which is subject to the vagaries of politicians and public sector bureaucracy, which lead to miscalculation and gross misallocation.
If government created assets occupy an increasing share of system-wide assets at the expense of the more sound, private sector created assets, there is greater misallocation and confidence in the monetary system is gradually eroded.
The Role of Central Banks in Asset Creation
Central banks, particularly in developed economies, are responsible for less than 10 per cent of money and liquidity creation in the financial system.
Nine-tenths or greater of the money in the financial system today is actually deposits held within commercial banks and their equivalents. Deposits, are of course, created by commercial banks engaging in the acts of lending or investing. The prevailing global currency regime, that of US dollar denominated deposits, allows (authorised) commercial banks to create and destroy deposits, within the bounds of regulations, at their discretion.
When a loan is repaid deposits, that is money, are destroyed. Deposits are also destroyed when commercial banks sell securities held on their balance sheets.
For central banks to increase their share of asset creation, it is will require undertaking transactions directly with sectors other than the financial sector. This is where MMT would hand central banks greater control of the process of creating and destroying money. More on that anon.
What About QE?
Quantitative easing (QE) and other refinancing programmes initiated by the major central banks following the Global Financial Crisis created the illusion of liquidity. Illusion because these programmes did not inject liquidity into the real economy, rather they forestalled a cascading debt default and asset impairment cycle in a bid to restore confidence in the financial system.
That is central banks, a few exceptions aside, continued to transact with the financial sector and not directly with sectors from the non-financial economy. Moreover, regulations, commercial and competitive considerations and structures created by central banks, such as the reverse repo facility, meant that QE did not result in money flowing to main street. And as such did not result in central banks having a bigger role in the creation and destruction of money.
Money Creation ≠ Inflation
“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.” ― A History of Interest Rates, Sidney Homer and Richard Sylla
If liquidity and money creation occurs in tandem with a growing productive capital base in the economy, money creation does not lead to inflation rather it contributes to rising living standards.
If money is created to sustain zombie companies or to avoid the mothballing of excess capacities, it drives down returns on invested capital. Declining returns eventually unleash deflationary forces as an increasing portion of debt in the system becomes unsustainable without ever increasing policy intervention. Simply put, deflation is the market’s signal for discouraging investment into additional capacities and an attempt to stoke consumption.
Inflation, the bad kind, occurs when continued policy intervention and money creation precipitates a loss of confidence in the central bank and eventually the currency. Credibility cannot be measured explicitly but we know the US has a lot more of it than, say, Argentina. It is this credibility that even allows a policy such as MMT to warrant a serious discussion in the US.
MMT: The Nuts & Bolts
Put simply, MMT is the recognition that government spending is not constrained by either taxation or its ability to borrow — at least not if the government has monetary seigniorage without the obligation to maintain a fixed exchange rate, whether against gold or another fiat currency. In these terms, the US federal government is not constrained, but the governments of European Monetary Union member states, say, or the Republic of Panama, are.
For governments meeting the above conditions, proponents of MMT advocate that policymakers can, nay should, create and spend as much money as necessary to achieve full employment and a targeted rate of inflation. Be it through the manipulation of aggregate demand or funding public healthcare or a universal basic income. If this entails running ever increasing fiscal deficits or devaluing the country’s currency, so be it.
Advocates of MMT only recognise resource constraints as limitations on a government’s ability to run larger and larger fiscal deficits. Take labour, for example. The government can pay public employees as much as it wants but it cannot employ more people than exist. The MMT framework also proposes that government spending should only focus on areas where it can utilise resources more efficiently than the private sector, otherwise there will be opportunity costs. Sticking with the case of labour, the MMT framework would encourage government to limit public sector employment to the extent that it does not draw employees from the private sector into the public sector.
Focus Should be on the Path, Not the Endgame
Most discussions on MMT devolve into either how it spells the end of the US dollar, or fiat currencies in general, or how it will spur uncontrollable inflation and therefore one must own gold or bitcoin or both. With time these proclamations may prove correct. The thing about capital markets, however, is that for the most part it is the path not the endgame that matters.
And as far as the path is concerned, it is not unreasonable, in our opinion, that initially MMT reinforces deflationary not inflationary forces. That is, by opening up the monetary spigots policymakers continue to keep cost of capital artificially suppressed thereby further delaying the inevitable impairment of excess capacities, zombie companies and unproductive debts. Ever increasing advantages would then continue to accrue to large companies, with access to low cost capital, at the expense of small and medium enterprises, further compounding the issues of inequality and declining productivity. Such a deflationary death spiral is what, we think, precipitates the endgame, not a sudden burst of inflation.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.