Blog 2 Columns

[This blog post is an excerpt from a TSI commentary published about two weeks ago]

MMT (Modern Monetary Theory) revolves around the idea that governments with the ability to create money are not limited in the way that individuals and corporations are limited. Whereas private entities can only spend the money they have or the money that another private entity is willing to lend to them, a government with the ability to create money is only limited in its spending by the availability of real resources. As long as there is ‘slack’ (what the Keynesians refer to as “idle resources”) in the economy, the government can spend whatever amount of money is necessary to bring to fruition whatever projects/programs the majority of voters desire. MMT’s appeal to the political class is therefore obvious. The only problem is that MMT is based on misunderstandings about money, debt, and how the economy actually works.

If you read the explanations put forward by MMT advocates you could come away with the impression that the ‘theory’ is a discovery or original insight, but nothing could be further from the truth. What MMT actually does is employ accounting tautologies and a very superficial view of how monetary inflation affects the economy to justify theft on a grand scale.

Expanding on the above, when the government creates money out of nothing and then exchanges that money for real resources, it is exchanging nothing for something. In effect, it is diverting resources to itself without paying for them. This is a form of theft, but it is surreptitious because the seller of the resources does not incur the cost of the theft. Instead, the cost is spread across all users of money via an eventual reduction in the purchasing power of money.

According to the MMT advocates, the surreptitious theft that involves diverting resources from the private sector to the government is not a problem until/unless the CPI or some other price index calculated by the government rises above an arbitrary level. In other words, surreptitious government theft on a grand scale is deemed to be perfectly fine as long as it doesn’t result in problematic “price inflation”.

Further to the above, there is a major ethical problem with MMT. However, there are also economic problems and practical issues.

The main economic problem is that the damage that can be caused by monetary inflation isn’t limited to “price inflation”. In fact, “price inflation” is the least harmful effect of monetary inflation. The most harmful is mal-investment, which stems from the reality that newly-created money is not spread evenly through the economy and therefore has a non-uniform effect on prices. That is, monetary inflation doesn’t only increase the “general price level”, it also distorts relative prices. This distortion of the price signals upon which decisions are based hampers the economy.

Another economic problem is that the programs/projects that are financed by the creation of money out of nothing will not consume only the “idle resources”. Instead, the government will bid away resources that otherwise would have been used in private ventures. The private ventures that are prevented from happening will be part of the unseen cost of the increased government spending.

A practical issue is that the government’s ability to spend would be limited only by numbers that are calculated and set by the government. There is no good reason to expect that this limitation would be any more effective than the limitation imposed by the “debt ceiling”. The “debt ceiling” was raised more than 70 times over the past 60 years and now has been suspended.

A second practical issue is that it often takes years for the effects of monetary inflation to become evident in the CPI. Therefore, even if there were an honest attempt by the government to determine a general price index and strictly limit money creation to prevent this index from increasing by more than a modest amount, the long delays between monetary inflation and price inflation would render the whole exercise impossible. By the time it became clear that too much money had been created, a major inflation problem would be baked into the cake.

It’s often the case that what should be is very different to what is, so MMT being bad from both ethical and economics perspectives probably won’t get in the way of its implementation. After all and as mentioned above, it has great appeal to the political class. Also, it could be made to seem reasonable to the average person.

In fact, even though it hasn’t been officially introduced, for all intents and purposes MMT is already being put into practice in the US. We say this because the US federal government recently ramped up its spending by trillions of dollars, safe in the knowledge that “inflation” is not an immediate problem and that the Fed is prepared to monetise debt ‘until the cows come home’. Furthermore, another trillion dollar ‘stimulus’ program is in the works and there is a high probability that a multi-trillion-dollar infrastructure-spending program will be approved early next year. Clearly, there is no longer any concern within the government about budget deficits or debt levels. They aren’t even pretending to be concerned anymore.

