19th February 2019
Economics, especially monetary economics, has a tendency toward utopian fantasy. The latest utopian fantasy to emerge from monetarist economics goes by the name Modern Monetary Theory or MMT. It is worth paying attention to the debate around MMT because it could have important implications for financial markets.
Some advocates of MMT are using the theory to claim governments can spend without limit, and that they can do so without raising taxes. They can do this, according to MMT, because governments can print their own money. As a result, governments can safely accumulate an unlimited about of debt, because they can always print new money to pay off that debt. Unsurprisingly, some critics of these ideas have dubbed MMT a Magic Money Tree.
The current environment of political populism is providing a willing audience for learned economists willing to tell politicians it is safe to spend without limit. As a result, MMT is beginning to gain an audience amongst policymakers.
The idea underpinning MMT is both simple and true: sovereign countries that control their own monetary system can print an unlimited amount of their own currency.
It follows therefore, a government who controls its own monetary system, and who borrows only in its own currency, need never go bankrupt. If its debts become too burdensome it can simply print the money to pay them off. If the government wishes to spend more it can simply print the necessary money. What’s more, because the spending can be funded with printed money it is unnecessary to raise taxes to match the higher spending.
This line of reasoning leads advocates of MMT to conclude that governments can and should fund any and all worthy causes ranging from infrastructure investment to social security and healthcare costs.
Hopefully by now MMT is sounding too good to be true, that is because it is too good to be true.
Although governments can print themselves unlimited money, they cannot turn that newly printed money into productive real economic activity.
A simple thought experiment helps explain what is likely to happen if a government chooses to print itself more money and then spend that money.
Because economic activity is a relatively slowly moving variable, we can assume the real economy – the amount of goods and services being manufactured and sold – remains roughly constant through the money printing exercise. As a result, when a government awards itself more spending power, through the printing press, it will be able to buy a greater share of the country’s economic output. This will leave a smaller share of economic output available for the private sector. In other words, the purchasing power of the money held by the private sector will fall. This is of course is what we mean by inflation – rising prices or equivalently a falling value of money.
Looking at the money printing process in this way is helpful because it makes the connection between money printing and taxation clear. A government may gain spending power by taxing its citizens, which reduces the citizens’ spending power, or by printing its own money, which also reduces citizens’ spending power in the same way. It would therefore appear that Government spending through monetisation and through taxation are equivalent. There is no free lunch and there is no Magic Money Tree.
In practice, however, there are some important political differences between a government funding itself through taxation and one funding itself though the printing press. A government funded through taxation will find its spending plans closely scrutinised by a population, quite rightly, resistant to excessive taxation. By contrast a government funding itself through the printing press appears to be giving without taking. Monetised spending is popular, even populist, and usually occurs without scrutiny.
It is the lack of oversight that accompanies monetised government spending that is especially dangerous. History has shown us once a government begins funding itself through the printing press the process often spirals out of control, leading to an inflationary spiral.
The inflationary spiral then tends to damage economic activity leading to a contraction in the real economy. As a result citizens find themselves suffering a falling share of a contracting economy. Zimbabwe is a recent example of such a monetised economic collapse, Venezuela a current example and Turkey a potential example.
To be fair to the more moderate faculty of the MMT school, some proponents of MMT recognise the inflationary dangers associated with monetised spending. This group tend to argue governments can and should increase spending but only up to the point at which inflation starts to become problematic. Though theoretically appealing this approach carries significant dangers.
The key difference between MMT and Keynesian stimulus appears to be that Keynesian policies are seen, in theory, as temporary counter cyclical measures whereas the proponents of MMT appear to be arguing for permanent stimulus on a much larger scale. Given the lags in the relationship between recorded inflation and monetised spending and the difficulty in reversing spending plans once enacted, it is hard to see how the MMT mindset, if adopted by policymakers, will not inevitably lead to an inflationary cycle.
For investors the most obvious consequence of MMT would be a significant reduction in the real spending power of money. Money would become worth less and in extremis literally worthless. Investors holding cash or nominal bond portfolios would likely suffer the greatest losses in real terms while those real assets would likely fare much better.
