An old trick well done is far better than a new trick with no effect ― Henry Houdini
Children possess an extraordinary capacity for boundless imagination, effortlessly transforming the ordinary into the extraordinary. Their minds are like fertile playgrounds where creativity flourishes without the constraints of conventional limits. From cardboard box spaceships to sprawling blanket forts that become secret kingdoms, children can turn any space into a realm of adventure and enchantment.
Through imaginative play, children explore complex emotions, experiment with social roles, and solve problems in ways that are both meaningful and enjoyable. A simple backyard can transform into a jungle teeming with exotic creatures, or a living room can serve as the stage for an epic quest to save the kingdom from dragons and villains.
One fictional character that embodies this attitude almost perfectly is Pippi Longstocking, a beloved creation of Swedish author Astrid Lindgren. Pippi is a spirited, unconventional young girl with a wild imagination and incredible strength. She is recognized for her distinctive appearance, including her fiery red pigtails sticking out sideways, mismatched stockings, and freckled face.
Pippi lives alone in a colorful house called Villa Villekulla, apart from her pet monkey, Mr. Nilsson, and her horse, Little Old Man. She enjoys a free-spirited lifestyle filled with adventures and mischief. Pippi's unconventional upbringing and lack of adult supervision allow her to live on her terms, doing things that most children can only dream of.
Her wild imagination is perfectly captured in the German version of the TV show's theme song, which differs from the Swedish original. In Swedish, Pippi declares, "I do as I please, I'm not a nice girl." In German, she sings "Ich mach mir die Welt, widewidewie sie mir gefällt," which roughly translates to "I make the world the way I like it."
Turning to economics, when I hear, "I make the world the way I like it," my mind leaps to Modern Monetary Theory. Despite numerous economists debunking the claims made by proponents of MMT and its predecessor, Georg Friedrich Knapp's "Chartalism," the theory has steadily gained popularity in recent years. Remember what Houdini said?
While it's unsurprising that those lacking economic literacy would be drawn to such theories, it's somewhat unexpected that they have also garnered support from individuals active in financial markets. However, in most cases, this support is not wholehearted. Instead, a growing number of people are selectively adopting certain aspects of MMT to reinforce their narratives. While some claims are outright wrong, others may seem logical in theory but lack empirical support when tested. In some instances, the relationship may appear intuitive, but reality proves to be far more nuanced. Often, assertions that "this time is different" have historically proven to be misguided.
This week, one of the assertions made by proponents of MMT once again came into focus. According to MMT proponents, countries can accumulate debt sustainably in their domestic currency without significant consequences. Considering this, let's examine recent events in Japan.
The Japanese yen faced renewed pressure, with its exchange rate reaching 160 yen to 1 US dollar on Monday morning before experiencing a sudden decline, causing the USD/JPY pair to drop to 156 in less than an hour. Although not officially confirmed, the Financial Times reported that some traders indicated this move showed signs of intervention by Japanese authorities.
Consequently, the yen is now trading at levels seen over 30 years ago, in the second quarter of 1990. Since 2012, the yen has depreciated by 50% against the dollar, highlighting flaws within MMT, which suggests that governments can engage in reckless borrowing without repercussions as long as there's no inflation.
The Japanese case is particularly noteworthy because Japan borrows in its own currency, unlike Argentina and Turkey. While the outcome may resemble those of Argentina and Turkey, MMT proponents argue that these countries' situations do not disprove MMT because they hold most of their debt in US dollars. Japan demonstrates that the outcome does not differ when countries borrow in their currency, which they can print.
The reason for this is quite apparent: initially, expanding the supply of currency units leads to depreciation against other currencies, while domestic users continue to use the yen as a store of value. However, as the government increasingly finances itself through the printing press, more citizens reconsidered and began to store their savings in other currencies or tangible assets, such as gold, further devaluing the currency.
Recent economic developments highlight the escalating challenges posed by diverging monetary policies between a country adhering to MMT and a nation whose currency is widely used in international trade. While the ECB and the Fed raised interest rates in previous years, the Bank of Japan continued its path of monetary expansion, quantitative easing, and yield curve control.
