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Long Story Short: Modern Monetary Theory Only Works Until It Doesn’t.
Countries are Promoting Growth by Raising Debt While Holding Rates Down
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Keynesian economic theory says that the government should expand and take on debt during downswings in the economic cycle and pay back the debt when the economy is strong. Keynesian theory has been thrown out the window by Modern Monetary Theory (MMT) advocates who believe the government should grow the economy up to the point of full employment (sometimes advocating for guaranteed jobs at a minimum wage) regardless of economic conditions. MMT challenges the notion that government spending should be funded by taxes, arguing that the government can finance expenditures by easing monetary policy. At the root of the argument is the belief that government debt does not compete against the private sector’s ability to issue debt. This is because the government has a unique ability to print money and the ability to influence interest rate levels through the Federal Reserve. Can Modern Monetary Theory work? Or is it creating a ticking time bomb that will create problems for future politicians and taxpayers?
Increasing financial leverage makes sense
during up cycles. Corporations typically are willing (and allowed) to take on additional financial leverage when cash flow is high. If the U.S. Government were a private corporation, now would be an ideal time to take on additional debt due to favorable economic conditions. In corporate finance terms, the U.S. government’s EBITDA-to-debt ratio has improved because of higher tax receipts.
If the cost of debt is low, entities can afford more debt. Corporations can take on more debt when their ability to service interest expense improves. That can occur when cash flow improves, but it also happens when interest expense is lower. With the cost of debt to the government near record low levels, the government’s ability to pay interest expense has improved. In corporate finance terms, its debt coverage ratios have improved.
If everyone else is doing it, why shouldn’t the United States. Other governments such as Germany and Japan have expanded government spending while pushing interest rates down until rates turned negative. Their actions support claims that there will continue to be strong demand for government bonds even if bond yields go lower.
It works when things are going right but will
be disastrous if things go bad. A key tenant of MMT is that government spending and the setting of interest rates are tied together. While that may work in countries with a centralized government, it is at odds in the United States where Congress controls spending and the Federal Reserve sets monetary policy. What will happen when there are periods of rising inflation and the Federal Reserve feels the need to raise interest rates? It is unlikely that Congress would respond to higher debt costs by raising taxes or cutting back spending to shrink the deficit. The result could be a downward spiral of hyper-inflation and rising deficits. It is possible that expanding federal debt levels will exasperate down economic cycles.
The country will face rising health care and social security costs so taking on debt now is wrong. People are living longer due, in part, to the advances of science. These advances come at a cost as witnessed by the sharp rise in health care costs over the last several decades. With the baby boomer generation entering retirement, government spending on social security and Medicaid is expected to grow. If the government expands its debt until it reaches full employment, as MMT advocates, it will hamper its ability to raise debt to meet future spending needs such as social security and Medicaid. In essence, MMT is simply kicking the can down the road for future generations.
Are we comfortable with foreign countries owning our debt? MMT argues that government debt is different from private debt and they do not compete for the investment dollar. That may be true, but someone is buying the government debt. Recently, that answer has been foreign governments including China and Japan, who each own more than $1 trillion of U.S. debt. The United States has run a federal trade deficit for many years, and the countries running a surplus have reinvested the dollars they receive by buying U.S. bonds. Increasing our debt as per MMT will only increase the ability of foreign entities to impact domestic economic conditions. Imagine, for example, if the Chinese government were to suddenly sell all its U.S. bonds at once.
MMT is sometimes cited as an unrealistic policy of the liberal left. In reality, it has characteristics of the economic policy of both parties. MMT is often cited by democratic leaders such as Alexandria Ocasio-Cortex and Bernie Sanders as a justification of increased spending for the Green New Deal or Medicaid For All. The basic tenets of MMT have also been supported by President Trump who has advocated for lower taxes and higher defense spending while pushing interest rates down. It is also similar to trickle-down economics in that debt is viewed as an investment that will provide future returns instead of simply a loan. Whether it is Democratic politicians seeking to raise welfare spending or Republican politicians seeking to lower taxes or increase defense spending, the net result is most likely the same: an increase in federal debt. While that may sound like a bad thing on the surface, an argument can be made that increased debt combined with low interest rates is a cheap way to grow the economy. However, MMT has not been tested over multiple economic cycles.
https://www.cnbc.com/2019/11/25/fed-economists-warn-of-inflation-and-economic-ruin-if-mmt-is-adopted.html, Jeff Cox, CNBC, November 25, 2019
https://www.economist.com/finance-and-economics/2019/03/14/is-modern-monetary-theory-nutty-or-essential?gclid=Cj0KCQiAt_PuBRDcARIsAMNlBdoQJdvqcjbzwJmtiIckZb3BfkcR8yzIqhBoNKjSXayoQd0VRPBbBhgaAsefEALw_wcB&gclsrc=aw.ds, The Economist, March 14, 2019
https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained, Dylan Matthews, Vox, April 16, 2019
https://www.bloomberg.com/news/features/2019-03-21/modern-monetary-theory-beginner-s-guide, Peter Coy, Katia Dmitrieva and Matthew Boesler, New Economy, March 21, 2019.https://www.forbes.com/sites/miltonezrati/2019/05/28/what-is-modern-monetary-theory/#74c1d4a63186, Milton Ezrati, Forbes, May 28, 2019