As I have explained, such swapping of equivalent financial instruments, as in QE, has no direct effect on the money supply or the rate of inflation. The FTPL explains why even the proportionally larger QE undertaken in Japan has not produced inflation. Japanese debt monetization has coincided with a tightening of fiscal policy and declining deficits.
As its name explicitly asserts, the key insight of the FTPL is the importance of fiscal policy to the determination of the price level and the rate of inflation. A corollary is the relative impotence of monetary policy. John Cochrane concludes his 2018 essay “Four Heresies of Monetary Policy” with the statement: “The Fed is nowhere near as powerful as conventional wisdom suggests.” These assertions of the impotence of monetary policy and the primacy of fiscal policy are echoed by MMT.
Modern Monetary Theory
I attempt an explanation of MMT with some trepidation. Little of MMT is published in the traditional manner. MMT’s promoters communicate their ideas primarily through blogs and podcasts. Even progressive economists, who support a larger role for government and downplay concerns about deficit spending, struggle to explain it. Paul Krugman has likened his engagement with MMT advocates as playing Calvinball, a fictitious game in which the rules are constantly changing. Nonetheless, here I go.
In common with Abba Lerner’s theory of functional finance, MMT argues that governments should coordinate monetary and fiscal policy to ensure full employment. Stephanie Kelton (2019) explains Lerner’s approach: “The government should use its fiscal powers (spending, taxing and borrowing) in whatever manner best enables it to maintain full employment….” So far, such a description of MMT seems to align with mainstream Keynesian proscriptions for fiscal policy.
A seemingly more sensational claim of MMT is that governments with fiat currencies can fund any amount of government spending simply by creating new money. We might reasonably assume that such a radical change in policy would require abolishing central bank independence. MMT advocates do not explicitly promote this change, so far as I can find. Rather, they envision a consolidated treasury and central bank. In the US context, Congress would direct the Fed or its successor to create whatever amount of money is necessary to fund government spending.
Released from the constraint to fund government spending with taxes, promoters of MMT back a massive increase in government control of the economy, from universal healthcare and free college education to an immediate transition to clean energy as well as government jobs for all of the unemployed. MMT acknowledges that too much government spending might cause inflation, but that taxes and regulation can and will prevent it. Relying on Congress to manage inflation through tax policy seems recklessly naïve regardless of whether it would be theoretically possible.
To be fair, when markets fail to provide sufficient investment in public goods—such as infrastructure, research, education, and healthcare—then government spending for such programs may well provide an economic return above the foregone alternative private investments. Advocating an expansion of government investment thus resides well within the bounds of conventional macroeconomics.
Where then does MMT depart from orthodoxy? MMT asserts that government investment doesn’t crowd out private investment because government spending creates bank reserves, which lowers interest rates. The obvious objection to this heterodox assertion is that real resources are finite. To the extent that government directs investment of finite real economic resources, less of those finite resources will be available for private investment. As Fed Chairman Jerome Powell recently testified before Congress: “The idea that deficits don’t matter for countries that can borrow in their own currencies I think is just wrong.... We’re going to have to either spend less or raise more revenue.”
James Mackintosh (2019) wryly observes that MMT is neither modern, monetary, nor a theory. Nonetheless, the embrace of MMT by influential progressive politicians has compelled many prominent economists to publicly warn of its dangers. Kenneth Rogoff (2019) refers to MMT as “nonsense.” Paul Krugman (2019), though deeply sympathetic to progressive policy goals and deficit spending, says unequivocally that “the MMT people are just wrong.” Larry Summers (2019) calls MMT a “recipe for disaster.”
As Bill Dudley (2019) explains:
MMT hasn’t worked out well for other countries. Consider Germany in the 1920s, or Venezuela and Zimbabwe more recently. The US tried a milder version in the 1960s and 1970s, when the government tried to pay simultaneously for the Vietnam War and Lyndon Johnson’s Great Society programs. The result was inflation, America’s withdrawal from the gold standard and the demise of the Bretton Woods system of fixed exchange rates. The Fed had to increase interest rates to double digits in the late 1970s and early 1980s, at great economic cost, to get inflation back under control.
Dudley’s warning resonates with me. I vividly recall the stagflation of the 1970s, the pain measured by the misery index, and the two recessions of the early 1980s as I began my first professional job search.
Financial Market Implications of MMT
What does a return to stagflation, similar to that of the late 1970s, imply for capital market returns? For the full decade of the 1970s, bonds and cash provided negative real returns as unexpected inflation turned real rates negative. If MMT becomes policy, then we can expect a similar bout of high and volatile inflation leading to negative real returns for bonds and cash.
Would the mighty US stock market provide protection from high and volatile inflation? Not if history is our guide. High inflation is associated with declining stock prices. Stocks provided a real return barely above zero for the decade of the 1970s. The Shiller P/E of the US stock market dropped from an average valuation of 17 at the start of the decade to below 10 in 1977, and then remained in a range between 6 and 10 until 1984. From the present Shiller P/E of 31, this historical valuation implies a plunge in stock prices of 70%, even before considering the damage to corporate profits!
Real assets provide a measure of inflation protection. TIPS, commodities, and REITs may appreciate as and when investors attempt to reposition for an inflationary regime. Unfortunately, today TIPS provide real yields below 1%, commodities pay no real yield at all, and REIT prices are highly correlated with the US stock market.
Repositioning portfolios to hold capital assets domiciled in countries with more conservative policies provides an alternative approach to protecting portfolios from inflation. Such protection comes at a cost. The premium the wealthy willingly pay to protect real purchasing power at least partly explains the current negative real interest rates charged on Swiss bank deposits.
One way or the other, a return to high and volatile inflation can be expected to depress future capital market returns. Informed investors can prepare by paring back positions in mainstream stocks and bonds, diversifying into real assets, and revising down future real return expectations.