In his recent annual letter to shareholders of his company, Berkshire Hathaway, Warren Buffett said something quite remarkable:
Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods. That’s 40,000%! Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To ‘protect’ yourself, you might have eschewed stocks and opted instead to buy 3¼ ounces of gold with your $114.75. And what would that supposed protection have delivered? You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle.
The Oracle of Omaha is challenging one of the basic tenets of modern finance.
We are constantly told that government deficits and debt are bad. We are advised to buy gold to protect against the “inevitable” collapse of the dollar that debt “must” bring.
But as Buffett observes, the historical facts don’t support this belief … at least not in the case of the United States. Deficits have increased, the dollar hasn’t collapsed and gold hasn’t saved anyone yet.
The truth is that deficit-phobia isn’t really about money at all. It’s about the role of government in the economy. Factual or not, fear of budget deficits is a handy tool when you’re opposed to a more activist government.
That ideological bias plays out in a lot of ways … including here on the pages of Sovereign Investor Daily…
Missing the Point
Over the past few weeks, some of my colleagues have written articles about “modern monetary theory,” or MMT for short.
Today I want to reply to them. I feel they misrepresented MMT, and leveled criticisms that reflect a misunderstanding of the theory.
Let’s start with how things work now.
In the U.S. today, the government borrows money to finance any spending that exceeds tax revenues. It does this by issuing Treasury bonds, IOUs that are bought by investors. These bonds are repaid with interest (yield) when they mature.
In this system, government debt is definitely a problem. The more debt the government issues, the higher Treasury bond yields must be to attract more investors.
Those higher interest rates mean the government must spend increasing amounts of money to service its debt. That crowds out other government spending, as well as investment by the private sector. The economy grows more slowly as a result.
Note, however, that our current system of deficit financing through Treasury bonds is separate from the creation of money.
The United States government does not create money. Instead, commercial banks create money when they issue loans. If a bank has $100 in reserves, and it lends me $1,000, it has created $900 out of thin air. That’s where new dollars come from.
What Modern Monetary Theory Really Says
MMT sounds complicated, but it boils down to a simple proposition. When a government issues its own currency, it does not need to “borrow” to finance its spending. It simply creates more currency and spends it.
In an MMT system, government would not issue Treasury bonds to finance deficit spending. That’s because there would be no deficits. The government would simply create more money to buy the goods and services it wants.
“Deficits” only exist in a system where the government uses borrowing to create the resources it needs to spend on goods and services.
So, the first error my colleagues make when they criticize MMT is by carrying over the concept of deficits and debt from today’s system into MMT.
The objection that MMT would lead to increasing deficits and debt is a non sequitur. In an MMT system, the government wouldn’t be borrowing anything, and it wouldn’t be repaying anything.
At one level, that should be uncontroversial. The government is legally empowered to create currency. There is no legal reason why it should borrow to finance spending, instead of simply creating more currency.
Critics of MMT typically don’t acknowledge this point openly. They do it indirectly by switching from concern about debt to concern about inflation.
They say that if the government just creates new money and spends it, inflation will skyrocket. And in our current system, if inflation rises, the Federal Reserve raises interest rates to slow down the economy.
That makes borrowing for everyone, including the government, more expensive. That slows economic growth.
But what critics of MMT invariably fail to mention is that MMT includes a mechanism to do exactly the same thing.
Instead of using interest rates to control the money supply, MMT proposes that government uses taxation to withdraw money from the economy if it gets too hot and inflation begins to rise.
Remember, inflation only becomes a risk if public and private spending outpaces the finite supply of workers and productive capacity in the economy. Our existing system addresses this via interest rates set by the Fed. MMT would address it by using taxation to withdraw money from the economy.
The core argument of MMT theorists is that this would be a much more efficient way of ensuring that the economy reaches and remains at full capacity than under the current system of Treasury bonds, interest rates and bank-created money.
Jousting at a Straw Man
My colleagues have presented a misleading picture of modern monetary theory. They accuse it of things it doesn’t do, based on the way our current system operates — even though that’s what MMT proposes to replace.
Does that mean that MMT is a workable alternative to our current system?
I don’t think so. But the problem isn’t with the theory. It’s with politics.
On paper, MMT should work fine. It would simply accomplish some of the core management activities of the U.S. economy in a different way.
The problem is that there is no way the current American political system would allow a full MMT system to be implemented. Facing lobbying pressure from banks and others, politicians would adopt elements of MMT and try to keep other elements of the current system. That would make things worse.
But even if our leaders did adopt MMT lock, stock and barrel, one thing would doom it: Politicians are great at spending money, and terrible at raising taxes.
No matter what the theory says, in practice, under an MMT system our politicians would do exactly what they do now: Spend hand over fist and cut taxes at every opportunity.
But that’s not a problem with MMT theory. It’s a problem of human nature … and one that afflicts us just as much under our current arrangements as it would under MMT.
Editor, The Bauman Letter