Once an obscure branch of economics, Modern Monetary Theory (MMT) has surged into the mainstream of political thought in recent years, as populist left wing movements have gained support in the US and Europe.  This week, we look at the possible implications of this radical economic model on currency markets.

The government can create money.  So what’s the point of taxes?

– Stephanie Kelton, Economist, ‘The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy’, 2020 –

They always say if you print money it will cause inflation.  They just printed 3 trillion.  Little or no inflation.

– Ice Cube, Rapper, Actor and Filmmaker, September 3rd 2020 (via Twitter)

The first panacea for a mismanaged nation is inflation of the currency; the second is war.  Both bring a temporary prosperity; both bring a permanent ruin.  But both are the refuge of political and economic opportunists.

– Ernest Hemingway, Novelist, 1899 – 1961 

Readers of Risk Insight will know that we have been focusing more and more on the risk of inflation since the beginning of the year and, in particular, following the economic carnage precipitated by the COVID crisis.  One reason for this is simply the huge increase in government borrowing that the crisis has caused (from an already high base) and the fact that governments will inevitably be tempted to print their way out of this debt trap.  

There is a second reason why we feel that inflation risks are growing, and that is the growing political willingness to completely cast aside any pretence of fiscal responsibility.  This is most commonly associated with the populist left.   Think of Labour’s call for a ‘People’s QE’ in the recent UK election, or Alexandria Ocasio-Cortez and her ‘Green New Deal’ in the US.  However, it would be hard to argue that the political right is immune.  After all, it has been Donald Trump and Boris Johnson who have run up the largest government debts for 50 years.

What is MMT?

The intellectual cover for the argument that government deficits do not matter is provided by MMT.  At heart, MMT asserts that governments that have monetary sovereignty should never need to default on their debts.  Monetary sovereignty just means that debts are issued in domestic currency, and domestic currency is not convertible (into gold or anything else).   In other words, countries like the US, the UK and Canada can cover any deficits by simply printing money.  The euro zone is an interesting exception, as member states are users, rather than issuers, of the currency.

According to neo-classical economic theory, a fundamental flaw with MMT is that it fails to account for inflation.  If the government simply prints money to cover spending, it will cause inflation and erode the purchasing power of the currency.  Proponents of MMT simply point to the last decade, where governments of advanced economies around the world have printed vast amounts of currency under the guise of quantitative easing, and inflation has barely budged (or even fallen), as Ice Cube has pointed out.  Their argument, in essence, is that inflation is caused by excess demand in the economy, rather than government monetary recklessness. 

For what it’s worth, I lean towards Hemingway’s take on this, as quoted above.   While it is true that a decade of monetary expansion has not caused inflation (with the notable exception of asset prices), it seems self-evident that there is a limit to just how reckless a government can be with the printing press, as numerous historical examples, from Argentina to Zimbabwe, appear to indicate.  (MMT sympathizers would no doubt make the case that these and other examples did not meet the conditions for monetary sovereignty in the first place).

MMT and Currency

According to most MMT advocates, printing money to finance government deficits should not significantly weaken the currency, assuming the conditions for monetary sovereignty are met.   There are two reasons for this.  Firstly, if we assume that money printing does not, by itself, cause inflation, then why should the currency weaken?  Again, the last decade or so seems to provide some support for this argument, as QE has not led to any dramatic currency depreciations, either on a relative or an absolute basis.

Secondly, even if inflation did occur, MMT supporters point to the fact that FX market, at >$5 trillion per day, dwarfs the size of the real economy.  In fact, global trade accounts for less than 10% of the FX market by most accounts, so changes in the relative prices of goods and services will not move the needle in an FX market dominated by capital flows. 

In essence, this argument is a repudiation of the theory of Purchasing Power Parity and the Law of One Price (LOP), which states that exchange rates will, over time, adjust to reflect changes in the relative valuation of goods and services.  If Canadian goods become more expensive than their US equivalents, savvy entrepreneurs will buy American goods to supply the Canadian market, thereby bidding up the US dollar relative to its Canadian namesake.   The MMT camp largely rejects this hypothesis, arguing that it is the flow of capital, rather than the purchasing of foreign goods and services, which drives currency movements.  Incidentally, this is why many MMT proponents are also advocates for capital controls, but that is a story for another day. 

What could MMT mean for the FX markets?  

Looking ahead, it is highly probable that government fiscal policy will come to play an increasing role in determining the direction of FX markets.  The rise of populist politics, combined with the impact of COVID on government finances, will place the debate over fiscal policy at the core of the financial market outlook for all asset classes.  It seems highly likely that the prominence of either explicit MMT policies or some form of ‘MMT-lite’, involving high deficit spending without acknowledging the fact this is (or will be) funded via monetary financing, will increase in most advanced economies.

I also believe that the MMT view on currency is wrong, at least over the long term.  First of all, I am not convinced that monetary financing will not be inflationary.  QE occurred in an environment of collapsing monetary velocity and there is no guarantee that this will also hold true when it comes to an aggressive expansion of fiscal policy.

Secondly, purchasing power parity may not have much (if any) predictive value over the short to medium term, but over a multi-year time horizon the forces of supply and demand do matter, irrespective of whether we are talking about goods and services or capital flows (after all, investors care about value just as much as consumers, if not more!).  Furthermore, the FX market is forward looking – once a country is viewed by the market as a risk (due to fiscal indiscipline) its currency will be sold.

When it comes to MMT and the FX market, it is difficult to pick winners and losers at this stage.  Much will depend on which way the political winds blow over the coming months and years.  Back in May, I wrote:

…the dollar’s stability is, and will continue to be, closely linked to the credibility of the Fed, and to its unique role as the global reserve currency.  If, as we expect, we experience a future phase transition into an inflationary environment, this will reduce the comparative advantage that the dollar currently holds over its peers, increasing the risk of US dollar depreciation in the longer term. (link).

Should Biden win in November, it will certainly increase the influence of prominent MMT backers like Ocasio-Cortez, moving this risk ever closer. 

Author: Kevin Lester