Feature Stories | May 15 2019
This article was first published for subscribers on May 6 and is now open for general readership.
The evidence is in: QE hasn’t worked. How now to stem the global slowdown when all options have been exhausted?
-QE hasn't worked
-Governments have not done enough
-MMT is not a new idea, but is gaining traction
-Something has to be done
By Greg Peel
Quantitative easing hasn’t worked, economists have decided. And they have the evidence to prove it.
It seems odd, given Wall Street has rallied from its 2009 bottom, when the US Federal Reserve first initiated QE, to this week’s new all-time high, by 340%. And having suffered The Great Recession, the US has since enjoyed a decade of uninterrupted economic growth. But things are not as rosy as they seem.
US GDP growth has averaged 4.4% per annum since World War II. In the period 2009-2019 to date, that average is 1.9%.
Back in 2015, then Reserve Bank of Australia governor Glenn Stevens declared “monetary policy alone cannot deliver everything we need and expecting too much from it can lead, in time, to much bigger problems”.
Last month, Wilsons’ head of global macro strategy, Tracey McNaughton, noted the intention behind QE (buying bonds to lower yields and thus push up valuations on risk assets) was that it would increase asset prices and create a wealth effect that would ultimately lead to higher consumption and a self-sustaining economic cycle. But as has now become increasingly evident, QE has done little more than increase income and wealth inequality.
“Relying on monetary policy alone not only failed,” says McNaughton, “it made the situation worse”. And this has underpinned a rise in populism. Think Brexit, yellow vests and growing incursion of nationalist parties into European parliaments.
Think Trump.
Wages for the top 1% of US households have increased by over 150% in the past 40 years. Over the same period, wages for the bottom 90% have increased by 20%.
Those on the right side of that equation may shrug this disparity off as “capitalism”, but the reality is 1% of the population cannot drive consumption, and thus economic growth, alone.
The RBA last cut its cash rate in August 2016. Before Lehman Brothers collapsed in 2008, that rate was 7.25%. By May 2015, it was 2.00%, where it remained for 12 months. “At this point, said Glenn Stevens, “monetary policy’s power to summon up more demand with lower interest rates could be less than it used to be”.
The RBA went on to estimate a 1.00% cash rate was as low as one could go before “unconventional tools” would need to be considered. In August 2016, the RBA cut to 1.50%, where the rate has been ever since. Many an economist is predicting 1.00% by year-end.
Then what? If QE has been shown to be a failure, what other “unconventional tools” could a central bank implement?
Modern Monetary Theory
“Arguably the biggest test monetary policy has ever confronted”, says Tracey McNaughton, “was dealing with the Global Financial Crisis. Dysfunctional politics within governments essentially meant that monetary policy was the ‘only game in town’. Central banks were called upon to perform miracles to get economic growth going again”.
“The deeper down the road of unconventional monetary policy we progress,” says McNaughty, “the more the line between fiscal policy and monetary policy becomes blurred”.
Enter Modern Monetary Theory.
One nutshell definition of MMT comes from Citi’s economists:
A sovereign nation with its own currency, its public debt denominated in its own currency and a floating exchange rate, cannot go broke. The only limit on public spending is inflation.
Chris Bedingfield, principal and portfolio manager at Quay Global Investors, qualifies Citi’s definition in suggesting countries can “go broke”, but they cannot inadvertently become insolvent. Insolvency is a political choice, not an economic one. The US debt ceiling, for example, is a political constraint, not an economic one.
As evidenced by constant Congress-approved increases.
If an economy prints its own currency, why can’t its government increase its own debt?
MMT suggests a country can never run out of the currency it prints and the government can use this debt to more directly boost growth through the targeted fiscal measures that were missing in US and EU policy tool kits post-GFC, notes McNaughton. The level of bond issuance can be controlled by the central bank purchasing of bonds directly from the government.
Which is QE.
When then Fed chair Ben Bernanke appeared on US television in 2009 to explain what QE was, he said it was “effectively printing money”. This was in fact incorrect, and Bernanke was later forced to qualify his remarks.
