Modern Monetary Theory, or MMT as it is often called, is a new term for an old idea.
Its proponents argue that a state which issues fiat money does not have to resort to taxation and borrowing to pay its bills. It can fund itself simply by printing money. While there are numerous historical examples of unfunded fiscal spending being followed by hyperinflation and economic collapse, the modern supporters of what would previously have been regarded as economic heresy say this time it is different, and that inflation can be controlled by using the tax system to manage private consumption. But can it really work in the longer term, and is it a solution for South Africa? Sandy McGregor provides background, analysis and insights.
The simple truth is that central banks in the United States, Europe and Japan have been applying the precepts of MMT for the past decade and, in responding to the COVID-19 crisis, have abandoned any sense of traditional financial prudence. The US Federal Reserve Board (the Fed) has been the most aggressive, increasing its balance sheet from US$4tn to US$7tn over the three months following the market meltdown in March. Most of this US$3tn of new money has been used to fund an exploding federal fiscal deficit. The balance sheets of the Fed, European Central Bank (ECB) and Bank of Japan have collectively increased by US$6.3tn this year. MMT has arrived almost by accident. Its longer-term unintended consequences pose a grave risk to the financial stability of the global economy.
The political allure of unconstrained government spending
For centuries, a golden rule of public finance has been that a state should live within its means. Fiscal spending should not exceed sustainable tax revenues and prudent borrowing. The wisdom of this precept was confirmed when governments tried to sustain economic growth by Keynesian deficit spending into the recession triggered by the first oil price shock in 1973. The consequence was damaging inflation, which was only brought under control in the early 1980s when the Fed raised dollar interest rates to levels which caused a serious recession. Following this bad experience, financial prudence again became the guiding principle of public finance.
In recent years, in many countries, political leadership has become increasingly restive about the constraint on government spending imposed by what generally have been regarded as prudent targets for fiscal deficits and the appropriate stock of government debt relative to GDP. This is not restricted to the political left, which usually favours increased expenditures. In the United States, the Republican party has pushed through major tax cuts, and in the United Kingdom, Prime Minister Boris Johnson has abandoned Margaret Thatcher’s legacy of fiscal conservatism. Usually the justification offered is pressing need, for example to combat climate change, to meet the growing cost of healthcare as the population ages, renovating ageing infrastructure and expenditures to address poverty.
...MMT is a dangerous drug to which political elites can easily become addicted...
The argument against these expenditures has been that, however desirable, they are unaffordable. The present orgy of spending financed by printing money sets an alarming precedent. It seems to give the lie to the idea that public spending must not exceed available resources. Politics is like water. It flows downhill by the easiest path. The rapidly developing habit of using central banks to finance governments is going to be difficult to break. MMT is a dangerous drug to which political elites can easily become addicted.
The inflation risk
Historically, financing the state by printing money has almost always ended badly. An early example occurred in France following the revolution of 1789, when the new government funded itself by issuing bonds called “assignats” which evolved into a currency. By 1793 these had lost 65% of their value and by 1796 were worth nothing. Perhaps the most notorious inflation occurred in Germany immediately after the First World War when massive money creation destroyed the savings of the middle class. More recently there has been disastrous hyperinflation in Venezuela and Zimbabwe.
To embrace MMT one has to be phlegmatic about inflation risks. One reason it has gained adherents over the past decade has been the failure of central banks in developed economies to counteract deflation. They tried to generate inflation using quantitative easing (QE), which is a euphemism for printing money. The money created had little impact on the prices of goods and services, although it dramatically increased asset prices. These powerful deflationary forces have made central banks increasingly complacent about inflationary risks and given them the confidence to act aggressively in response to the economic turmoil caused by the current pandemic. The failure of QE to ignite inflation is offered by proponents of MMT as justification for the statement that things are different now.
But are they? Aggressive expansion of the monetary base following the March crisis had an instant impact on equity and currency markets. One of the justifications advanced for increased buying of equities was the fear of future inflation. The share market has recovered to its old highs and the dollar has depreciated by 8%. Printing money always affects something.
Our attention should be focused on the United States. Its response to the COVID-19 economic crisis has exceeded that of other countries both relatively and absolutely. It has a freedom to act that others are denied because the dollar is the world’s reserve currency. Spending to sustain household incomes and support business has been funded by printing money. However, a deficit of US$3tn, equivalent to 14% of GDP, has not satiated political demands for greater spending. The ease with which the spending taps have been turned on has prompted calls for more. The Republicans want to spend an additional US$1tn and the Democrats a further US$3tn. Given the toxic political climate they could not agree on the lowest common denominator before going into recess, but now the congressional session has resumed, greater spending is likely to be approved.
Regardless of who wins the November elections, the US looks set on a path of increasing fiscal deficits, which cannot be financed by normal taxation and borrowing. Increased government spending will rapidly take up any slack in the domestic economy. While this may be regarded as desirable, it will have a cost in the form of rising prices. Inflation is a manifestation of an inefficient use of resources within an economy. As government spending is notoriously inefficient, expanding its share of GDP is inherently inflationary. When government programmes get going, they are difficult to stop. There is a danger that inflation becomes hardwired into the system.
