the next generation of monetary policy€¦ · 004 006 008 010 01 014 016 018 0 0 us japan urozone...

VARIANTPERCEPTION THEMATIC

May 2019

It is said the seeds of the next war are planted in the last peace treaty. MMT (modern monetary theory) is seen as a panacea by many because QE has lost the inflation war while creating huge amounts of wealth-skewing asset-price inflation. QE’s failure to create sustainable inflation has led to a false sense of security that more extreme policies can be tried with little risk. However, QE and MMT are profoundly different beasts with the inflationary tail-risks from MMT considerably larger than with QE.

We make no prediction whether unfettered MMT becomes policy in the US or elsewhere. What is apparent is that the current stock of monetary policies are running out of road and there is a thirst to try new policies. While we may not get to “full” MMT, the direction of travel towards a more activist role in the economy for the government is clear, and this requires a profound change of attitude to investing.

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The next generation of monetary policy

Contents

4 The path to MMT5 The failure of QE5 MMT to the rescue6 Potential MMT problems I: high debt and deficits9 Potential MMT problems II: rising rates11 Sailing close to the flationary wind *11 From monetary to fiscal dominance - and inflation13 Potential MMT problems III: trusting the government14 A new investment landscape**Excluded from light version

This is a slimmed down version of a report we published earlier this month. If you would like to enquire about access to the full version, which includes our recommendations as to how investors should navigate their portfolios through a new financial landscape, as well as a trial of our services, please get in touch with our sales team at [email protected]

THEMATICVARIANTPERCEPTION

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OVERVIEW OF CONTENTS

> A new generation of monetary policies are coming into vogue as existing policies reach the end of their shelf life. Policies that involve a more activist role for the government, such as MMT, are being taken more seriously by policymakers and are becoming politically more palatable. Such policies have merits, but they also come with considerable tail risks, which must be acknowledged and taken seriously.

> QE is seen to be a failure as it has not created sustainable inflation while it has led to wealth inequality. This has opened the door to policies like MMT. But MMT is a very different beast to QE. Central-bank financing of large government deficits expands the monetary supply while creating demand, which materially increases the risks of higher inflation.

> MMT states that the primary constraint on the government should not be the deficit, but the real productive capacity of the economy. Governments can raise revenue through taxes and borrowing. Under MMT, governments should borrow and spend until the economy is at full employment, while taxation is used to stimulate and dampen demand and for the redistribution of income. Central banks become little more than printing presses and repositories for government bonds.

> Debt and deficits do not matter, say MMT proponents, as the central bank can print the money the government debt is denominated in. However, a critical caveat is the debt is not owed to other nations. Foreign investors own almost one third of USTs while the Fed owns 11%. Under MMT, there would have to be a major shift to Japanese-like levels of bond ownership, where the BoJ owns more than 50% of JGBs. Until then, deficits do matter, along with the debt ratio which in the US is already over 100%, a level empirically associated with weaker economic growth.

> Supporters of MMT believe as long as the government does not stimulate beyond the productive capacity of the economy, inflation will not develop. However, governments have an inherent inflationary bias and often the temptation to spend to win votes is too great. Every high or hyper-inflationary episode in the 20th century was preceded by large deficits and central-bank monetisation of those deficits past certain thresholds.

> A central assumption of MMT is that the government is best placed to know the needs of the economy. This raises a whole host of questions. How do we define full employment? How do we know when we get there? Would the government raise taxes to dampen the economy - as MMT prescribes - in the


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run-up to an election? Furthermore, what are the implications of the government becoming the explicit, permanent borrower and spender of last resort? Will this change the nature of private investment, making private companies extremely risk averse, or worried that if they do invest they are caught up in a deluge of public investment that massively waters down their returns?

> A gradual erosion of central-bank independence and a shift towards a more activist role for the fiscal authority in the economy will have profound investment implications. Investors will have to adapt to a new financial landscape to that which has preceded it for the last 30 to 40 years.

MONTHLYVARIANTPERCEPTION

| 15Charts Source: Bloomberg, Macrobond and Variant Perception

THE PATH TO MMT

Today’s monetary polices are becoming less effective, and QE is seen as exacerbating wealth inequality. There is a gradual shift towards the government taking a more active role in managing the economy through polices like MMT

Monetary policy is running out of road. In 2016 we wrote a thematic report (Helicopter Money: Why, What and How) detailing the next generation of monetary policies after QE and negative rates. We have not yet hit the next downturn after the financial crisis, but that time is drawing inescapably nearer. Rate cuts and central-bank balance-sheet expansion will not be sufficient to rehabilitate the economy the next time recession hits, and new policies will be required.

