The IC guide to Modern Monetary Theory

MMT is not a panacea and its implications for economic policy carry some noteworthy risks. It would, however, be a mistake to accept the characterisation of MMT as crack-pot, money-printing, leftwing wish-fulfillment, as peddled by some of its vocal detractors. 

This five step guide examines what the theory is, and the risks and opportunities that this new paradigm could bring.

What’s the big idea?

MMT only applies to economies with “monetary sovereignty”. To have monetary sovereignty, a country must: (i) issue its own “fiat” currency; (ii) operate a floating exchange rate; (iii) and have the significant majority of its debt denominated in its currency. A currency is considered “fiat” when its value is not tied to any other asset (eg, gold or the dollar). 

Monetary sovereignty is the defining characteristic of a “currency issuer”.

The observation at the heart of MMT is that a currency issuer cannot run out of money and go broke because it can always print what it needs – either with an actual printing press or electronically via a keystroke from a central banker. 

As Alan Greenspan, the former chairman of the US Federal Reserve (a currency issuer), told the House Budget Committee back in 2005: “There's nothing to prevent the federal government from creating as much money as it wants and paying it to someone.”

This puts the borrowing of a currency issuer in a fundamentally different category to that of a “currency user”. 

A currency user cannot print the currency(ies) it borrows in and therefore can run out of money and go broke. Examples of currency users include: members of currency blocs (eg, Greece); countries that borrow significant amounts in currencies other than their own (eg, Argentina), businesses (eg, Lehman Brothers) and households (eg, chez Mark Twain).

So what does this all mean?

Proponents of MMT argue that the special position of the currency issuer (eg, the US, Japan, the UK) means that in and of itself “balancing the books” does not matter. It therefore makes little sense to make this a central objective in managing a currency issuer’s economy.

Instead, currency issuers should focus on the use of fiscal policy to achieve an appropriate level of inflation alongside other broader economic objectives. From this perspective, low inflation is considered a sign of insufficient fiscal stimulus, while high inflation signals too much. 

A common misconception of MMT is that it gives carte blanche to spending funded by money printing. This is a misconception because the principle of strict inflation targets creates a real constraint – in theory, at least. Essentially, while MMT removes the need for the question of “how do we pay for it?”, it replaces this with what it regards as the better question of: “should we do it?”. The level of inflation provides the answer to the question rather than the level of the budget deficit/surplus. 

Despite MMT’s association with the political “left”, in practice fiscal policy based on inflation targeting could prove harsh medicine when it comes to engineering a slowdown. What’s more, fiscal policy itself is apolitical. As leading MMT economist Stephanie Kelton says in her book The Deficit Myth: “MMT can be used to defend policies that are traditionally more liberal (eg, Medicare for all, free college, or middle-class tax cuts) or more conservative (eg, military spending or corporate tax cuts)”

What could possibly go wrong?

If one accepts the MMT viewpoint, the main risk is that once the fiscal taps are turned on they will be very hard to turn off, leading to out-of-control inflation. 

Additionally, excessive use of the “printing press” risks debasing a currency as foreign capital takes flight. This is also a potential cause of significant inflation by pushing up the cost of imports. The risk of currency debasement is higher for currency issuers that are very reliant on imports, have large trade deficits and are weaker economic players.

Once inflation takes hold, history shows that if not checked it can quickly run out of control and be very economically damaging. But moving from stimulus to austerity, especially at speed, is difficult due to the long-term nature of many fiscal commitments and public resistance. And it can be very difficult and painful to put the inflation genie back in the bottle once it's out. 

In the real world, the politics of using fiscal policy to target inflation could create more boom and bust.

Will MMT ever happen?

While MMT has yet to be adopted overtly, some aspects can be considered to have been in covert use during the past decade.

The quantitative easing (QE) used to refinance banks’ balance sheets in the wake of the financial crisis employed some key elements of MMT. Meanwhile, the massive fiscal and monetary stimulus now being used to deal with Covid-19 also looks very MMT-ish. 

We could see MMT go mainstream as the debate about after-the-event Covid-19 book-balancing comes to the fore. Politicians eager to present a case against unpopular austerity measures could use MMT’s arguments to suggest it would inflict needless economic damage. 

So far, the extremely low inflation and interest rates that have accompanied the monetary experiments of the past decade support MMT’s case that currency issuers should not kowtow to balanced-budget orthodoxy. 

MMT’s ability to form a new consensus may be aided by the fact that the economic establishment has been slow to take its arguments seriously. That’s despite the fact that MMT addresses many of the most pertinent economic questions raised in the aftermath of the credit crunch and now Covid-19.

As James Montier, a free-thinking strategist at investment firm GMO, wrote in a 2019 piece on economic groupthink: “Modern Monetary Theory (MMT) seems to provoke a visceral reaction amongst the ‘great and the good’... However, when reading their criticism I am often left with the impression that they haven’t actually bothered reading anything on the subject of their critique.”

What  would MMT mean for equity investors?

Given the very low level of inflation in major currency-issuer economies, a key objective of MMT were it explicitly adopted today would be to use fiscal stimulus to get inflation up to a decent level (stimulating untapped productive resources). The kind of cyclical growth this would be likely to create, along with the increase in interest rates it would justify, could be expected to benefit many sectors that are considered  “value” plays – financials, commodity producers, and asset-focused industrials. 

Fears of inflation getting out of control and currency debasement should also continue to benefit the gold price as well as other “hard assets” such as property.

Higher inflation should also cause investors to put less value on future earnings. This would be expected to mean a de-rating of “growth” stocks, which promise higher earnings in the future versus now.

Growth stocks currently command very high valuations while value shares are very unpopular. This suggests that following a decade in which returns from “growth” investments have substantially outstripped the returns from “value”, MMT could flip these major market themes on their heads.

Bonds with no inflation-link would also be expected to suffer.

That all said, despite runaway inflation being a key MMT risk, it may not necessarily be that easy to stoke. Japan is a case in point. After enacting many MMT-ish manoeuvres it has debt to GDP of about 240 per cent, around half of which is owned by the central bank yet still very little inflation.

Modern monetary theory or magic money tree?

"Who’s going to pay for it all? When the music stops, someone must pick up the tab. At least this is how the conventional wisdom goes. Governments around the world have injected massive stimulus to offset the shutting down of large swathes of the economy. Central banks have marched in lockstep, hoovering up bonds to keep a lid on financial market stability and keep interest rates near zero."

Click here to find out more about what this unprecedented period of spending could mean for your investments.