1. Modern monetary theory and the case for gold. With central banks around the world loosening monetary policy in response to flagging growth and possible trade-war fallout, modern monetary theory (MMT) is again in the air. This radical development of “ignore the deficits” economics was created decades ago, but found a new hearing after the events of the Great Financial Crisis, which mainstream economists had mostly failed to predict. Although MMT is currently a fringe theory, it has been seized on by a vocal minority of politicians as justification for a new and intensified kind of government spending — “Keynesianism on steroids.” Although politicians and policy wonks like to present their monetary theories as if they were neutral, rational, mathematical models, these models all necessarily conceal political goals and political presuppositions. In the case of MMT, the politics are clear: that it doesn’t matter whether government or private citizens are basically in the economic driver’s seat. We think it matters a lot. While it is not likely that MMT will suddenly gain a hearing from mainstream economists and policy makers, it’s important for investors to monitor such theoretical developments, because these ideas might gain influence when the next crisis rolls around. In any event, the influence of radical theories such as MMT will certainly be supportive of the “barbarous relic” that Keynesian and free-spending economists love to hate: gold, the form of money that governments can’t control.
2. Market summary. A trifecta of disappointing Fed communication, trade-war escalation, and self-reinforcing recession fears have accompanied an S&P 500 decline of about 4.7% since last week, and a strong rally in bonds (as interest rates decline) and gold. The correction was not a surprise, and given the strength of the U.S. stock market thus far in 2019, many technical analysts were calling for a decline to relieve its overbought condition.
We have been increasing cash positions since July, and gold positions for months; in December we wrote that 2019 might be “the year for gold” and have mentioned it frequently. Very recently, we have taken some profits in gold for our more tactically oriented clients, but positions have been maintained, and we will add to gold and to silver on any dips.
We believe that gold will likely correct near-term, but that longer-term it will continue to move higher. Current investor psychology is turning from regarding gold simply as an inflation hedge, to regarding it as more of an all-purpose “stupidity hedge” against the ill-considered actions and policies of governments and central bankers.
While we believe that investors should begin to give more attention to gold and their gold allocation, we are not fundamentally bearish on U.S. equities. The present correction may become deeper, but economic and financial conditions in the U.S. remain strong, and as Bank of America analyst Savita Subramaniam notes, thus far, earnings are holding up and we have not entered an “earnings recession” like that of 2015. From our perspective, the U.S. remains “the only game in town,” for now. In the long run, opportunities may emerge, particularly in India and Brazil, but under current conditions, we see no compelling reason to diversify globally. Trade and growth concerns weigh everywhere — trade in emerging markets, and growth in Europe.
Modern Monetary Theory and the Case For Gold
U.S. investors woke up on Wednesday to news of surprisingly aggressive rate cuts from India, New Zealand, and Thailand, as more Asia Pacific central banks act to preempt a global economic slowdown. At its last meeting, the U.S. Federal Reserve called an early end to the balance sheet runoff that had been unwinding the mountain of assets accumulated during the years of quantitative easing. Around the world, as we have noted in recent letters, monetary policy has shifted back towards easing, in response to signs of flagging economic growth and fears of trade war fallout. Fed Chair Jerome Powell’s take on the U.S. economy remains positive, but he noted concerns about developments outside the U.S. as reasons for concern and potential catalysts for further Fed easing action. Many analysts are now calling for a further two Fed rate cuts in 2019.
The shift in global monetary policy has of course created an environment favorable for gold, which in U.S. dollar terms is up about 17% on the year as of this writing, currently outperforming U.S. stocks. We’ve commented on a number of other dynamics favorable to gold — central bank purchases, anxiety about “policy mistakes,” etc. — but global monetary policy is obviously a central element to consider in gold’s position among other investment assets.
