Modern Monetary Theory Will Only Be Respectable When It’s Depressing

There is no canonical explanation of what Modern Monetary Theory is. There are explainers, and there’s an understanding, but there’s not one official text.

MMT is still catching on, and I’m sure someone will get around to writing the official MMT book one of these days. But it hasn’t taken the world by storm, to its adherents’ surprise. This fits a normal pattern. Ignoring whether or not a theory is true (it’s economics; you’ll never know), there are three things that make a theory popular:

  1. It makes anyone who holds it sound smart and contrarian.
  2. If people believed it, the theorists would be more powerful and influential.
  3. It’s depressing.

Take the efficient market hypothesis: it sounded contrarian to say that throwing darts a list of stocks would outperform the average mutual fund after fees, but it was true. It made academics more powerful relative to money managers by making money managers less powerful overall. And it’s depressing to think that everyone who ever got profiled by Fortune for their fund performance was basically famous for being the one person in a thousand to flip a coin ten times in a row and get heads every time.

An effective risk manager showcasing the value of diversification.

Compare that to Andrew Lo’s adaptive markets hypothesis. This holds, more or less, that the market is always in the process of getting more efficient with respect to whatever investors pay attention to, but less efficient in other ways. This is smart but not contrarian; it’s a more formal way to reiterated a common-sense conclusion. It’s action guiding in a broad sense, in that it tells investors not to lose hope — there’s alpha out there somewhere! And it’s not depressing at all, for the same reason. As long as you’re one of the ~95% of finance professionals who believe you’re above-average[2], adaptive markets theory tells you exactly what you want to hear.

Which is why nobody really talks about it. Either in finance pop culture or in intra-industry professional debates, I still only hear people talking about whether or not they believe variants of EMH, not whether or not they believe in adaptive markets. Andrew Lo is a smart guy, but a bad marketer; he needs to make his theory sadder and more confusing. MMT advocates must do the same.

Towards Sad MMT

The correct and useful claim Modern Monetary Theory makes is that governments are not constrained by how much money they have, but by real resources. If the US government owes me a lot of money and doesn’t have the cash on hand, they can just print it up. Printing money doesn’t mean free money, of course; it just dilutes the value of everybody else’s dollars. But if the net effect of diluting dollars is higher economic growth, this is a win, and a redistributive one at that.

This insight gives MMT-ers permission to be bigger, bolder Keynesians. Any level of deficit spending fueled by money printing is fine, as long as it raises the expected real production of goods. You can always shrink the money supply later through taxation, and use other ex post redistributive policies to mitigate the bad effects of inflation itself.

In the MMT framing, governments spend first and borrow second. If they don’t borrow, spending is inflationary, but in a deflationary environment — after a collapse in asset prices, say — that’s just what the doctor ordered. This explains why, after the Great Recession, the inflation hawks were wrong and the stimulus fans were right. We didn’t see huge price increases from deficit spending and quantitative easing, because these offset what would have been a brutal decrease in spending fueled by a domino of debt defaults.

In fact, one of the key insights of Modern Monetary Theory is that treasury bonds aren’t debt. If you own a printing press, you can print as many dollars as you need to service treasuries as they come due. That’s about $22tr right now. But this brings up the depressing counterpoint: medicare ($30tr), social security ($20tr), the real value of unfunded pension liabilities (about $10tr), all of these are debt. In fact, to the extent that our social contract assumes rising standards of living, all of our future consumption is a form of debt that can’t be inflated away.

If we can’t raise taxes to pay treasuries when they come due, we can print dollars. If we can’t provide the medical care we’ve promised, we can’t print doctors. Debt and inflation, then, are tools we can use to manage the economy to maximize total production of real goods, which is the only way to pay real debts.

The Impossible Promise

MMT presents two core policy prescriptions, which are pretty close to the Keynesian playbook:

  1. When the economy is weak, print currency until inflation rises.
  2. When the economy is strong, raise taxes to “buy back” dollars.

Their understanding of currency is basically correct: currency is the bubble that never pops; like any bubble asset, it’s supported by the expectation that a greater fool will buy it for more than it’s worth. In the US context, the greater fool is the IRS, and every year they sell you your freedom in exchange for green pieces of paper. Knowing that there’s an irrational dollar buyer, we’re willing to own dollars, and denominate our assets and liabilities in them as well.

