Markets sprang back from their Christmas drubbing with barely a look in the rearview mirror. This vibrant recovery was due more to the U-turn in Federal Reserve monetary policy than a bullish outlook for the economy. Indeed, earnings estimates have been moving lower as the effects of the trade war have slowed foreign economies and the domestic one alike, and exporting countries in Asia and Europe have reported large drops in activity. South Korean exports are down 8% year over year in March, and Germany's Manufacturing Purchasing Manager’s Index (PMI) was 44.1 (below 50 signifies economic contraction). That was the worst PMI in Germany since 2012. Japan's Tankan March sentiment survey of large manufacturers was at a six-year low.
It was the change of heart by the Fed that caused Wall Street to break out the punch bowl. After the March Fed meeting, it was announced that the Fed would probably not raise interest rates for the remainder of 2019. Of course, jaws dropped as the blunt implications of that message sank in. Far from worrying about an overheating economy, the Fed signaled the slowdown was real enough to warrant abandoning their tightening policy. But that U-turn gave Wall street more of the financial drug it has become addicted to over the last ten years: liquidity.
The reaction to the promise of more liquidity underscores the Pavlovian conditioning of investors today. The monetary tightening undertaken in 2018 ultimately resulted in the abrupt sell off in last year’s final quarter. Having gorged on easy money for ten years Wall Street laid an egg once the effects of “quantitative tightening” started to bite.
The promise of liquidity brings with it the promise of low interest rates, and hopefully broad-based borrowing on the part of consumers and businesses. This has been the economic policy since the recession of 2008. It is hoped that more and more borrowing will keep the expansion alive. But, as we discussed in the March Market Outlook, levels of debt in the U.S. are reaching levels that previously marked economic turning points. As of the end of 2018, total federal debt has now reached 105% of gross domestic product (GDP), a number that was only exceeded in WW II. Corporate debt to GDP ratios have reached 45%, a new peak that is consistent with that marked the pre-recession peaks of 1991, 2000, and 2007.
Can a nation borrow its way to prosperity? We believe not, and that it is a “March of Folly” to believe so.
March of Folly-From Troy to Vietnam is an insightful chronicle written by historian Barbara Tuchman. The book covers one of the most compelling paradoxes of history: the pursuit by governments of policies contrary to their own interests. She covered four instances of government folly in human history: the Trojans' decision to move the Greek horse into their city, the failure of the Renaissance popes to address the factors that would ultimately lead to the Protestant Reformation in the early sixteenth century, England's policies relating to the American colonies under King George III, and the United States' mishandling of the conflict in Vietnam. Folly arises when governments persist in the face of evidence that their policy is wrong for their nation. And changing policy seems in a public way seems tantamount to failure.
Tuchman defined folly by three criteria. First, it must have been seen as such (i.e. a folly) by contemporaries. Second, another, better, course of action must have been available. Last, the course of action must have been pursued by a group rather than an individual over the course of more than one political generation.
We believe the current policy of artificially repressing interest rates and ultra-easy monetary conditions will go down in history as the twenty-first century’s march of folly. The Fed had little choice but to pursue their radical policies in the wake of the collapse of the credit bubble in 2008 (due also to their utter failure to enforce their own rules on the banking system). But these policies have now morphed from being extraordinary to being the norm. Financial markets now assume that whenever they run into trouble, central banks will be there to bail them out. We had the impression that Fed chairman Powell would stand firm in bringing monetary policy back to normal and force markets to stand on their own two feet, but that view evaporated in March when the Fed caved in to Wall Street’s temper tantrums. In a sobering turn of events, we can say that Wall Street now controls the Fed, rather than the other way around.
The “new normal” of perpetually easy monetary policy has allowed congress to escape its responsibility for any fiscal restraint. The current federal budget will approach $1 trillion this year, and will certainly exceed that in years to come based on current spending and taxation policies. The Fed’s bond buying policy (quantitative easing, or QE) has provided a ready buyer for Treasury bonds, allowing congress to borrow without the repercussions of higher interest rates. In fact, QE financed most of the budget deficit from 2009 to 2014. Such is the magic of being able to print money.
This has in turn given rise to a new view of monetary policy known as Modern Monetary Theory (MMT). MMT has been broached in academic circles for several years, but the recent experience of no ill effects (so far) of today’s ultra-easy central bank policies has brought it to the forefront of political thinking. The basic idea behind MMT is that deficits don’t matter.
Essentially, MMT espouses that the public, through the government, owns the process of money creation, and that in addition to borrowing and taxing, should simply issue currency as payment for its obligations. This is not the sleight-of-hand that quantitative easing was. This is direct monetization in lieu of borrowing. If that sounds like printing money, that’s because it is.
The central idea of MMT is that governments with a fiat (government-backed, not gold-backed) system can and should print as much money as they need to spend because they cannot go broke or be insolvent unless a political decision to do so is taken. The government issues the debt and the cash in the same currency so it can print money to pay itself back.
