Modern Monetary Theory - It's Already Here

For the past six months, Modern Monetary Theory (“MMT”) has been making heads explode all over the blogosphere and in the financial press. Most of the commentary is from ride-or-die free market capitalists shouting about socialism and the End of Days. Few seem to have taken the time to know where MMT comes from or appreciate that (spoiler alert) the Federal Reserve has been practicing MMT for 10 years.

‍Beginnings

‍MMT has a precursor in what is known as Chartalism. The word "Chartalism" has its roots in the Latin word "charta" meaning a token or a ticket. The term was coined by economist Georg Friedrich Knapp, in a book entitled The State Theory of Money, published in 1905. The central tenet of Chartalism is that money is a creature of law, rather than a commodity, unit of exchange, or store of value. This view of money has profound implications:

• As a creature of law, money is an instrument of the state to direct economic activity;
• State issued money has veracity from the state's willingness to accept it as payment for taxes (instead of sheep or Teslas);
• Money is created by the state by printing it and destroyed by the state when collecting taxes paid in it.

In short, if the populace knows it has to pay taxes in state issued fiat currency, it will necessarily conduct transactions and business in that currency in order to have the specie to pay the tax due.

‍Modern Monetary Theory

‍MMT has been around for a while in the fringes of heterodox economic circles but has gotten a lot of press in the past year, ironically because of Donald Trump’s tax and budget policies.The core belief of MMT is that governments which control their own currency enjoy an extraordinary privilege that makes them completely different from households, corporations, and any other entities that have to conduct their business in the currencies of others. The difference, MMT professes, is that such currency-issuing countries cannot go bankrupt. (I will return to this, and the other tenets of MMT, after explaining the theory.)  From this, one implication is that U.S. Treasury bonds owned by China and other countries are not really debts (as they are for individuals) because the government can pay them back in dollars that it creates from trees.MMT asserts that economists have completely misunderstood how government finance works because they have it backwards. The received view is that governments tax individuals and corporations and then spend the tax revenue.  MMT contends that governments create money to spend first and then tax individuals and corporations after.The central MMT policy proscription is to create money (either out of thin air, or by issuing debt - it depends on who you're reading) in order to keep the economy at full capacity.The only constraint to the spend and tax doctrine is inflation.  If inflation ensues, then the remedy is to tax individuals and corporations so that money is destroyed and the inflation contained. If there's no inflation, then money can be created forever.In a sense, MMT puts a market-based throttle on money creation.  Money creation should be used to keep the economy running at full potential until the market tells it to stop with an inflation signal (which can be interpreted as a loss of faith in the currency, or the old-fashioned too many dollars chasing too few goods).Image 1: Tax and Spend or Spend and Tax Infographic[1]

Mechanics of Spend and Tax

‍Under MMT, assets are only created by the government running a budget deficit. Budget deficits add net financial assets to private bank accounts, either indirectly through the banks or directly through giving the money to individuals through a job guarantee or other transfers. Conversely, a budget surplus destroys private assets because the government is taking assets out of private accounts via the tax mechanism. It this way of thinking, money is viewed as a standard of deferred payment (debt) and the government is paid back on this debt through taxation. All of a country’s citizens own a piece of the debt and service it by paying taxes. This belief is what drives the MMT policy recommendation of running constant budget deficits to keep the economy running at maximum potential with no output gap. In theory, this will achieve a policy objective of full employment, where everyone who wants to work has a job. Importantly, in the purest form of MMT, if traditional government debt is issued, it is viewed as an offset against government spending, not a way to finance spending.  (Because MMT is inchoate, it is unclear if its proponents support issuing debt to create the money or just printing it.)

‍MMT is Already Here

‍MMT has been underway since the Global Financial Crisis and the institution of the Federal Reserve’s Quantitative Easing programs. It doesn’t matter that they don’t call it MMT, the money creation is the same and it is financed by debt issuance.Indeed, the U.S. government and Federal Reserve have done exactly what MMT suggests in order to remedy an output gap:  create money, see if there’s inflation (there wasn’t), and tax if necessary (it wasn’t).The reason the Bernanke-Yellen-Powell version of MMT has been so ineffective is that the money was given to the banks, which, for the most part, have not lent it out to job-creating businesses. Instead, the banks have lent the money to hedge funds and private equity funds for leveraged bets on financial assets and financial engineering. This has done nothing but inflate financial asset prices and increase the wealth gap, stoking populist furor.Ironically, President Trump has given credence to MMT by enacting a pro-cyclical tax cut at the end of a record economic and market expansion.  This has given every politician, irrespective of political party, permission to not only completely ignore budget deficits, but to intentionally expand them as far as the eye can see. MMT proponents are already seizing on these facts to support their theories. The theory will likely gain traction because the populace has watched the government make trillions of dollars of handouts to Wall Street and now they want theirs. Who can blame them?In my next post, I will critique MMT and explore the long-term investment implications if it is continued.