Saturday, April 4, 2020

Modern monetary theorists are flooding the system with myths

Printing unlimited fiat money is unsustainable – the Gold Standard was abandoned long ago

Leading up to and shortly following the Federal Reserve’s recent announcement for the purchase of Treasuries, MBS and other assets in “the amounts needed to support smooth market functioning and effective transmission of monetary policy” [1], we saw a plethora of Modern Monetary Theorists (“MMTers”) appear in the financial media with calls for unlimited quantitative easing (QE) from the Fed and unlimited stimulus (“Helicopter Money”) from the Treasury [2,3]. The same calls abounded by the way for the U.K.’s Bank of England and Exchequer. 

Let me make this clear: Printing unlimited fiat money through “asset” (or distressed debt) purchases or outright helicopter money drops into the economy is not sustainable. There are all sorts of end consequences: inflation/hyperinflation, reserve currency damage, otherwise failed zombie companies and distressed debt essentially owned by the government (taxpayer), moral hazard, lemon socialism. 

Deflation need not apply here – I’ve heard enough false and erroneous arguments that boil down to “if we don’t flood the system with money (liquidity), we will get a massive deflationary depression like that of the 1930s Great Depression or the supposedly ongoing post 1990 deflationary recession of Japan”. Likewise, we hear that the Fed’s policy response of zero interest rates is needed indefinitely to avoid a depression. And finally, MMT’ers are using this crisis to claim that sound money and free markets. e.g. monetary standards and unmanipulated markets, are a failed experiment of the past. These are tired arguments that deserve to be killed outright, so here goes. 

Deflation during 1930s Great Depression, and other Great Recessions

The deflation during the early 1930s Great Depression was primarily caused by an overwhelming use of fractional reserve banking to leverage deposits for loans to businesses that were insolvent and eventually failed, exacerbated by several periods of bank runs (panics) by depositors. Even the Fed admits this in one of its policy papers [4], though not quite in my direct terms here. The Fed apologetically writes that it should have then “flooded the economy with additional liquidity to stop consumer prices from falling”, with “liquidity” defined as money injected into the system “by purchasing Treasury securities, which increases bank reserves and, all else equal, lowers nominal interest rates.” 

The problem here is that the deflation, however deep, acute and transient, was a result of an unstable fractional reserve banking system to begin with. Yet this fundamentally unstable model has perpetuated in multiple forms throughout the last century, causing Japan’s Great Recession post 1990 and the U.S. Great Recession in 2008.

Central bank policy makers in Japan (the Bank of Japan, BoJ) responded by buying up massive amounts of bad debt of essentially every type, including its own government debt, resulting in a $5T balance sheet that has exceeded the national economy [5] and persistently negative interest rates. The BoJ didn’t just buy bad debt that will sit on its books in perpetuity, it also bought equities. Japan hasn’t suffered from asset and various consumer price deflation in years – the official inflation numbers reported are understated like they are here in the U.S. What Japan suffers from is a policy response that has caused persistent inflation combined with slow growth, the latter a result of negative interest rates. 

The Fed in 2008 corrected its apologetic actions from the Great Depression by applying massive monetary stimulus injections into the system, through QE and other “liquidity” programs [6] that included bailouts to distressed financial institutions. Like the BoJ, the Fed bought massive amounts of bad debt, notably mortgage backed securities (MBS), so much so that the federal government became the primary participant and guarantor in the mortgage market. Put another way: The U.S. government has nationalized the mortgage market, following a failed model based on the fundamentals of fractional reserve banking. Like the BoJ, the Fed continued to buy up bad debt via several rounds of QE, for years following 2008, swelling its balance sheet to over $4T. Meanwhile, the Fed Funds Rate had been driven to near zero, asset and consumer price inflation in various categories soared, yet economic growth has been anemic, in part due to negative real interest rates and the continued interventions to prop up a fundamentally unstable system. 

Sound Money

MMT’ers routinely make the argument that market failures and depressions of the past were caused by tight monetary policy, and notably monetary standards such as the Gold Standard. MMT states that monetarily sovereign countries (countries that issue fiat money, or inconvertible paper money made legal tender by government decree/monopoly) are not constrained by revenues in issuing debt (spending). So far, we’ve seen Japan and the U.S. start to follow this path, with the BoJ and the Fed essentially acting as hedge funds to enable MMT. China, who surpassed Japan in 2018 as the second highest debtor nation [7], has caught on to this game. How sustainable is this, and are MMT’ers right about sound money and monetary standards, such as the Gold Standard?

First, the U.S. abandoned the Gold Standard long ago – well before the 1971 Bretton Woods conference where the U.S. unilaterally terminated convertibility of the U.S. dollar to gold, officially marking the dollar a fiat currency. The first notable break with the Gold Standard goes back to the Civil War in 1862, with the government taking on war debt it could not pay for. Greenbacks were fiat money not convertible on demand at a fixed rate into specie. After the war, it took some 15 years to return to a Gold Standard. Credit and fractional reserve banking gained substantial traction in the U.S. after 1900, and the first major financial crisis in 1907, the 1907 Banker’s Panic, was caused by the unstable fundamentals of fractional reserve banking. Having tired of bailing out the banking system, J.P. Morgan helped push for the creation of a Federal Reserve banking system, which could act as a “lender of last resort”, but also facilitate credit markets, including stable management of the Treasury market. The 1913 Federal Reserve Act only required 40% gold backing of its demand notes. Banking panics of a similar nature plagued the U.K. in its centuries of monetary history, causing numerous financial crises and deep recessions [8], with a central banking model from the beginning, and a lack of commitment to a true standard. The U.K. moved to abandon the standard completely in 1931, as it coped with immense bank runs and the Bank of England losing massive reserves. FDR took the U.S. off the Gold Standard in 1933 for much the same reason, and when it was “reinstated” in 1934, the convertibility was devalued by 40% (the Gold Reserve Act). A chronology is shown in Fig. 1, a log plot of USD in mg of gold, from 1787 to 2020, courtesy of

The question to ask here is this: Is the problem a Gold Standard (or any sound money standard), or the unstable fundamentals of fractional reserve banking? A Gold Standard, or the instability of too much debt issuance? My answer is the latter. MMT’ers cannot have the unlimited debt growth with the limited monetary standard. So, they did away with the standard. Meanwhile, money supply growth, inflation growth and debt have exploded exponentially. Fig. 2 is a reprint of a graph I made in 2011 [8] succinctly showing this. Also, meanwhile, we live with repeated financial crises and recessions. As the Fed continues to be influenced by MMT and employ the policies that define it, we can expect its balance sheet to swell to the national economy level of $23T and beyond. 

Free markets vs. manipulated markets

We have not had free financial markets in the U.S. and elsewhere for some time. Markets have become both managed and manipulated. When there is a crisis due to too much bad debt, over leverage, asset price inflation, and the underlying instability of fractional reserve banking, the responses have migrated to “liquidity” injections and interest rate policy, the Open Market Operations (OMO) that were strengthened in the 1933 Banking Act. The MMT’ers behind this didn’t foresee the root cause of the problem, so the problem will recur until the system reverts back to a free market. 

MMT’ers have led us to believe that only “managed” markets will truly save us from the next financial crisis. The problem is that they’ve had the reigns of our markets for almost a century, influencing bad policy and promoting instability through unsustainable systems. They cannot show us a time in modern history where free markets have failed, so they promote false claims to support the continuance of manipulated markets. 


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