- Victor C. Bolles
Henry's Silver Coins
Recently, one of my readers/listeners forwarded to me an article posted on LinkedIn by Ray Dalio, called “It’s Time to Look More Carefully at “Monetary Policy 3 (MP3)” and “Modern Monetary Theory (MMT)”.” It is a rather wonky document regarding how to use MP3 and MMT to stimulate the economy and is based on Mr. Dalio’s view on how the economy works that is explained in rather wonky PowerPoint presentation called “How the Economic Machine Works.”
Mr. Dalio is a very smart man who has made billions of dollars managing the world’s largest hedge fund, Bridgewater Associates (and also by taking advantage of the carried interest tax loophole available to fund managers). Links to explanations of Mr. Dalio’s economic thinking are embedded in my blog post and can also be found on LinkedIn if you want to delve into the details of these ideas. I will try to give you the CliffsNotes version before I make my comments.
I will start by attempting to explain Mr. Dalio’s theory of how the economy works because that background will help you understand why he thinks that Monetary Policy 3 and Modern Monetary Theory will help to rebalance some of the shortcomings of the current direction of the US (and global) economy. Mr. Dalio has a very finance-centric view of the economy (as he explains in his PowerPoint presentation, “credit is the most important part of the economy”. And not only finance-centric, but government-centric. He believes that government controls the pace of economic activity through monetary and fiscal policies implemented by the government to a) juice up the economy by lowering interest rates and increasing government spending, and b) holding back inflation by raising interest rates.
Mr. Dalio believes that the two principal policies of the central bank (the Fed) are controlling interest rates to expand or contract the amount of credit available in the financial system (which he calls Monetary Policy 1) and quantitative easing to push cash into the financial system by purchasing financial assets from financial institutions (which he calls Monetary Policy 2), which is why he calls his alternative Monetary Policy 3 (we'll get into that later) .
In Mr. Dalio’s economic universe, the economy is made up of all the economic transactions conducted by buyers and sellers across the country. Buyers use their income to purchase the seller’s products or services. If the buyer can borrow, he can increase his purchases and live better (at least, temporarily). The buyer’s cash and borrowed money means extra income for the seller, which with the additional borrowing possible due to his higher income allows the seller to buy even more and improve his (or her) life. However, when the original buyer has to repay the loan (plus interest) he must reduce buying and use some of his money for loan repayment. This reduction in buying reduces the income of the seller who then has to reduce buying, creating a downward spiral. Multiply this one buyer and one seller millions of times and you have the economy as a whole. The expansion and contraction of credit creates cycles in the economy but, thanks to improving productivity, the bottom of each cycle is higher than the previous bottom such that over time the economy keeps improving.
The problem with this model is that the economy is much more than the expansion and contraction of credit. Finance and credit is the tail, not the dog. The United States grew to be the world’s economic powerhouse long before there was a Fed and long before the government came up with the idea of juicing the economy through government spending.
The Fed wasn’t created to manage the economy, it was created to provide stability to the banking system and to prevent banking panics that had plagued the US economy from time to time. Banking panics occur when banks have liquidity problems and depositors worry that the bank will not be able to repay their deposits, so they rush to withdraw their money causing the bank to collapse. The root cause is a loss of public confidence in their bank or depository institution. The Fed acts as the Lender of Last Resort so that in a crisis of confidence banks can borrow from the Fed to honor their obligations. The Fed also acts as the check clearing system so that merchants and others will accept the checks of their customers no matter which bank in the Fed banking system it is drawn on.
Obviously, the details of Fed operations were and are more complex than presented here but this explanation provides the gist of why the Fed was created. It had a limited role to support the US banking system and operate an inter-bank check clearing system. National banks are all members of the Fed and most of the Fed governors are bankers or academics (which drives the leftists nuts). Fed independence from political interference has been a cornerstone of Fed charter and operations since its inception.
Over time the Fed’s role in the US economy has expanded. The Fed’s powers were inadequate to deal with the banking panic created by the Great Depression, so President Roosevelt expanded the Fed’s ability to act as Lender of Last Resort by removing legal restrictions on how much it could lend. The Fed’s powers and responsibilities have been expanding ever since.
Government spending to spur economic growth was a novel concept at the time of the Great Depression. The concept received formal theoretical underpinnings from British economist John Maynard Keynes’ seminal work “General Theory of Employment, Interest and Money” (published in 1936). Politicians, of course, received the new ideas with enthusiasm, as Keynes seemed to give them license to increase spending and hence increase their influence in the economy (and their ability to raise campaign funds). Government spending had represented a minuscule percent of economic activity for most of our history (except during wartime). It was only three percent of GDP in 1929 at the onset of the Great Depression rising to around ten percent during FDR’s presidency before WWII. The efficacy of government spending to counter economic downturns remains an open question. Even FDR’s Secretary of the Treasury Henry Morgenthau stated in congressional testimony on May 9, 1939 that, “I say after eight years of this Administration we have just as much unemployment as when we started. … And an enormous debt to boot!” Many economists credit the advent of World War Two for the end of the Great Depression rather than FDR’s New Deal and the deficit spending by the Federal Government that came with it.