However, the MMT understanding of politics is flawed. While governments have the will to print more money to solve demand problems, they don’t have the will to print less money to solve the inflation problem. Tax hikes are unpopular — even tax cuts that are perceived as tax hikes are unpopular.

If a theory requires governments to toggle back and forth between popular and unpopular policies, in practice it just tells them to do the popular thing all the time. It’s like a diet that lets you eat anything you want as long as you stay in a calorie deficit, or a productivity guru who tells you the secret of success is to do crystal meth so you stay motivated at work, but to stop any time you start to get addicted.

Even when the policy prescription is clear and popular, MMT forces some hard tradeoffs: within a currency union, for example, different countries have very different ideal deficits. Italy’s government is correct to call for higher deficits. Arguably, Germany’s is correct to tell them to back down.

(My pet solution is simple: Italy should be able to borrow as much as they want in Lira-denominated bonds, engage in Lira-denominated quantitative easing, and allow taxpayers to pay taxes in Euros or Lira. The Lira wouldn’t be used as a means of exchange, but it would be a vehicle for savings, and it would be a pseudo-currency that could operate at an Italy-appropriate rate of inflation.)

In the US, savers with large positions in treasury bonds would benefit from lower inflation, or even deflation, which would increase the real returns on their assets. Workers and equity owners benefit from higher inflation, at least when debt defaults are hitting spending power. But there’s a level of deficit spending past which the economy overall benefits but treasury bond holders don’t, so even the right call from a total-GDP perspective or a utilitarian perspective involves redistributing money away from some savers.

Even worse, overseas lenders will take a more cynical view of the American political system; they’ll be the first to calculate that we won’t implement the hard part of MMT even if the easy part proves effective. Since foreign lenders still expect a real return, i.e. they buy treasuries expecting to get more goods in the future than they forgo in the present, even moderate inflation risk can make them nervous.

Good Theory, Bad Practice

The absence of post-financial crisis hyperinflation more or less converted me to the MMT camp, in that I consider it a good description of how inflation and asset prices respond to deficit spending and changes in the money supply. Trillions of dollars of wealth were vaporized, but at least I learned something.

I remain unconvinced, though, that MMT theory can be implemented by politicians in a representative democracy. Inflation risk is a distant risk now, and will be a distant risk for a long time — people consume less when they retire, so retirement in the short term is deflationary. But an aging world is a world where health care spending rises, and health care’s elasticity of supply is extraordinarily low. With healthcare inflation outpacing general inflation over time (healthcare CPI is up about 29% in the last decade, versus a 17% increase in overall CPI), we’re already seeing real resource constraints in healthcare spending.

So the risk is even closer than it looks; under an MMT framework, if the supply of healthcare remains limited, we’d end up with high inflation for medical spending but low inflation everywhere else. In consumption terms, we’d look like a prosperous country with a red-hot economy and high inflation to everyone over 65, while everyone else will be living in a 70s economy where supply shocks and high spending drive prices higher and real consumption lower.

I’m reluctant to give my two cents on MMT. It’s a contentious debate, the landscape is constantly shifting, and anyway if the MMTers get their way the zinc contents of two pennies will make me a billionaire.

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[1] This might be an improvement, unless, like a friend of mine, you’re a Sacks Truther who thinks there’s no way one guy could meet that many interestingly-mentally-ill people.

[2] Source: author’s survey of himself and his imaginary survey of twenty of his closest friends in the industry. Okay, fine, actual source: on a risk-adjusted basis, BBB-rated bonds underperform other investment-grade bonds; 30-year treasuries underperform other treasuries; the most volatile stocks underperform other stocks. Always and everywhere, we see evidence that if someone is presented with a risk bucket, they take the most extreme risk they can within that bucket, indicating that they believe they’re more skilled than average. Also, there’s an anecdote in The Accidental Investment in which a class of investment bank trainees has the same opinion — the instructor asks the class to raise their hands if they think they’re above the class average, and nearly every hand goes up.

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