“Deficits don’t matter” may still be heresy among fiscal hawks. But unprecedented government debt spending amid ballooning central bank balance sheets and still-elusive inflation prompts fixed income PM Jeff Klingelhofer to examine the myths and assumptions around “modern monetary theory.”
Jeff Klingelhofer: Are we actively engaged in MMT? I’d say it’s a philosophical question more than anything. In the last number of months, we’ve seen central bank balance sheets around the world increase by $10 trillion, so undeniably we are monetizing debt.
Charles Roth: Welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Charles Roth, global markets editor at Thornburg. We’re joined today by Jeff Klingelhofer, co-head of investments and the co-pilot on our global fixed income strategies. Jeff, thanks for coming on.
Jeff Klingelhofer: Absolutely, it’s a pleasure to be back.
Charles Roth: Well yeah, so the last time we spoke, was in August when we discussed central bank asset purchases, otherwise known as quantitative easing, which we’ve seen in the U.S., Europe and of course Japan which has also been engaging in, in yield curve control since 2016. Over the last few years, we’ve heard quite a lot about MMT or Modern Monetary Theory, which describes currency as a public monopoly, and an economy’s failure to operate at full capacity is evidence that a central bank is overly restricting money supply, it posits that an economy is only limited by its productive capacity, so as long as there is slack in the economy, the government can safely borrow and the central bank can safely monetize that debt up to the point that the additional spending, or the demand side stimulus doesn’t surpass economic capacity and, and pressure inflation beyond what is, is deemed accessible. Generally, like 2 percent is the agreed-upon inflation target among central bankers generally. And so, once that is past, then you would have offsets, the necessary offsets, that is taxes. And is that a fair description of MMT and are policy makers from central bankers and treasury or fiscal authorities in Japan, Europe and the U.S. where, where the fed has cut benchmark interest rates to 0 and is buying 120 billion a month in, in treasuries and, and mortgage backed securities, are they already effectively engaging in it?
Jeff Klingelhofer: Let me, let me talk on those two questions separately. First, is that an accurate description of, of Modern Monetary Theory? I mean it broadly is. What I would draw out of that in particular is that under the economics that many of us studied that certainly myself studies is that the capacity of an economy to produce is the capital within the economy. And I think what you appropriately touched on is within Modern Monetary Theory or MMT, that capital is essentially limitless, right. We have printing presses. We, we can just simply print as much currency as we want. Now that doesn’t mean there aren’t any limits. As you point out, the limit is inflation, but at least from a general academic construct, which is another important point of MMT, MMT is, it’s just another economic theory, right. We have Keynesian economics and Austrian economics and all sorts of, of, of various economic theories, and this is just another one. And when we look at the environment today, which starts to get into your second part, is are we already engaging in MMT is clearly central banks are missing on inflation, right, and it’s not just the U.S. and it’s not just Europe or Japan. It’s, it’s central banks in many, many parts of the developed world. But secondly, it, we are in many ways already engaging in at least, in theory, short-term MMT. Now as central banks or, or as the treasury prints currency and as central banks expands its balance sheet, many people are still operating in an assumption that eventually we’ll have to pay all of this debt back; eventually we have to take the balance sheet back to zero. We have to level it. But I would point out that while the U.S. has definitely swung between deficits and surpluses over its, you know, many, many years of economic history, it really hasn’t ever taken its, its broad balance back to zero. And today I would argue that MMT’s primary assertion is that you have to think about the balance sheet of an individual or of a corporation, a private entity very differently than you would think about the balance sheet of a sovereign nation. And with my balance sheet, eventually I have to pay that back. If I take out debt, I have to pay it back. If a corporation takes out debt, eventually it has to pay it back. But under a, a sovereign nation, the argument under MMT is that that the deficit or surplus is just, it’s just an economic history of, of whether it’s run deficits or surpluses. They don’t ultimately have to be paid back, and I think at this point when you just look at the history of the U.S., it, it actually does make some sense, that there are potential challenges with MMT, absolutely, but at least as an academic theory, it, it does an okay job of describing the world that we are, are in today. Now to directly answer your last question, are we actively engaged in MMT. I’d say it’s a philosophical question more than anything. In the last number of months, we’ve seen central bank balance sheets around the world increase by $10 trillion, so undeniably we are monetizing debt. The question is, is are we operating with the assumption that we never have to pay it back or are we operating with the assumption that, that we do have to pay it back. I would argue that broadly we’re still operating with that assumption, but the reality is we won’t actually try to pay it back, and therefore, we are certainly closer to MMT than we ever have been, if not in outright MMT.
