Modern Monetary Nonsense
I got my first lesson in inflation when I was about 10 years old. One rainy day I was playing up in the attic and I discovered a bag full of paper money. A lot of it was paper money from the Confederate States of America that I realized wasn’t worth very much. But there were also millions upon millions of German marks. I recall that I knew that German marks were not worth as much as the dollar and I vaguely remember that somehow I found out that the exchange rate was around 2.6 to one. But even then, there were tens of millions of marks worth millions of dollars. I told my parents what I discovered and that we were rich. I don’t recall if they laughed (it was a long time ago) but they told me that these were old PapierMarks from the Weimar Republic and that they were worthless because of hyperinflation in Germany during the 1920s. They told me an apocryphal story about a German going to the bakery with a cart stacked high with PapierMarks. The man went inside to see if there was any bread for sale but when he came out his cart had been stolen but the thief left behind the worthless paper money.
My second lesson about inflation came when I worked on a bond issue for the Mexican oil company Pemex. In 1982, Citibank helped Pemex issue $150 million in 12-year bonds with a fixed interest rate of 17.75%. The fixed rate was set so high because US inflation was running rampant (and also because Mexico was not a very strong credit). Many of the investors in the bonds were banks. Banks (because of their deposit structure) do not like fixed rate investments, so we offered them a fixed-floating swap where they would pay Citibank an amount based on the fixed rate of 17.75% and Citi would pay them a floating rate based on the three-month London Interbank Offered Rate (LIBOR) plus a premium of 3.75% to reflect the credit risk of Mexican bonds. (LIBOR was an international substitute for the US Prime Rate and was usually a bit higher than the short-term fed funds rate.) After Ronald Reagan and Fed Chairman Paul Volcker reduced US inflation the fed funds rate dropped and so did LIBOR, Citi made a ton of money on the swap (a lot more than on issuing the bonds).
My third lesson on inflation also came in the early eighties. I was traveling to Mexico regularly for business prior to moving there in September 1982 (that’s another story altogether). I remember going to dinner at my favorite restaurant in Mexico City’s Zona Rosa, Cicero’s, which was not far from my hotel. My bill in pesos after my first meal translated to around $100 for just one person (but the peso was way over-valued, and Mexico was very expensive back then). Several months later on another business trip my meal at Cicero’s cost around $60. My meal at Cicero’s during my final visit to Mexico before moving there was $22. Of course, this story is about Mexico’s deteriorating exchange rate that made my dinners at Cicero’s more affordable in dollars. But Mexico’s deteriorating exchange rate was a result of runaway inflation compared to that of the United States.
These lessons I learned came to mind as I watched a Ted Talk by Stephanie Kelton, a proponent of Modern Monetary Theory (MMT). This theory that is popular among the progressive left asserts that governments can just print all the money they need. According to Kelton government accounting and budgeting is different than private sector accounting and budgeting. She and other MMT theorists assert that governments can print fiat money (money that is not backed up by anything such as gold) to pay for programs and purchases and whatever it needs or wants as long as there are resources available in the economy. In an economy at less than full employment they claim that the printing of government money will not result in inflation and, as long as there is little or no inflation, the government need not worry about deficit spending. Nor does the government need to worry about repaying its public debt as long as that debt is denominated in the government’s fiat currency. All the government needs to do is to print more money to repay the debt.
MMT theorists admit that public debt borrowed in foreign currency would be a problem because a country can only print money in its fiat currency, not in foreign currency. But that should not be a problem, they say, because governments do not really need to borrow money, just print money. To MMT theorists, the public debt is merely a monetary policy tool and taxation does not fund the government but, rather, is a tool to reduce money in circulation to manage interest rates and private sector employment.
If Modern Monetary Theory sort of makes your head begin to swirl, don’t be alarmed. Like many theories of the progressive left (including critical race theory, transgender theory, queer theory and others) these theories defy common sense and lack any empirical evidence to support their wild and illogical conclusions. MMT and other progressive left theories are mainly popular among academics and are not viable in the real world. MMT was thought up by leftist economists to support their social justice agenda, not by traders or bankers that understand markets.
According to MMT there should be no inflation if the economy is not at full employment, and at this point in the economic recovery from the Covid pandemic, employment is still about five million below pre-pandemic levels. So, there should be no inflation. But inflation is hitting levels not seen in thirty or forty years in the prices of food, energy and building materials among many others. But the fact that the Consumer Price Index (CPI) had been quiescent for years despite massive injections of monetary stimulus from the Fed along with near-zero interest rates was deceptive. Because the stimulus was directed at banks and other financial intermediaries, the injections in cash did not reach consumers but were directed toward financial and commodities markets. The trillions of dollars injected into the financial system were invested in the stock market driving stock prices to record levels and further enriching the already wealthy. The current S&P 500 price/earnings ratio is 36.8, almost double the historical average. But financial markets are reaching the limit of their ability to absorb all the cash being pumped into the country, so price increases are seeping into real estate and consumer markets.
