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“Modern Monetary Theory” (MMT) & What It Means for Markets

As the 2020 election comes into view, and as presidential candidates look to win over public opinion, there comes the question over paying for all the various proposed policy prescriptions.

As developed economies become more indebted and monetary authorities find themselves more constrained in their power to help alleviate economic downturns, there comes the question of what comes next with traditional tools reaching their effective limits. 

“Monetary policy #1” (short-term interest rates) has little or no room in most developed economies.

“Monetary policy #2” (asset buying) is less effective when spreads begin to close (i.e., spreads further out on the yield curve compress to zero, like the case in Japan). When spreads are compressed the marginal impact is diminished and won’t stimulate demand.

Currently, 50% of all global sovereign debt yields less than 1%. When rates hit zero and that spread is gone, reducing rates further has little to no impact.

Policymakers can go below zero to try to stimulate more borrowing activity, but that doesn’t have any effect on the deposit rate. If there’s no impact on the deposit rate, then there’s no stimulative impact on banks’ funding costs. Thus, there’s no increase in banks’ willingness to lend through that policy alone and there is no influence on the credit creation capacity of the economy and successive output in the real economy.

The ECB, which uses a negative deposit rate, uses open-market refinancing operations (TLTRO programs) to reduce the adverse impact of negative rates on the banking sector by providing cheap financing. The BOJ uses a form of yield curve control to keep a positive spread between its overnight rate and 10-year bond yield positive. These are imperfect solutions.

So there must come a third form of policy.

On one side of the spectrum you have what some today call “helicopter money” where the government puts money in the hands of spenders and ties it to spending incentives. More generally, it’s the concept of a central bank adopting the power to engage in fiscal policy. The goal would be to break the relationship between spending and borrowing. That means circumventing the financial markets. 

On the other side, you have debt monetization. When fiscal spending exceeds revenue taken in, that produces debt. One way to relieve debt is to pay it in nominal terms assuming it’s in your own currency by simply creating the money. This comes with a devaluation of the currency, holding all else equal.

Historically this has all happened before going back to the earliest monetized economies (e.g., Ancient Rome). It seems like a novel situation because it hasn’t happened in our lifetimes or in our society.

MMT is a new name that references a very old idea (the government monetizing debt). It’s the notion that government spending is not revenue- or fiscally-constrained but only inflation-constrained. Put another way, the notion that if the government owes money, it can simply create the money to relieve the burden until the point where price inflation becomes too onerous.

In many countries, including the US, bond issuance funding deficits is currently what’s been written into the laws. So those would need to be changed or they could circumvent it through another transaction.

 

Modern Monetary Systems

There are two basic monetary/currency systems: commodity-based and fiat.

In a commodity-based system, the currency is backed by a good that is not subject to large fluctuations in supply and demand. Gold and, to a lesser extent, silver have been the most common backings wherein these goods can be exchanged for currency at a fixed price.

In a fiat system, no such commodity backing exists and money and credit growth is influenced by the central bank managing the currency and the incentives of borrowers and lenders to expand credit.

Governments normally prefer fiat systems due to their flexibility. It gives them the capacity to create credit, influence the money supply, and redistribute wealth in a way that can’t be done under “hard money” systems. However, because of the natural human tendency to prefer near-term gratification over longer-term benefits, such prolific credit creation practices eventually lead to debt crises.

This leads to a mix of measures to alleviate the burden – lowering interest rates, austerity, wealth transfer payments, write-offs, and debt monetization. Lowering interest rates and debt monetization are typically the most convenient, but come at the expense of debasing the currency.

When this becomes too uncomfortable, governments will typically be forced to go to a different monetary system – either commodity-based (e.g., gold standard) or pegged to a more stable fiat regime (e.g., Ecuador’s dollarization). Likewise, when the constraints to money and credit creation become too restrictive under commodity-based or pegged systems, these systems will inevitably be abandoned as well.

Consequently, over time, governments will cycle between the two systems given the imperfections of each. Nonetheless, monetary systems tend to work well for long periods. Central banks control money and credit growth by adjusting policy such that major changes in currency regimes are made infrequently.

 

What “MMT” Means for Markets 

Developed market economies are late in their business cycles, denoted by the inclination to pursue tighter policy to preclude inflation and/or financial instability.

In the context of that, developed market central banks have limited capacity to ease to help weakening economies. The Fed has room under its traditional policy options to stimulate, but much less so in Europe and Japan. Economic growth and inflation will weaken in all developed markets over the next year. Financial markets have limited upside with inverted yield rate curves (e.g., fed funds, eurodollar) or years-long spells before any tightening is priced into the curve (e.g., EONIA, MUTAN). When there is no room left in the curve, that’s an indication that markets are relatively fully priced.

An asset price is simply a series of cash flows discounted back to the present. With US growth rates still priced at slightly beyond 2% a year out (too high), and rate cuts priced into the curve, the market generating high returns from this point forward is not likely.

The long-term return of stocks will a function of the sum of real growth potential (1.75%; breakdown below), 2% or slightly lower inflation, some contribution from dividends, and movements in the forward expectations in interest rates dictating the ebb and flow. 

Stocks are perpetual instruments, making their structural volatilities high. Their effective duration is about 30 years, though it varies over time. That means each 1% parallel shift in interest rates impacts their valuation by about 30%.

The Fed has the ability to squeeze 60%+ out of stocks – taking their effective duration multiplied by their capacity to ease rates along the curve. The Fed had much more capacity to push financial assets higher coming out of the last recession relative to other central banks. That still holds true, just to a lesser extent (less than half the capacity now relative to then). Most stock markets are lower than they were heading into the financial crisis. Japan’s market is lower than where it was 30 years ago. 

But the barriers to switching from tightening to easing are high. (The Fed is expected to run another $300 billion off its balance sheet.)

No developed market central bank wants to ease with rates where they are, but the next step should be toward easing. This means that developed market currencies are not that attractive with cash rates being low and many needing to go lower. Most developed market economies have deteriorating balance sheets, with fiscal and balance of payments situations that will get worse, a negative for currencies over the long-run.

The basic cash alternative, as mentioned earlier, is gold. Gold’s fundamental value is a function of the monetary base (total currency and reserves) in circulation divided by global gold reserves. In the US alone, the monetary base is about $3.4 trillion against $1.9 billion in gold reserves, a valuation of close to $1,800 per ounce.

Gold should be a part of most people’s portfolios, just not in a large allocation (something less than 10%). At the least, it is a form of currency diversification and provides one type of counterbalance to traditional portfolios that typically have a strong bias toward risk assets.

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