The good news is that the implementation of MMT should accelerate the demise of the current monetary system. It means that there is now a high probability of systemic collapse during this decade. The bad news is that what comes next could be worse, with a one-world fiat currency, or perhaps a few regional fiat currencies, replacing today’s system of national currencies.

[This blog post is a modified excerpt from a recent TSI commentary]

Financial market discussions and analyses often focus on fundamental issues that don’t matter, or at least don’t provide useful clues regarding the likely future performance of the market in question. A good example is the so-called “global US$ short position”, which is regularly cited in support of a bullish outlook for the US$.

The argument is that the roughly $12 trillion of US$-denominated debt outside the US constitutes a short position that will create massive demand for dollars and thus put irresistible upward pressure on the Dollar Index (DX). There is an element of truth to the argument, but the “global US$ short position” always exists. It exists during US$ bull markets and it exists during US$ bear markets, because it is simply an effect of the US$ being the currency of choice for the majority of international transactions. Furthermore, the shaded area on the following chart shows that the quantity of dollar-denominated debt outside the US steadily increases over time and that even the 2008-2009 Global Financial Crisis resulted in only a minor interruption to the long-term trend. Consequently, the existence of this debt isn’t a major intermediate-term or long-term driver of the US dollar’s exchange rate.

Source: https://www.bis.org/statistics/gli2004.pdf

The element of truth to the “global US$ short position” argument is that a significant strengthening of the US currency relative to the currencies of other countries will increase the cost of servicing dollar-denominated debt in those countries. This lessens the ability to borrow additional US dollars and puts pressure on existing borrowers to reduce their US$ obligations. In effect, it leads to some short covering that magnifies the upward trend in the US dollar’s exchange rate. This means that while the “global US$ short position” won’t be the cause of a strengthening trend in the US$, it can exacerbate such a trend.

We mentioned above that there is no empirical evidence that the “global US$ short position” drives trends in the US dollar’s exchange rate, but that doesn’t guarantee that the pile of US$-denominated debt outside the US won’t become an important exchange-rate driver in the future. The reason it won’t become important in the future is that prices are driven by CHANGES in supply and demand. The US$12T+ of foreign dollar-denominated debt represents part of the existing demand for dollars, meaning that the demand-related effects of this debt on the dollar’s exchange rate are ‘in’ the market already. At the same time, the total supply of dollars is growing rapidly.

At this point it’s worth addressing the idea that the Fed would be powerless to stop the US$ from appreciating if a major ‘debt deflation’ got underway. This is nonsense. Until the law of supply and demand is repealed, someone with the unlimited ability to increase the supply of something WILL have the power to reduce the price of that thing.

The Fed’s power to reduce the relative value of the US dollar was very much on display over the past few months. The financial-market panic and economic collapse of March-2020 predictably resulted in a desperate scramble for US dollars, leading to a fast rise in the Dollar Index. However, it took the Fed only two weeks to overwhelm the surging demand for dollars with a deluge of new dollar supply.

The upshot is that the so-called global US$ short position is not a valid reason to be a US$ bull.

With regard to performance over intermediate-term (3-18 month) time periods, the fundamentals that matter for the US$ are relative equity-market strength and interest rate differentials. This combination of drivers has been neutral for more than a year but soon could turn bearish for the US$.

[This blog post is an excerpt from a recent TSI commentary]

The year-over-year rate of growth in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, has continued its journey “to da moon.” Based on the monthly monetary data for May-2020, it is now at 27% and still rising rapidly. The following chart shows that the money-supply growth surge engineered by “Mississippi Jay” Powell* now dwarfs the earlier efforts of “Easy Al” Greenspan and “Helicopter Ben” Bernanke.

Anyone who thinks that this year’s monetary inflation moon-shot won’t lead to much higher prices for many things is kidding themselves. It has already fuelled the fastest 40% rise in the S&P500 Index in history, but unlike the other money-supply growth surges of the past 20 years the current episode also should lead to substantial gains in what most people think of as “inflation”. Not so much this year, because in the short-term there are counter-balancing forces such as an increasing desire to hold cash, but during 2021-2022.