Inflation is a monster, and it is a particularly difficult one to control. Since Ronald Reagan and Paul Volcker corralled this monster in the eighties, inflation has been kept in control through globalization that depressed wages and kept product prices low, no matter the monetary policy regime. But the pandemic highlighted the vulnerability that these extended supply lines created and the market adjustment to this new reality is letting our old monster out of its cage.
But there is another reason we cannot allow these leftist progressives get a hold of our monetary system and try to make their crazy Modern Monetary Theory a reality.
America’s greatest strategic asset is the US dollar. Yes, yes, I know. We have oodles of nuclear missiles in silos, submarines and antiquated bombers. But a lot of other people have nuclear weapons as well. Only we have the US dollar. And as long as we have the world’s reserve currency, we have a unique and powerful tool to back up our role of global leadership.
Global trade runs on the dollar. When a Peruvian company imports a product from a Chilean company, it could try and pay with Peru’s fiat currency, the Sol. But the Chilean company can’t buy anything in Chile with Soles so It would want to immediately sell the Soles and convert them into Chilean pesos. The peso/sol market is not very big which means that transactions costs are high. It is much easier to do the transaction in US dollars. And the Chilean company doesn’t have to immediately convert its dollars into pesos. It might want to hold onto the dollars. Many banks around the world offer dollar deposit rates because they can use those dollars to make loans and many foreign companies want dollar loans to finance their international transactions. This is the Eurodollar market, and it amounts to trillions of dollars and finances a substantial portion of world trade and development. Even China is dependent on the dollar because all its export transactions must be cleared through SWIFT in dollars, because nobody trusts the yuan or the renminbi or whatever they call their local currency.
The currencies of other countries, such as the British pound, the Japanese yen and the Swiss franc, are also used as reserve currencies but these markets are small compared to the dollar market. The European euro tries to compete with the dollar but it is not a fiat currency it is 19 fiat currencies so the euro can be problematical. The Chinese would love to supplant the dollar and are attempting to promote a digital yuan as an alternative to the dollar, but investors holding Chinese currency are at the mercy of the Communist Party of China, which is not subject to market discipline, only party discipline and the commands of Xi Jinping.
When countries run persistent trade deficits, their currencies tend to devalue because there is an excess of their currency in the market and when supply goes up prices go down. But a persistently devaluing currency is not a good asset to own because your asset is constantly losing value. But because foreigners are willing to hold dollars and not resell them on the market, the dollar does not devalue and the US can purchase real physical goods and services with paper money created out of thin air. This is why the US can maintain a persistent trade deficit while the dollar remains fairly stable.
But this unique and very advantageous situation is not bullet proof. Huge amounts of deficit spending supported by the Fed’s bond purchases has not destabilized the dollar as of yet because other major economies are doing the same thing. But the equilibrium between the developed economies is in danger of being disrupted by President Biden’s massive spending program which will create even more massive deficits no matter how much he raises taxes. And Modern Monetary Theory would only make matters worse. Progressives tend to have tunnel vision and do not foresee the unintended consequences of their proposals. Even more so, they are blind to the international consequences of their policies. MMT does not work in a dynamic global market. Internationally, the creation of massive amounts of dollars to fulfill the American left’s social justice goals would reduce the confidence foreigners have in the dollar. A greater reluctance of foreigners to hold dollars would mean that the dollar would have to lower its price (relative to other currencies) to stimulate demand for dollars. That would not only increase the cost of imports but would make the dollar less reliable as a reserve currency.
The utility of a fiat currency lies in the trust the people have in the currency. When monetary policy is oriented toward maintaining the stability of the currency and accommodating economic growth, the people have a high level of trust in the currency. When countries start printing money to accommodate political agendas, as was the case in Weimar Germany and is currently the case in Venezuela, people lose their trust in the currency and demand more of the currency in exchange for a real product such as a loaf of bread. In other words, printing money for political reasons instead of economic reasons results in inflation.
Modern Monetary Theory subjects a currency to political goals, regardless of the economic situation or how it affects the users of the currency. Stability of the currency is not the goal; a specific social justice outcome is the goal. People’s trust in the currency is lost and inflation begins to surge. Rampant inflation causes people to lose trust not only in the currency but in the government issuing that currency.
If the progressive left gets their way and passes President Biden’s massive spending bills, they will tell you not to worry because Modern Monetary Theory says there will be no inflation. But right now, amidst all the rancor and division, trust in government is extremely low, and soon the trust people have in the dollar will have a similar fate. And China will be very happy that America destroyed one of its greatest assets.