The central tenet of MMT is that the only limit to government spending is inflation. And because inflation had been dormant for so long, saying “inflation is the only limit” started to sound a lot like “there is no limit.”
“Myth number 2: deficits are evidence of overspending. Reality: For evidence of overspending, look to inflation.”
— Stephanie Kelton, The Deficit Myth
To pick just one of the many prominent voices calling on the Fed to get more aggressive against inflation, Larry Summers says interest rates should go to 5%.
That is, of course, the orthodox playbook: Ever since Volcker slayed the inflation dragon with draconian hikes in 1981, the assumption has been that lowering inflation is just a matter of the Fed’s willingness to do it.
Things have changed in the four decades since.
Amongst other things, the US deficit is now about 120% of GDP, up from just 25% in Volcker’s day.
So when today’s Fed raises rates, the first-order effect is that the federal government pays out a lot more money in interest payments.
Economist Eric Leeper estimates that taking Fed funds to Summer’s preferred level of 5% would add $1 trillion to the federal deficit.
That’s $1 trillion of money-printer money.
Running the money printer even harder sounds like a funny way to fight inflation. (Especially as the money would be going to those who least need it: banks, foreign governments, large savers.)
So raising rates may be less effective now than it was in 1982.
And raising rates in 1982 may have been less effective than you think as well.
Volcker’s rate rises also forced deficit spending higher, but the money printing was offset by a belief that fiscal policy would adjust accordingly.
Which is, in fact, what happened: President Reagan, known for his big 1981 tax cut, then raised taxes in five subsequent budgets.
His raises were never quite as big as that first cut, but they reinforced the long-standing assumption that budget deficits would be followed by budget surpluses.
And that is a large reason why Volcker’s rate hikes were so effective: Holders of Treasurys, reaping the windfall of higher rates, were unlikely to spend that income, because they expected to be hit with higher taxes in the near future.
Their current income was rising, but their future, post-tax income, was falling.
Higher interest payments did not have an inflationary wealth effect because of the ingrained belief that budget deficits would be followed by budget surpluses.
We may have lost that belief.
Partly because COVID relief has thrown the Overton window on deficit spending wide open — was there even any debate over how the stimulus packages would be paid for?
And partly because of the popularization of Modern Monetary Theory (MMT).
Marmite Money Theory
MMT is the Marmite of economics: Most either love it or hate it.
I’m actually in the middle, however. (I have mixed feelings about Marmite, too.)
I think MMT is a great explainer of both the origin of money and our current financial plumbing — two topics that are more important than ever in this age of questioning what money really is and how governments are creating more of it.
The political incarnation of MMT, however, is less useful.
It’s effectively become the left-wing version of supply-side economics — a theory to justify every government expenditure, just like the Laffer curve was a theory to justify every tax cut (starting with that big one in 1981).
The central tenet of MMT is that the only limit to government spending is inflation.
And because inflation had been dormant for so long, saying “inflation is the only limit” started to sound a lot like “there is no limit.”
But with CPI hitting 8.5% this morning, inflation is clearly back.
The circumstances are unusual — pandemic stimulus meets supply-side shock — but even the doyen of MMT, Stephanie Kelton, should now acknowledge that the government has overspent, as per her quote at the top.
The MMT textbook would say the government should now raise taxes. Which of course won’t happen — good luck waiting for a politician to tell suffering constituents that tax hikes are the answer to their inflation problems.
So the Fed is on its own — there is no help coming from fiscal policy.
Able. But Willing?
But monetary policy is not designed to work on its own.
It might even be counter-productive: If we no longer expect higher current income to be taxed back in the future, rate hikes may have an inflationary wealth effect.
Which is to say, if we get Volcker rate hikes without Reagan tax hikes, we could be in trouble.
Shorter term, I still think deflation is the greater risk. But not because I have any faith in the effectiveness of monetary policy.
If anything, I think the primary risk to markets is that the Fed is overly aggressive and keeps raising past the point when they should actually be cutting.
But longer term, risks may be growing in the other direction, too.
US Treasurys are backed by the ability and willingness of the government to create budget surpluses at some point in the future.
We still have the ability, but we may have lost the willingness.
If so, you might want to own some bitcoin. Just in case.