Apart from its larger scale, there are three reasons that the money-supply growth surge engineered by “Mississippi Jay” should lead to much higher “price inflation”** than the money-supply growth surges engineered by his predecessors. The first is that although the Fed is still buying US government debt via Primary Dealers as opposed to directly from the government, it is crystal clear that the Fed is monetising the US government’s deficit. That’s why the Federal government is no longer even pretending to be concerned about the level of its spending and indebtedness. In effect, MMT (Modern Monetary Theory) is now being implemented in the US.

MMT is based on the ridiculous idea that there should be no upper limit on government spending/borrowing, facilitated via the creation of new money, as long as the CPI’s growth rate is below a certain level. It completely ignores all effects of monetary inflation apart from the most superficial. It also ignores the reality that government spending tends to be counterproductive because it is driven by political considerations and not market forces.

The good thing about MMT is that it should short-circuit the boom-bust cycle, in effect almost skipping the boom and going directly to an inflationary bust. This is because it lays bare the crudeness of the central bank’s monetary machinations. No longer is the central bank (incorrectly) perceived as finely tuning interest rates to keep the economy on an even keel. Under MMT it is seen to be pumping out whatever amount of new money the government demands.

The boom associated with this year’s monetary inflation moon-shot began in April and probably will end within the next six months. Actually, it might have ended already.

The second reason to think that this year’s money-supply growth surge will be followed by substantial “price inflation” is that the lockdowns of the past few months have damaged supply chains. This, combined with the shift away from globalisation, will lead to reduced supply and/or less efficient production of goods.

The third reason is supply constraints on important commodities. Firstly, this year’s lockdowns caused the mining industry to delay expansion plans and cancel new developments. Secondly, in labour-intensive mining countries such as South Africa, the requirement to implement social distancing following the return to work has made and will continue to make the mines less efficient. Thirdly, many small-scale commodity producers that together account for a significant portion of total supply have been put out of business by the lockdowns. Fourthly, the “El Nino” weather event of 2020-2021 and the Grand Solar Minimum that should start becoming influential in 2021-2022 probably will result in extreme weather volatility, which potentially will disrupt the supply of important agricultural commodities during 2021-2022. Lastly, due to the virus-related lockdowns and associated economic pressures there is heightened risk of war in the Middle East, implying heightened risk of an oil supply shock.

In summary, the latest flood of new money created by central banks will be more widely perceived to be “inflationary” than the other ‘money floods’ of the past 20 years. In addition, the latest money flood has occurred near the start of a multi-year period during which the production of many commodities and manufactured goods will be hampered. A likely result is substantial “price inflation” during 2021-2022.

*“Mississippi Jay” is the nickname we’ve given to current Fed Chair Jerome (Jay) Powell. The name links Powell with John Law, the roguish Scotsman (is there any other kind?) who, while residing in France in the early-1700s, engineered the Mississippi Bubble via a scheme that involved creating an extraordinary amount of new currency.

**We don’t like the term “price inflation”, because there is no such thing as an economy-wide average price level and because at any given time some prices will be rising while others are falling. However, we use the term because it is generally understood to mean a rising cost of living for most people.

[This blog post is an excerpt from a commentary published at TSI last week]

In most countries/regions, the money-supply growth rate bottomed in 2019 and by the beginning of this year was in a clear-cut upward trend. Then came the “coronacrisis”, involving widespread economic lockdowns and unprecedented central bank money/credit creation designed to counteract the effects of the lockdowns. A result was a veritable explosion in monetary inflation rates around the world during March and April (April being the latest month for which there is complete money-supply information). Here are some examples:

1) The combination of US and euro-zone money supply that we call G2 True Money Supply (TMS) was at a 10-year low in the middle of last year. It is now at an all-time high. This is by far the most bullish force currently acting on equity and commodity prices.

