MMT Storm Warning

Central banks control interest rates and money supply, but they are not God and are still subject to market forces. Governments want low interest rates, providing temptation for the central bank to defy reality for too long. What happens if they fly too close to the sun? It depends upon whether you believe traditional monetary theory or Modern Monetary Theory (MMT). My June 16 posting alluded to some potential problems with the type of deficit spending that MMT adherents believe to be OK. Now there are signs coming from Japan that it is important to understand MMT in a hurry. 

First, some background. This Investopedia article on MMT covers some of the basics. The central idea of MMT is that

governments with a fiat currency system under their control can and should print as much money as they need to spend because they cannot go broke or be insolvent unless a political decision to do so is taken.

MMT proponents are optimistic about the side effects of government spending, typically saying that increased government spending has benefits with no side effects, and that traditional ideas of "crowding out" of debt investors will not cause interest rates to rise. Often they support expansive spending policies and use MMT to justify larger deficit spending.

Japan may be a current test of this idea, in that Japan has been holding interest rates at 0.25% and expanding its money supply in order to intervene in debt markets. A series of Zero Hedge recent articles have been sounding the alarm, warning that Japan's monetary policy has potential for an explosive collapse:

June 20: Bank of Japan Spends A Record $81 Billion To Avert Collapse, But $10 Trillion JGB Market Is Now Completely Broken

June 14: Japan On Verge Of Systemic Collapse With "Dramatic, Unpredictable Non-Linearities" In Financial Markets, DB Warns

June 14: Giant Hedge Fund Goes "Soros" On Bank Of Japan: Bets Billions That Japan, And MMT, Will Break

June 8: As Yen Crash Accelerates, It Puts Catastrophic End Of MMT Experiment In The Spotlight

March 30: Yen At Risk Of "Explosive" Downward Spiral With Kuroda Trapped... And Why China May Soon Devalue

The signal of interest is the value of the yen against other currencies. Over the past year it has moved lower, stair-stepping from 110 to the dollar, to 115, then ramping to 135 with much recent turbulence. 

Tug of War for Real Resources

According to the Investopedia article MMT says that

the only limit that the government has when it comes to spending is the availability of real resources, like workers, construction supplies, etc. When government spending is too great with respect to the resources available, inflation can surge if decision-makers are not careful.

We get inflation when too many dollars chase too few goods. Under MMT, how does government remedy that?

Taxes create an ongoing demand for currency and are a tool to take money out of an economy that is getting overheated, says MMT. This goes against the conventional idea that taxes are primarily meant to provide the government with money to spend to build infrastructure, fund social welfare programs, etc.

In other words, under MMT government must raise taxes to quell inflation. By removing money from the marketplace, there are fewer dollars chasing goods.

Inflation, however, leads to an ongoing confrontation with government if it is prevented from raising taxes. If raising taxes is too unpopular, then inflation continues and government cannot use this purported MMT mechanism for cutting inflation. Instead, it may roll out price controls, as has been discussed in recent op-eds in the mainstream media. 

Price controls or higher taxes in turn, however, lead to other side effects. Let's use potato chip manufacture as an example. With high taxes, wages paid to potato chip workers are worth less. The company has an incentive to pay workers in potato chips rather than dollars. With price controls, the dollar value of the chips is constrained, so even if the government forces a barter tax to be paid in dollars, the tax has less effect. If the workers then barter their potato chip wages for other goods, either government will receive less tax from unreported transactions, or reduced taxes (on fixed goods prices) even if they succeed at taxing the barter. In short, MMT leads to pressure to use something other than the sovereign's currency as a medium of exchange.

Another way of seeing this is to note that MMT depends on government having a monopoly on a medium of exchange. If it is in competition with other currencies, then market participants may be able to escape from any coercion that is implied by MMT money expansion. Then MMT succeeds only if government is an honest and trustworthy market participant, and refrains from policies that are coercive. In the case of a medium of exchange, "coercive" means not engaging in behavior that would cause a devaluation of the medium of exchange. Inflation causes devaluation, so in order to show good behavior, government then has to refrain from policies that cause it.

If higher taxes were truly an option for government, then it might get away with using MMT-like policies. But so far all real-world reactions to taxes appear to be significant, in that higher taxes significantly impact output. In practice, setting tax policy is constrained.

The Politics of MMT

Supporters of MMT are generally progressive, believing in Keynesianism, higher government spending, more involvement of government in the economy, and higher taxes. Perhaps this is not surprising in that proponents of traditional monetary theory are generally classically liberal believers in the free market, which go with lower taxes, smaller governments, and less involvement of government in the economy.

Nevertheless, some prominent left-leaning economists are not on board with MMT. The Investopedia article cites Paul Krugman's criticism of MMT:

Nobel Prize-winning economist Paul Krugman’s views on U.S. debt are similar to many MMT ideologues, but Krugman has been strongly opposed to the theory. In an op-ed in The New York Times in 2011, he warned the U.S. would see hyperinflation if it was put into practice and investors refused to buy U.S. bonds.

“Do the math, and it becomes clear that any attempt to extract too much from seigniorage—more than a few percent of GDP, probably—leads to an infinite upward spiral in inflation,” he wrote, “In effect, the currency is destroyed. This would not happen, even with the same deficit, if the government can still sell bonds.”

The question to ask is when would investors refuse to buy U.S. bonds? There are several scenarios:

• When they can move their money into real assets (real estate, commodities) with higher rates of return.
• When they can move money into other currencies offering higher rates of return.
• When the interest rates on government debt are significantly lower than inflation, and trading in real goods as a medium of exchange is possible. (Think in terms of buying the next five year's goods in advance, since the value of the goods would advance in parallel with inflation.)
• When they run out of money.

The first three strategies are also worthwhile defenses against hyperinflation.

Japan is especially vulnerable right now to the second problem, which is that Japanese investors can do better by buying dollars and investing in U.S. debt. As the yen declines in value they benefit. This leads to the situation covered in the Zero Hedge articles.

We have already seen the first scenario happen, starting in 2020. People bought toilet paper or houses. 

Ultimate Recourse

Behavior at the margins illustrates the consequences of deficit spending and use of MMT beliefs. When taxes are high, labor force participation declines due to early retirements and consumption of government transfer payments. Clipping a few percentage points off production then drags on economic output, lowering tax receipts and depressing production and general economic activity. This causes inflation. MMT then responds with higher taxes, causing further marginal declines in production, and more inflation. MMT makes no provision for the consumer's "ultimate recourse", which is to do nothing and vote for politicians willing to pay them to do nothing. 

Producers, on the other hand, have the ultimate recourse of producing only for their own account. A farmer who eats what he produces, barters for what others make, and does not sell into the market will escape MMT's effects. 

In effect, the government must make a market for its own currency, and ignoring the interests of the customers of the medium of exchange will result in diminishing the customer base and the robustness of the marketplace for that currency.