We are writing this opinion piece today because we believe that all investors are currently placing their bets, whether passively or actively, on Modern Monetary Theory (MMT) as the new driving force behind economic markets. Investors seem to implicitly trust in the validity of MMT, which is reflected in the relative calmness and high(er) prices in fixed income and equity markets, as well as the lack of distinction in currency markets for large, indebted countries. Given that both leading candidates in the upcoming US presidential election are discussing new expansive fiscal policies, we believe it is an opportune moment to shed light on the theory and its potential pitfalls. As seasoned market participants and economists, we are naturally skeptical of theories that we believe lack common sense, and MMT falls into that category.
Modern Monetary Theory (MMT) gained considerable interest in the 2010s. One reason was the inability of monetary policy to generate sustained economic growth or obtain consumer inflation targets, instead promoting asset price inflation and widening income inequality. The explanation for this failure generally centers on the reliance on banks as the monetary policy transmission mechanism, using bank reserves to buy existing assets, which resulted in higher reserves but not an increase in the money supply. Banks were not willing to lend, choosing to hold reserves to repair balance sheets and satisfy reserve requirements, while households were not willing to borrow, preferring to save to pay down debt.
This prompted some to call for a “reform” of capitalism1 and others for a shift in focus from monetary to fiscal policy. Fiscal policy resolves the transmission problem by directly increasing the money supply through spending. MMT provides a justification for accommodative fiscal policy, appearing to offer a silver bullet of unlimited spending, without the risk of default, that generates economic growth, resulting from direct government-driven demand and full employment (i.e., 0% unemployment) while narrowing wealth and income inequality.
Unsurprisingly, MMT (or at least the assertion that deficits don’t matter) has been embraced by both parties, it is and has been the de facto (if not admitted) policy of both parties, despite protestations and the ongoing theater around the debt ceiling².
Republicans have increased deficits by cutting taxes while demanding austerity to control debt when not in control. Democratics can propose expanded spending without corresponding tax increasesto offset the increase in the deficit. As a result, total government expenditures have risen consistently regardless of which party controls the White House and/or Congress. The largest average annual increases have occurred when Republicans are in the White House and Congress is split, with Democrats controlling the House. The smallest average annual increases when Democrats control the White House and Senate with Republicans controlling the House.
As a result, the federal deficit as a percentage of GDP has grown since 2001 and is currently at a level only surpassed during WWII, the GFC and COVID despite solid growth and relatively tight labor markets.
Though popular interest in MMT has waned, markets appear to accept MMT as policy and the premise that deficits do not matter, or at least the Fed can target rates and manufacture a soft landing. The US Treasury curve is basically flat from 2 years and longer while inflation expectations remain grounded between 2 and 2.5%.
While MMT may work in theory, we do not believe there is a silver bullet. Economic policy involves trade-offs, i.e., promoting growth and employment means accepting higher inflation and/or a larger deficit that eventually has to be repaid. The risk is that these trade-offs become binding, resulting in falling growth or rising inflation volatility and inflation expectation that push longer-term borrowing costs higher across developed countries with meaningful implications for financial portfolios.
This note summarizes the foundations and policy implications of MMT as well as the implications for portfolio allocation. In short, we agree with Sean Corrigan’s assessment of MMT that “It’s not Modern; It’s not Monetary; and it’s not really much of a Theory.”
Modern Monetary Theory (MMT) advocates using the central bank to finance government deficits. Its foundation is “chartalism,” a theory outlined in 1905 that claims money originated with the government’s attempt to control economic activity, rather than developing naturally as a medium of exchange that allowed for more efficient transactions.
Since the government has a monopoly on the currency and all taxes must be paid in that currency, the government must first issue currency to individuals before it can then tax those individuals. This interpretation reverses / breaks the link between taxes and government spending.
Further, the accounting identity that assets equal liabilities is interpreted to equate government debt with savings. Spending as a liability on the government balance sheet results in a corresponding asset, which is claimed to prove that spending does not pull forward growth, reducing future growth and passing a burden on to future generations.
The policy implications derived from MMT mirror those of “functional finance” a concept developed by Abba Lerner in 1947.
The challenge is that MMT is based on a number of dubious assumptions:
Economics can be defined as the study of allocating finite resources to satisfy infinite human wants. MMT assumes away the concept of finite resources, either physical or the means to repay borrowing, and concludes that there is no limit on deficits. History has shown that at some point lenders will demand higher compensation, either in recognition of higher potential default risk, in anticipation of higher taxes to repay a growing deficit, or due to inflation. For example, during Liz Truss’s short reign as prime minster of the United Kingdom, she espoused aggressive MMT beliefs and the bond vigilantes effectively had her run out of town in less than 2 months.
The portfolio allocation implications include favoring real assets and stores of value over financial assets and long volatility over short volatility. It also requires a reconsideration of 60/40 portfolio construction.
In short, MMT is perhaps best summarized by Henry Hazlitt, who said of Keynes’ General Theory that it “contains much that is original and much that is true. Sadly, that which is true is not original and that which is original is not true.”
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