As the US government debates how much “free” money to give out as stimulus, I realized there is something important missing from the conversation. Where does this free money come from? And do we have to pay it back to someone?
Given the desire to keep raising the bid on stimulus checks, one might think there is an unlimited supply of dollar bills that we can always print more of when we need them. In fact, this is what the fans of modern monetary theory (MMT) believe!
They suggest deficits don’t matter and we should be more like Japan. Borrow forever without consequence! This is very convenient if you are a politician motivated wholly by what’s between you and the next election. You now have “academic” backing to have a zero discount rate (i.e. do what’s you want today while ignoring future consequences).
And who can argue with something as prestigious sounding as Modern Monetary Theory! Why, that sounds like something they give out Nobels for! We all like things that are modern! Who wants that old fashioned monetary theory? That’s so brick and mortar!
Unfortunately, modern doesn’t always mean better. It was all those modern financial models that led to AAA subprime securities and CDO squareds! It was modern derivatives hedging that led to explosive growth in variable annuity sales.
Progress rarely goes in a straight line and new approaches often come with unexpected side effects we have to endure before we get the benefit of the good parts.
But, MMT isn’t progress. It’s sleight of hand made to let us feel like we can have something for free that comes with painful, long lasting disease.
It’s a theory about as rigorous as “home prices never have gone down, so they never will go down”. How did that work out for everyone???
Revisiting the Housing Bubble
That’s actually a good transition to the next part of the story. Back in the early 2000s, as we all recall, housing prices only went up and we were all encouraged to get NINJA mortgages to get bigger houses for “free”.
After all, housing prices only went up and if you needed money for a down payment, you just went to the ATM called the “cash out refi”. Why you could even day trade – sorry, “flip” – houses in your spare time and get filthy rich! There was no downside. Remember, housing prices only go up!
As a result, as you can see below, mortgage debt went up from 65% of GDP in the mid 90s to nearly 100% at the 2008 peak. The idea that you could keep levering up and there would be no consequences…yeah, that sounds an awful lot like MMT, doesn’t it?
Visiting the Pending Government Bubble
Now, the MMT crusaders will say, their approach is totally different. After all, the government can print its way out of any corner so there will never be the comeuppance that individual mortgage borrowers faced.
And that is all well and good, but remember, we had similar theories about how home borrowers would never get stuck – housing prices only go up! Worse, government deficits don’t always avoid inflation. In fact, we have strong evidence that they directly cause inflation.
MMT advocates point to Japan to say deficits don’t matter. However, they are only describing today’s state of play. I mean look at China…housing prices still only go up there. Does that mean you believe that will last forever? If not, why would you believe Japan will never face the consequences of its borrowing?
At this point, I should probably introduce some evidence of the profligate borrowing.
You can see that debt as % of GDP was relatively stable for about 20 years at 60%. Then, the financial crisis happened. Note, how we traded a mortgage debt bubble for a government debt bubble. As households have delevered over the past decade, the government has in place doubled public indebtedness well past the peak of the 2008 mortgage debt.
Let’s even do a little bit of basic math. The combined government + mortgage debt in 2008 was 160% of GDP. Today, they have edged over 200% of GDP. We have traded one crisis for another and those peddling MMT’s “governments can borrow without consequence” are just as dangerous, if not more so, than mortgage brokers pushing you into a bigger house you couldn’t afford.
Playing the Confidence Game
Like all bubbles, timing is hard to predict as so much of it is psychology, but it often boils down to simple supply and demand. In the tech bubble, the pop began with an excess of new issues relative to new money coming in to the market. The mortgage bubble stopped when every subprime borrower had a home (or two…or three).
The government debt bubble will end when there aren’t enough buyers at the next bond auction. It will likely be preceded by ominous signs like inflation proxies jumping in value (hey, look, it’s Bitcoin’s chart breaking out!).
The Fed will try to put its finger in the dike by printing more money, but this time, rather than be soothed by it, the market will reject it like an organ transplant gone bad.
It really is a very basic confidence game. Once the market tells the Fed “we don’t want any more stimulus and we’re selling bonds”, the Fed is bankrupt of tools to prevent more inflation.
This is the giant flaw of MMT. It is not, in fact, a theory. It is a belief system. And once the markets don’t believe in it, like Santa Claus (don’t let your kids read this!), it loses its power to amaze.
Once inflation starts, governments can’t control it. It’s like an on/off switch, except it can only be flipped by the invisible hand. Once it’s on, there’s no turning back without extreme financial pain.
There is no “undo” button or “do overs”. Extricating an economy from inflation takes years and the psychological impact on risk tolerance can last for generations (ask the Germans).
Just remember, there is no need to be a hero in a bubble. Plenty of people called the internet top in 97. More called the housing top in 2005. Some have been preaching imminent inflation for ten years now!
There was still plenty of money to be made on the downside once it was clear the bubble had burst. No reason to storm the barricades yet. Be patient, but be prepared.
Bringing It Full Circle
Which brings us back to my original question: where does all this stimulus money come from and do we have to pay it back? It comes from you and me in the form of tax payments…and yes, the government has to pay it back to the people and institutions that buy Treasuries.
The government is acting like an insurer that doesn’t have to put up reserves. It is giving away cheap policies to accumulate float and thinking that, when a claim comes in, they’ll have either made so much on the investment portfolio that they can pay the claim from there or…well, we’ll sell another policy to get premium to pay someone else’s claim.
How does it get away with this? Because we let them! Nobody questions if we can afford stimulus checks for everyone.
Or if there is a problem with a program where a large number of people don’t need the cash (estimates of the poverty rate are actually flat yoy – perhaps it’s a bad estimate but even so, we’re talking millions in need, not hundreds of millions), so they go and buy stocks or a new home or upgrade the IPhone they bought last year.
Certainly nobody asks what the plan is to pay the money back before it becomes a genuine crisis that has long term consequences for our standard of living.
Remember, the government “solved” the financial crisis through easy money. It’s called “easy” because it was a politically easy choice. There was no immediate pain.
When the market rejects easy money and demands higher yields to bear inflation risk, there is no pain free solution. In fact, the choices are very difficult and will end political careers (because it will end careers for many individuals as unemployment grows). Stagflation is an ugly thing nobody should want to experience.