Doc's Daily Commentary

Mind Of Mav

How Debt Has Changed & Why That’s Dangerous

Modern Monetary Theory (MMT) is slowly but steadily becoming a bigger and bigger part of mainstream economics and central banking. If you’re not familiar with its basics, here’s a brief primer I wrote about it:

The biggest divide between MMT and traditional economics is its view on federal debt. Under MMT, the national debt is nothing more than a formality — because the U.S. issues debt in its own currency, it can never default. It can always print more dollars to pay off its debt.

The limiting factor in the MMT world is inflation. As long as inflation is under control, then the government should readily accept fiscal deficits (even growing ones) in its pursuit of zero unemployment.

This Is Dangerous

Low unemployment is a fine objective. I actually like the idea of a job guarantee as an economic shock absorber (as proponents of MMT recommend). But what would be the cost of such a job guarantee?

Currently there are around 10 million unemployed in the US. Providing all of them a minimum wage full-time job ($7.25 an hour for 2,000 hours) would cost $145 billion a year. Considering that there are many more who work part-time (and fewer hours than desired) and that some states have higher minimum wages, a conservative annual cost estimate is probably closer to $180 billion. Accounting for the overhead needed to run the program, a job guarantee program could easily exceed $200 billion.

During a recession when unemployment spikes, this cost would be even higher — something like $400 billion a year is possible. Also, this cost only partially replaces fiscal stimulus such as small business loans and unemployment. Unemployment benefits, especially after being boosted by the various stimulus packages, paid out far more than what you could earn working a minimum wage job — so people would definitely exhaust their unemployment benefits first before thinking about working.

So how would all this get paid for? MMT says no worries, debt is no more than a state of mind — it’s not real. So rack up as much of it as necessary to prop up the economy and reduce unemployment. Everything will be fine as long as there’s no inflation.

Is That Really True?

Let’s think about what ever expanding federal debt would mean. In a world of expanding debt, Treasury bond issuance would likely exceed demand.

If the U.S. government floods the Treasury market with supply, prices will fall and interest rates will rise. Of course, Wall Street and the government don’t want that — higher rates would significantly raise interest expenses as a percentage of GDP and hurt risky asset prices (e.g. stocks and real estate).

So in order to keep prices steady (i.e. manipulate the market down), the Fed (Federal Reserve) must step in and absorb the excess supply by printing dollars and buying Treasury bonds. These printed dollars can then be and are directly spent by the U.S. government. Critically, this is different from QE where the printed dollars are not spent — QE doesn’t increase the supply of money, rather it takes existing long duration bonds out of the market and replaces them with cash.

Debt Monetization

In MMT’s case, the government prints money in order to buy its own newly issued bonds and then spends that money into the economy. If it all sounds kind of circular and redundant, that’s because it is. What’s the point of issuing bonds if the government is literally issuing those bonds to itself (as opposed to investors or banks)? Why not just directly spend the printed money and skip the bond issuance step?

Under MMT, we could if we wanted to. Then again, even in a MMT world we would still want a bond market as it theoretically provides savers a way to earn a real return without taking on much risk. Long duration bonds also allow institutions to hedge their liabilities that are far off in the future. So as little as they might pay, a sizable portion of the world still needs bonds.

So, in the MMT world, the government issues a ton of bonds every year (in order to finance its spending needs in excess of what it has collected in taxes) and pays for them with printed money.

This flood of printed dollars is obviously very bearish for the U.S. Dollar. Ever higher debt levels also locks the U.S. into requiring low interest rates indefinitely. When federal debt levels get too high, rising interest rates can cause a nasty feedback loop where interest payments that can’t be fully paid off increase debt to GDP which further increases interest rates and interest expenses (as default fears rise). Thus, bond yields must remain exceedingly low. Moreover, to make bonds palatable as an investment, cash rates must be even lower than bond rates (so bond investors can at least earn a positive spread).

Permanently low interest rates on cash and bonds increases economic fragility. Traditional monetary policy relies on decreases in the cash rate to stimulate the economy. QE relies on decreases in longer duration Treasury bond rates to encourage risk taking and boost asset prices. In a MMT world of high debt and very low yields, these levers will no longer be available.

MMT’s counter is that the U.S. can’t default — the money needed to pay off the debt can always be printed. Ditto for the money needed to stimulate the economy. But if the answer to everything is “no worries, we can print”, then the ultimate result can only be inflation and perhaps even the loss of reserve currency status.

MMT Puts Too Much Responsibility On Politicians

Sure, taxes can be raised to rein in excess inflation. But think about it — since when have politicians been able to do the hard but necessary things?

It’s easy to print money and spend it. It makes everyone feel happy and good (besides bond holders). It’s very hard to raise taxes when the need to cool things off arises. So knowing human nature, my guess at the ultimate result of a MMT world is lots of printing, lots of inflation, and very little discipline.


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