2) Early last year Australia was in danger of experiencing monetary deflation, but this country’s monetary inflation rate has since rocketed to an all-time high of 24%. This is not bearish for the A$ relative to other currencies and especially not relative to the US$ (we suspect that the A$ will trade at parity with the US$ within two years), because the A$’s exchange rate is influenced to a far greater extent by the commodity markets than by the local monetary inflation rate. However, it suggests that in Australia the prices of goods, services and assets will go up a lot over the next few years.

3) The Bank of Canada has been a little more circumspect than most other central banks over the past few months, but in response to the recent crisis it has done enough to boost the country’s monetary inflation rate to near a 10-year high. A year ago it was near a 20-year low.

4) We occasionally read articles that attempt to make the case that central bank money pumping does not lead to higher prices, with the situation in Japan cited as evidence. Japan supposedly is relevant because the Bank of Japan (BOJ) has been aggressively monetising assets for a long time with minimal effect on prices.

As we’ve noted many times in the past, prices have been stable in Japan because Japan’s monetary inflation rate has oscillated at a relatively low level for decades. Whatever the BOJ has been doing, it has NOT been pumping money at a rapid rate. Even now, in the face of additional monetary stimulus, the year-over-year rate of growth in Japan’s M2 money supply is below 4%. This contrasts with a US money-supply growth rate of almost 20%.

Therefore, the low rate of price inflation in Japan is in no way mysterious. It’s exactly what would be expected from an economy with a low rate of monetary inflation and some productivity growth.

In summary, outside of Japan the supply of currency is increasing at such a fast pace that there WILL be substantial price increases over the next two years. However, the price increases won’t be uniform. For example, due to a high unemployment rate the price of labour probably will be a laggard, and due to their relative supply situations the price of oil probably won’t rise by as much as the prices of uranium, natural gas, copper, nickel and zinc.

[This blog post is an excerpt from a commentary posted at TSI last week]

The rebound from the H1-2020 plunge into recession probably will look like a ‘V’, at least initially. This is not because conditions will become positive as quickly as they became negative, but because conditions got so bad so quickly that charts of economic statistics such as industrial production and retail sales will appear to make a ‘V’ bottom in Q2-Q3 of this year. However, the ‘V’ won’t mark the start of a genuine recovery.

The following charts show what we mean by “got so bad so quickly”.

The first chart shows that within the space of three months the Small Business Optimism Index collapsed from a level that indicated a high level of optimism to one of the lowest levels in the 34-year history of the index. The only other decline of this magnitude occurred during the 2005-2008 period and took more than two years.

The second chart shows that Industrial Production has just registered its largest month-over-month decline in at least 101 years. By this measure, even the worst months of the Great Depression were not as bad as April-2020.

Source: dshort

Source: Hedgeye

There are thousands of people who have lost their businesses — in some cases, businesses that they spent the bulk of their adult lives building — over the past two months as a result of the lockdowns. These people probably are feeling angry and/or devastated. However, we get the impression that the vast majority of people have accepted the lockdowns with equanimity. They haven’t taken to the streets to protest the economic destruction that has been wrought by their political overlords. Instead, they have shrugged off the most rapid decline in industrial production in history and a sudden rise in the unemployment rate from below 4% to above 20%. How is this possible?

It’s possible only because the government and the Fed have showered the people with money. The money that has been created out of nothing is acting like pain-suppressing medication. In effect, the government and the Fed have administered anaesthetic so that the patient felt no pain as vital organs were removed. Without this anaesthetic, the populace would not have remained docile as its basic rights were cancelled and its economic prospects were greatly diminished.

Money, however, is just the medium of exchange. It facilitates the division of labour*, but it does not constitute real wealth. For example, if every current dollar were instantly replaced by ten dollars, there wouldn’t be any additional wealth. The point is that the government and the Fed cannot make up for the decline in real wealth caused by the lockdowns by providing more money. All they can do is change the prices of the wealth that remains.

There will be a ‘V’ shaped recovery, but due to the destruction of real wealth stemming from the lockdowns the rising part of the V is bound to be much shorter than the declining part of the V. This will lead to a general realisation that life for the majority of people will be far more difficult in the future than it was over the preceding few years.