Charles Roth: Let’s talk about that constraining limit of inflation in MMT. As, many, observers and advocates and opponents of MMT have pointed out and acknowledged, we have failed in, in the U.S., Europe, Japan really as you pointed out the developed countries to reach or at least sustain targeted inflation levels. You know, since the March lows though, we’ve seen risk assets log huge increases in value, so based on precious metals, agricultural commodities, energy prices, real estate, equities if you’d like to include those and MMT proponents argue that not all inflation is caused by excess demand. It may be driven by businesses that decide to exercise their pricing power to raise profit margins or pass on costs and the regulators for those forces of inflation where tax offsets, tax increases, for instance, wouldn’t necessarily be appropriate, but the regulators could step in, and they’ve pointed to Medicare and Medicaid, legislative cuts to those programs as proof that you can contain in, inflationary pressures through regulatory fiats. Is that a realistic assessment of inflation on the demand side or through corporates and is the solution of regulation realistic?
Jeff Klingelhofer: You know, I think that’s where MMT gets a little challenging, right. I mean, capitalism is generally of the belief that, that lower government regulation generally results in, in stronger economic efficiencies, but I think that that efficiency’s part is, is definitely part of the equation, right. MMTers would say that ultimately if you believe that the government or an, an individual sovereign nation is the monopoly supplier of currency, which it is, I can’t print my own currency, certainly not legally and nor can any corporation, then they operate on the assumption that currency is the limiting factor, the supply of capital, perhaps, is the limiting factor and it shouldn’t be. But the flip side of that is as we’ve heard many times before, there’s an economic school of thought that inflation always and everywhere is a monetary phenomenon and, and too much currency, too much money in the system can create inflation. So there’s lots of ways of potentially squashing down inflation, regulation, as you point out, absolutely. Can that be a potential solution? It can be. Is it the best solution is a highly uncertain concept, right. I think what MMT would point to is today we’re not operating in an environment of too much inflation. We’re operating in an environment of too little inflation and, and broadly I think what we can mostly agree upon is that no one quite understands exactly where inflation comes from with perfect certainty, nor do we perfectly understand how to squash it. Absolutely, if you take out significant amounts of, of money supply and, and force interest rates notably higher, as, as Paul Volcker did, that can squash inflation. But I would argue so can regulation. Now which is more efficient? I don’t know that there’s a clear answer there. I think they both have tradeoffs. You know, a larger government and, and the ability to control inflation and, and minutia, little markets as you point out and, you know, medicine markets perhaps, can exist but do we trust the government to, to squash inflation on all regard, on medicine and housing and all sorts of other consumer spending to have thousands of laws on the books perhaps to squash inflation. You know, I think that’s the challenge, but I do want to point out MMT doesn’t operate under the assumption that there are no limits that you can just print as much currency as you want and there are no consequences. MMT is of the assertion that there are consequences when you over print, when you over supply the, the system with, with excess capital and that is inflation. But ultimately what MMT at that point would argue is you’ve reached the, the capacity limits of MMT, that you don’t just print all the currency in the world, that you would simply pull back at that point. So, I would argue MMT doesn’t rely on, on regulation alone. It relies on a combination of lots of things, on a combination of regulation, perhaps in individual markets, but broadly it would ultimately rely on then restricting the flow of capital, if inflation is becoming a, a system-wide problem.
Charlie Roth: So let’s go back for a moment to the idea that, um, MMT aims to create full employment, um, and, greater prosperity for the general population, you know, perhaps through a universal basic income, um, but, um, pre-pandemic, the United States was at about 3 ½ percent inflation. Wages had been rising for the lowest echelons in the, um, income bracket and, um, and inflation was not really much of a risk. Um, do you think that once the pandemic is over that we could start to see inflation as employment comes down, given how much money printing there has already been, how much debt monetization has, has already taken place?