Cometh the hour, cometh MMT. QE’s reputation has been tarnished by largely uncontroversial accusations that it has been a driver of greater wealth inequality. By creating bank reserves to buy existing assets, QE has done more to bolster the incomes of those who benefit from asset-price inflation than those who rely on salary or wages alone. This is why MMT is currently in vogue: it is seen as a way to boost the economy in a much more egalitarian way than QE.

MMT is nothing new. It has been tried many times before in several guises and - as history shows - it comes with some real risks. However, after years of policies that are deemed to have failed among much of the public and the political class, the appetite for new policies is strong. Such a yearning, though, is enough to mute out a balanced debate on the merits and risks of MMT.

In this report, we’ll try to give an apolitical, agnostic, data-driven and empirical appraisal for the next generation of monetary policies such as MMT, and what the long-term implications are for investment portfolios. “Full”, unrestrained MMT may lead to a fall in cyclical risk but it will lead to a rise in structural risk.



THE FAILURE OF QE

QE merely changes the composition of the private sector’s savings, from bonds to reserves, while it does little to change the level of savings. Thus while QE failed to create consumer inflation, it generated much asset-price inflation due to huge reserve creation, worsening wealth inequality. MMT addresses the central problem of the private sector’s saving surplus

Quantitative easing has become the go-to monetary policy for central banks after it was pioneered by the BoJ in the mid 2000s to try to resuscitate a stubbornly lacklustre economy.

After the financial crisis, all major DM central banks have resorted to QE through both an expansion (by creating money to buy assets) and a deterioration (by buying non-government debt) of their balance sheets. However, other than preventing the credit system going into a deep-freeze in the immediate aftermath of the financial crisis, it is doubtful the impact QE has had on the broader economy.

Inflation is the target of central banks, often an arbitrary 2% - chosen by them and their government masters - and on this basis QE has been an unequivocal failure.

QE merely changes the composition of the private sector’s savings, not their level. It enables the private sector to swap one saving asset (bonds) for another saving asset (reserves). It does nothing to lower the savings of the private sector, or create the demand for loans that would cause broader forms of money such as M1 and M2 to rise.

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Note: Parts of this section have been excluded from the light report.



MMT TO THE RESCUE

MMT simultaneously expands the money supply and creates demand for that money. Conventional monetary policy becomes obsolete under full MMT, and taxation becomes the primary mode to stimulate or dampen demand

How does MMT address the shortcomings of QE and aim to solve the central problem of the private sector’s propensity to save? Principally it does this by circumventing the banking sector.

In a nutshell, MMT is central-bank financed government deficits. There are two ways a government can finance itself - through taxation and through borrowing. Conventional thinking has it that a government should be constrained by its borrowing. Running too high deficits risks an intolerably high debt burden and an expectation (“Ricardian equivalence”) from taxpayers that higher taxes will eventually result, meaning they curb their spending today. Moreover, there is a greater risk of higher interest rates as the debt burden grows.

MMT, though, avers that the only binding constraint on the government should be the real productive capacity of the economy and a government should borrow as much as it needs until the economy is at full employment with stable prices. The central bank should facilitate this by buying government debt, keeping a lid on interest rates and - as the debt is in a currency the central bank can print - there is never any need to default on the debt.

Taxation in the MMT framework has one main purpose - and that is to dampen or stimulate economic demand - while also being used to redistribute income. Rates are considered inferior for these purposes. In MMT, it is believed that the main source of inflation comes not from too much growth, but from the excess pricing power of businesses due to monopolies. So there is a natural regulatory-driven anti-monopoly angle to MMT as well.

Overall, under MMT fiscal policy would supplant the role that has been played by monetary policy since the 1980s.

POTENTIAL MMT PROBLEMS I: HIGH DEBT AND DEFICITS

MMT proponents contend that debt and deficits don’t matter when the central bank is financing the government’s deficits. This may be true if the debt is predominantly held domestically, but is categorically not the case in the US

The MMT debate has been controversial. Vaunted individuals from Laurence Summers to Paul Krugman and from Ken Rogoff to Jay Powell have tried to rubbish it. But as Oscar Wilde put it, the truth is rarely pure and never simple.

On its basic premises, MMT is fairly sound: a) governments need not default on debt their



central bank can print; b) full employment is a laudable goal; and c), principally MMT, unlike QE, circumvents the banking sector by creating its own, government-driven demand.

But there are some considerations. A critical caveat of MMT is a government can borrow as much as it likes as long as it is not owed to other nations. It is feasible to keep bond yields in check if your central bank is buying most of your debt, but if you are reliant on the kindness of strangers then you are at risk of a buyer’s strike in government debt - or worse a sudden stop of inflows - and a surge in bond yields. In the US, foreigners own almost a third of outstanding debt. The Fed currently owns only 11%. It is likely if there was a full shift to MMT the Fed would end up owning BoJ-like levels of its own debt (the BoJ now owns over 50% of outstanding JGBs).

