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Weekly Commentary: Dudley on Debt and MMT

Doug Noland writes….December’s market instability and resulting Fed capitulation to the marketplace continue to reverberate. At this point, markets basically assume the Fed is well into the process of terminating policy normalization. Only a couple of months since completing its almost $3.0 TN stimulus program, markets now expect the ECB to move forward with some type of additional stimulus measures (likely akin to its long-term refinancing operations/LTRO). There’s even talk that the Bank of Japan could, once again, ramp up its interminable “money printing” operations (BOJ balance sheet $5.0 TN… and counting). Manic global markets have briskly moved way beyond a simple Fed “pause.”

There was the Thursday Reuters article (Howard Schneider and Jonathan Spicer): “A Fed Pivot, Born of Volatility, Missteps, and New Economic Reality: The Federal Reserve’s promise in January to be ‘patient’ about further interest rate hikes, putting a three-year-old process of policy tightening on hold, calmed markets after weeks of turmoil that wiped out trillions of dollars of household wealth. But interviews with more than half a dozen policymakers and others close to the process suggest it also marked a more fundamental shift that could define Chairman Jerome Powell’s tenure as the point where the Fed first fully embraced a world of stubbornly weak inflation, perennially slower growth and permanently lower interest rates.”

And then Friday from the Financial Times (Sam Fleming): “Slow-inflation Conundrum Prompts Rethink at the Federal Reserve: Ten years into the recovery and with unemployment near half-century lows, the Federal Reserve’s traditional models suggest inflation should be surging. Instead, officials are grappling with unexpectedly tepid price growth, prompting some to rethink their strategy for steering the US economy. John Williams, the New York Fed president, said on Friday that persistently soft inflation readings over recent years could damage the Fed’s ability to convince the general public it will hit its 2% goal. Central banks in other major economies are likely to face similar problems, he warned… Persistent shortfalls relative to the Fed’s 2% target have already helped prompt officials to shelve plans for further rate rises. But they are also thinking more broadly about the US central bank’s inflation mandate… Officials are debating new approaches which could sometimes lead them to deliberately aim for above-target inflation. Richard Clarida, the Fed’s vice-chairman, said on Friday the central bank will be open-minded about these new ideas…”

Markets are raging and crazy talk is proliferating – and it’s already time to commence another momentous election cycle. Bill Dudley must have felt compelled to opine:

“People from across the political spectrum are challenging a bit of long-held conventional wisdom: that if the U.S. government runs big, sustained budget deficits, its mounting debts will eventually cause grievous harm to the economy. They have a point — but it is important not to push that point too far. The arguments come in different forms. Some mainstream economists — such as Olivier Blanchard, former chief economist at the International Monetary Fund –- note that sovereign debt is more manageable in a world where economic growth exceeds governments’ very low borrowing costs. On the more extreme end, proponents of Modern Monetary Theory argue that because the U.S. borrows in its own currency, it can always just print more dollars to cover its obligations.” Bill Dudley, former President of the New York Federal Reserve Bank, Bloomberg Opinion, February 19, 2019

Mr. Dudley surely appreciates the precarious state of things. “Deficits don’t matter.” Rebuild infrastructure; universal healthcare; universal basic income; reverse climate change; free college tuition; strong military; and low taxes. Where’s all the money to come from? Borrow a ton of it for sure. And, depending on your political affiliation, soak the rich.

Dudley: “Turning first to Blanchard, I agree that deficit spending looks less problematic than in the past. The government’s debt burden, measured as a percentage of gross domestic product, remains stable as long as debt and GDP grow at the same rate. This is easier to do now because the long-run nominal growth rate (around 3.5-4.0%) is well above the U.S. government’s borrowing cost (around 2.5%). So the government has some leeway: The debt can grow at nearly 4% per year, or 1.0% to 1.5% net of interest expense, without increasing the debt-to-GDP ratio. The low level of interest rates might help explain why markets have proven more tolerant of large, persistent budget deficits around the world, with Japan the most notable example.”

Could it be that markets are “more tolerant of large, persistent deficits around the world” specifically because of historic and far-reaching changes in central bank doctrine and policies? A decade ago, no one contemplated central banks purchasing more than $16 TN of government debt securities. Only a nutcase would have pondered ten years of near zero – or even negative – interest rates (and $10 TN of negative-yielding bonds). “Whatever it takes” central banking? Crazy talk.

These days, markets believe that central banks will be willing and able to purchase unlimited quantities of government bonds to ensure that yields remain low and markets highly liquid. No crisis necessary. Indeed, markets have been convinced without a doubt that central bankers will do whatever it takes to ensure no crises, bear markets or recessions.

The reality is that global central banks have fundamentally inflated the price of government debt, while systematically altering market risk perceptions. And, yes, it has made deficit spending appear much less problematic. As illustrated most starkly in Japan, on an ongoing basis governments issue enormous quantities of debt instruments without markets demanding one iota of risk premium. Heck, the bigger the deficit (and heightened systemic risk) the lower risk premiums. It’s all astonishing, entertaining – and has turned almost comical. But it has seriously become the greatest market distortion in history – today viewed as “business as usual.” And, importantly, with “risk free” sovereign debt the foundation of global finance, distortions in prices and risk perceptions encompass securities markets (and asset markets more generally) around the globe.