As Hoisington Investment Management, based in Austin, Texas, points out, Fed liabilities cannot be used directly to pay US government expenditures. They are not legal tender. They can only purchase a limited class of assets, such as US Treasuries, from the banks, who in turn hold the proceeds of the sale at an account at the Fed. The money does not hit the economy. Artificially low interest rates drive investment.
There is nevertheless currently a proposal to make the Fed’s liabilities legal tender so that the central bank can directly fund the expenditures of the federal government. This, says Hoisington, is MMT.
That Way Be Dragons
By now readers are probably thinking “Whoa!”
Central banks can print as much money as they like, directed by politicians to do so, so spending can be increased without limit? It would sure be a way to win an election.
And surely it would lead to unfettered inflation, indeed hyperinflation, the collapse of the currency, a blowout in government debt and thus bond yields going through the roof? In short, Zimbabwe?
Well before jumping to conclusions, consider this from Chris Bedingfield:
“At its core, MMT is a framework and detailed description on how the monetary system actually works across most developed countries. [His emphasis.] If you are reading this in Australia, the US, UK, Canada, Japan or New Zealand (and a few more countries) then congratulations, you are already living in an MMT world”.
Since its emergence in the 1990s, MMT recognised the difference between currency issuers and currency users. Currency users include households and businesses as well as state and local governments. But the list also includes the likes of Italy, Portugal, Greece and company which, within the eurozone, do not issue their own currency.
MMT scholars accurately predicted the eurozone crisis ten years before it happened, notes Bedingfield. On the other hand, currency issuing governments such as Australia et al are never financially restrained.
Then why has it been the Holy Grail of all post-GFC Australian governments to return to a budget surplus? Under MMT, surely deficits don’t matter?
Yes they do. Printed money can buy any good or service but it does not guarantee that good or service is available to buy. Thus while Australia, for example, can never run out of its own currency, it can run out of labour, energy, food or water. “Put another way,” says Bedingfield, “the real budget constraint is inflation”.
Which is why, advocates argue, MMT does not implicitly lead to hyperinflation.
To put some colour to this premise, consider that among the various Democrat presidential hopefuls, policies have been advocated such as “The New Green Deal” (massive spending to counter climate change), “Medicare for all” (which Australia already has, to a certain extent), and “Free college tuition”, (which Australia once had, to the benefit of this writer, albeit there remains no upfront cost for Australian students).
All of these policies require spending, which could simply be covered by printing money. But is there really enough labour and technology available, Bedingfield asks, to transition the US economy to renewable energy over the next ten years? Are there enough doctors and nurses to provide medical services to 330m people? Do universities have enough lecture halls and teachers to cope with the influx of non-paying students?
Or looking at it the other way, if Australia can print its own money so readily why is every election about a lack of funding for schools and hospitals? Why is there any unemployment at all? Why do we need charities? And if the government can just print money, why are we paying tax?
I’ll come back to the important role taxes play in an MMT framework, but for now, consider the above is evidence of resource constraint, which keeps fiscal non-constraint at bay, and prevents a descent into hyperinflation. There’s no point offering even more money for something that’s already run out.
When QE was first touted, critics offered the hyperinflation argument. MMT advocates predicted QE would not lead to increased inflation. Ten years on, US core inflation remains under the Fed’s 2% target.
Okay, so if the government can just print money, why am I paying tax? The answer to this question, under MMT, is that taxes do not finance the government.
Taxes paid to the government by businesses reduce the purchasing power of those businesses. Businesses are constrained in their spending, freeing up resources in the economy so the government can purchase goods and services, without forcing up inflation, to meet its social and political objectives. These include enough labour and funds for a military, a judicial system and government schools.
To the matter of wouldn’t the currency collapse if the government could just print all the money it wants, it is taxes that give a currency its value. One can only pay tax in a country with that country’s currency. Taxes create a demand for that currency, thus supporting its value.
Taxation does not fund the government. Government spending has to occur before it can be taxed.
A Myth in Practice?
Critical to President Trump’s core policies, meeting tax cuts with increased spending (for example, on infrastructure) is that the inevitable debt blowout suggested by these double-whammy approaches will in a short period of time be offset by the subsequent boost to US economic growth. Trump can see 4%. As noted earlier, the post-GFC average is 1.9%. But it’s early days.