Massive government intervention did little to mitigate the Great Recession of 2008 (although the Fed and the Treasury working together through the Troubled Asset Relief Program (TARP) did save the financial system). Tax rebates (from President Bush) and deficit spending (from President Obama) did little to goose the economy which staggered on with sub-par growth for several years after the recession was over. The Fed meanwhile shoved trillions of dollars into the economy through its Quantitative Easing program (QE). But all that money just sat in the banks (actually back in the Fed in the form of excess reserves) as banks were unwilling to lend and borrowers were unwilling to borrow because the confidence of consumers and producers throughout the economy had been severely shaken.
All the machinations of government did little to lift the gloom of the American people, who hunkered down and used their tax rebates to pay down debt even as interest rates plummeted. Because it is people that drive the economy and if people do not have faith in the soundness of country’s economic system (and the government’s ability to solve economic problems) then there is little the government can do until it can rebuild the public’s confidence in its leadership and economic policies.
So all of this is prelude to comments about Mr. Dalio’s essay on MP3 and MMT. Of course, in order to understand why he is recommending these policy changes you have to read his essay (actually two essays), Why and How Capitalism Needs to Be Reformed (Parts 1 & 2), also published on LinkedIn. In the essays he makes the case that the economy has not been performing very well for most over the last several decades.
While President Trump may brag about three percent GDP growth, record low unemployment and sky-high stock exchange, much of the 2020 presidential elections will hinge on uneven economic performance and income inequality. So we can concede that the economy is not performing well for everybody without having to read Mr. Dalio’s essays. The real question is whether his recommended reforms are the right prescription for the country.
Mr. Dalio believes that interest rate cuts (Monetary Policy 1) and Quantitative Easing (Monetary Policy 2) do not relieve the economic plight of common people because interest rate cuts are disseminated through the financial system (they only indirectly affect common people) and QE principally raises the prices of financial assets (which are principally held by already wealthy people). He advocates a coordination of monetary and fiscal policies to increase the effectiveness of government actions by more directly targeting common people.
Linking monetary and fiscal policy requires the elimination of Fed independence and makes monetary policy subject to political considerations. Mr. Dalio concedes this point noting, “The big risk of this approach arises from the risks of putting the power to create and allocate money, credit, and spending in the hands of politically elected policy makers.” His feeble solution to this dilemma is that “the system would have to be engineered in a way that decision making would be in the hands of wise, not politically motivated, and highly skilled people.” That our politicians would put this tremendously powerful system in the hands of some sort of Platonic philosopher kings is about as likely as you know what freezing over.
Despite this flaw, which I believe is fatal, Mr. Dalio insists that the coordination of monetary and fiscal policy would result in a new New Deal that would lift the economic boats of the common folk just like FDR’s did (except keep in mind what Mr. Morgenthau said). Concentration of power into the hands of politicians is dangerous, how much more into the hands of the unelected technocrats Mr. Dalio recommends?
How would we fund the new New Deal that Mr. Dalio envisions? He suggests that Modern Monetary Theory is the answer. MMT states that governments that borrow in their own currency can print all the money they want because government debts can be repaid by printing more money. The fact that every government that has tried this has gone down in flames does not deter the supporters of this concept. They assert that as long as there is excess production capacity and unemployment in the economy there will be no inflation and, therefore, no problem.
The problem with this thinking is it ignores the matter of who is willing to hold dollars or dollar denominated debt (US Treasury Bonds) when the Government is rapidly printing much more of them? The traditional analyses of comparing the amount of debt to the size of the economy and the government’s tax revenues may not matter to believers in MMT. But to non-believers (still the majority) they DO matter. A lot!
Printing more money may be great for a country that is isolated from the world. But the reality is that we trade with other countries around the world and a large part of our currency and Treasury Bonds are held by foreigners (like China). If we have the printing presses churning out dollars like nobody’s business, sooner or later foreigners will be reluctant to continue to hold dollars, or will demand a higher interest rate to hold them, thus taking a larger bite out of our government tax revenues. Too many dollars floating around also means that the demand for the dollar (the exchange rate) will fall against other currencies making imports expensive and driving up prices. Our populist friends on the left and right would cheer this development and argue for high tariff barriers on foreign products and push for import substitution which favors (inefficient) domestic producers. This is a formula for crony capitalism and politically derived outcomes that gives great power to politicians and often is a first step toward totalitarianism. It does not move the economy in the direction of the invisible hand of the market allocating resources to the most productive uses.
MMT proponents assert that the central bank can buy up the government’s debt by printing money as long as there is no inflation. A recent article in the Wall Street Journal points out that Japan is already doing this as the Bank of Japan buys more and more government debt (almost 500 trillion yen). But Japan’s economy has been stagnant for decades despite government spending that far exceeds revenues, with or without MMT. And one wonders what will happen when the house of cards collapses. Sovereigns were debasing their currencies long before Henry VIII added base metals like copper to gold and silver coins. People can be fooled for only so long.
Mr. Dalio believes that a country can be run based on the kind of relentless meritocracy that he has implemented so successfully at Bridgewater Associates. But as I wrote in my essay, “On the Limits of Thought Meritocracy” (January 19, 2018) his company bears more resemblance to China under Mao than it does to American free market capitalism. The ability of Mr. Dalio to translate his business practices into public policy remains to be seen.
The point is: it was not government management of the economy that made America the wealthiest, most prosperous country in the world. It was the free market, with the profit incentive and stable rules of the game creating the most wealth by allocating resources to their most productive use. Giving the government (or some unelected technocrats) greater sway over the economy jeopardizes our prosperity and that of our children and grandchildren.