According to MMT, a large government debt isn't the precursor to collapse we have been led to believe it is. Countries like the U.S. can sustain much greater deficits without cause for concern. In fact, a small deficit or surplus can be extremely harmful and cause a recession since deficit spending is what builds people's savings. Therefore, the government should print money to promote full employment. From this perspective, deficits aren’t the problem, they are the solution.
MMT advocates also propose that tax policy should become an anti-inflationary monetary tool. If there is too much money in the economy the government should tax some of it, thereby taking it out of circulation. The role of tax, however, goes to the conceptual core of MMT, which is about how money originates and how it is removed. Traditionally, economists see the role of government as setting taxes in order to raise revenue. Tax revenue is then used to pay for the things government needs to do: police, military, roads and so on. This conception likens the government to a household budget. That is, it cannot spend money until it has taken in money. Any extra money it spends must be financed by borrowing.
MMT backers argue that the "household" metaphor is exactly backwards, because the government has to create the money first in order to spend it, and only after it is in circulation can it be taxed back. So the role of inflation fighting moves from the central bank raising interest rates to the congress raising taxes in order to control inflation.
The idea of increasing taxes as a deflationary measure is probably one of the most controversial aspects of MMT. Critics are highly skeptical than any government would have the courage to increase taxes during a period of inflation. And tax policy is difficult to implement quickly, whereas inflation can take root rapidly. Relying on taxation to extract money from the economy and cool it down could well be politically unfeasible in countries where tax hikes are deeply unpopular, such as the US.
MMT is being espoused by the growing chorus of politicians who are calling for a socialist rebalancing of the wealth gap that has developed over the last 20 to 30 years. The green energy revolution, student loan debt forgiveness, and Medicare for All can easily be paid for, and therefore justified, by embracing the MMT mantra. If deficits don’t matter, and the needed money can simply be printed, why not make these promises? After all, Japan’s total government debt is currently 240% of GDP and they have not experienced runaway inflation.
But there is an elephant in the room which MMT fans either try to avoid discussing, or pretend doesn’t exist: the bond and foreign currency markets. Countries aren't economic islands. Their economies are linked to their neighbors and worldwide trading partners. Even if everything MMT proposed were true, and money creation and deficit spending were not inflationary at the national level, runaway inflation might still kick in if foreign investors decide that MMT is going to make a nation's currency worthless, its government bankrupt, and prompt its central bank to default.
Bond, credit, and foreign exchange investors essentially make bets on the health of national economies--and their currencies-- by buying and selling government debt, and currency, based on how risky it appears to be. The foreign exchange markets might decide they don't want to hold the currency of a country that is printing money to pay its own bills. Bond market investors might decide they don't want to buy the debt of a country that has no intention of curbing its deficits. This is a practical reality that could make MMT difficult to implement.
Moreover, it is important to remember that borrowing is, at its core, bringing future consumption into the present. If we want a good but don’t have the cash to pay for it, we can borrow in order to consume it now. While this creates present-day demand, what does it do to future demand? If we perpetually encourage borrowing, and continually bring forward consumption, what happens to the demand profile in the years to come?
The Japanese experience provides some insight into this question. After their market went bust in 1989, Japanese interest rates were lowered to zero. Subsequently, their economic growth stalled for many years, leading to the economic malaise known as the “Lost Decade.” Even now, Japanese growth is anemic, 30 years after the Japanese miracle peaked.
An analogy can be found in the U.S. In the wake of the 2008 recession, we experienced the weakest recovery since WWII. It is no mystery why. The Fed’s policy of encouraging debt-based consumption at any cost left less and less demand for future years.
Our children and grandchildren will get a double dose of bad news, as they will have to face the fallout from today’s debt folly. Weakened future demand will impact their job prospects, careers, and earnings potential. There are already numerous studies that are indicating that today’s young adults are the first generation in America that may not be better off than their parents. We are saddling future generations with a bill that will not be paid in cash. Instead, because of the inevitable low economic growth that results from today’s debt binge, future generations will pay the bill in lost opportunities for wealth accumulation (note the popularity, or is it necessity, of the “gig” economy today).
The current policy of encouraging borrowing for the sake of boosting current demand is a march of folly on an epic scale. Policymakers have become conditioned to no repercussions (yet) from pursuing a policy of easy money and ever growing debt and deficits. Moreover, the rise of MMT as a serious economic strategy should put investors on guard, as it offers the seductive promise of a free lunch with which we can solve many fundamental problems. But these policies are robbing the economy of future demand, perhaps leading us down the road that Japan has travelled for three decades.
March of Folly-From Troy to Vietnam can serve as a mirror into which we can look, and ask ourselves whether the solutions we are pursuing are the right ones for the problems we face. Or rather, are we simply repeating the same policies in hope of a different outcome in the future. Mrs. Tuchman provides a cautionary observation we should all heed regarding the power of folly:
“Wooden-headedness, the source of self-deception, is a factor that plays a remarkably large role in government. It consists in assessing a situation in terms of preconceived fixed notions while ignoring or rejecting any contrary signs. It is acting according to wish while not allowing oneself to be deflected by the facts.”