Foreign demand for USTs is elastic. We can see that as rates have risen in the US, the percentage of treasuries held abroad has fallen. This is because in recent years the marginal buyer of USTs went from foreign central banks managing FX pegs - who are price insensitive - to foreign non-official accounts, who are price sensitive. As LIBOR rose, the cost of hedging the FX became more expensive, and foreign demand for Treasuries fell.

From a Japanese or European’s perspective - who are the largest foreign buyers of USTs - most of the UST curve is negative and inverted. (China buys fewer USTs these days as it has a smaller external surplus and also wishes to diversify away from the USD.)



Thus the UST curve from the perspective of foreigners after FX hedging is an important dynamic of the Treasury market and cannot be wished away overnight. In that case, at least until the point where the Fed is like the BoJ and buying all net issuance of debt and owning an ever-growing proportion of outstanding debt, then deficits do matter.

On that point, after 2018’s pro-cyclical fiscal stimulus, the US is already running a deficit that is over 4% of GDP. The US’s twin deficit - budget plus current account - is the fifth largest in the world.

Public Debt to GDP in the US is now over 100%. Reinhart and Rogoff, in their landmark book about debt and financial crises, This Time Is Different, surmised that countries whose public debt-to-GDP exceeds 90% experienced a drop-off in economic growth. While there was some controversy over how they arrived at that number, the literature is generally agreed that larger debt loads are not cost-free, and at some (tipping) point interest-rate payments spiral and become a headwind for growth. Deficits matter, and so does the total debt load.

Another claim made by some in favour of MMT is that government debt can just be cancelled. Firstly, that would be more difficult in the US than in a country like Japan, where foreigners hold a comparatively small proportion of government debt outstanding (although even in Japan this is steadily growing).



Secondly, even in Japan, cancelling the debt does not cancel all the monetary liabilities (reserves and cash) created on the back of it. Cancelling the debt means these liabilities are now permanent, and makes this permanence explicit. This is not something seen before, and it cannot be taken for granted that it will be non-inflationary.


POTENTIAL MMT PROBLEMS II: RISING RATES

MMTers contend that under MMT rates are biased lower not higher. However, this is only true until it’s not, and in our view the tail risks shift considerably to higher inflation under MMT

A central contention of MMT - and one that makes many a macro-economist choke on their coffee - is that large government deficits financed by the central bank lead to lower not higher rates. On its own this is not outrageously controversial. Loans create deposits rather than deposits creating loans, and as fiscal deficits are monetised, this creates more banking reserves, which pressures rates lower. This is what we have seen in Japan in recent decades.

However, once again there are caveats. A surfeit of reserves may keep a lid on short-term rates, but it is not binding on longer-term rates, which are more susceptible to inflation and inflation expectations.

This really gets to the heart of the risk with MMT: when does the fiscal authority know when to stop borrowing and spending? If the aim is to stimulate until they can see “the whites of the eyes of inflation”, or when every single able-bodied and minded individual has a job, then this may be too late. Inflation is like toothpaste - much more difficult to put back in the tube



once you’ve taken it out.

Moreover, inflation has a clear positive skew. Extremely high CPI prints are more likely than extremely low prints, and there is a greater volatility on the right-side of the distribution. Higher inflation is likely to lead to higher and more uncertain inflation.

The response from the proponents of MMT is likely to be that with the central bank buying government debt without limit, then higher rates driven by inflation are not a problem. However, low rates in an economy with a freely-floating exchange rate, as in the US, would likely lead to the USD becoming a funding currency in FX carry trades.

Investors borrowing the USD would pressure it lower, which raises the risk of inflation (unless you intend to close the capital and current accounts). Under MMT, taxation is the primary tool to regulate inflation so this would require higher taxes. If, then, government spending was ramped up to offset the rise in taxation, this would add to the money stock, which would weigh on the USD, in turn adding to inflation pressures - you are back to where you started.

An MMTer may also respond that the yen has been a carry funder for years with no major inflation problems in Japan, but this neglects the fact that the primary driver of the yen is not foreign flows, but domestic flows, and these often act to support the currency. Japan is the world’s largest net creditor, while the US is a net debtor.

A final point is that even if you have low rates, the interest cost can still become very high if there is oodles of outstanding debt. We can see that in the US, the interest outlay is set to skyrocket even after years of low rates. Under MMT, the central bank would likely end up having to monetise the interest repayments as well.