“The government’s debt burden, measured as a percentage of gross domestic product, remains stable as long as debt and GDP grow at the same rate.” Okay, except that for a decade now debt has been expanding more rapidly than GDP – for what is now among the longest expansions on record. And I strongly caution against extrapolating 3.5-4.0% economic growth into the future. A scenario of 5% to 7% debt growth, with zero to 2% real GDP expansion, is not only not unreasonable, it’s realistic. And let’s not disregard demographics and the projected surge in entitlement spending. Truth be told, we’re now a mere garden-variety bear market and recession away from Fiscal Armageddon. At some point, markets may even place a risk premium on Treasury debt. Interest payments on federal borrowings are projected at $364 billion in fiscal 2019. Factoring only a small increase in market yields, debt service is projected to more than double by 2018. In the event of a deep recession and another round of bailouts, annual deficits approaching $2.0 TN are not crazy talk.

Dudley: “How and when the government spends the money also matters. Infrastructure investment, for example, can actually pay for itself by boosting the economy’s productive capacity. This is particularly relevant in the U.S., where dilapidated roads, ports and other public works desperately need an upgrade. (Imagine the benefits of a second rail tunnel between New York City and New Jersey.) Deficit spending in recessions can also be self-funding, because it engages unused resources — for example, by employing people whose abilities and skills would otherwise be wasted.”

The past decade has seen an incredible expansion of federal debt. To come out of such a period with “dilapidated roads, ports and other public works” does not instill confidence that funds have been – or ever will be – spent wisely.

Dudley: “Yet Modern Monetary Theory goes one big step further. It suggests that a government like the U.S. needn’t worry about debt at all. As long as it borrows in its own currency, there is no risk of default or bankruptcy. It can spend as much as it wants on any projects, such as education and health care, and just create additional IOUs to cover the cost.”

Like Dudley, I have few kind words for Modern Monetary Theory (MMT). I basically liken it to crackpot theories that have haunted monetary stability throughout history. Every great monetary inflation is replete with deeply flawed notions, justifications and rationalizations. But that MMT seems even remotely reasonable these days is owed directly to “activist” central banking – and the perception that central bank rate manipulation and the unlimited purchase of securities ensure forever low market yields and endless demand for government obligations.

It’s now been almost a decade since I began warning of the incipient “global government finance Bubble.” In true Epic Bubble form, after a decade of unprecedented expansion of government and central bank Credit, there’s a deeply embedded market perception that basically no amount of supply will impact the price of so-called “risk free” debt. And it’s precisely this perilous delusion that ensures an eventual crisis of confidence.

Today’s crackpot theories hold that central banks can continue to suppress interest rates and stimulate financial markets so long as consumer price inflation remains muted. It’s the old “money” as a “medium of exchange” focus that has led to scores of fantastic booms followed certainly by devastating collapses. The infamous monetary theorist John Law and his experiment in paper money were celebrated in France – that is until the spectacular 1720 collapse of his scheme and the attendant Mississippi Bubble. It literally took generations for trust in banking to return. Contemporary central banking is both the architect and enabler of crackpot theories. The celebration, today seemingly everlasting, will prove tragically transitory.

“Money” as a “Store of Value.” It is delusional to believe that endless issuance of non-productive Credit will not at some point significantly impact the value of these instruments. And the more central bankers manipulate the debt markets, the greater the issuance. Arguably, one of the greatest costs associated with the ongoing experiment in “activist” monetary management is the bevy of market distortions that promote the rapid expansion of government and other non-productive debt.

Moreover, central banks injecting “money” directly into – and furthermore supporting – securities markets is an allocation of Credit predominantly benefitting the wealthy. Sure, there’s some “trickle down.” The unemployment rate is historically low and jobs are more plentiful. By now, however, it should be abundantly clear that employment gains do not abrogate a system that has evolved to distribute wealth so inequitably – or the perception that the system is rigged for the benefit of the wealthy.

Even with gainful employment, many see the system as hopelessly unfair. The Fed can now feign trepidation for CPI missing its 2% inflation objective. Yet tens of millions struggle making ends meet against constantly inflating costs (including housing, healthcare and tuition). We’re now clearly on a trajectory for risking a crisis of confidence in financial assets and our institutions more generally.

Dudley: “Alas, there is no free lunch. For one, the economy might not have enough resources — in the form of workers and industrial capacity — to meet the combined demand from the government and the private sector. The result would be inflation, as too much money chased too few goods and services.”

That it has the appearance of a “free lunch” is at the heart of the quandary. And it’s not that “the result would be inflation.” Indeed, the result is and has been inflation, just not the typical variety. The prevailing source of monetary inflation is central banks injecting new “money” into the securities markets, while essentially promising liquid and levitated markets. The upshot is too much “money” chasing financial market returns. Monetary Disorder. Booms and Busts. Unmanageable Speculation. Intractable Resources Misallocation. Economic Maladjustment and Global Imbalances

The dilemma today – as it’s been with great inflationary episodes throughout history – is that inflation becomes deeply ingrained and halting it too painful. Policymakers refuse to accept mistakes and change directions. Instead, there is denial and the irresistibility of rationalization and justification. Throughout the devastating Weimar hyperinflation, Germany’s central bank refused to accept that they were the party of primary responsibility – but instead rationalized the bank was being forced to respond to outside forces. Today’s great global inflation is characterized by contrasting dynamics, but some of the devastating consequences of failing to recognize the essence of the problem are all too similar. Markets. Social. Political. Economic. Geopolitical.

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