From the beginning of the year until Monday, when the yen reached its year-to-date lows, it depreciated by approximately 8% against the euro and 11% against the dollar. This depreciation reflects diverging market expectations regarding the future trajectory of monetary policy. In January, market participants initially anticipated more interest rate cuts in the euro area and especially in the US, whereas the Bank of Japan did not signal a commitment to tightening monetary policy.
Consequently, the widening yield differential made selling yen and buying dollars more attractive to capitalize on higher yields. This situation parallels the causes of the Asian Financial Crisis, which raises doubts about the claims of the MMT advocates. They can only argue that MMT would only be effective in the country that produces the world's reserve currency.
Considering the current monetary policy environment, the yen's weakness is primarily a result of policies adopted abroad. It is reasonable to conclude that the yen will continue to face pressure as long as the US maintains interest rates at current levels. If the Fed raises rates again, this pressure should intensify; conversely, if the Fed cuts rates further, the yen should benefit more because the Bank of Japan has less room to ease with interest rates at 0.1%.
Despite this, I am concerned that the MMT proponents will persist in arguing that MMT-like policies do not cause Japan's situation and will come up with further excuses to dissociate the recent fall of the yen from MMT. This tendency is characteristic of MMT discussions, as exemplified by a Stephanie Kelton post on X regarding current inflation numbers in the US.
In her post, she asserts that the numbers support the claim that higher yields lead to higher consumer price inflation. However, inflation has decreased substantially since the Federal Reserve began hiking interest rates. An increasing number of financial market professionals have echoed this claim, borrowing it from MMT proponents.
The argument hinges on the theoretical premise that higher interest rates increase interest income for holders of interest-bearing assets, enabling increased consumption, which drives demand, prices, and GDP higher. However, I have consistently challenged this argument by pointing out that the share of interest income relative to GDP and broad money supply appears too small to impact the price level significantly.
Bob Elliot from Unlimited Funds published research this week examining this claim and analyzing changes in interest income for households and corporations. He found that interest income increased by roughly $300 billion since 2022, whereas nominal GDP increased by $3.6 trillion, supporting my contention that the impact of higher rates on GDP is minimal.
Furthermore, this underscores that plotting correlations on a chart does not necessarily imply a causal relationship or indicate that the effect is as robust as it appears. Nevertheless, in our current era of quantitative analysis, there is a tendency to identify correlations and incorporate them into trading strategies. While this may yield positive trading results, it does not necessarily constitute sound economic theory.
Another example is the correlation between liquidity changes and stock prices. Initially, the relationship may appear straightforward, as rising liquidity typically translates into increased demand for risk assets, while reduced liquidity has the opposite effect.
However, upon closer inspection of the relationship between US liquidity and stock price movements, the correlation is not as evident as some claim. It is noteworthy that the correlation has strengthened since the beginning of the QE era compared to the early 2000s when US liquidity remained largely constant.
The takeaway is not that markets are unaffected by liquidity levels but rather that the relationship is not as straightforward as many assume. For instance, before the GFC, stock market movements showed little correlation with changes in liquidity. However, this correlation increased post-GFC, following the Federal Reserve's interest rate cuts to zero and the implementation of QE.
What's intriguing is that the correlation appears more pronounced during periods of falling or negative liquidity growth rates. In such cases, risky assets come under pressure as investors respond to shrinking liquidity by selling risky assets and increasing their holdings of safer assets to reduce portfolio risk.
Moreover, it's not surprising that the correlation strengthened during the era of NIRP and QE, as these policies pushed investors further along the risk curve. Riskier assets become more appealing when safe bond investments yield less (lower interest income).
However, even stabilizing the liquidity growth rate seems sufficient to prompt investors to increase exposure to risk assets. During the 2010s, stock market gains often preceded liquidity increases, suggesting that these liquidity expansions were driven by improving sentiment rather than vice versa.
Additionally, this phenomenon was partly driven by interest rate levels, raising questions about whether the effect will remain as pronounced in an economic environment with higher interest rates. Economic sentiment appears to play a more prominent role than liquidity changes, with shifts in liquidity often reflecting changes in sentiment.
