Silver bullets are not magnetic
03/10/2019
Andrew Norelli
Since my last dispatch, the Fed executed two hawkish rate cuts, waited one meeting too long to cut the IOER rate an extra 5 basis points, and was forced to intervene in the funding markets to keep the Fed Funds rate from breaching the top of their target band; President Trump twice escalated his tariffs, got a Chinese retaliation, continued his assault on independent monetary policy in the United States, called both Xi Jinping and Jay Powell “Enemies” on Twitter, very clearly “ordered” US firms to stop doing business with China, and opened himself up to an official impeachment inquiry; the ECB was compelled to cut rates further negative, adopt a tiering mechanism for bank reserves, and restart their QE program.
But hey the US data got better there for a bit! I was asked repeatedly whether I thought the probability of recession in 2020 was dropping and global growth was rebounding. The answer was (and remains) unfortunately no, because the damage done by the US-China geopolitical conflict has simply not been undone, at all. To me, the global economy seems to be in a perilous situation, because economic momentum is weakening (trade is the epicenter), and monetary policymakers have far less ammunition than in prior cycles to address the problem. The ECB and the BOJ never got any hikes done during the entire the business cycle1, so they’re staring down the pike at rising recession risk with policy rates already negative, and all central bankers seem either reluctant or unable to ease aggressively without the clear and present danger of imminent recession. If I put it like that, it seems fairly concerning, with no clear long-term solution or endgame.
And yet, stocks are high, spreads are tight, volatility is low. Financial conditions are still remarkably easy; capital is cheap, unicorn implosions notwithstanding. Why is this? Well I think the reason is at least partially a form of modern, market-related “whataboutism,” the classic propaganda technique. In markets, there is an expectation of support from policymakers and governments that is bordering on entitlement. After all, post-crisis markets have been clearly supported by a very diverse array of stimulus. So now, markets expect more: yes, growth is slowing, but whatabout Chinese stimulus? Whatabout more QE? Whatabout fiscal stimulus? Whatabout a shock-and-awe interest rate cut by the Fed? Whatabout a payroll tax cut? Whatabout indexing capital gains for inflation? Whatabout “whatever it takes?”
In much the same way as whataboutism has worked for generations as a political propaganda tool, so too it appears to be working to engender market optimism even when it is difficult to extrapolate the various “whatabouts” into sustainable and painless prosperity. For skeptics who try to look forward, the question is: how does it all end… are we really going to deficit spend and QE our way to a new business cycle? In a nutshell, the simultaneous increase in fiscal deficits and central bank bond purchases at near full employment reeks of “MMT” or Modern Monetary Theory. MMT suggests that as long as governments control the use and supply of their own currency, central bank-financed deficits may persist without limit until inflation pressure arises. Or, inflation is the only limit to governmental profligacy financed with printed money. I am almost embarrassed to admit that the theoretical underpinnings of MMT make some sense to me2, but much like other controversial economic systems, I think it can only work in theory. Human nature, especially (but not only) in democracies, prevents MMT from fulfilling its promises.
In practice MMT would go something like this: when faced with the current environment of slowing global growth, tenuous labor market stability, and unremarkable inflation pressure, the political pull toward MMT’s magnetic combination of deficit spending and central bank bond buying will overcome the handwringing over sky-high debt levels. Tax cuts will happen. Near-term, there will be no adverse effects, and the economic expansion will be prolonged for a time. But at some point, inflation pressure will arise. I see no other possible outcome when taken to the extreme3. Politicians will then be faced with a choice: under MMT, the budget deficit rather than monetary policy is supposed to regulate inflation, so when inflation pressure occurs, politicians must shrink the budget deficit rapidly. The other option is to deviate from MMT, and maintain (or increase!) the budget deficit. Ramping down that deficit, after a period of time in which economic growth has been sustained by the deficit, will trigger a self-inflicted recession almost for sure, and likely result in politicians’ ouster from office. On the other hand, politicians can roll the dice with inflation and keep their jobs until it gets really bad. Which do you think will occur? This element of political economy is a reason why young democracies or tenuous authoritarian regimes periodically have to lop off a bunch of zeros from their currencies, and why a rescue lender like the IMF still occasionally faces political opposition in countries which need its help.
It doesn’t take a huge philosophical leap to see that central-bank financed fiscal profligacy (whether restrained in the case of MMT or completely unrestrained) ultimately leads to pain, so there should always be some opposition to it. It’s not clear that the major economies will even pursue it in the absence of a crisis and lots of labor market slack. But if they do, which would satisfy many of the “whatabout” questions supporting the market today, it is not a silver bullet. On the contrary, adopting such policies to extend an ageing business cycle can deepen the eventual pain of a recession. If a country pursues pro-cyclical fiscal policy or MMT, it takes the option off the table when it’s truly needed in the depths of a recession (the traditional counter-cyclical response), just like the seemingly more limited monetary policy options we have now.
1 Except for the pair of quickly regrettable ECB hikes under Draghi’s predecessor back in 2011.
2 See: Seven Deadly… by Warren Mosler, founder of the hedge fund Triple-I, and also the builder of the fabulous MT900.
3 Other than perhaps an implausibly huge level of wealth inequality I discussed here and here, and like that satirized in the movie Elysium.