Politics and Monetary Policy
Of course, monetary policy is not some mythically objective, mathematically derived, foolproof prescription for economic prosperity. On the contrary, although it is obviously informed by the experience of its architects, it is basically political in the broadest sense. The academic theories that undergird it and justify it are political also; any policy that involves trade-offs (between savers and borrowers, for example) must involve political choices.
The financial crisis of 2008, which was not anticipated by many mainstream economists, afforded an opportunity for dissident economic theories to gain a wider audience. Many of those alternative economic theories — mostly, more radical developments of Keynesianism — include monetary theories that differ widely from the consensus view. One of these has been in the news over the past few months: modern monetary theory (MMT).
MMT has been adopted by a small but vocal group of advocates within the Democratic Party (and has even found support from a few Republicans and Wall Street analysts). Therefore it’s important to understand something about what it is — and something about the effects that it might have if it began to influence the makers of monetary policy, or if it began to influence the demands placed on them by the politicians who write the U.S. budget.
The Secret Source of All Prosperity?
Modern Monetary Theory
MMT was largely created by a Marxist economist named Abba Lerner,starting in the mid-1940s. (We say “Marxist” with no animus against his scholarship; Lerner was well-respected by academic economists for his careful reasoning and incisive writing, and was often in consideration for a Nobel Prize, although he never won it. Lerner was an economic Marxist, not a political one.)
Without getting into technical details, at its core, MMT says simply that any country which is a true monetary sovereign (i.e., can print its own money) can never be forced to default on its debt. It also says that the level of government debt can never become a problem for a monetarily sovereign nation, since the public sector’s liability is always simply the private sector’s asset. Rather than looking at the nation as a big household which will get into trouble if its expenditures consistently outrun its income, MMT theorists say that the nation is fundamentally different from a household, because it has the ability to create money. What the state should do, they say, is simply create enough money to take up all the slack in the economy — and if the government does this, that money creation will not generate inflation. Inflation, they believe, is simply a consequence that occurs when demand outstrips the economy’s actual productive capacity. Therefore, the government could fund expensive initiatives simply by creating money and spending it into the economy — and as long as the economy’s productive limits weren’t being reached, no deleterious effects would occur.
So much for the theory. The political advocates who have seized on MMT translate it into some simple policy prescriptions. Spending limits and deficit worries are foolish. Enormous social projects — such as universal health care, or the Green New Deal — could be financed at the push of a central bank button. And to these politicians, any concerns of fiscal conservatives and deficit hawks are basically misguided, or even malicious.
Spotting the Flaws
Again, without getting into technical details, it is easy to say where MMT goes wrong, and what realities it ignores.
First, MMT rests on the presumption that money is a creation of the state. In fact, of course, money existed before there were any states, and there are forms of money that still exist largely outside government control. Gold is the ancient and obvious example; now, we have bitcoin and other cryptocurrencies emerging as another potential form of money. Fortunately, fiat currencies will always have competition from alternatives that are beyond the state’s control.
Second, while it is true that the state can create fiat currency, obviously, the value that people ascribe to that money as they exchange it for actual goods and services will depend on their view of its value and the future trajectory of its value. So although on paper, a monetary sovereign need never default, it may face an out-of-control spiral as it tries to pay back its mounting debts with money that the people increasingly believe is decaying in value. This is called “hyperinflation,” and although it has thankfully been a rare occurrence and contained within single countries, it has happened many times throughout history.
Third, although as an accounting identity, it is true that all the government’s liabilities are the private sector’s assets, that identity is useless and misleading when applied to the real world. It is not as if “the country” is a single person who doesn’t care whether the money is in this hand (the public sector) or that hand (the private sector). The state and private civil society are two very different creatures with different motivations and desires, different track records of enabling human welfare, and a fraught and difficult historical relationship
In fact, successfully navigating that relationship — limiting the power of the state, and protecting the independence of civil society — has been, in our view, the foundation of American economic success and prosperity since this country’s founding.
At the root, money is nothing but a type of consensual power to direct the use of real wealth and human labor. The balance of that power between government on one hand, and free individuals on the other, matters for economic outcomes — and it matters a lot.
