Modern Monetary Theory: Part 3
In my previous post I laid out the main, structural tenets of modern monetary theory without passing judgment or critique. In this, and subsequent posts, I will discuss the views of a few prominent economists who don’t agree with the tenets nor the application of MMT in the United States or anywhere else. In this post I begin this series of critiques with sentiment from Dr. Lacy Hunt, PhD. Dr. Hunt is the chief economist at Hoisington Investment Management and has been a prominent economist and thinker for more than 50 years.
Dr. Hunt offers a comprehensive view of the overall macroeconomy. However, one specific perspective he shares is particularly relevant to the claims made by MMT supporters that more debt, without inflation, is the solution to our current ills. Dr. Hunts theme is this: Extreme Over-Indebtedness Creates a Crisis of No Growth & Lower Standards of Living. All major global economies are extremely over-indebted which acts as a hindrance to growth and restrains inflation and interest rates. These global economies have exacerbated the problem by trying to solve the sluggish growth experienced with additional debt, initially relieving the problem but eventually making it worse. Over the long-term, extreme indebtedness leads to weaker economic activity, lower inflation and lower long-term bond yields. The U.S. is going to persist with this lower inflation and interest rate environment for a long period of time.
In support of this theme Dr. Hunt cites a recent article entitled, “The Impact of High and Growing Government Debt on Economic Growth: An Empirical Investigation for the Euro Area” by Cristina Checherita and Philipp Rother. This paper investigates the average impact of government debt on per-capita GDP growth in twelve euro area countries from 1970 to 2010. It finds a non-linear, negative impact of debt on growth at about 90-100% of GDP (the U.S. is at 105% today). There is evidence that the annual change of the public debt ratio and the budget deficit-to-GDP ratio are negatively and linearly associated with per-capita GDP growth.
This research is supported by the theoretical construct known as the Production Function, which states that physical output is determined by the inputs or, factors, of production: capital, labor, natural resources and technology. The overuse of one factor of production, such as debt capital, results in diminishing returns at some point. Then, one factor must increase to offset the overuse of debt. However, in today’s developed economies, the other three factors of production don’t show much promise of picking up the slack. Demographics in each of the developed economies are weak. Population growth has slowed way down and workforces are aging and shrinking. Japan’s population is actually declining. Thus, we are unlikely to get a boost in production from labor any time soon.
Natural resources as a factor input have been relatively stable, and haven’t really been a factor for a long time. And recent inventions have been more evolutionary than the revolutionary compared to the impacts of electricity, modern communications, the internal combustion engine, urban sanitation, pharmaceuticals and chemicals.
Thus, the developed world has defaulted to the idea that in order to boost output one must take on more debt.
A derivative of the production function is the law of diminishing returns, which is non-linear. When you initially increase debt capital output is boosted but eventually, as more debt is added, the rate of gain will slow, and then flatten, and then turn negative. The real crisis today is not a potential financial calamity as much as it is a falling growth rate and standard of living. The overuse of debt doesn’t have to create a debt crisis, but it does grind down the growth rate, making the entire economy a slave to excessive debt. Furthermore, this debt induced weakness in growth is causing an increase in the income and wealth divide. Weaker growth causes many people to be left behind.
According to Dr. Hunt, an interesting way to look the effects of over-indebtedness is to look at the amount of GDP growth generated by each new dollar of debt. Globally, in 2007, each dollar of debt generated $0.36 of GDP growth. Today its 20% lower at $0.31. 10 years ago in China a dollars worth of debt generated $0.61 of GDP and today its $0.33. Today in Japan, a dollar of debt only generates $0.22 of GDP, and the U.S. is generating $0.40 of GDP, down 10% from 2007. The important point is that there are no major areas of the world that are lightly indebted, and each country is getting the same results. The only way out of this, outside of some exogenous shock event, is a prolonged period of austerity and living within our means.
In my last post I outlined MMT’s use of Japan’s most recent 30 years of economic history as empirical proof that MMT works, or more specifically, a country can radically increase its debt load without suffering the consequences of inflation, and ipso facto act as a benefit to its constituents. However, Dr. Hunt likes to point out a few inconvenient facts about Japan’s recent history that largely discredit the MMTers claim. In Japan, government debt to GDP jumped from 52% in 1988, to 80% in 1998, to 200% in 2018, an all-time high, including periods of war. Japan has had four recessions in the past ten years and they may be entering their fifth in 2019. Presently, the 10 year and 30-year JGB’s are yielding -0.1% and 0.5% respectively. Apparently massive government spending didn’t help Japan’s growth. The same holds true in the U.S. In the past 20 years the government debt to GDP ratio surged 45 percentage points to the highest level on record, with the exception of war years and the year immediately thereafter. If such large increases in federal debt were supportive of economic activity, the economy would’ve grown above growth trend. Instead, growth was far below trend. In the past two decades, real per capita GDP growth in the U.S. was 1.2% per annum, 37% less than the average from 1790 to 1997.
Thus, in Dr. Hunt view and experience, excessive debt drives down inflation and interest rates because too much debt slows down growth, lowering standards of living and helping to create a wider disparity in wealth. MMT has chosen to focus only a portion of this story and failing to realize the larger context of the facts surrounding their so-called empirical evidence. After more than 10 years of massive debt build-up in the world’s developed economies we have undoubtedly moved into the realm of diminishing marginal productivity of debt. And issuing more debt would only increase the negative rate of change in productivity and therefore growth. The bigger picture seems to indicate that MMT, if implemented, would only make things a lot worse – mainly in terms of even slower economic growth, and greater wealth divide.
