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 amounts of stimulus to offset the shutting down of large swathes of the economy due to the pandemic. Central banks have marched in lockstep, hoovering up bonds to keep a lid on financial market stability and keep interest rates anchored at or near zero.
Such stimulus efforts mean government debt is soaring to unprecedented levels. OECD data indicates average debt-to-gross domestic product (GDP) levels will rise to 137 per cent from 109 per cent over the next year.
The US federal budget deficit doubled in May to $399bn from a year earlier, taking the year-to-date deficit to $1.88 trillion. That’s already ahead of the previous record of $1.4 trillion in 2009 and may easily exceed $4 trillion this year.
Britain’s borrowing for this year is calculated to be £298bn, according to the Office for Budget Responsibility (OBR). UK public debt is now higher than GDP, the Office for National Statistics (ONS) grimly told us in June. That’s not happened since the 1960s as we recovered from the second world war, highlighting the damage being wrought on the public finances by the pandemic response. War-like economic catastrophe requires war-like borrowing. Back to the 1950s it is.
Perhaps not: the question that inevitably follows is how do we pay it back? Or, more importantly, do we even need to? Many will argue that soaring government debts are going to be a problem, but they don’t need to be.
There has been talk about raising taxes and this would be the standard approach to dealing with debt. According to reports, Treasury officials have been sounding out private banks and asset managers about a possible ‘wealth tax’. That may chime with the energetic and vocal calls for ‘equality’ in some camps – redistribution of wealth is a central tenet of socialists everywhere. The pandemic is the perfect excuse; the fact that wealthier families appear to have done alright during the crisis, while poorer families are more likely to have seen their earnings fall only seems to make the case for punitive taxation stronger. The fact that anyone on government-backed furlough has had their income paid for by the state – or, more accurately, taxpayers – does not seem to matter.
Boris Johnson has distanced himself from any serious tax rises or one-off wealth grabs. An infrastructure splurge will be financed with more borrowing; there will be no return to austerity, even though he has refused to rule out breaking a manifesto pledge not to raise taxes. Americans seem set to be burdened by higher taxes – Joe Biden is leading the US election polls and has plans to increase taxes for both individuals and corporations.
But taxation alone cannot rein in the deficit – austerity could make it worse. And indeed, as former vice president Dick Cheney once put it, Ronald Reagan proved that in politics “deficits don’t matter”. In thrusting modern monetary theory (MMT) into the centre ground, Covid-19 and the ensuing fiscal and monetary response may prove at last that this holds true in economics, too.
What is MMT?
Modern monetary theory is not as new as it sounds. In 1945 New York Federal Reserve chairman Beardsley Ruml argued that "taxes for revenue are obsolete”. In this paper, he expounded on the idea that governments whose currency is not convertible into gold or any other commodity do not need to tax to raise revenue, as they can print as much money as they requires to spend and meet their budget commitments. Taxation is therefore only used to stabilise prices, or to "express public policy in the distribution of wealth and of income […] in subsidizing or in penalizing various industries and economic groups”. Under MMT, tax is only a policy tool, not a means to raise revenue. Tax is for controlling inflation, incentivising consumers, redistributing wealth and to assess the benefits of certain national benefits, such as infrastructure spend. It is interesting that this argument was put forth at the time of the last great coordinated fiscal and monetary intervention to push up the national debt in a period of crisis.
Alan Greenspan, former chairman of the Federal Reserve, put it succinctly in 2011: "The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.”
MMT argues that because tax is used to control inflation, interest rates should remain at the zero-lower bound. In other words, you don’t need to raise taxes to pay off a deficit and deficits don’t matter because you can simply print more money to pay for government spending. It might sound more like a magic money tree, but there are plenty of reasons for believing it has become common practice already.
The difference between debt monetisation and QE
Although critics of extraordinary policy actions by global central banks in the wake of the financial crisis argue that quantitative easing (QE) amounts to running the printing presses á la Weimar Germany, it’s not really the same thing. There is a difference between outright debt monetisation and the post-great financial crisis (GFC) era asset purchase programmes.
Ostensibly if a central bank wishes to lower interest rates, it creates new money and uses it to purchase government debt. To raise rates, it simply destroys money by selling the debt. Over the course of any business cycle, therefore, central banks like the Fed are monetising and de-monetising debt.
As St Louis Fed economist David Andolfatto and research associate Li Li explored in a 2013 economic synopsis, when we talk about monetising the debt, we mean creating new money as a permanent source of financing for government spending. Therefore, whether central banks are engaging in outright financing of government spending depends on their plans. If it’s permanent, it’s debt monetisation; if temporary, it’s just part of the usual cycle of managing rates and inflation.
In a November 2010 speech, St Louis Fed President James Bullard said: “The (FOMC) has often stated its intention to return the Fed balance sheet to normal, pre-crisis levels over time. Once that occurs, the Treasury will be left with just as much debt held by the public as before the Fed took any of these actions.”