The Core of the Problem
We said above that monetary policy is inevitably political. MMT is a perfect case in point. While it offers up tautologies and accounting identities, and paints a rational, academic picture, it conceals a basic political viewpoint presupposed at its very core: that it is a matter of indifference whether a given economic function is performed by the state, or by private citizens and civil society. In fact, MMT is a prescription for the acceleration of the state’s dominant role in the economy.
MMT theorists acknowledge that the economy has capacity limits — this many people, this much plant and equipment, this much current access to raw materials. Of course this is true. But what they don’t acknowledge is that the historical verdict is obvious and unavoidable: when governments are in charge of economic capacity, economic growth and human well-being languish; when private civil society is in charge of economic capacity, economic growth and human well-being flourish. If the history of the past two hundred years has shown us anything, it has shown us that.
MMT, if implemented, would simply remove the brakes from the process of government’s inexorable encroachment on private initiative and personal economic sovereignty. Ultimately, that would be the opposite of what history tells us is best for human welfare.
Investment implications: Investors should be aware as ideas like MMT begin to enter mainstream political discussions and influence the viewpoints of elected officials. It is unlikely that MMT will suddenly gain decisive influence; more likely, it could gradually change political attitudes towards monetary policy and enable more radical prescriptions in the event of future financial dislocations. As we have written in recent letters, the current rally in gold feels to some analysts like an initial harbinger of a coming change in the economic and monetary environment that has characterized the post-crisis period. Clearly, gold will be a beneficiary if ideas like MMT begin to influence the political environment more deeply. As we have long noted, while stocks are the undisputed leaders of wealth creation in the long term, gold can provide indispensable wealth protection when the environment becomes more hostile, and at such times, investors neglect a gold allocation at their peril.
The U.S.: Stocks, Gold, Cryptos
Since we wrote last week, a trifecta of disappointing Fed communication, trade-war escalation, and self-reinforcing recession fears have accompanied an S&P 500 decline of about 4.7% as of this writing, and a strong rally in bonds (as interest rates decline) and gold.
The correction was not a surprise, and given the strength of the U.S. stock market thus far in 2019, many technical analysts were calling for a decline to relieve its overbought condition. We have been increasing cash positions for clients since July in anticipation of such a correction; we have been increasing gold positions for many months.
We have taken some profits in gold for our more tactically oriented clients. We believe that gold will likely correct near-term, but that longer-term it can move much higher. We have noted that during the current correction, bitcoin has performed less like a risk asset, and has risen with gold, while in previous corrections, it has often declined with stocks. We watch bitcoin’s behavior during stock-market corrections closely to judge the psychology of investors and speculators surrounding cryptocurrencies. So far, it has not been a consistent risk-off performer.
Current investor psychology is turning from regarding gold simply as an inflation hedge, to regarding it as more of an all-purpose “stupidity hedge” against the ill-considered actions and policies of governments and central bankers.
While we have been stating for some time that investors should begin to give more attention to gold and their gold allocation, we are not fundamentally bearish on U.S. equities. The present correction may become deeper, but economic and financial conditions in the U.S. remain strong, and as Bank of America analyst Savita Subramaniam notes, thus far, earnings are holding up and we have not entered an “earnings recession” like that of 2015.
Therefore, as the correction unfolds, we will use the opportunity to add to positions — for growth-oriented clients, primarily in tech-related growth names, and for income-oriented clients, in attractive, solid dividend-yielding stocks.
Outside the U.S.
From our perspective, the U.S. remains “the only game in town,” for now. In the long run, opportunities may emerge, particularly in India and Brazil, but under current conditions, we see no compelling reason to diversify globally. Trade and growth concerns weigh everywhere — trade in emerging markets, and growth in Europe.
Thanks for listening; we welcome your calls and questions.
Equities Contributor: Guild Investment Management
Source: Equities News