Modern Monetary Theory: Part 1

In March 1951, the U.S. Treasury and the Federal Reserve reached an agreement to separate government debt management from monetary policy, laying the foundation for the modern “independent” Fed. This agreement was known as the Treasury-Federal Reserve Accord and grew out of a substantial amount of research showing the connection between excessive monetary growth (by governments paying for their bloated budgets) and price inflation. The act established the central bank's independence from fiscal concerns and set the stage for the development of monetary policy as we all know it today.

For a couple of decades, it seemed the question of Fed independence had been put to rest. But beginning in the 1960’s and 1970’s substantial inflation concerns swept the country and began to sow the early seeds of discontent with the Fed. This concern grew through the1980s with soaring oil prices and, after replacing Fed Chair William Miller, new Fed Chairman Paul Volcker’s famous act of breaking the back of inflation as interest rates ventured into the low 20%’s. Since then the cacophony of outrage over the Fed no longer have the people’s best interest in mind has grown. Many critics site the Fed’s involvement with the banking system which unavoidably entangles it with the political side of government. The most recent case in point came in the aftermath of the Great Recession of 2008-09, which included the Fed directly supporting the banking system through Quantitative Easing, and then later enacting new policy to keep it afloat during future crises.

Facilitating the continual groundswell of anti-Fed sentiment in the ten years following the Great Recession has been the growing divide between the have and have-nots. QE, ZIRP, and all other forms of financial repression practiced by the Fed was a significant cause in the massive growth of assets held by the haves, while wage growth came to an absolute halt for the have-nots. The voice of the have-nots began to show in earnest during the 2016 presidential election through the words of Rand Paul, Ted Cruz, and Marco Rubio. This group actually sponsored a bill that would have given them effective oversight of Fed policy. Now, we’re hearing threatening words to Fed independence from President Trump in his relentless twitter attack on Fed Chairman Jay Powell and his team have raised interest rates too high and for too long.

As of mid-July 2019, we appear to be sitting on the precipice of what is expected to be several Fed rate-cuts over the ensuing quarters. A review of the inverted U.S. Treasury curve, the inverted EuroDollar Futures curve and the relationship between the Effective Fed Funds Rate (“EFFR”) and the Interest On Excess Reserves (“IOER”) the Fed is paying to banks (where EFFR exceeds IOER), all indicate a rate cut is imminent during the upcoming July 30-31st meeting. However, given the timing and sequence of events, you have to ask whether rate cuts now, are a byproduct of good logical thought, or too little too late and driven by Chairman Powell’s efforts to appear independent from White House rhetoric. We will never know, but clearly, Trump is a threat to continuing Fed independence.

Time will tell the magnitude of Trump’s threat to Fed independence. However, there is a new and growing threat that makes Trump’s attacks look like cupcakes, and once again, it's coming through the platform of another presidential campaign. This time its Alexandria Ocasio-Cortez (she’s too young to run for president now but is likely positioning for future years), Elizabeth Warren, Bernie Sanders, Corey Booker, Kamala Harris and other Democrats advocating various programs that use the Fed’s balance sheet to fund new social programs. Modern Monetary Theory is the new paradigm and its proof of concept, for supporters, is found in the simultaneous, current low level of interest rates and inflation for the better part of ten years. Japan’s economic history over the past 30 years is additional proof. Lastly, economic models that view inflation as partly a function of the unemployment rate clearly don’t work given where the U.S. economy is today.

MMT, as its more popularly known, has become the justification for all of the outrageous social programs such as the Green New Deal, free college tuition for all, Medicare for all, and student debt forgiveness the candidates are promoting. It seems the campaign dialogue now is really about claiming something more outrageous than your competitors in an effort to gain more followers. No moderates in this crowd!!!

At its core MMT is about taking control of monetary policy completely out of the hands of the Fed and giving it to Congress, thereby establishing itself as a threat to Fed independence and perhaps its existence. MMT’ers espouse that macroeconomic management is best handled by government spending and taxation, or fiscal policy, through the political machinery in Washington. Let the people decide what macro policy is best!!!! They also believe that financial constraints in the economy are politically imposed, like balanced budgets, and do not come about naturally.

MMT’s theory begins with the claim that monetarily sovereign governments, like the U.S., can issue their own currency to meet commitments denominated in their own unit of account and can bypass self-imposed budget constraints on their budgetary operations. The government should stay focused on full employment and price stability through its ability to issue money when inflation is low and tax it out of the economy when inflation becomes a threat.

With a Republican President and Democratic hopefuls both advocating policies linked to MMT, I believe it’s important that all voters learn the nature of MMT and the implications it could have on the U.S. and global economies, including the independence of the Fed and many other central banks.

In future blogs, I’ll delve more deeply into the tenets and the criticism of MMT.