The Bear’s Lair: Another new theory to bash

In an inevitable development, the proponents of greater government spending have developed a new theory to encourage it. With Senator Bernie Sanders (I.-VT)’s appointment of its proponent University of Missouri-Kansas City professor Stephanie Kelton as minority chief economist to the Senate Budget Committee, the new Modern Monetary Theory is about to get a serious airing. Those of us who are hoping against hope that some day the global economy will return to sound monetary and fiscal principles should understand this new form of economic sophistry, and divert some of our fire against it.

Modern Monetary Theory (MMT) goes back a fair way; the beginnings of the theory were propounded in a 1905 work “State Theory of Money” by Georg Friedrich Knapp (1842-1926), since when others including Wynne Godley and Hyman Minsky have added to the superstructure. Knapp was the first to propound that money had no intrinsic value and was simply a government token; he was unlucky to live long enough for the Weimar Republic’s Rudolf von Havenstein to put this theory to a thorough test and disprove it pretty decisively.

Under MMT, the central bank printing money and the Treasury running a budget deficit are regarded as equivalent; both involve the public sector running a deficit, thereby allowing the private sector to run a surplus. Hence balanced budgets are regarded as highly restrictive, as is taxation in general. An MMT government seeking to maximize private sector output would run permanent large budget deficits, thereby encouraging the private economy to invest and expand. Cutting budget deficits curbs private saving, since the saving/investment relationship is supposed to be fixed.

On the trade side, the last couple of decades have made MMT look somewhat plausible. MMT theorists consider that the goods are irrelevant to a trade transaction; it the demand for the importer’s currency that makes it work. Thus imports are beneficial to an economy, because they provide valuable goods and services, whereas exporters deprive domestic users of the goods and services exported. Under MMT therefore, the continual U.S. $500 billion payments deficits for the last decade are beneficial, the result of sound policy.

Under MMT, while private sector debt is genuinely debt, government debt is really a benefit to the private sector, since governments can always fund their own debt by handing out newly printed $100 bills to the lender. The theory rests on a central fallacy: that governments and countries can continue increasing their debts ad infinitum, without ever having to pay them back.

It was indeed the Weimar Republic’s von Havenstein, as President of the money-printing Reichsbank, who provided the clearest disproof of that theory. By trying to fund the Weimar Republic’s excessive deficits through printing money, he produced hyperinflation and collapse. The Weimar authorities had found the proto-MMT attractive, because it appeared to provide them with the collateral benefit of bilking the Allies of the war reparations they demanded. However even in this limited objective it failed over any but the shortest timeframe.

However 1923 is not really within living memory, even in Germany, and we need to examine the implications of MMT to today’s economy, in which inflation appears notably absent. Clearly MMT provides a renewed rationale for those whose principal wish is to increase government spending, of whatever kind. If government can either print or borrow money, without having to increase taxes or suffer any other adverse consequences for the economy, then government spending is indeed a free good. Were that true, the left could indeed indulge their hobby of devising infinite new ways to hand out what, according to MMT, is not even the taxpayers’ money.

There’s no doubt that the policies pursued in 2009-11 followed the prescriptions of MMT pretty closely. The Federal budget deficit was allowed to soar well over $1 trillion, aided by $800 billion of spending “stimulus” while interest rates were kept at rock bottom levels and the Fed engaged in multiple rounds of “quantitative easing” – buying Treasury bonds rather than printing money directly, thus subsidizing Wall Street rather than ordinary people.

Since 2012, while the Fed has continued to pursue the dictates of MMT, the Republican-controlled House of Representatives has reversed course, allowing taxes to rise at the end of 2012 and then imposing the spending “sequester” in 2013 and to a lesser extent in 2014-2015. This has resulted in an acceleration of growth and job-creation, as government’s deadweight on the economy has been forced to decline. Because of the deficit’s decline, banks have been less able to buy government bonds and borrow short-term, profiting from the interest rate “gap.” Thus bank lending to small and medium sized businesses has increased, by 16.2% in the year to December 2014 according to Fed figures, reversing the dearth of 2009-12. Of course, MMT would have predicted the opposite to occur in both cases.

