Making Sense of Modern Monetary Theory

If past history was all there was to the game, the richest people would be librarians

-- Warren Buffett

USD 12.8 trillion of negative yielding debt¹ – an unprecedented yet true illustration of the world today as investors seek for yield amidst ultra-low interest rates. Even Greece is getting paid for borrowing money (See Fig. 1). Very possibly, the amount of negative yielding debt is growing as the minutes tick by.

Fig. 1. Greece 3-month Treasury Bill (%)²

In the hope of meeting inflation targets, central banks have utilised their balance sheets by buying government bonds to improve financial conditions, in addition to lowering interest rates. According to an analysis done by Union Investment³, the volume of freely tradeable Bunds is expected to fall below 70 billion Euros by 2024 from more than 600 billion Euros in 2014.

Japan’s struggle with deflation since the late 1990s has given the Bank of Japan (BoJ) greater justification to embark on more innovative monetary policies. This include extending its government bond purchases to equities, spearheaded by its Exchange-Traded Fund (ETF) purchase program which began in 2010. Despite the central bank owning more than three-quarters of the country’s ETFs, valuations of Japanese equities has struggled to move considerably higher. The Topix’s forward price to earnings (P/E) ratio has ranged between 11x to 15x over the past 8 years (See Fig. 2).

Fig. 2. Bank of Japan’s equity ownership vs Japanese equity valuations⁴

All this begs the question of the effectiveness of traditional monetary easing measures – Are lower interest rates, asset purchases and forward guidance adequate to combat the next global economic downturn? Is it time to consider other economic tools?

A recent bright spark is the wave of political consensus moving towards greater fiscal stimulus to boost economic growth. In her address to the European Parliament (as part of her nomination process as the European Central Bank (ECB) president), Christine Lagarde called on European governments with low deficits to stimulate their economies by spending during the downturn⁵.

The subsequent question over the financing of more aggressive spending has in turn led to a discussion of Modern Monetary Theory (MMT), an emerging school of thought among economists and policymakers.

MMT proponents believe that sovereign countries that can issue debt in their own currencies would be able to increase government spending without worrying about fiscal budget constraints. That is - these governments can ease fiscal policy until inflation expectations reach their target levels.

As Stephanie Kelton, leading proponent of MMT, suggests “We should balance the economy, not the budget.”⁶ The key constraint, however, is the lack of real resources in the economy to absorb ambitious spending programs, in turn triggering an inflation problem instead.

Yet, in a way, such a model has been evident in Japan over the past couple of decades, where the government ran persistently negative budgets to offset high levels of corporate and household savings. However, despite government debt levels rising to nearly 240% of GDP in 2019, Japan’s GDP growth and inflation rates have remained relatively low, with the latter consistently falling short of the BoJ’s 2% inflation target (See Fig. 3).

Fig. 3. Japan’s surplus/deficit (% of GDP) versus growth and inflation trends⁷

A subtle but key difference with Japan’s fiscal policy approach versus MMT is MMT’s proposition of maintaining interest rates at zero. Low or zero rates give the government room to spend without raising the debt-to-GDP ratio materially. This also has the effect of shifting income from lenders to borrowers. The process will hopefully reduce income inequality, which in recent years has led to a rise in populism.

While MMT may have its merits particularly when economies are on the brink of becoming liquidity traps; it is still hard to believe that interest rates do not matter when economic conditions normalise. It is extremely unlikely that easy monetary and fiscal policies can be sustained over the long term without igniting inflation concerns. While MMT does not have a budget constraint, its key constraint, is the lack of real resources in the economy to absorb ambitious spending programs.

As the global economy slows and a potential recession looms amid limited inflationary pressures, both monetary and fiscal policies need to work in tandem to extend the current economic cycle.

Central bankers in major Developed Markets need to ready their toolkits to provide an effective response in the next downturn. And this time, they may not be able to do it alone; the coordination with various government agencies and financial institutions to tackle the potential threats of deflation during stressed periods will be required. The good news is there may be several precedence from the 1930-40s for policymakers to take reference in shaping policy responses. As Ray Dalio explored the variants of “Monetary Policy 3”⁸, he reiterated the need for such policies to be better directed at spenders, rather than investors/savers. He has also rightly highlighted the key element to success is to design a system such that decision making would be in the hands of wise, not politically motivated, and highly skilled people. It is critical that governments tighten policies when economic slack disappears, otherwise economies will overheat, and inflation will rise.

Today, in the absence of confidence driven by concerns over future growth, counter cyclical fiscal policy is needed, even if it is just to prolong the current economic cycle. Interestingly, former IMF economist Olivier Blanchard’s suggestion that fiscal multipliers are bigger when interest rates are at the zero lower bound implies that policymakers may possibly get more done if they ease fiscal policy⁹!

As the debate around MMT continues, countries that succeed in implementing the appropriate policy mix would be in good stead to not only cushion deflationary pressures, but also to reward equity investors over bond investors in the years to come. This is especially so given the attractive Equity Risk Premiums (ERP) we see across most markets today (See Fig. 4).

Fig. 4. Equity Risk Premium¹⁰

This puts the spotlight on Germany – a market with the highest ERP and the only G7 country with a budget surplus since 2012. With a debt/GDP ratio below 65%, it implies that Germany has some fiscal flexibility to stimulate its economy. The question is will it?