The Fed is committed to injecting US$80bn per month into financial markets seemingly ad infinitum. In his recent speech at the Jackson Hole conference of central bankers, Chairman Jerome Powell said that the Fed will adopt a symmetrical inflation target, which is newspeak for condoning higher inflation than was previously regarded as appropriate. Interest rates will be kept close to zero for a long time to come. Theoretically, the Fed is independent of Congress. In practice, it requires a clear and present danger to aggressively increase interest rates. Until then, it is likely to be slow to respond to a growing inflationary threat and will facilitate excessive fiscal spending by expanding the money supply. Many public officials regard inflation as a good thing, being a form of financial repression which facilitates other agendas. Given the crucial role the dollar plays in international finance and trade, rising inflation in America will have adverse consequences throughout the global economy. It is too soon to ignore historical experience that funding governments by printing money produces inflation, which is difficult to control.
Using the tax system to control inflation
The advocates of MMT dismiss the inflationary threat, claiming that the tax system can be used to control domestic expenditure to eliminate excess demand. This is a flawed Keynesian macroeconomic view, which ignores how the tax system actually operates. Increased taxes are politically unpopular and even necessary changes face considerable resistance. It is not a system which can be switched on and off at will. As a result of the workings of the Laffer curve, the outcome of increasing tax rates can be lower collections. Business needs a tax system which provides long-term certainty. Increased taxation can lead to reduced investment, leading to shortages which push up prices.
Taxation should be focused solely on efficiently raising revenue. Imposing other agendas introduces complexity, which erodes collections and can have unintended adverse consequences. Taxation is not an effective tool for short- or medium-term macroeconomic management. It cannot be used to meet an inflation target. This lesson was learnt during the 1970s, after which the tax system was widely simplified, which greatly enhanced collections. It is remarkable how short the collective memory is.
Can South Africa fund its fiscal deficit by printing money?
The developed economies of the northern hemisphere can pursue imprudent fiscal policies because in the short term they can get away with this. They have large, diverse and robust economies. In the case of Europe and Japan, they have external surpluses, so are less vulnerable to capital flight. The United States enjoys the inordinate privilege of the dollar being the world’s reserve currency. Even though in all likelihood these nations are creating serious problems for the future, they have the freedom to be irresponsible without immediate adverse consequences. The same does not apply to emerging markets and, in particular, does not apply to South Africa.
...Historically, financing the state by printing money has almost always ended badly...
South Africa’s immediate problem is a paucity of domestic savings. In recent years we have been trapped in economic stagnation. There is widespread agreement that escaping from this unhappy situation will require increased investment by productive enterprises. Unfortunately, our fiscal deficit has grown so large it is currently consuming our national savings in their entirety and, even on the most optimistic projections, threatens to crowd the private sector out of domestic capital markets for years to come.
To fund a growing economy, South Africa requires foreign capital. Historically we have been an attractive destination for international bond investors, which at the peak owned 40% of outstanding domestic government bonds. These have been sold down to less than 30% during the COVID-19 crisis but, providing the confidence of these investors is retained, South Africa should be able to attract its normal share of international capital flows into emerging markets. We also benefit from short-term flows taking advantage of our higher interest rates.
Foreigners who invest in emerging markets are particularly neurotic about governments that are unconventionally imprudent. They wish to avoid investing in a country that will become the next Zimbabwe, Venezuela or Argentina. Among the warning signals which would prompt instant capital flight, is funding the government by printing money.
A central bank acts as a lender of last resort. The SA Reserve Bank performed this role in the March financial crisis and its aftermath. In the process of restoring financial stability, it bought R30bn of government bonds. Such purchases were totally appropriate. They were what Italians would call a “piccolo peccato”, a small sin.
What market participants would regard as totally unacceptable would be continuing purchases to facilitate the funding of the fiscal deficit. This would prompt immediate capital flight, which would make financing the government more difficult and more expensive. Even the dollar has weakened 8% following the Fed’s massive creation of money earlier this year. The rand would be much more vulnerable. There is a lot of foreign money in South Africa, including about R500bn in government bonds, the owners of which could panic. The rand would weaken with inflationary consequences, which would force the Reserve Bank to increase interest rates. While there would be immediate short-term costs, even more damaging would be the long-term consequences of exclusion from international capital markets. Who in their right mind would invest in a country which is adopting the policies which bankrupted Zimbabwe?
While funding South Africa’s fiscal deficit is a formidable challenge, it does not have the freedom to copy developed economies and print the money. To do so would make matters even worse. MMT is not for us.
Sandy McGregor
Sandy joined Allan Gray as an investment analyst and economist in 1991. Previously, he was employed by Gold Fields of South Africa Limited in a variety of management positions for 22 years, where much of his experience was focused on investment-related activities. His current responsibilities include the management of the fixed interest component of the balanced portfolios. He was a director of Allan Gray Limited from 1997 to 2006.
