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Modern Monetary Theory

Changing the questions?
Ruffer Review
Edward Roe
Investment Manager

Stephanie Kelton, guest speaker at Ruffer’s Family Office Conference in November 2019, is a leading authority on Modern Monetary Theory.

She is Professor of Economics and Public Policy at Stony Brook University, and has been a Senior Economic Advisor to Bernie Sanders’ campaigns for US president. Kelton sees Modern Monetary Theory as a disruptive force. It isn’t just “changing the answers that economists have been giving for many decades – it’s changing the questions”. Ed Roe, an Investment Associate at Ruffer, presents some of the highlights from Kelton’s address to the conference. Her views are not Ruffer’s, but we value the challenge and different perspective they bring.

This piece was written in late 2019 and published before the outbreak of the coronavirus pandemic.

Years have happened in the last few months. Unemployment has soared to the highest level since World War II, locked-down businesses are fighting for survival and livelihoods have vanished almost overnight.

In response, central banks have launched a tsunami of monetary stimulus and government cheque books have been blown open to help plug the gap.

The ideas at the heart Stephanie Kelton’s Modern Monetary Theory are being put to the test, sooner perhaps than anybody might have predicted.

To understand MMT, Professor Stephanie Kelton argues, we must address a myth about government financing.

Mainstream economic thought runs something like this. To be able to spend money, governments must first raise funds from elsewhere, through taxation or borrowing.

From this comes a familiar call and response. A politician proposes an increase in spending; “who’s going to pay for it?” comes the reply. Cue cat-fighting and political mud-slinging.

This back-and-forth assumes that, for a politician to spend another dollar, they must demonstrate a credible plan to take a dollar out of the economy. MMT says this isn’t the case. In the MMT view, governments spend money that the central bank creates, then they tax and borrow some of it back.

Before you or I can use dollars, euros or pounds to settle tax obligations, this money has to come from somewhere. The government has to “spend the money into existence”. Kelton uses a story from Warren Mosler, another prominent figure in the development of MMT, to illustrate her point.

Giving value to business cards

Mosler wanted his children to help around the house, doing various chores. He decided to ‘pay’ them, with his business cards, for every job they completed. At first, this flopped. His children had no need for business cards; as a currency, they were worthless.

Then Mosler had a eureka moment. A new rule. If his children wanted to continue living in the house, and to maintain privileges such as seeing their friends at the weekend, they had to give their father 20 business cards at the end of each month.

All of a sudden, the cards, with no intrinsic value, became valuable. Mosler’s children started to do chores immediately, without being asked. All Mosler had done was invent a tax. The only way to pay that tax was with business cards. The only source of these cards was Mosler himself – for his children to be able to pay the tax, Mosler first had to spend the cards into existence.

Beyond printing money

Stories like this have led critics of MMT to see it as simply about ‘printing money’, shaking the fruit from a Magic Money Tree.

To Kelton, this is a fundamental misunderstanding both of MMT, and of how federal governments currently finance themselves.

Today, the US government is already financing every dollar of its spending with new money creation; taxes and bond issuance are merely secondary operations. Therefore, if you describe MMT as printing money, you should level the same accusation at the federal government. What’s more, central bankers agree a currency-issuing government operating a floating exchange rate regime faces no financial constraints – as Mario Draghi has said “the ECB can never run out of money”.

Does this mean a government can go out and spend as much as it wants? No. What it does mean is that the limit to such spending is in the real economy, not the financial one: inflation is the only relevant constraint.

As Kelton puts it: “If the economy has the capacity to take on additional demand, and suppliers can match it with higher production, provided you don’t get inflationary pressures, increased spending is a perfectly responsible way to proceed.” To support her explanation, Kelton notes that nobody has a good model of inflation. In particular, ideas such as the Quantity Theory of Money and the Phillips Curve are not accurate or useful models of the real world.

New approach to taxation

The role of tax in macroeconomic policy is thus radically changed. While tax is currently seen as the key funding mechanism for government spending, MMT argues that in reality it simply acts to diminish spending power in the private sector. Taxation should therefore be used as an offset to dampen any inflationary pressures arising from government spending.

Another important result of the MMT framework is that the short-term natural rate of interest is zero. The outcome of the government running a deficit is to increase reserves in the banking system – the bigger the deficit, the larger the reserves. In a world where everyone is flush with reserves, the price paid for them (the overnight lending rate) simply goes to zero. There are two reasons this doesn’t currently happen.

Today, the US government is already financing every dollar of its spending with new money creation.

First, the government issues bonds, which act to drain reserves and make them scarce. Second, the central bank pays interest on the remaining reserves, using an artificial, arbitrary, positive rate.

A linked conclusion is that larger deficits actually push down interest rates, in direct contrast to conventional thinking. And much like taxation, bonds are not issued to fund expenditure but in order to drain reserves from the financial system.

Trump and trade

Trade imbalances are also treated entirely differently as a result of MMT. “What Donald Trump focuses on are cash flows,” Kelton notes, “but what about the real flows? We may be sending China hundreds of billions of dollars but we’re taking their stuff – their people are working hard to make things that they just send to us. So in real terms, exports are a cost, and imports are a benefit.”

What does China get in return for everything they send the US? They receive dollars in an account at the Federal Reserve. But the US government can simply print dollars. It can’t print consumer goods.

