Central banks stumble into MMT

An independent Scotland shouldn’t consider for a second running a budget surplus in the early years. It shouldn’t even seek to reduce the deficit – because both these things would simply suck demand out of the real economy. It would harm economic development.

Rather we should be driven not by ‘balancing the books’ but by investment. The more we are investing in the economy in those early years, the better. Public debt is just another way of saying public investment. (Robin McAlpine, Common Weal*)

When times are bad and you cannot cut interest rates anymore, just buy bonds and stick it on the balance sheet.

When times get better, just sell those bonds back into the market and “hey presto!, we are back to normal”.

At least that was the idea.

Given the near impossibility of reversing QE, central banks have effectively started to finance government spending directly. The Bank of England’s £400m “Way and Means” facility is just the latest example of what was meant to be temporary, becoming permanent.

It is almost time for policy makers to stop pretending and openly admit that we have now entered into a Modern Monetary Theory policy world and to make it work as effectively as possible.

Traditionally, economists have looked at the risk of owning a government bond by comparing how much a government owes to the size of their economy or the debt to GDP ratio. The theory says that the bigger the economy, the more able governments are able to pay it off their debts.

However, in this brave new world of super low interest rates, servicing this debt is extremely affordable. The US can borrow money for 20 years at 1.22%, costing $12.2 billion for every trillion borrowed. With tax revenues of $3.5 trillion a year, they can afford to service their borrowings.

MMT theorists go even further. Neither the Fed, Bank of England nor Bank of Japan will ever default on the debt issued in their own currency because they can just print the money they need so analysing the debt to GDP ratio is much less useful in understanding what is happening.

It is much more useful to look at the total amount of debt outstanding and the proportion of that held by the central bank. The BoE and Fed hold about a third of all the outstanding government bonds in their respective currencies and the BoJ holds nearly half.

When you have a single owner of any product that tells you that at some point, as a matter of public policy, they have to sell what they own; you can imagine with what downward effect on prices. In the bond markets where the lower the price, the higher the rate of interest, this would be devastating for the economy.

Caught in a QE trap

Twice the Fed has tried to unwind QE, leading to the ‘taper tantrum’ of 2013 and the Quantitative Tightening of 2018/9. In both cases, bond prices fell in anticipation of the Fed selling more and more bonds into the market, raising interest rates. Rising rates led investors to sell shares that compounded each other in a downward negative spiral of confidence so great as to stop the Fed’s actions.

At least they tried.

The BoE has so far not sold a single asset on the balance sheet accumulated from QE.

The warning signs are there. Lyn Aldan Schwartzer points out how the Treasury ran out of buyers with enough cash to buy US government bonds to fund a $1 trillion deficit. This selling soaked up much of the available dollars washing around the market like a sponge. As QE soaked up all the “liquidity” in the system, the cost of borrowing cash in the repo market spiked up aggressively back in September 2019. The Fed had to intervene again by injecting more dollars into the system. This occurred before COVID-19 hit the economy.

The shift from using the debt to GDP ratio to looking at how many of the bonds are held by the central banks highlights just how dislocated the financial markets are from the underlying economy. Nobody really knows what anything is worth anymore and they are instead now focused in watching where the vast amounts of QE money flows to next.

The Fed/ECB are now both buying corporate bonds too. Apple has $100bn more cash than debt but it still went and borrowed $7bn because it was so cheap to do so. Companies are using this opportunity to borrow at all time low rates to strengthen their resilience by either boosting cash reserves, undertaking share buy backs or refinancing existing debt at lower rates.

How does this part-nationalisation of the bond markets affect us?

The main critique of MMT is that it posed an inflation risk by increasing the monetary base yet the Japanese example has shown just how hard it is to create inflation, even when it wants more of it – desperately. If the traditional link between money creation and inflation has been broken, what are the real risks of having the central bank own bonds issued by the national treasury in perpetuity?

Socialism in one country

As a theory, MMT always worked beautifully in a world without other nations and this made it particularly attractive to one-nation socialists. In the real world, where many competing currencies are freely exchanged without any capital controls, printing vast amounts of money risks a rapid currency devaluation that leads to import inflation.

However, given the central banks have been debasing their currency at approximately the same rate, which currency do you target as the weakest?

If there is no medium-term inflation that can be seen on the horizon and no currency devaluation risk imminent, why are we still pretending that MMT is an abstract economic theory instead of the circumstantial reality?

The real danger is that society has lost one of the basic functions of money in a market-based capitalist system – the ability to measure the real value of something. Effective price discovery in the financial markets has been eroded as the markets now know that the Fed will always step in when the economy is in trouble. It argues that its actions preserved the liquidity of the markets at precisely the time that they were required yet market prices are supposed to tell you the real value of things and when that function breaks down, nobody can see where the economic risks are.

Fred Goodwin found out back in 2009 that a reliance on market liquidity and an excessively high share price masked the true  state of RBS. That came with a final reckoning when that mask slipped, with a catastrophic loss of confidence in that institution.

Counting on the Fed

In this brave new world where MMT-in-all-but-name has removed the ability for the markets to price risk, what are financial market prices telling us about what is going on in the real world, except that the Fed is going to prop everything up?

The NASDAQ just hit an all-time high of above 10,000 with the SP500 and Dow Jones trading near their pre COVID-19 levels, when all the traditional indicators such as unemployment and deficits have deteriorated at a pace not seen before. There is simply nowhere else but stocks to put all that money being produced by all the central banks in the world right now.

Think of it this way, if it was your job to put other people’s money to work, where else would you put it?

Yet that is a false reality being played out that is hiding some very real risks.

What happens if we get a second wave of the pandemic and the world has to lockdown once more because there is no vaccine/treatment available in time? What happens if this second wave is compounded by political instability that leads to mass civil unrest?

It takes a brave individual to bet against the Fed and I would advise against it yet MMT has created so many bubbles in so many markets. None of the experts are pretending any longer that they are doing anything but following the money instead of measuring the fundamental value of things.

If QE was a policy response to the idea that banks were too big to fail, the MMT response is based on the idea that an entire country cannot be left to fail.

The question is: what happens if MMT doesn’t work to save a country in a crisis?

* Indy and MMT, Robin McAlpine, Brave New Europe

Featured image: Federal Reserve by Nick Youngson, via Picpedia CC BY-SA 3.0

Further reading: What you need to know about MMT, Gavyn Davies, FT; Fine to have massive deficits, Stephanie Kelton, FT; Labour’s fiscal credibility rule, Richard Murphy, Tax Research UK; Don’t rule out MMT, Dan McCurry, Labour List; Nonsense economics, Jonathan Portes, Prospect; Why is MMT so popular?, Simon Wren-Lewis, mainly macro; What is MMT?, Steven Hall, The Conversation