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Economics

Debate rages over practicality of modern monetary theory

Joachim Fels fields questions about the ‘very hot topic’ of modern monetary theory at almost every client meeting.

Given the current political and economic climate, it's no wonder a renewed debate around modern monetary theory — an unconventional macroeconomic view introduced in the early 1990s by economist and former hedge fund manager Warren Mosler — has drawn experts at some of the world's largest money managers into the discussion.

The stage is being set for the 2020 presidential race, Congress is preparing to tackle the government's debt ceiling and President Donald Trump's proposed government spending plan, released last month, has roiled Washington.

That's helped push to the forefront the conversation about MMT, which contends that the U.S. government cannot go bankrupt because it prints and borrows in its own currency and is not constrained by the budget deficit. The Treasury Department estimated recently that the current budget deficit would reach $1.1 trillion by the end of fiscal year 2019.

Joachim Fels, managing director and global economic adviser at Pacific Investment Management Co. LLC, Newport Beach, Calif., noted in a phone interview that MMT is certainly a "very hot topic," and hasn't escaped the attention of the bond giant's institutional investors and wealth management clients.

"When I speak to clients, I get a question about MMT in almost every meeting now. It's a very hot topic. If MMT became reality it would have huge consequences for financial markets and investors," Mr. Fels said.

A PIMCO cyclical outlook report last month, co-authored by Mr. Fels and Andrew Balls, managing director, CIO-global fixed income, noted: "In a nutshell, proponents of MMT postulate that active fiscal policy should be used to target full employment, and that monetary policy should finance directly … whatever deficit level fiscal policy chooses. Expansionary fiscal policy would thus automatically increase the money supply rather than the bond supply, and financing the deficit would never be a problem."

While, in theory, MMT "can work," Mr. Fels said, it is the implementation of this view that raises his doubts.

Mr. Fels called it "very naive" to expect the government to move swiftly on matters of fiscal policy, such as raising or cutting taxes, as "more often than not, you get gridlock in Congress."

"Fiscal spending is always politicized. The difference is, under MMT, you put the entire burden for stabilizing the economy on the government, and therefore on Congress," Mr. Fels said. The view turns the division of labor between the Federal Reserve and Congress on its head, he added.

Effect on interest rates

PIMCO is fielding more questions from clients about MMT because "monetary and fiscal policy have a big impact on interest rates, and thereby affect the prices of bonds and other fixed-income assets," he explained.

Furthermore, interest rates impact equity markets and valuations.

"This debate is relevant for all asset classes, but first and foremost, for fixed income," Mr. Fels said.

MMT essentially offers the idea that government spending or deficit financing can be used to "prime the economic pump," according to Lori M. Heinel, executive vice president and deputy global chief investment officer of State Street Global Advisors, Boston.

There are several implications of MMT that concern her, including the potential impact of these ideas on interest rates, but a major issue for her is how to determine which spending programs would stimulate the economy.

"How do you decide which programs warrant the capital expenditure? That can become very political. Our view would be, how do you think about the range of things that money can be spent on and identify ones that are additive to the economy more broadly and drive more longer-term economic growth," Ms. Heinel said.

Also, as the U.S. enters the 2020 presidential race, "either party could use modern monetary theory to justify whatever pet projects they have," she added.

Investment impact

Mr. Mosler, who developed MMT and now resides in St. Croix, said in an April 10 interview that if his take on monetary operations gained widespread acceptance, the result for investors, including institutions with a longer-term investment horizon, would be the opportunity to invest with less risk of macro volatility.

As such, investor worries of a looming crisis would be alleviated, and riskier assets, such as early stage companies, would carry a "different kind of risk," as "the whole definition of risk shifts," he explained.

Institutions would "not just be investing because (a company) can weather the storm," but because the company is well-managed, and its products or services are "superior and can flourish."

MMT recognizes that the government is the monopoly issuer of the currency, and that the money to pay taxes and buy bonds flows from government spending, so it must "spend first," according to Mr. Mosler. Therefore, the idea that the government is revenue-constrained is "entirely inapplicable."

MMT has gained a following from economists, such as Stephanie Kelton, a professor of public policy and economics at Stony Brook University, N.Y., and politicians, such as Rep. Alexandria Ocasio-Cortez, D-N.Y., who sees the theory as an answer to funding social programs.

Even PIMCO's Mr. Fels said "there is some truth to some of the claims that MMT does make."

"(MMT) does not necessarily lead to high inflation or hyper inflation as some people claim," Mr. Fels said, referencing the MMT view that the government can continue spending, or run a higher deficit, to achieve full employment.

Yet the view has drawn criticism from industry heavyweights, including Laurence D. Fink, chairman and CEO of BlackRock (BLK) Inc. (BLK), who called MMT "garbage," in a March interview with Bloomberg Television, stating that he was a "big believer that deficits are going to be driving interest rates much higher and it could drive them to an unsustainable level."

'Very skeptical'

Nathan Sheets, chief economist and head of global macroeconomic research at PGIM Fixed Income, a unit of $1 trillion manager PGIM Inc., Newark, N.J., said, overall, "we find ourselves very skeptical of modern monetary theory."

He added, however, that "there is a grain of truth in the observation that several countries, including Japan, have been able to run high debt levels at low interest rates."

"Further, a case can be made with rates low, that it makes sense to borrow in the United States some large amount to build infrastructure projects," as infrastructure is likely to return more than its costs, Mr. Sheets explained. Following the global financial crisis, the American Recovery and Reinvestment Act of 2009 ushered in a $105.3 billion package for infrastructure investment.

But, from a high level, he likens MMT to driving down a mountain road and trying to remain as close to the edge as possible, while not going off the cliff, which is not advisable.

"When you are going down the mountain, you don't drive as closely to the edge of the road as you can," Mr. Sheets said.

Over the medium term, if the U.S. doesn't address rising federal debt levels, the inaction is likely to weigh on the economy and be a source of uncertainty for investors in the U.S. market, he continued. For institutional investors, a shift toward an MMT view could have two ramifications:

"On the margin, it would tend to make U.S. assets less attractive," such as domestic fixed income and equities, he explained. "It would make people more uncomfortable and nervous about the future and move people away from riskier assets into safer assets," such as government securities as a safe haven.

Although Mr. Sheets sees some truths in MMT, PGIM Fixed Income does not incorporate the macroeconomic view into its investment outlook and does not see it as one the U.S. should follow, he said.

Separately, if the view was to become mainstream in the U.S., he believes institutional investors would find that "concerning."

"The traditional view that deficits are bad is still deeply rooted in the investment community," Mr. Sheets said.