It is somewhat disconcerting that despite all the years of free money over the past decade, and after a brief shift towards normalizing interest rates, both sides of the Atlantic are now back to talk of lowering rates and quantitative easing once again. Despite ten years of financial repression which severely punished savers with very low rates, the underlying problem of too much debt is a bigger issue than ever. More concerning, in light of a potential upcoming economic slowdown, proponents of all types are indicating that the solution is to pile on even more government debt, based on the concept of Modern Monetary Theory (MMT).
Prior to the financial crisis in 2008, the western world believed in a disciplined approach towards monetary and fiscal policy. Monetary policy focused on cutting rates to encourage lending and borrowing in order to stimulate the economy during downturns. If this was not enough, then fiscal policy was administered whereby the government would borrow and spend in order to create employment and growth during recessions. This type of debt generally would have a multiplier effect on the economy increasing economic output and the prices of goods and interest rates. Once the economy was back on its feet again, the government would cut back in order to pay for that debt.
The idea was never for governments to just pile on debt to infinity like drunken sailors passing on the liability for repayment to future generations. The reason for this is the belief that if you print enough money eventually your currency becomes worthless, wiping out all purchasing power, with Venezuela being the latest example. Also, in the past, too much federal debt would eventually raise interest rates. As government debt is favoured by borrowers because it is lower risk, private borrowers are then forced to pay more for their own capital needs through higher rates or a weaker currency (known as “crowding out”).
Venezuela notwithstanding, since the financial crisis, the major economies of the US, Japan, the UK or the European Union have not seen inflationary pressures from their increased debt levels, nor higher rates from crowding out. In fact, in all these countries central banks have been successful at keeping interest rates down even as government debt went up. The biggest reason for that is that the majority of the debt found its way into financial markets and not the real economy. Where corporations borrowed to buy back shares and very little of the money was invested by businesses in the real economy. Consumers at the start of the financial crisis had too much debt already and were more interested in paying it down than taking on more debt and spending the money. Demographics certainly also played a role as aging baby boomers everywhere began to reduce spending as their needs changed.
Although the new debt has not been that productive for the overall economy, ultimately the higher taxes required to pay off that debt will still depress economic growth and lower both inflation and interest rates. However as this “free lunch” of printed money has not appeared to have negatively impacted inflation and currencies to date, the belief is now maybe we can ramp it up even more and introduce Modern Monetary Theory (MMT).
MMT is based on the idea that a country can run large deficits, without facing default on its sovereign debt, as long as they can print their own currency to service or repay any quantity of public bonds that they have issued. It implies the possibility of covering an exploding budget deficit by printing money, without any upward pressure on bond yields.
The world today has about $20 trillion on central bank balance sheets, roughly five times more than the amount they held back in 2006 when everything started to go off the rails. Loading up government balance sheets with debt made sense at the time. Banks needed to be bailed out from their bad debts as the economy does not function without credit via their loan books. When businesses borrow to expand, they create jobs and demand, resulting in positive growth for the economy.
Sadly, despite the vast amounts of cheap financing that would allow the private sector to lower debt levels and adjust their balance sheets accordingly, the opposite has occurred. Global corporate debt today is much higher than it was at the start of the last three recessions. Corporate debt was not used for business expansion that could ultimately generate cash flow to help in paying back that debt, but rather to buy back shares to reward executives and shareholders. Should a global recession materialize at some point in the future, corporate defaults will skyrocket. In fact, the debt of many companies will go from investment grade to junk, which would force pension funds, insurance companies and other investors to sell (at any price) as they are not allowed to hold non-investment grade debt. Likewise, consumers in countries like Australia and Canada invested in overpriced real estate will be demolished in the event of higher interest rates or stricter lending rules.
As the economy is now starting to slowdown, proponents of MMT are pushing for even more printed money to create growth. However, economic growth is not sustained by having your government print endless money to provide all sorts of wonderful idealistic projects or to pay entitlements you cannot afford. This “money tree” fantasy is an illusion. Economic growth is a function of population growth and productivity growth. Population growth unfortunately is not a feature of any western world economy and with immigration under populist attack, it is unlikely to be a constructive factor going forward. For productivity to grow, it takes spending on innovation (R&D) and capital investment in equipment and technology and more emphasis on education and training. These expenditures are easily deferred when executives see a more direct path to earning per share growth by using the funds to buy back shares, thereby ensuring their bonuses are not threatened. This is why confidence in the future is so important and unfortunately somewhat lacking at the present time. Trade wars have increased uncertainty by putting a tax on consumption and forcing a broad disruptive and costly realignment of supply chains, slowing growth. Ultimately, there will be no growth if there is no population growth and no investment in capital and research that create the new jobs of tomorrow that will boost tax revenues and incomes.
Based on where we are today already in terms of government debt, we believe the world overall will be stuck in an era of slow growth for a long time to come. Politically there is no appetite for cuts in spending and short term more debt will be the solution for all the world problems. There is no question interest rates will be taken down during the next recession and central banks will keep selling more bonds and running up the debt. The path of least resistance is always to just simply inject the next fix of monetary stimulus. The end result will be maximum debt, low interest rates and low growth. The real concern will be debt deflation and a global depression against which every scheme, including throwing money from helicopters, will be considered fair game.
Nevertheless, in a global environment of massive debt loads, the US continues to be considered the safest haven. As anemic as its growth has been over the past decade, it has been better than anywhere else. Although MMT in a normal world would threaten its currency, as every other country is in the same boat, it represents the best option among many poor choices. There is nowhere else to go with your money and feel safe. People do not buy currencies of other countries, they buy their bonds as long as the coupon is reasonable and the currency is expected to hold its value. The US market is the most liquid market in the world. Japan has been the buyer of last resort for its own bonds as there is no liquidity (and yields are negative) in their bond market. Europe has no real market – your choice is to buy German Bunds with negative yields, or Italian bonds at just about the same price as US bonds, which should scare even the bravest of investors. The UK has Brexit to deal with so nobody really knows what their currency will ultimately be worth. US bonds are therefore the last liquid man standing. Until the day somebody decides the US dollar currency is not worth the risk, it is game on, at least in the US.
So can MMT save us during the next downturn or crisis? Maybe, maybe not. Certainly not without a heavy price to pay eventually. It represents one giant ‘field goal’ kick of the can far down the road. Nobody knows how or when this will end. The vast amounts of quantitative easing, created by the central banks over the last decade, got us out of the last financial crisis and created financial repression for savers around the world. We are issuing new credit cards to pay off the interest and payments on all the last cards we fully maxed out. Removing this liquidity will inevitably create a bigger crisis if those with debts to pay are not prepared for it. This will likely be the case until somebody can figure out how to unwind all this debt without throwing the world into a tailspin. Adding even more debt to the pile under the concept of MMT seems like lunacy, but lunacy has been the order of the day for the last few years and we have all lost the power to feel shock regardless of what we hear.
We do know we are facing an uncertain future as this great financial experiment runs its course. MMT might kick the can down the road but in the end, debts do have to be paid. In the meantime, we prefer to avoid investing in any companies that would be vulnerable under this scenario, regardless of their price. Quality and strength has never been more important. Those that can grow their earnings (and dividends) through a low growth period will not be the cheapest, but will be the only ones that can weather any storm. Companies with the best balance sheets are poised to keep outperforming. As in all else in life, when times get really tough, only the best prepared will survive.
The Summerhill Team