Close, But No Cigar
Despite the continued gush of cash emanating from Washington, the books almost balanced in July. This is not due to a return to fiscal norms, but rather to the inflow of income and estimated tax payments, which had been deferred from their customary due dates in April and June. Thanks to this shift, July had a stunning $312 billion increase in revenues over last year, but even this was not enough to offset the stupendous spending, which rose to $624 billion for the month.
Well, now we have a particularly unusual
set of circumstances whereby we’re in the midst of forced, or involuntary,
utilization of modern monetary theory…This is not unheard of. And I’d say this
was done during World War II, where the Fed guaranteed the Treasury that it
would buy Treasury bonds at a very low rate to keep interest rates low to keep
the debt servicing costs of the of the government low. So theoretically, this
can last a very long time as long as the Treasury is making these big bond
issues a regular occurrence as it appears.”
“And the Fed’s Jay Powell has said he is going to, in effect, continue to keep rates low. But he said also something we should be aware of: ‘The Fed can’t do it all and the Fed cannot do this indefinitely.’ But what is indefinite? How long can this occur? What are the end results of this, at some point, if trees don’t grow to the sky? What could disrupt the markets and what could cause either the Treasury to run into trouble with its issues, or the Fed to feel uncomfortable underwriting those issues for the indefinite future? We don’t know that. This is all terra incognita.”
Robert Hormats, Goldman Sachs
Most of our discussions of Modern Monetary Theory wind up with this question—how long can it go on? (By way of review, Modern Monetary Theory, or MMT, suggests that governments which can issue their own currencies are not constrained by deficits, but rather can simply spend whatever money they desire to accomplish their goals, at least as long as the value of the currency is not diminished too greatly. Of course, the country’s central bank is required to repress interest rates, both by setting the overnight rate low and by buying large amounts of government bonds.) We naturally are suspicious of “free money,” but if the last few months have shown anything it is that the federal government can spend without concern for the debt markets. But like Mr. Hormats, we suppose that it must all come crashing down one day—and naturally we would like to know when and how.
While it is difficult to predict how “the utilization of Modern Monetary Theory” will end, it is easier to say how it will not end. This commentary sees little chance that the eruption of money will be reversed by the renormalization of the credit framework, with market-based interest rates and constraints on government issuance. This is because even a slight move towards positive rates would be too painful to the economy for the politicians to accept. Witness the vituperations visited upon Jerome Powell by the current administration when he raised the fed funds rate to a mere 2% (still below the reported rate of consumer inflation). It will take a very stubborn and thick-skinned Fed chairman who has the backing of the entire institution to reverse the low-interest rate regime; it is difficult to see how one would be appointed in the current climate in Washington.
Contrast the Treasury/central bank’s actions of today with those of World War II, a crisis-imposed exercise in MMT. Faced with the prospect of a costly war for survival in which no effort could be spared, the financial authorities set interest rates at 0.375% for the duration, and the Fed promised to buy whatever debt it needed to, much as Mr. Powell has done. However, when the war was over, the Washington took steps to immediately and drastically reduce spending and the deficit. This led to a sharp recession and a regime change in Congress in 1946, but the federal budget was soon back in balance, largely due to the hostility of the business and financial class towards government borrowing. Meanwhile, persistent consumer-price inflation, which spiked as high as 14% in 1947, led to the increasing reluctance of the Fed to maintain near-zero rates. Harry Truman forced out Marriner Eccles, the Fed chairman who had been in office since 1934, but eventually the central bank prevailed and reached an accord with the Treasury which returned the control of short-term interest rates to the Fed’s (somewhat) market-based regime in 1951.
The point is that the return to “normalcy” after World War II was prolonged, economically painful, and driven by political motives; we would expect nothing less if it were to happen today. However, policymakers in the forties were willing to end the MMT “experiment” by returning to roughly balanced budgets immediately after the war ended—and unwilling to repeat the World War II experience as spending for the Korean War ramped up in the early fifties. Taxes were increased to pay for the conflict rather than relying on additional borrowing. Rightly or wrongly, this policy option not seriously contemplated today.
Another major difference is that the level of non-governmental debt and the relative size of the asset markets 75 years ago were tiny compared to our present situation. Having lived through the Great Depression, most companies and people were wary of borrowing. Investing in stocks was the exception and viewed as speculative by the general public; rising equity prices were thought of as dangerous and the harbinger of a new bubble. There were Congressional hearings into the state of the stock market when the Dow finally made new highs 25 years after the crash of 1929.
Contrast this with the present day, when publicly-traded stocks and bonds are the mainstay of retirement assets and real estate is highly leveraged. Any sustained substantial increase in interest rates would threaten asset prices as well as the amount of leverage willing to be assumed. The knee-jerk reaction against any Fed tightening campaign would make the move risky for the personnel involved. Finally, while we certainly have inflation in the asset markets (as witnessed by the price increases for gold and bitcoin, not to mention some equities) the consumer price inflation index has been neutered by methodological practices like substitution and hedonic effects. While living a middle-class lifestyle (a house, a car, a college education, and health care) has become more and more difficult, these price increases do not move the official inflation indicators very much and therefore do not figure into the analysis or consciousness of the financial deciders.
Given these differences, our own “forced” utilization of MMT (as Hormats puts it) will not end in the same way as the World War II experience. Like it or not, reducing federal debt and allowing interest rates to float freely is not in the cards. So what, if anything, will end the MMT “experiment”? This commentary hopes to lay out some scenarios very soon.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
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