The Taiwan Banker

Suppose a certain amount of the workforce is diverted for a year to work on some large public works project, which is financed by government debt. Ten years later, does it matter whether or not that debt is paid back? The laborers have long returned to their normal jobs, but there is no way to get back those man-hours spent a decade ago. Whether or not those costs were reasonable at the time, they will never be “recovered.”This is the question posed by the latest intellectual force to sweep global finance, called modern monetary theory (MMT). MMT provocatively suggests that government debt doesn’t bear any essential relation to the size of the underlying economy. The term probably originated with Randall Wray’s 1998 book Understanding Modern Money, and has become increasingly prominent in left-leaning politics in the US as well as a number of European countries.The term has come up most recently in connection with the “Green New Deal” proposed by US Representative Alexandria Ocasio-Cortez (D-NY), an ambitious plan to combat global warming by decarbonizing the economy, making reference to the Depression-era “New Deal.” Aside from the environmental portion of its agenda, it also aims to achieve social objectives such as “[providing] all members of our society, across all regions and all communities, the opportunity, training and education to be a full and equal participant in the transition, including through a job guarantee program to assure every person who wants one, a living wage job.” It is not clear how exactly the program would be financed, although a number of creative schemes were proposed.Theory or political movement?Job guarantee programs form a central tenant of MMT. The substance of the theory is that fiscal policy can be used to replace monetary policy. Within the academic community, it is not clear exactly how much of MMT is truly novel. Its advocates are known for having a testy argumentative style, frequently accusing detractors of misunderstanding the theory while eschewing the models used in mainstream economics which would help clarify its innovations.In the political sphere, though, it is less relevant whether or not some aspects of the theory may have been foreshadowed by Keynes’ original writings. It is not surprising that a political movement may emerge in response to the failure of austerity in the aftermath of the financial crisis. Meanwhile, the center-left in the US is facing the possibility of a left-leaning populist movement which could form a mirror image of that on the right.In part, the current popularity of this heterodox theory reflects the response of the US left to the rise of China’s rise. The response on the right, represented by Trump, is clear. It was never quite clear what the “again” of “Make America great again” referred to, but the rise of China has clearly affected the American psyche across the political spectrum. The response on the left has been more subdued, but no less profound.One area where fiscal policy shines is currency manipulation, which was used by both China in Japan during their industrialization stages of development. In this process, the central bank prints new money to fund purchases of foreign sovereign bonds. In monetarist economics, the new money would eventually make it back into the country, causing domestic inflation. (Moreover, the market would expect this process and start demanding higher prices immediately.) The essence of manipulation is however that the real prices – even after accounting for inflation – still remain low.This feat is accomplished through the dark art of foreign exchange “sterilization.” Excess liquidity is mopped up through forced savings at low returns, and funneled into domestic government bonds. Residents are discouraged from buying foreign goods through unbalanced trading practices. Thus, fiscal policy manages to overpower monetary policy for a sustained period.As an aside, currency manipulation has been in the news recently as the US declared China a currency manipulator following the devaluation of the RMB. There is however no evidence that this sterilization process is occurring at the moment. The decline seems market-based, and the IMF has also concluded that no manipulation is taking place.The Weirdness of Central Bank Balance SheetsAlthough it difficult to imagine today, its rise was once the subject of paranoia and soul-searching in the US, similar to with China today (although with fewer political dimensions). Both countries’ economic models have a great deal in common, although Japan started several decades earlier. Japan’s use of aggressive policy to offset the Great Depression mirrors China’s multiple trillion-dollar stimulus which prevented the financial crisis from spreading there. Japan now faces the above question: does it really need to “pay back” its infrastructure binge from decades earlier?Government debt on central bank balance sheets can act like quantum particles, simultaneously existing and not existing. Markets are closely watching whether quantitative easing in Western countries and Japan can be unwound. Even if the debt appearsde factoto be retired permanently period, the consensus is that ade jureannouncement would arouse market skepticism and questions of institutional independence.Japan’s public debt is a world-beating 250% of its GDP. More importantly, inNovemberof last year, its central bank holdings broke 100% of GDP. Although formal monetization remains a nuclear option, the economy remains mired in a persistent low-flation slump. Japanese policymakers eschew unorthodox economic theories, but many commentators assert that permanent monetization is already a fact.The policy suite it used during its period of rapid growth, combining expansionary monetary policy with a corporate sector aligned closely with government policy objectives, tends to work reasonably well until the needs of savers are considered (aside from antagonizing trading partners). Specifically, one of the most important groups of savers is retirees. Will their needs be met when it comes time to withdraw their savings?In some sense, this question goes beyond economics to more qualitative issues like infrastructure quality. MMT works best in cases where economics no longer applies, and a single or small number of factors (like demography) can substitute. If Japan can find ways to provide for its elderly population through good planning, it doesn’t matter so much whether the actual funds can be withdrawn.But does it really work?To answer the question posed at the beginning of the article then, it matters whether a given project is paid back when making a decision on the following project. A proper accounting helps guide the decision, and prevents politicians from taking credit for failures. If a proper decision can be made from the start, the monetary aspects are superfluous. In the real world, and in the long run, however, most of these decisions are repeated games. It is not possible for the market to repeatedly and reliably ignore price signals, even when the government might think it has some degree of control. (It also may not be entirely realistic to ignore the inputs required during the process of operations however, but this thought experiment is highly simplified).The Chinese system of state-owned and state-controlled finance provides a ready example of this phenomenon. Specifically, in the past, and particularly since 2008, it has long had an expansionary stance. China’s stimulus package following the financial crisis resulted in large quantities of capital intended for SOEs leaking into sectors like residential and commercial real estate.Real estate is one of the most important types of wealth everywhere, but particularly in Asian societies. Housing asset prices are not typically counted in inflation statistics, but they can be an important form of hidden inflation. Worries about the housing market typically focus on whether prices will crash, but in an equally bad scenario, they could continue reaching for the sky, inspiring unrest such as in Hong Kong.In the last two years, for the first time since reaching global scale, China has engaged in deleveraging. In theory, this shift would have been a perfect opportunity to decrease the size of the state sector and reaffirm the role of the private sector in the economy. The state sector was in the perfect position to provide new impetus to the economy by relinquishing its own resources. (MMT treats state and private resources very differently, literally on opposite sides of the balance sheet.)In practice, however, the opposite occurred. The state sector almost escaped the impact of the policy, while the private sector was forced to make do. Despite a clear mandate from the center, the role of self-interest continued to define the actions of government organs which nominally act in the public interest. China is known for having a sprawling bureaucracy and weak legal protections, but it must take truly exceptional circumstances for fiscal policy to work in the public interest when policy-makers have the power to print money.Theorists may not have discovered perpetual energy this time, but the debate over the role of the central bank will only intensify as we enter the next recession – whether it occurs in 2020 or in the following years. Unless the downturn ends up being relatively light, such fringe positions may even become mainstream.