Christopher Querée: What does modern monetary theory mean for stewards of charitable assets?

04 Feb 2020 Expert insight

Are we drifting towards a new phase of experimentation within the financial system, asks Christopher Querée.

You can be easily forgiven for being unfamiliar with the term modern monetary theory (MMT). Equally, before 2008, the term quantitative easing (QE) was relatively unknown outside Japan. Yet it would seem that QE is now a regular part of the everyday political and financial lexicon. Indeed, the leader of the UK’s current opposition has called for a people’s QE. The debate as to how policy evolves to address the next phase of socio-economic challenges is moving on and MMT is at the heart of the debate. So what is MMT, how did we get here and what might it mean for you as stewards of charitable assets?

At a basic level, we need to start with the question: what is money? We can agree that money is a creation of the state. The state can be defined as either the central government or an institute of the state such as the Bank of England. Crucial to the understanding of the concept of MMT is the relationship between the government and the central bank. First, I will outline the current and conventional relationship between the two entities then, second, consider the relationship under an MMT framework. In many ways, the differences are as much about perception as structure.  

Conventional wisdom and current practice suggest that if a government spends more than it generates through taxation and other revenue, the resulting deficit must be funded through higher future taxes or increased government borrowing. So, as the government spends more and runs a deficit, the books need to be balanced by borrowing from investors. In turn, the cost of financing this increased debt rises, placing additional pressure on the existing deficit. But is this the only way? This wisdom is now being challenged notably within Democratic party circles and economists in the US and, indeed, by our own Labour party. Here comes the MMT view… 

'MMT recognises that money is the creation of the state'

MMT recognises that money is the creation of the state. The central bank is the bedrock of the interbank system – commercial banks settle transactions between each other through accounts at the central bank. Hence, the financial system relies upon the central bank to create the medium of exchange through which all transactions ultimately settle. Critically, the central bank is de facto also the government’s banker. Decisions by the government to increase spending can be thought of as instructions for the central bank to transmit money to the beneficiary of said spending (via commercial banks). Those beneficiaries are happy being paid in money – banks’ deposit liabilities, which in turn are nothing more than central bank money. Proponents of MMT argue that since the central bank’s balance sheet can be expanded ad infinitum, there is, in theory at least, no technical limit to government spending – inflation is the only binding constraint. This is the magic of double-entry book-keeping in a world of fiat money, which has been referred to historically as fountain pen money.  

So how did we get here? After over a decade of emergency monetary policy from global central banks in the form of minimal, and latterly in some geographies, negative interest rates, there is now much debate as to how the role of the central bank will evolve from here. Since the financial crisis, the toolkit employed by central banks has morphed beyond recognition with QE becoming a mainstream tool actively employed across the world. The old perception of the central bank as the institution that simply sets the policy or base rate has seemingly been consigned to history with pressure for more policy innovation intensifying. If fountain pen money can be used to inject liquidity into the financial markets to purchase government bonds, why not government spending per se. Bring on the people’s QE!  

A transition phase

It would seem that we are now at a transition phase as central banks take a supporting role and central governments increasingly step forward to support the real economy. Adding to this pressure is the vexed question of how the authorities would respond in the next cyclical downturn. The post-crisis recovery has been too muted to allow central banks to meaningfully raise interest rates, leaving little in the cupboard in terms of prospective cuts. Equally, in as much as post-2008 monetary policy response has been successful to a point, the disparity between asset price inflation and real inflation (including wage growth), has made for an increasingly polarised socio-economic order. There is growing support for the notion that MMT is a solution to this disparity, especially within the resurgent radical left wing of the Democratic party in the US. The notion is simply that as the government essentially owns the institution that creates the money that underpins the whole financial system, there is no reason why the central bank cannot simply create new money to directly finance government spending.

As advocates of MMT recently expressed in an article for the Financial Times, “a monetarily sovereign country like the US with debts denominated in its own currency and a floating exchange rate cannot go broke… The only limit on government spending is inflation.” And the latter point is where most traditionalists will hear the DeLorean that takes us back to the future revving up. Can the old methods of government finance (more tax or more debt) during times of unbalanced budgets be bypassed? Some now argue that this is possible without unduly stoking inflation and that suitably targeted government spending will reach the areas of the economy that are largely untouched by QE and low interest rate policies. As in many situations, the answer to the question is perhaps yes, to a point. The point where the magic money tree loses its magic is finely balanced and there are countless historical examples where such experiments have ultimately ended in financial disaster.

So, this is a debate very much worth following. It might be argued that an additional boost to the economy would benefit equity investments held within most endowment portfolios. That said, any hint of a meaningful rise in inflation would quickly be detrimental to bond holdings and, plausibly, equity holdings too. A sense that this money creation might result in anything other than modest inflation could easily de-rate equities as investors lose faith in a government that has lost control of its money supply. The Heath-Barber boom in 1972/73, which preceded Britain’s great inflation, is a fascinating historical case study. It saw a combination of dramatically looser fiscal policy and negative real interest rates. MMT is only a small step from what we saw in this era. Despite the growth surge at the time, equity investors suffered significant losses. As such, is MMT the next big thing? Time will tell, but it is clearly a policy where the stakes are incredibly high for asset owners such as charitable endowments.

Christopher Querée is investment director and head of charities at Ruffer

Charity Finance wishes to thank Ruffer for its support with this article

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