The fallacies in MMT are the same as those within Keynesianism itself. First, it ignores both productivity and interest rates. It takes government spending at full value in the calculation of GDP, without taking into account the lower productivity of government compared to the private sector, and the fact that some government expenditure (e.g. much regulation) actively destroys output from the private sector. Thus unrestrained expansion of government, whether financed by printing money or by borrowing, diverts resources from the private sector and suppresses private sector economic activity.

Second, just as Maynard Keynes sought the “euthanasia of the rentier” believing that private savings had no useful function, and suppressed desirable consumption, so MMT proponents ignore the effect of their policies on private saving. But of course, the ultra-low interest rates which their policies produce, because the money creation makes liquidity plentiful in all corners of the economy, suppress private saving, thereby depleting the economy’s long-run capital stock.

High interest rates encourage savings, low interest rates depress them, and in the long run the latter policy reduces the amount of capital available in the economy to employ each worker, as well as encouraging outsourcing to emerging markets that have suddenly lost their capital cost disadvantage against the United States (because money sloshing about everywhere reduces the interest differentials between good and bad credit risks.)

Thus the MMT contention that government deficits increase savings would be true if they occurred in a world in which the money supply was held constant, even though the increased savings would be forced to flow into government bonds as interest rates rose. However in today’s world, where the Fed enlarges money supply to match the deficits, they are either neutral in their savings effect or suppress it, if as today the Fed is more expansive than the Treasury. To the extent that the call on savings from government borrowing is increased, the savings available to finance private investment are reduced.

Thus the MMT is damaging even in conditions like the present, when inflation is absent and confidence in U.S. obligations is very high (largely because of the brave and unpopular de3ficit-reducing actions of the 2011-14 Republican House of Representatives.) If we go into another recession, and MMT policies are followed, with ballooning budget deficits, perhaps to the $2 trillion level, investor confidence in U.S. debt obligations will inevitably decline, as will confidence in the dollar.

The truth is, in today’s market, government securities with their absurdly low interest rates are sold not bought, like stocks from a Wall Street bucket shop. Anyone watching “The Wolf of Wall Street” now available on Netflix, will have noted that there really wasn’t much difference other than the quality of the suits between the low-lifes at Stratton Oakmont and the brokers at the supposedly more gentlemanly traditional Wall Street house L.F. Rothschild, Unterberg, Towbin.

Indeed, from Michael Lewis’ account of them in “Liar’s Poker” the legendary bond desks at Saloon Brothers weren’t that different, either. They had the same drug abuse, same level of profanity, same contempt for the customers, same high-pressure sales techniques and almost the same total disregard for business ethics.

This is therefore the technique that will be used when U.S. Treasuries become difficult to sell. Wall Street’s legion of high-pressure salesmen, somewhat underemployed in stocks because the market will have taken a sharp downturn, will be re-deployed to hustle T-bonds, both domestically and internationally, seeking to create an artificial demand for them. To the extent they are able to find suckers, whether in Peoria or Peru, the deficit will continue to be financed – albeit at the cost of distorting the economy even further from its natural course.

Eventually, of course, even the Stratton Oakmonts of Wall Street, drug habits, hookers and all, will be unable to find enough foolish investors to buy T-bonds, even in the wilds of Uzbekistan. At that point, the game will come to a sharp halt. Probably the Fed will buy the surplus T-bonds – it does, after all, have the capacity to do so, as the MMT proponents keenly point out – in which case it will cause a collapse in the value of the dollar and a revulsion against the dollar’s use in international transactions. As the dollar’s value collapses, inflation will soar, as it did for the unfortunate holders of Weimar Germany’s Reichsmarks.

At that point Ms. Kelton’s theories, along with the Fed career of Janet von Yellen or her like-minded successor, will, one hopes, be confined to the trash can of history.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)