Back to the budget

Having turned most of what we think we know about how modern economies work upside down, Kelton swoops back to focus on budget deficits.

Under the sectoral balances framework developed by British economist Wynne Godley, a country’s economy can be seen as a closed system. In a closed system, the combined deficits and surpluses of the government sector, the private sector and the foreign sector must, by definition, sum to zero.

Since the most important thing for a strong economy is the robustness of the private sector – that the private sector runs a surplus – then it’s right for the government to run a budget deficit. This is particularly important in a country with a significant trade deficit, such as the US. In Kelton’s words, “government surpluses are built on the back of private sector deficits. A government deficit should actually be seen as a positive household surplus”.

The key factor for whether a country is able to adopt an MMT-like system is whether it issues its own fiat currency. “Currency is the difference between sustainability and crisis,” Kelton argues. With any fixed exchange rate regime (such as the euro), or with foreign currency debt, comes the risk of a government not honouring its formal commitment on convertibility.

Kelton acknowledges that it’s here, on monetary sovereignty, where MMT has tended to receive its biggest challenges. The assertion that there are only two types of country – those that issue their own fiat currency and those that don’t – isn’t correct. In reality, there’s a spectrum. Kelton explains that ex-change-rate risk has become more and more integrated into the MMT framework. MMT thinkers are highlighting issues such as countries that have full monetary sovereignty yet depend on the rest of the world for critical imports such as food and energy – in a situation like this one, policymakers need to think carefully about domestic choices, with the exchange rate a key consideration.

Lessons from Japan

When turning her attention to interest rates, as set by the world’s central banks, Kelton argues we have huge belief bound up in their ability to steer economies. MMT is uncomfortable with this. She agrees that raising rates increases the cost of borrowing, but argues it also increases private income, since the government is a net payer of interest. If rates go up, bondholders earn more. “Therefore, there is a sense in which a rising interest-rate environment could be expansionary, since you’re creating billions and billions more interest income,” Kelton argues. “But it’s pretty hard to believe that there’s a strong direct channel between interest rates and inflation rates – just look at Japan!”

The key factor for whether a country is able to adopt an MMT-like system is whether it issues its own fiat currency.

Japan, for Kelton, is a source of valuable lessons. “It is a neat example that it’s possible to massively increase the size of the monetary base without inflationary consequences,” she says. Deficits haven’t forced interest rates higher. Debt sustainability hasn’t been a problem. All that matters is inflation.

As David Zervos, Chief Market Strategist at Jefferies, put it during a recent visit to Ruffer: Japan has the best bridges, the best trains, the cleanest streets, multi-decade lows in unemployment – all due to deficit-financed fiscal spending – and they don’t have any inflation.

A descriptive project

When taking questions from the room, Kelton was asked whether politicians will really be willing to raise taxes when needed to fight inflation. Her response was two-fold – that central banks don’t have the tools to manage inflation effectively anyway; and to reiterate that she isn’t advocating endless spending. “What I’m advising is that we need fundamentally to overhaul the federal budgeting process, to integrate the inflationary risks of any legislation.” In her view, the primary concern of the Congressional Budget Office in the US (and the equivalent departments in other countries) should be whether the spending will spark inflation, not whether it will add to the deficit.

When asked for investment recommendations in an MMT world, Kelton said for her MMT is not a thing that’s going to be implemented or adopted. “It’s 95% a descriptive project. It’s about helping us get a better appreciation for how government finances and monetary operations work.

I’m just describing things as they are.” She is calling for a healthier debate, one without myths and misunderstandings.

“Is President Trump intuitively an MMT believer?” Kelton thinks he actually is, noting that in her lifetime, “Donald Trump is the only person I’ve seen run for President, stand before the American people and say ‘if you vote for me the national debt is going to go up’”.

Momentum and attention

“So, what’s changing?” asks Kelton, bringing her session to a close. Well, people have started talking about the end of monetary policy. And not just any people, but central bankers such as Robert Holzmann, the current governor of the Austrian central bank, and Christine Lagarde, the new president of the ECB, as well as influential figures in the financial world.

As a school of economic thought, MMT is seeing a surge of interest and attention – where this momentum takes us remains to be seen.

Modern Monetary Theory in 60 seconds

Modern Monetary Theory (MMT) is a macroeconomic framework that has at its core a simple idea – money is a creation of the state and, as such, a government that issues its own currency never needs to default on its debts. It can simply ‘print’ more money to repay the debts it owes.

From this base, MMT argues the only real limit to government spending isn’t the deficit, but inflation. Additionally, since the government can simply print money to pay for goods and services, it has no need to match spending and taxes.

MMT proposes that full employment, not price stability, should be the primary aim of government economic policy. Unemployment is evidence that the government is overly restricting aggregate de-mand, and thus under-utilising the economy’s resources.

To this end, many MMT economists advocate a government job-guarantee scheme. This would offer employment to those unable to find work in the private sector. Advocates believe it would eliminate involuntary unemployment and act as an automatic stabiliser to the economy – expanding when the private sector is weak, and contracting when private hiring is strong.

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Photos: Johnny Green / Photocall Productions

This article was originally published in the Ruffer Review 2020.

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. This document does not take account of any potential investor’s investment objectives, particular needs or financial situation. This document reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. Read the full disclaimer.


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