Although changes in liquidity do impact markets, the specific beneficiaries depend on market participants' decisions, which are shaped by their expectations of future market conditions and their subsequent purchasing actions. Currently, the spread between liquidity growth rates and the S&P index resembles highs seen before the GFC, potentially signaling diminishing stock market returns.
That aligns with the thesis that the economy is currently in a phase where financial markets trade sideways around their current highs. The US economy seems robust enough to withstand current interest rate levels, with job market indicators showing no signs of imminent weakness. However, notions that the US Treasury and the Fed can manipulate markets like characters in a chess game appear more fictional than realistic, given the complexities of human action.
Moreover, recent US CPI data have reduced expectations of future rate cuts and prompted suggestions that the Fed may need to raise rates to combat inflation. Nonetheless, this week's FOMC meeting did not indicate a shift towards rate hikes.
As expected, the Fed maintained interest rates at current levels but made interesting changes to its statement. Notably, the Fed announced a reduction in the pace of balance sheet reduction from $60 billion to $25 billion per month. While market participants anticipated tapering, the extent of the tapering was more significant than expected, given the market reactions post-announcement.
This raises the question of why the Fed is reducing its balance sheet reduction pace if the economy is performing as well as the data suggests. Speculation aside, one might wonder if the Fed possesses additional data than the general public.
While this remains speculative, Powell's comments did little to dispel such notions; in fact, he acknowledged the solid pace of economic growth and the prolonged return of inflation to the 2% target, yet the Fed is proceeding with balance sheet tapering starting June. If economic conditions are favorable, why alter the current course?
Additionally, Powell reiterated remarks from previous press conferences, emphasizing that the Fed would not hesitate to cut interest rates if the job market significantly weakened. Although this may appear coincidental, a pattern seems discernible, despite last month's Nonfarm Payrolls suggesting otherwise about labor market weakness.
Further, this week's Employment Cost Index pointed in a similar direction, rising from 0.9% to 1.2% instead of the expected 1%. This development sparked bond sell-offs and fueled speculation about potential interest rate hikes, a scenario Powell dismissed. Surprisingly, Powell did not mention this data in his statements.
Instead, Powell referenced the Indeed wage growth tracker, indicating continuous declines in wage growth. He also cited the JOLTS job openings data released earlier that day, which showed lower-than-expected job openings in March, reaching their lowest levels since 2021. Could this explain Powell's reassurance that the Fed is ready to act if the labor market “unexpectedly” weakens further? After all, historically, lower job openings tend to lead to lower Nonfarm Payrolls. Will this time be different?
Nevertheless, it's worth noting that there were significant lags between job openings and Nonfarm Payrolls in the previous two downturns. Therefore, it remains unclear how long it will take, but given that job openings peaked in March 2021, the convergence may occur sooner rather than later, possibly by the end of this quarter or the next.
The common counterargument is that government spending will persist and sustain nominal growth and inflation, utilizing "MMT-ish" arguments. However, there are two issues with this claim. First, the incremental benefit of government spending on GDP growth is diminishing.
I would argue that the recent robust growth was primarily driven by the money the Fed injected into the economy in early 2020, which stimulated income and spending. While government spending did contribute, it was largely financed through indirect debt monetization.
At the moment, government spending cannot be highly inflationary because it is not financed through direct money creation. Without Fed involvement, government spending is typically funded through taxation or borrowing. In both cases, it represents a zero-sum game, although it can be contended that the money taken from investors is redirected from financial markets to the real economy. However, most government borrowing consists of treasury bills with short durations (up to 12 months), considered nearly as liquid as cash and readily available for consumption.
Given the historical track record of government spending, it is reasonable to assume that the costs outweigh the benefits and that governments make poorer investment decisions than individuals. Ironically, this also refutes another assertion from MMT—that debt monetization is inconsequential as long as "idle resources" are utilized.
The fundamental issue lies not in the availability of "idle resources" but in whether they are utilized efficiently, with public servants having a skewed incentive structure to optimize their use. Thus, yet another claim advanced by MMT crumbles under scrutiny, undermining the theory's foundations.
Shed my skin. Take me from my home.
I give all I am. I give all I own.
Shed my skin. Steal my heart again.
Take from me my bones.Make Them Suffer - Bones
Have a great weekend!
Fabian Wintersberger
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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.