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THIS TIME IS DIFFERENT

Would you like some free money?

Under Modern Monetary Theory, governments can spend first, then decide how to fund it: by taxes, borrowing, or printing

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Under Modern Monetary Theory, the thinking is that governments don't need to repay their spending; they can simply print more money.

WE THINK of government spending in the same way as our own spending. If you take a loan today to buy a car, you are 'pulling forward' earnings from the future into the present, thus reducing your future spending power as you repay the loan with interest over time.

Applying the same logic to governments means that the current 'unsustainable' levels of government debt in developed countries are a burden on future generations, as they will be forced to pay off this debt with future earnings (via higher taxes).

Another argument against current government debt levels is that debt should be used for productive purposes, like spending for infrastructure projects with a positive return, rather than on unproductive uses, the worst of which is more debt to pay interest on existing debt. The comparison to personal spending comes up again: a loan to buy an appreciating asset (a house) is good. A loan to buy a depreciating asset (say, a car) is bad. Credit card debt to pay off other debt is the worst of all.

Finally, economists fret that all this government spending must lead to higher inflation, an undesirable event, despite the fact that every central bank in the world bemoans its inability to hit its 2 per cent annual inflation target.

Modern Monetary Theory (MMT) throws all these arguments out the window. You may not know it, but you've already been a recipient in an MMT experiment during the Covid-19 lock-downs. The Jobs Support Scheme, Solidarity payments, and Passion card cash top-ups we got recently are all forms of MMT. Now that the world has gotten a taste of this, we are likely to get more of it, so investors need to understand the concept and the investment implications.

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Governments are not constrained in their spending the way individuals and households are. We logically think that governments tax and borrow first, then spend the money obtained. Like us, we need to earn money (or borrow it first). We cannot spend what we haven't secured ahead of time. But governments that borrow and issue their own currency are not subject to the same rules.

Doing it backwards

They can do this backwards by spending first, and then determining later how to fund this. By taxes, by borrowing, or under Modern Monetary Theory, by simply printing it. Economists have been predicting that large amounts of deficit spending in countries like the US would cause a collapse in the currency, and higher inflation. It's now two decades later and we have no sign of either, so these concerns so far have been incorrect.

Previous central bank stimulus, known as Quantitative Easing (QE), relied on the banking sector. QE breaks down when either banks did not want to increase lending (as in 2009, when they had to first fix their balance sheets), or when people and businesses didn't want to borrow due to a highly uncertain economic future, despite near-zero interest rates.

Instead of helping the average consumer, QE failed to increase the velocity of money in the economy, and instead only contributed to asset price inflation, further widening the income inequality that was already at too-high levels. After a decade of QE, it is clear that the conventional monetary policy of central bank easing via lower interest rates and balance sheet expansion did not create the incentives for a stronger economy: more private borrowing, more spending, and more investment. All we got was lacklustre economic growth with higher equity, bond, and real estate prices.

During Covid-19, governments adopted a different policy by deciding to bypass the banking system, and create monetary stimulus directly to businesses and people by crediting their bank accounts. This is the essence of MMT, which is also referred to as 'helicopter money': imagine helicopters flying over the population dropping money from the sky for everyone to pick up and spend as they wish.

While some emerging market countries would be constrained in conducting MMT due to their US dollar debt, which would quickly lead to hyper-inflation, devaluation and possible default, developed countries are under no such constraints. How is this largesse paid for? Under MMT, the theory is that government does not need to repay this spending, it can simply print more money. If consumers are saving the free money or paying down debt instead of spending it, additional shots of MMT stimulus can be executed. MMT can even be extended whereby the central bank buys assets, as the Fed did earlier this year to support the US high yield bond market. Clearly federal governments are nothing like individuals when talking about spending and budgeting.

Is there a limit to how much MMT can be done? Theoretically it would be when the inflation rate becomes too high, because there's too much money chasing too few goods. Japan's three decades of QE and now MMT have yet to create any discernable inflation.

What happens when politicians begin to think that the federal debt does not need to be repaid with future income? Why not go further, and cut taxes at the same time while monetising all deficits? If a government spends $1,000, but only collects $800 in taxes, it has created a deficit of $200. But this amount is not gone, it is in the economy, and the flip side of a government deficit is an asset of the private sector. Could taxes be cut to zero, so that the deficit increases to the full $1,000? Some proponents of MMT say yes, and the additional $800 would become an asset of the private sector.

If these ideas gain more traction, it's difficult to see how most governments would not continue down this path. Once inflationary pressures are finally seen in the economy, MMT is supposed to tackle this by removing the excess money supply, by actions such as increasing taxes.

Additionally, the more extreme version of MMT states that during an economic downturn when many have lost their jobs, the government can create jobs paid for by printing money, without needing to tax or borrow it.

If this sounds like something that will be abused and eventually go horribly wrong, you're probably right. Traditional economists would already be aghast by now, and there have been many articles penned recently on why MMT cannot work. Over the coming years if we see more and more such policies adopted, the last four decades of persistently lower inflation will become a thing of the past. Most investment managers assume that the recent benign inflationary environment will continue, and they have not yet experienced a hyper-inflationary investment environment.

Big turning points

But one of the keys to successful long-term investment management is to anticipate the big turning points, and the current advent of MMT is likely to be a significant one. Deflationary forces still abound, so this is not an imminent call for higher inflation, but other than MMT there are other inflationary events occurring, such as a move away from globalisation and increased tariffs.

The investment implications are many-fold. Most importantly, the 60 equity/40 bond portfolio that we have grown accustomed to as an effective asset allocation will not work well. The negative correlation between equities and bonds that we have seen over the last 30 years is an aberration of financial history. Over the long run stocks and bonds have instead been positively correlated, and in periods of higher inflation, both correlate together to the downside.

Current portfolio construction methods would never allocate to commodities, given the terrible performance compared to equities over many decades. Why take the volatility risk of commodities when returns are so much lower? Higher inflation is still likely to be years away given that we've just gone through a sharp recession and a massive deflationary shock. But over the medium term we are likely at a generational turning point in the global investment environment, so investors should start thinking about an initial allocation to an inflation portfolio.

  • The writer is co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund-management services to endowments and family offices, and wealth-advisory services.

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