In the most recent InFi podcast episode, I reviewed the recent ZeroHedge debate I had with Nathan Tankus, who represented the Modern Monetary Theory (MMT) camp versus my Austrian School position. We covered several topics, but in this post I want to focus on one particular dispute in order to carry the analysis further than we did in the debate itself. Specifically, Nathan reiterated throughout the debate that the federal government helped households after Covid struck by running massive budget deficits. This supplied an enormous amount of safe assets to the private sector, increasing their financial wealth and repairing their balance sheets. There are serious problems with Nathan’s claim—which is standard in the MMT world—that I will elaborate in this post.
First, we need to understand the accounting that the MMTers have in mind. When the government runs a budget deficit, it borrows money from households by issuing them new government bonds (Treasury securities, if we’re talking about the US), and then returns the money itself to the households by spending it. Thus, the end result is that the private sector has accumulated a larger stockpile of IOUs issued by Uncle Sam. The US government owes trillions of US dollars to the private individuals or organizations that own its debt securities.
Yet as I pointed out in the debate, to call the Treasuries held by households “net financial assets” is dubious. After all, there are only three ways the Treasury can honor its commitment and pay the holders of the Treasuries: (A) It can tax the public. (B) It can issue new bonds to pay off the old bondholders. Or (C) It can run the printing press. I argued that both (A) and (B) clearly did not make the private sector wealthier, while (C) was simply a form of hidden taxation that effectively financed government deficit spending through inflation that diluted the value of all USD-denominated assets. I concluded that printing money didn’t actually make Americans richer (on average), because mere inflation doesn’t create more factories or farmland. It just makes everything more expensive.
Now in the actual debate, after I made the above arguments Nathan responded by appealing to history. He asserted that US households saw their financial net worth increase after the deficit spending in the wake of Covid, and thought that settled the matter.
Do Government Deficits Fill the Shortfall in “Safe Assets”?
But in the rest of this post, I want to pursue a different line of argument that Nathan could have pursued, in order to think more deeply about these matters. Specifically, the sophisticated MMTer could argue in this manner: “In times of crisis, households and private firms rush to safety. The safest asset in the world is the US Treasury security, which means the US government has a duty to issue loads of new debt during crises. This will bolster the net worth of the private sector and prevent the entire system from seizing up.”
My reaction to this hypothetical MMT argument would be to argue that, in times of crisis, it’s crucial to allow the financial markets to evolve without government interference. In a laissez-faire framework, the response of market prices on different assets would guide businesses and consumers to revise their plans and reorient the economy into a more resilient structure, given the underlying facts that spawned the crisis in the first place.
How Unfettered Financial Markets Would Respond to a Looming Crisis
For a fanciful example, suppose humanity becomes convinced that in 12 months, a calamity will strike the planet. For our purposes in this post, the specific calamity is unimportant. But for whatever reason, most people become convinced that in one year’s time, the economy will be in bad shape. What would happen?
Among other effects, we would see households rush to shift their financial portfolios into safer assets. (On this narrow point, the MMTers are correct.) In particular, households would attempt to sell down their holdings of corporate stock, and replace it with corporate bonds. (Remember, in this thought experiment the government doesn’t interfere with the economy.) For example, if the typical household started out with (say) 40% of its portfolio in corporate bonds and another 40% in stocks, then the mass (attempted) exodus from stocks and into bonds would crash the price of the former and raise the price of the latter. When the dust settled, the new prices might mean that the typical household now had (say) 50% of its portfolio in corporate bonds and only 30% in corporate stock.
(Remember that if one person sells a share of stock, there must be another person on the other side of the trade buying it. Immediately following the news of the impending catastrophe, the total number of shares and bonds is the same; prices adjust until household portfolios have moved to their desired allocations.)
Yet the changes in prices will affect the yields on stocks vs. bonds. Specifically, by pushing down the price of stocks, the implied internal return on owning those stocks goes up. On the other hand, the increase in market value of bonds implies a drop in the yield-to-maturity on them.
But consider what that means: The expected rate of return on corporate stock has gone up, while the interest rate on corporate bonds has gone down. This will give an incentive for corporations to issue more debt in order to buy back some of their outstanding stock.
The altered financial position of corporations will (at least in some cases) give an incentive for safer planning. For example, if a company has 5 different product lines it could pursue, it might be more conservative if it has a large amount of bonds coming due over the next two years, rather than being more heavily financed by equity shareholders (who are merely residual claimants on the company’s assets, rather than being owed a specific flow of dollars at various dates).
If we take a step back, we see that in an unfettered market, a sudden belief in an impending crisis will lead businesses to behave more prudently, focusing on “sure thing” product lines rather than “swinging for the fences” with a new product line. This shift to conservatism is exactly what we want to happen, so that the world’s resources are shepherded more carefully in the wake of alarming news.
Government Deficits Produce the Wrong Outcome
In complete contrast, suppose that after the news breaks about humanity’s fate in 12 months, the government steps in to prop up panicked financial markets. Specifically, suppose the government runs large budget deficits, which creates new Treasuries to make their way onto the balance sheets of companies and households.
The problem is that just when we want every organization to become more frugal with how it spends, in this scenario the US government is throwing caution to the winds. Moreover, even if the government “succeeds” in quelling panic and restoring the economy to its pre-crisis configuration, that simply means the economy hasn’t adjusted to the new reality. Rather than firms pivoting away from riskier projects and into safer ones, they will continue plodding along like they were before the crisis. Although this might avoid short-term disruption, it’s actually marching humanity towards the cliff (metaphorically speaking) rather than changing course.
Conclusion
A superficial analysis makes it appear that the US government and other major powers are doing the world a favor by running up their debt in order to reassure private households and businesses that their financial future is secure. Yet in reality, printing money doesn’t make the economy more nimble. To actually become more robust and “anti-fragile,” the economy must be allowed to genuinely adapt to the new information. Some businesses must fail and some workers need to change occupations. This is painful in the short term, but in the long run it is the foundation for a robust and sustainable recovery.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
Twitter: @infineogroup, @BobMurphyEcon
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