“We suggest that a budget constraint be replaced by an inflation constraint.”
— Three MMT economists in a 2019 letter to the Financial Times
MMT in a nutshell
Modern Monetary Theory (MMT) is often dismissed as a fringe concept regarding unlimited government spending, but it’s a bit more nuanced than that. Basically, MMT holds that a nation’s budget doesn’t (or shouldn’t) really constrain spending because the government can always print more money if needed. Thus, it’s the “real” economy — the production, purchase, and flow of goods and services — that truly matters.
Taking it a step further, the government can theoretically spend as much as it wants to until said spending begins to create excess demand, thereby generating inflation, at which point the government should pull back to prevent the economy from overheating (easier said than done).
A paradigm shift in the making
It seems clear to me that this view is significantly influencing government spending policy these days, particularly in the US, but elsewhere as well. And I don’t think it’s necessarily a short-term phenomenon. For now, it’s widely seen as some new policy “alchemy” we’ve developed that has no real cost attached to it, so it’s likely to continue until the risks (costs) become apparent in the form of higher inflation, rising interest rates, and perhaps macroeconomic instability.
Bottom line: Policy-led inflation, not a lack of demand for goods and services, is the main risk posed by this new cycle we’ve entered. That’s very different — a paradigm shift — from the decade of secular stagnation that we just experienced.
As I survey this shifting landscape from an investment perspective, I wonder if what is generally considered a “defensive” asset now will in fact behave defensively in the new environment. For example, what about shares of a steady-earner company that hasn’t had to worry about cost inflation for over a decade? Personally, I think gold equities look like a more attractive defensive asset for this cycle.
Meanwhile, the broader US equity market remains in more or less buoyant mode, seeming to “believe” we’ve discovered that generous government spending can, by itself, solve structural distribution-and production-related problems and lead to a prolonged state of strong growth with easy money. In reality, this type of policy tends to be great for stocks for a period of time, until it’s not anymore.
Indeed, we’ve been here before, where inflationary policy helps drive a bull market that ultimately proves to have a weak foundation as price inflation follows the asset inflation. For example, US equities traded at lofty valuation levels in the late 1960s amid multidecade-high inflation and procyclical fiscal policy enabled by the US Federal Reserve. And we know how that ended, with the market crashing in January 1973 (Figure 1).
This is an extreme example and far from my base case for US stocks as of this writing, but it highlights the somewhat fragile underpinnings of today’s market. (Aside: I also suspect the bull market still has further to go, making it difficult for investors to adopt an overly defensive stance these days.) Although policy remains supportive for now and near-term economic data strong, I’m skeptical that we have a long runway of real GDP and earnings growth ahead of us and fear that a worse inflation/growth tradeoff could be the endpoint of today’s policy backdrop. That may not be great for equity valuations longer term (Figure 1).
- Five common misconceptions about inflation (March 2021)
- How the world saved its way to secular stagnation (March 2021)
- Is this the end of secular stagnation? (February 2021)
- A new inflationary regime: Why the next decade could look different from the last (January 2021)