Returning to our medical analogy, eventually the anaesthetic will wear off and the patient will have to start dealing with the consequences of having lost a kidney, a spleen, a lung and half a liver.

*In the absence of money, a tomato farmer who needed some dental work would have to locate a dentist who needed a few crates of tomatoes.

[This blog post is a modified excerpt from a recent TSI commentary]

At around this time last month we noted that the Fed had pushed the year-over-year rate of growth in US True Money Supply (TMS)*, also known as the US monetary inflation rate, to a multi-year high of 11.3%, and that based on what the Fed subsequently had done the monetary inflation rate could reach 15%-20% by the middle of this year. With the monthly monetary data for April having been published last week, we now know that the aforementioned range has been reached already. As illustrated below, as at the end of April the US monetary inflation rate was close to 20%. Next month’s rate should be even higher.

This is banana-republic-style money creation, although it isn’t unprecedented for the US. The above chart shows that a near-20% monetary inflation rate also was attained in January-2002. Back then it was the bursting of the stock market bubble followed by the 9/11 attacks that caused the Fed to panic and flood the financial system with new money.

In a way, the shock to the financial markets resulting from the attacks by terrorists in September-2001 is similar to the shock to the financial markets resulting from the COVID-19 lockdowns. That’s despite the huge differences in the economic ramifications (the damage inflicted on the overall economy by the 9/11 attacks was minor and short-term, whereas the damage inflicted on the overall economy by the virus-related lockdowns of 2020 will prove to be major on both a short-term basis and a long-term basis).

The similar reactions of the financial markets (most notably the stock market) to the events of 2001 and 2020 firstly can be put down to the fact that both situations involved a sudden increase in uncertainty. Investors and speculators knew that the world had changed for the worse, but were ‘in the dark’ regarding many of the details. Secondly, in both cases there was an immediate and aggressive attempt by policy-makers to ‘reflate’.

Some of the results of this year’s monetary inflation moonshot should be similar to the results of the 2001 episode. In particular, this year’s explosion in the supply of US dollars should lead to a weaker US$ on the foreign exchange market (the Dollar Index commenced a multi-year bearish trend in January-2002 and probably will do the same within the next few months), a higher gold price, higher commodity prices and — eventually — higher equity prices.

The most important difference is that over the years ahead the economy will stay weak and, as a result, the unemployment rate will stay high. This is because flooding the economy with new dollars not only does nothing to make up for the destruction of real wealth caused by the lockdowns, it gets in the way of wealth creation by falsifying price signals and keeping ‘zombie companies’ alive.

*TMS is the sum of currency in circulation, demand deposits and savings deposits. It does not include bank reserves, time deposits or money market funds.

According to my Gold True Fundamentals Model (GTFM), the gold market’s “true fundamentals” most recently shifted from bearish to bullish in December of last year. As indicated on the following weekly chart by the blue line being above 50, at the end of last week they were still bullish. This means that the fundamental backdrop is still applying upward pressure to the gold price.

As previously explained, I use the term “true fundamentals” to distinguish the fundamentals that actually matter from the largely irrelevant issues that many gold-market analysts and commentators focus on.

According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the amount of “registered” gold at the Comex, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These things are distractions at best. For example, a gold investor/trader could have ignored everything that has been written over the past 20 years about the amount of gold in Comex warehouses and been none the worse for it.

On an intermediate-term (3-12 month) basis, there is a strong tendency for the US$ gold price to trend in the opposite direction to confidence in the US financial system and economy. That’s why most of the seven inputs to my GTFM are measures of confidence. Two examples are credit spreads and the relative strength of the banking sector. The model is useful, in that over the past two decades all intermediate-term upward trends in the gold price occurred while the GTFM was bullish most of the time and all intermediate-term downward trends in the gold price occurred while the GTFM was bearish most of the time.