Of course, anyone who really thought the Fed could pay it all back was being very optimistic before the pandemic struck; post Covid-19 they’re barking up the wrong tree entirely. We have now entered a period of de facto MMT – central bank balance sheets are not going back to where they were before 2008. The illusion of being temporary only provides the cover to make something permanent.
Veteran investor Paul Tudor Jones believes the scale of the economic collapse caused by the pandemic “took MMT from the theoretical to practice without any debate”.
If governments allow the kind of de facto MMT that already exists to become dogma, then the current deflation we are seeing may well turn into inflation. Whether they do or do not may be moot; the incredible increase in the monetary base may be enough for inflation to rear its head. Inflation has positives and negatives of course – it would wipe out government debts, boost equities and other assets, but destroy savers. On balance, it looks as though inflation needs to move higher – just as former Federal Reserve chair Paul Volcker tamed inflation after President Nixon goosed the money supply in the 1970s, we need to do the opposite today, which may require an even more radical approach to monetary policy to unleash inflation. Crippling taxation won’t work. Moreover, inflation would tend to favour younger people who are more likely to have debts and who possess a long work life ahead of them over the older, asset-rich generations above them' It would therefore have some social merits beyond just fixing government deficits.
In a letter to investors in May, Mr Tudor Jones noted that a total of $3.9 trillion (6.6 per cent of global GDP) had been “magically created through quantitative easing”, explaining: “We are witnessing the Great Monetary Inflation (GMI)—an unprecedented expansion of every form of money unlike anything the developed world has ever seen.”
The magnitude and speed at which new money is being created is overwhelmingly inflationary, albeit the fall in the velocity of money in the near term as aggregate demand collapses is evidence of the near-term deflationary impulse from the pandemic.
This can be shown by the ballooning balance sheets of not just the Fed, but of most global central banks.
Growth in the money supply like M1 and M2 doesn’t always lead to inflation, but as Milton Friedman put it, “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output”. We did see these rise considerably since the GFC without any undue impact on inflation as central banks persistently were unable to stoke the price growth their mandates required. This time is different for a couple of reasons. One, the austerity movement is now well and truly dead, so we have a fiscal expansion in tandem with the explosion in the monetary base, which creates a more inflationary landscape. Moreover, growth in M2, as Mr Tudor Jones explains, was never that high in the period after the GFC since banks were absorbing the increase in money to bolster their liquidity and capital requirements.
But the rate of expansion in the monetary base is consistent with past bouts of high inflation in the 1930s, 1940s and the 1970s. There are other factors affecting inflation – the software and tech-based economy has upended the structural assumptions about inflation that Mr Friedman developed (production can increase exponentially without equivalent increases in the cost of production), while on the other hand Covid-19, rising geopolitical tensions and populism could force supply chains to be radically reshaped, forcing up costs. Moreover, most market-based forecasts for interest rates don’t signal inflation in the slightest – but the rally in gold does.
Ultimately, Mr Tudor Jones says the question of whether this bout of money printing is inflationary comes down to this: how reasonable is it to expect that in the recovery phase the Fed will be able to deliver an increase in interest rates of a magnitude sufficient to suck back the money it so easily printed during the downswing? Most of us agree it won’t be easy.
The Fed has made it clear it is in ‘whatever it takes’ mode and is not even thinking about raising rates, or as chair Jerome Powell put it: “not even thinking about thinking” about rate hikes. As we saw with the abortive quantitative tightening phase, the more an economy is hooked on leverage and low rates, the harder it is to hike. The latest splurge only makes us more addicted to cheap money, so any hiking cycle is likely to be “delayed and unambitious”, in the words of Mr Tudor Jones. His view is that there is no chance of a Volcker-esque aggressive hiking cycle. I think this may be true and combined with the sharp rise in the money supply could see inflation expectations start to slip their anchors.
He concludes: “High debt accommodated by money printing is difficult to banish. Inflation expectations could one day respond to this reality. It is the risk of fiscal dominance that makes the current GMI potentially inflationary during the next cyclical upswing. After all, fiscal dominance was a key reason for inflation to flare up in the late 1930s and the 1940s when the Fed was strong-armed to keep rates low and to monetise Treasury debt issuance well beyond the economic recovery phase.”
So we come back to the question of whether the increase in central bank balance sheets and rise in the monetary base is going to be permanent or temporary. While the Fed and others kidded themselves it would be the latter in the wake of the GFC, it’s becoming clear that reducing balance sheets and M1 and M2 will be virtually impossible. In many ways we are already living with MMT, but that does not mean taxes won’t go up – in fact it might be a necessary evil to rein in inflation or to redistribute wealth from one section of society to another. Such are the demons unleashed by the pandemic, who knows what radical changes to social and economic policy may take root across Western so-called democracies. As John Maynard Keynes reportedly put it, “when the facts change, I change my mind”. MMT may not be such a crazy notion any more.