To be clear, we don’t see the inflation risk posed by MMT as an imminent threat. But populism is on the rise and historically populist leaderships have proven especially susceptible to monetary snake oil. We have been surprised by increasing commentary around MMT and the degree to which it is being taken seriously.
We will be keeping a close eye on the MMT debate and advise others do the same.
12th February 2019
Our recent posting, Beware the Mean Reversionists, showed how the current US growth spurt is unremarkable in terms of its longevity or impact and, even if it was an outlier, the current growth rate itself is average by historic standards. Of all 283 twelve-month rolling growth rates since 1948, the current run-rate is about midway.
When economies do slow dramatically it’s often down to debt. When households and companies overstretch themselves, they effectively experience an economic exhaustion. Growth slows when the private sector comes to realise it’s overspent and over-indebted.
When we look at the headline numbers in this respect, we are reassured. The US private sector is not as indebted relative to GDP as it was before the Global Financial Crisis.
Moreover, although some pundits have pointed to historically low unemployment as a limit to growth, there’s room for optimism.
The recession after the financial crisis, for a myriad of reasons, kicked a high number of participants out of the jobs market – a fall too steep to be driven by demographics alone. It’s not unreasonable, therefore, to assume that the participation rate - the percentage of the civilian population that make themselves available for work - could pick up meaningfully from here.
The global economic backdrop isn’t providing a tail-wind for the US right now, but headline data in the US at least doesn’t suggest the current growth spurt will die of old age.
8th February 2019
We’ve heard it said a lot recently that the US economy has peaked and, although the world isn’t without challenges, much of this argument hangs on the simple view that it’s had such a good run of late, what goes up must come down.
The Mean Reversionists, as we call them, generally assume that the longer the period of unbroken growth, the more likely it is to break.
We’ve looked at the numbers and, even if the Mean Reversionists are correct, the current US growth spurt really isn’t that remarkable in terms of either length or magnitude.
This chart shows US real GDP since 1947, with the duration of growth spurts (in quarters) on the horizontal axis and the increase in GDP (rebased to 100) on the vertical.
Given the economy stalled briefly at the start of 2014, the current period of unbroken growth (the blue line) is neither mature nor profound by historic standards.
To be fair the decline in 2014, as in 2011, was extremely small so being less purist with the data we also show the period from the end of the Global Financial Crisis to now (the dashed line). Although this growth spurt has a few grey hairs, it’s been very anemic by historic standards in terms of cummulative growth.
We’ll address some of the broader challenges in later blogs but for the Mean Reversionists, at least, the data doesn’t back up their argument.
7th February 2019
Welcome to Rational Exuberance.
The team here at Equitile constantly analyse the world around us and so we decided to launch a new blog as an informal way (you can expect the odd typo!) to share some of our observations, insights and ideas with our clients.
We have called the blog Rational Exuberance to remind ourselves to pay due attention to the positive processes of innovation which drive economic growth and, ultimately, investment returns. Naturally, we remain alert to risks, and we will share our thoughts in this respect, but we endeavour not to fall too far into the very human trap of focussing unduly on hypothetical negative scenarios – especially those which dominate the media. To gain a deeper understanding of why we think this way, we recommend the late Hans Rosling’s Factfullness or our own synopsis of his work The Anxiety Machine.
Our title, ‘Rational Exuberance’, is of course a nod to the famous ‘Irrational Exuberance’ phrase coined by Alan Greenspan, Chairman of the Federal Reserve, in a speech to The American Enterprise Institute in December 1996. He asked: “how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
When he made that speech the US stock market had rallied 200% over the previous decade. His thinly veiled warning of irrational exuberance looked eminently sensible and doubtless encouraged some prudent investors to divest their holdings.
A little more than two decades on from the Irrational Exuberance speech the US stock market has rallied another 280%.
In the years since December 1996 there have certainly been some wrenching financial crises. Nevertheless, innovation has continued driving economic expansion, people around the world have become healthier and richer and the investors that remained rationally exuberant over the time have enjoyed the benefit of that progress.
In coming decades there will doubtless be more financial crises and market setbacks, but there will also be innovation, economic growth and, we are sure, good investment returns to be enjoyed.