Jeff Klingelhofer: You know, I think that’s the million dollar question, and I think that’s one of the biggest risks to MMT. But it goes back to the earlier point that MMT or not, it, it, it’s pretty clear to me, at least, that we don’t understand exactly the, the, the, the drivers of inflation, right? We, we had a fed that started raising rates in anticipation of reaching full employment, um, under the belief that we were getting close to, to the potential limits of, of the U.S. economy. We, we had central banks around the world that did the same thing, and yet here today, we find ourselves with very, very low inflation. And then ultimately, we have a country like Japan which hasn’t seen any significant inflation in, in many decades, right? So I think the core part of your question is not, “Is it a risk?” absolutely it’s a risk. Um, but also there’s a risk on the flip side, that perhaps 3 ½ percent unemployment wasn’t truly the, the, the production capacity of, of the United States that there was a significant portion of the labor force that wasn’t unemployed per the government’s definition. They just simply weren’t actually in the labor force altogether, um, and that’s where you get that 3 ½ percent. It doesn’t count the person not looking for a job. It only counts the people looking for a job that can’t get one. And so overall, labor participation hadn’t ticked back up to pre-global, financial crisis, the, the previous recession, type levels. And therefore, I think you can make an argument that, that, that ultimately we weren’t actually at full capacity. We certainly didn’t see problematic inflation. But one potential challenge with MMT is that the assertion is you’ll see it as you get there and you can simply dial back the level of, um, money printing or, or, um, monetizing of the debt. An, and that’s the big assertion is that perhaps because we don’t understand inflation, that once you get it, it, it’s maybe too late. But I think that argument exists under the current system just as well. Clearly, we haven’t understood what is driving low inflation, and I think it’s, it’s hard for somebody to suggest that, that the central banks around the world under the, the standard system would, would see inflation coming and would be able to slow it down preemptively, as well. Um, and so again, to me, this is just another, philosophy within the economic, academic economic communities. Um, it’s one way of looking at the world, but it’s one that just, given the environment, perhaps we as a, as a community need to not adapt but, but incorporate in, into our mindset and we as investors need to dismiss the idea that it’s always and everywhere bad, right? I think that’s the most interesting part of MMT is most of us don’t understand what it is and because we don’t understand what it is, it’s very scary. It’s assumed that it, it’s just destined to fail. Um, but in many ways, just like all other schools of thought before it, it can contribute to the broader understanding of, of how the economy works and the tools that we have. And given what we’ve seen with central banks and how they operate, you know, I think there’s a case to be made that, that we are already certainly further along the road than, than maybe we care to admit.
Charles Roth: So let’s get to the real world implications of, of inflation and the outlook for 2021. I, I say this because, as I noted earlier, we have seen tremendous rises in various categories of risk assets, from commodities to housing to financial markets. And so how, how are you looking at this landscape ahead? I mean, are you doing anything to tilt the portfolio against any sort of inflation threat or how, how, how are you thinking about portfolio construction and allocation as the world comes out of coronavirus and sees it in its rear-view mirror?
Jeff Klingelhofer: Yeah, absolutely. You know, I think it’s important that we always remember portfolio construction is not a discrete outcome. Um, I would argue you’re destined to fail if you are designing a portfolio for a very discrete outcome, simply because the world is incredibly complex and, and you generally don’t get a pre-identifiable outcome, right? So, the idea of portfolio construction is a continuum. It’s a not necessarily normally distributed bell curve, but it, you have left-tail events and you have right-tail events and as any, you know, good portfolio manager, you need to be considering both sides. And so you, to directly answer your question, currently the system absolutely has many potential threats for an inflationary environment in the future as the world heals. You know, I wouldn’t say that’s necessarily my base case, but it’s not something we should dismiss either. Inflation protection today is relatively inexpensive, certainly in the world of low rates and where nominal treasuries are, so in many ways, rather than owning treasuries, we do own inflation protection in the form of treasury inflation-protected securities, right? It’s part of our allocation, right? I would also argue you’re not compensated to step out in risk-free rates, for a significant, duration. So, keeping, keeping cash flows very short to maturity would allow us to reinvest potentially if we do see a higher inflationary environment and thus ultimately higher rates available on bonds. So again, you have to think about the world of portfolio construction as a continuum. we have to consider both left-tail and right-tail events and, and potentially one of those left-tail events in, for fixed income in particular, is a world of high inflation. The way we’re playing that is staying short in duration and owning some direct, inflation protection within the portfolios.
Charles Roth: Excellent. Well, thank you, Jeff.
Jeff Klingelhofer: Absolutely. Thank you very much.
Charles Roth: Today’s episode was produced and edited by Michael Nelson. You can find us on Apple, Spotify, Google Podcasts or your favorite audio provider or by visiting Thornburg.com/podcast. Subscribe, rate us and leave a review. Please join us next time on Away from the Noise.
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