Critics of Trump’s debt binge suggest the result will be rising US bond yields and a devaluation of the global reserve currency. Neither have happened, yet.
Markets have been preparing for rising US bond yields long before Trump. When the Fed first began “tapering” QE, a year before its first rate hike off zero, the assumption was the US ten-year yield will start accelerating towards 3%, maybe 4%. There were a couple of brief forays above 3%, but today the ten-year yield is 2.5%. The Fed has not only tapered QE but has to date implemented a level of quantitative tightening, and has raised its funds rate nine times since the GFC.
At 2.5%, the US ten-year yield is not much above where it was when the Fed began tapering in 2013.
“Federal debt accelerations ultimately lead to lower, not higher, interest rates,” asserts Hoisington Investment Management.
Consider that in the past two decades, government debt to GDP ratios have risen by 45% in the US, 119% in Japan, 15% in the eurozone and 63% in the UK. Debt is funded by issuance of government bonds and greater issuance should imply higher bond yields, yet bond yields have fallen in the above countries by 2.85 percentage points, 2.35pps, 3.80pps and 4.00pps respectively.
Debt-funded fiscal stimulus is extremely fleeting, notes Hoisington, when debt levels are already inordinately high. Larger deficits provide only transitory gains in economic activity which are quickly followed by weaker business conditions. Economic growth thus slows, inflation falls and thus, so do bond rates.
“Any short-run increase in yields caused by greater supply is eventually reversed by deteriorating economic and inflation fundamentals”.
Surely the evidence suggests MMT, which advocates a central bank “printing” money for the government to spend, must ultimately fail. But the response to such reality from supporters is that low interest rates in high income countries is a sign fiscal policy has done too little, and is that is why interest rates are low. To remedy the problem, substantially larger fiscal deficits are recommended.
However, Japan has had four recessions in the past ten years, Hoisington points out, and may enter a fifth in 2019. The Japanese ten-year yield is -0.1%. Massive government spending (Abenomics) has apparently not helped.
The debt to GDP ratio of the US over the past 20 years has been greater than any other time outside a war. If such growth in debt is supposed to be supportive of economic growth, why is the US GDP growth rate trending lower?
Since Trump has been in power, debt growth has only accelerated through massive corporate tax cuts, household tax cuts and major spending programs. Such stimulus was apparent in strong GDP growth in the June quarter last year, but by the December quarter, “the stimulus was hard, if not impossible, to detect,” suggests Hoisington.
“Large indebtedness eventually slows economic growth as resources are transferred from the highly productive private sector to the government sector”.
Hoisington believes massive increases in government debt, funded by central banks, would inevitably lead to hyperinflation.
So clearly, the jury is out.
Conclusion
There isn’t one.
In 2017 the market buzz-phrase was “synchronised global growth”. It appeared as if the world may have finally shaken off the GFC. The Fed was hiking, the ECB was winding down QE and looking towards its first hike, and even the Bank of Japan was contemplating a move off negative cash rates. In 2018, synchronised global growth turned to synchronised global slowing. The US economy appeared to be the only remaining bastion of strength, but growth there, too, has slowed and the Fed has “pivoted” from its previously hawkish policy.
To be fair, the global “trade war” has muddied the waters, thus any resolution on this fiscal front may serve to reverse the current trend. But the bottom line is, if central banks are forced back into QE, having not achieved any sort of escape velocity this past decade, what has QE achieved?
It has achieved surging asset prices (the US stock market, the Australian housing market, until recently) but not commensurate economic growth. The rich have gotten richer and the not-so-rich have enjoyed none of the spoils.
“Whatever you want to call it,” says Tracey McNaughton, in reference to MMT, “there is a need for government to step in and address income and wealth inequality".
And it’s not about socialism:
“Without more income equality there is no gain in wages. Without wage gains there is no consumption. Without consumption there is no inflation. If monetary policy has failed, as it appears to have, then government needs to play a greater role”.
Much has been written about MMT of late, notes Chris Bedingfield, despite the “theory” being hardly new. A lot has been dismissive, passing it off as a bad policy idea.
“Anyone that has spent time reading any MMT academic literature will recognise these arguments carry very little weight, and most criticism has yet to challenge any of the core understandings that come with these decades of literature.”
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