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Overall, this matters less if the central bank owns most of the debt, but as shown above the US is still highly dependent on foreign buyers. Interest payments that leave the country have a negative impact on the economy as that income is not recycled.

FROM MONETARY TO FISCAL DOMINANCE - AND INFLATION

Governments are inherently inflationary. A gradual shift away from central-bank independence back towards fiscal dominance greatly skews the tail risks to upside inflation surprises

Democratic governments have an inflationary bias. Governments often concentrate the benefits of their actions on small segments of society whose votes they want to retain or win in order to get re-elected. They would prefer to spread the costs associated with these benefits as widely possible, so they are not felt too acutely by anyone. Rather than putting taxes up to pay for its spending, it’s much easier for the government to borrow. However, the more they borrow, the more interest rates rise, crowding out other sectors in the economy.

We can see a structural relationship between the government’s budget and inflation. Taking the US and UK as two examples, we can see that growth in government spending tends to imply structurally higher inflation (even in the absence of MMT).

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Years of central-bank management of the economy (monetary dominance) looks like it is gradually coming to an end, to be replaced by the government becoming the principal agent in managing the economy (fiscal dominance). Fiscal dominance is more the norm and it is only the last 20-30 years we have had monetary dominance (and rather than that leading to lower inflation it may be the other way around, with monetary dominance in actual fact a consequence of an organically low-inflation era).

As governments tend to be inherently inflationary, we should expect in the coming years as we shift back towards fiscal dominance that the tail-risk will shift from low inflation or deflation (which the micro-managing central banks were so intent on avoiding) back towards higher inflation (as we saw in eg in the 1970s). This has implications for investing and portfolios that we’ll discuss in the last section.

The stagflation of the 1970s was precipitated by pro-cyclical fiscal stimulus abetted by the central bank in the late 1960s. The government of the time over-estimated the productive capacity of the economy and eased fiscally, thinking there was more slack. A compliant Fed kept rates lower. The high inflation of the 70s saw several shocks, such as Nixon closing the gold window in 1971 and the oil shock in 1973, but the seeds were planted before by Fed-supported government spending on an already ‘hot’ economy.

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We can see a similar dynamic today: the US’s budget deficit is rising while the unemployment rate is falling. This is unusual, and the last time it happened to the same extent was in the late 1960s, just before inflation began to rise notably through the 1970s.


POTENTIAL MMT PROBLEMS III: TRUSTING THE GOVERNMENT

Will the government have any better knowledge of the requirements of the economy than the central bank? We don’t think so, and raise several questions on the matter

Our main criticism for MMT can be boiled down to one thing: can you trust democratic governments to do the right thing for the economy over the long term? Central-bank independence was brought in so that there would be, in theory, an independent steward of the economy, mitigating downturns and keeping inflation stable and positive. Central-bank governors and those on rate-setting committees have long tenures, and are not subject to change every time there is a change of government so they can act with more independence and are not swayed by having to win votes.

MMT necessarily compromises this independence. Under MMT, it is the government that decides how much to spend; it is the government that decides when it should stop spending as full employment has been reached - if that is even something that can be known at the time; and it is the government that decides when to raise and lower taxes in response to a cooling or over-heating economy. The central bank becomes a mere supplicant, there to print money and buy the government’s debt.

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As we discussed above, governments are inherently inflationary, and there is no guarantee the fiscal authority will step in to take the punch bowl away before inflation develops. Doubly so if this in the run-up to an election - which government wants to raise taxes just before the electorate takes to the polling booths?

The version of MMT as promulgated in the US contains a job guarantee. But this also brings with it a host of questions. If the economy is in a slump, it may be there are only unproductive jobs for the government to create (“digging up holes to fill them in again”). Otherwise is the government best placed to know where jobs are needed? Furthermore, how does the government know what is the correct wage to pay? If it’s too low, it’s exploitative, and if it’s too high it could crowd out the private sector.

Also, when the slump is over, how smoothly will it be able to transition jobs back to the private sector, given the likely mismatch between jobs expiring and new jobs required? Moreover, it would be highly politically inexpedient for the government to sack lots of workers just because the economy is on a stronger footing (making central banks’ punch-bowl removal look like a trifle).

Additionally, as we touched on earlier, what are the implications of the government becoming the explicit, permanent borrower and spender of last resort? Will this change the nature of private investment, making private companies extremely risk averse, or worried that if they do invest they are caught up in a deluge of public investment that massively waters down their returns?

Ultimately, as discussed above, governments are inherently inflationary. Shifting back towards fiscal dominance and away from monetary dominance profoundly changes the investment outlook, with higher inflation becoming the main tail risk. In the final section we’ll discuss some of the investment implications of this.

Please get in touch with our sales team, [email protected], to enquire about access to the full report.


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