This article is for folks who are interested in economics, especially about how monetary and fiscal policy will work differently in the future. It will focus on Monetary Policy 3 (the new type that we will see more of around the world) and Modern Monetary Theory (a recently proposed new approach that has received a fair amount of attention). It comes in two parts. The first part is important for folks who care about such stuff but it’s a bit wonky and the second which shows historical cases is very wonky so feel free to wade into this in whatever depth suits your interest.
Part 1: Understanding MP3 and MMT
When I look at economies and markets I look at them in a mechanical way much like an engineer would look at cause-effect relationships of a machine. To me the economic machine has a limited number of basic cause-effect relationships (see “How the Economic Machine Works”) that can be put together in numerous ways that can lead to an infinite number of combinations, just like the 26 letters of the alphabet can be combined to make up an infinite number of words. More specifically there are two basic building blocks of economic policy, which are monetary and fiscal policy, and under these there are a few ways (taxing and spending for fiscal policy, and interest rates and quantitative easing and tightening for monetary policy) and under each of these there are various ways they can be configured. At the big picture level, monetary policy determines the total amount of money and credit (i.e., spending power) in the system, and fiscal policy determines the government’s influence on where it’s taken from (i.e., taxes) and where it goes (i.e., spending).
To me the most important engineering puzzle policy makers around the world have to solve for the years ahead is how to get the economic machine to produce economic well-being for most people when monetary policy does not work. I don’t mean that monetary policy won’t work at all; I mean that it won’t work hardly at all in stimulating economic prosperity in the ways that we are used to having it stimulate economic activity, which are through interest rate cuts (what I call Monetary Policy 1) and through quantitative easing (what I call Monetary Policy 2). That is because it won’t be effective in producing money and credit growth (i.e., spending power) and it won’t be effective in getting it in the hands of most people to increase their productivity and prosperity. Hence I believe we will have to go to Monetary Policy 3, which is fiscal and monetary policy coordination that is of a form that we haven’t seen before in our lifetimes but has existed in various forms in others’ lifetimes or faraway places. It is inevitable that this shift will happen because it is inevitable that central bankers will want to ease when interest rates are pinned at 0% and when quantitative easing will be ineffective in achieving the goal. I recently refreshed my prior exploration of past cases and future possibilities of such coordination, which I will share below.
Modern Monetary Theory is one of those infinite number of configurations that is in my opinion inevitable and shouldn’t be looked at in a precise way. For those of you who don’t know what Modern Monetary Theory is, it’s described here (link). It’s described differently by different folks so it has slightly different configurations. For example, some might change fiscal policy so that there is a wealth tax that is used to eliminate student loans, and others might change taxes and spending in other ways, and there are an infinite number of ways these changes can be configured that we shouldn’t delve into at this stage because that will drive us into the weeds and the particulars that will stand in the way of seeing the big important things. Also, people who are focusing on MMT as a package will limit their thinking to the specifics of that package rather than thinking about the wider range of MP3 policies to find the best one.
MMT’s most important configuration is the fixing of interest rates at 0% and there is the strict controlling of inflation via the changing of fiscal policy surpluses and deficits, which will produce debt that central banks will monetize. In other words, whereas during the times we have become used to, interest rates moved around flexibly and fiscal deficits (often) and surpluses (rarely) were very sticky so interest rates were more important in producing buying power and the cycles, in the future interest rates will be very sticky at 0% and fiscal policies will be much more fluid and important and the debts produced by the deficits will be monetized. In case you didn’t notice, that is by and large what has been happening and will increasingly need to happen. In other words, interest rates are now pinned near 0% in two of the three major reserve currencies (the euro and the yen) and there is a good chance that they will be pinned there in the third and most important reserve currency (the dollar) in the next economic downturn. As a result, fiscal policy deficits that are monetized is the contemporary stimulation configuration of choice. That existed long before there was a concept called “Modern Monetary Theory,” though MMT embraces it. Putting labels aside, it is certainly the case that the configuration of having 1) an interest rate fixed at around 0%, 2) more flexible fiscal policies with debt monetization to fund the resulting deficits with 3) rigorous inflation targeting exists and is increasingly likely, necessary, and possible in reserve currency countries. An added benefit of this approach is that the money and credit created can be better targeted to fund the desired uses than the process of having the central bank buy financial assets from those who have financial assets and use the money they get from the central bank to buy the financial assets they want to buy. There are many historical cases of this happening (see the 1930s-1940s prewar and war periods which, as you know, I think are analogous), which offer worthwhile lessons about how this was and could be engineered.
The big risk of this approach arises from the risks of putting the power to create and allocate money, credit, and spending in the hands of politically elected policy makers.In my opinion, for these MP3 policies to work well, the system would have to be engineered in a way that decision making would be in the hands of wise, not politically motivated, and highly skilled people. It’s difficult to imagine how the system will be built to achieve that. At the same time it is inevitable that we are headed in this direction.
Looking at Our Thinking about MP3 and MMT
In the following section, I will outline some of my thoughts on what MP3 is likely to look like in more detail, but the main points me and my Bridgewater colleagues believe to be true are:
- We agree with the notion that fiscal policy has to be connected with monetary policy to provide enough stimulus in the next economic downturn. That is because Monetary Policy 1 (based on moving interest rates) is in most cases either unable to happen alone or unable to happen much, and Monetary Policy 2 (based on central banks “printing money” and buying financial assets) has limited power to stimulate. For reasons explained in “Principles for Navigating Big Debt Crises,” as long as countries have their debts denominated in their own currencies, the combination of monetary and fiscal policies would likely work to smooth out economic downturns, and the only things that stand in the way are the limited capabilities of economic policy makers and/or the limited political abilities to do the right things.
- We’ve described the coordination of fiscal and monetary policy as a type of Monetary Policy 3 (MP3)—and this is a critical policy tool when interest rate cuts (MP1) and QE (MP2) have limited effectiveness.
- We think that interest rate cuts and QE will be significantly less effective in the next downturn for reasons we’ve described in depth elsewhere. We also don’t believe that monetary policy is producing adequate trickle-down. QE and interest rate cuts help the top earners more than the bottom (because they help drive up asset prices, helping those who already own a lot of assets). And those levers don’t target the money to the things that would be good investments like education, infrastructure, and R&D.
- Obviously, normal fiscal policy is usually the way we handle those sorts of investments. But the problem with relying on fiscal policies in a downturn (besides them being highly politically charged) is that it is slow to respond: it has long lead times, you have to make programs, concerns over deficits can make it more challenging politically to pass fiscal stimulus, etc.
- Imagine instead if you had taxes operating in a swing way, the same way that interest rates move, so that it could be a semi-automatic stabilizer. If you had a recession you would have the equivalent automatic reduction in taxes. On the opposite end, a tightening would result in a rise in taxes.
- We could imagine semi-automatic increases in investments with high ROI to underfunded areas (e.g., education, infrastructure, R&D) rather than just going through financial markets to the areas that companies and investors find most profitable for them.
- Funding such things with money printed by the central bank means that the government doesn’t have to worry about the classic problem of the larger deficits leading to more debt sales leading to higher interest rates because the central bank will fund the deficits with monetization (QE). As we’ve described several times before and have seen since the 2008 financial crisis, such monetization won’t cause too much inflation. That is because inflation is determined by the total amount of spending divided by the quantity of goods and services sold. If the printed money simply offsets some of the decline in credit and spending that happens in an economic downturn, then it won’t produce inflation, e.g., over the last decade central banks struggled with inflation being too low, not runaway inflation, while they have massively monetized debt.
Continue reading here.