However, upward corrections can occur in the face of bearish fundamentals and downward corrections can occur in the face of bullish fundamentals. For example, there was a sizable downward correction in the gold market in March of this year in the face of bullish fundamentals. Such corrections often are signalled by sentiment indicators.

Right now, the fundamentals are supportive while sentiment is warning of short-term downside risk.

As long as the fundamentals remains supportive, any short-term decline in the gold price should be ‘corrective’, that is, it should be within the context of a multi-year upward trend.

In a blog post on 31st March I argued that MMT (Modern Monetary Theory) had been surreptitiously put into practice in the US. However, according to a quote from Lacy Hunt (Hoisington Investment Management) included by John Mauldin in a recent letter, what the Fed and the US government are doing doesn’t qualify as MMT.

According to Lacy Hunt: “For the Fed to engage in true MMT, a major regulatory change to the Federal Reserve Acts would be necessary: The Fed’s liabilities would need to be made legal tender. Having the Treasury sell securities directly to the Fed could do this; the Treasury’s deposits would be credited and then the Treasury would write checks against these deposits. In this case, the Fed would, in essence, write checks to pay the obligations of the Treasury. If this change is enacted, rising inflation would ensue and the entire international monetary system would be severely destabilized and the US banking system would be irrelevant.”

One problem with Lacy Hunt’s argument is that some of the Fed’s liabilities are already legal tender and have been for a very long time. I’m referring to the $1.9 trillion of “Currency in circulation” (physical notes and coins). This currency sits on the liability side of the Fed’s balance sheet. Also, the money that the US Treasury spends comes from the Treasury General Account, which also sits on the liability side of the Fed’s balance sheet.

Admittedly, the Fed currently does not buy Treasury debt directly. Instead, it acts through Primary Dealers (PDs). The PDs buy the debt from the government and the Fed buys the debt from the PDs. When this happens, new money is credited by the Fed to the commercial bank accounts of PDs and thus becomes a liability of the private banking system. At the same time, the private banks are ‘made whole’ by having new reserves added to their accounts at the Fed.

In other words, rather than money going directly from the Fed to the Treasury General Account (TGA), under the current way of doing things the money gets to the same place indirectly via PDs. This enables the commercial banking system to get its cut, but from both the government’s perspective and the money supply perspective there is no difference between the Fed directly buying government debt and the Fed using intermediaries (PDs) to do the buying.

Now, the Fed’s QE programs of 2008-2014 generated a lot less “price inflation” than many people feared. This was largely because the new money was injected into the financial markets (bonds and stocks) and only gradually trickled into the ‘real economy’. To some extent what happened over the past couple of months is similar, but with two significant differences.

One significant difference between the Fed’s recent actions and the QE of 2008-2014 is that for some of its new money and credit creation the Fed is bypassing the PDs. No regulatory change was needed for this to happen. Instead, as I explained in my earlier post, the Fed created Special Purpose Vehicles (SPVs) that do the actual monetising of assets and the lending of new money into existence. In effect, new money is now being created by the Fed and sent directly to various non-bank entities, including municipalities, private businesses and bondholders.

The second significant difference is the crux of the issue and why the US now has MMT in all but name.

You see, the essence of MMT isn’t the mechanical process via which money gets to the government. The essence is the concept that the government is only limited in its money and debt creation by “inflation”. The idea is that until “inflation” becomes a problem, the government can create as much new money and debt as it wants as part of an effort to achieve full employment. A related idea is that government spending does not have to be financed by taxation.

Is there really any doubt that the US government no longer feels constrained in its creation of debt, the bulk of which is being purchased indirectly using new money created by the Fed? After all, in the space of less than two months the US federal government has blown-out its expected annual deficit from around $1T to around $4T and is talking about massive additional spending/borrowing increases to support the economy. Clearly, no senior politician from either of the main parties is giving any serious thought to how this debt will be repaid or the future implications of the deficit blow-out.

The bottom line is that the US doesn’t have MMT in law, but it does have MMT in fact.