Henry Chan, Senior Visiting Research Fellow of Cambodia Institute for Coopertaion & Peace.

The September financial market worldwide experienced one of the most volatile months since the Covid lockdown of March 2020. The U.S. dollar exchange rate surged more than 5% based on DXY, and the S&P index dropped more than 5% until September 27. The exchange rate & interest rate transmission mechanism from the global anchor currency, the USD, had caused spillover effects worldwide. The U.S. macroeconomic uncertainty today can be traced to the excesses caused by the unorthodox Modern Monetary Theory.

Modern Monetary Theory (MMT):

MMT is a heterodox macroeconomic proposition that says monetarily sovereign countries that do not need to borrow in foreign currencies to fund deficits are not constrained by revenues regarding government spending. Countries like the U.S., UK., and Japan do not need to follow the spending principle of funding government expenditure by either raising taxes or borrowing. They can create more money to pay off all their deficits without worrying about economic collapse; the only important thing is their central bank keeping interest rates low.

MMT proponents believed that government deficits and national debt don't matter as much as commonly believed. An interesting extension of the MMT is that free lunch is not impossible. It happens when the central bank keeps the real interest rate below the long-term economic growth rate, thus allowing the government to use higher growth-generated tax revenue to repay loans. This unorthodox view allows the government to pursue unfunded tax cuts and spending, disregarding spending constraints and discipline.

The belief in an almighty central bank is exemplified by former Federal Reserve Chairman Alan Greenspan in 2005 when he said," There's nothing to prevent the federal government from creating as much money as it wants."

The quantitative easing (Q.E.) implemented in 2009-2014 helped to resolve the U.S. economy from the Great Recession of 2007-2009 after the bursting of the housing bubble and global financial crisis. The massive monetary easing and the fiscal injection to buy distressed assets and support federal activities during a recession had not caused inflation and gave the proponents of MMT the support for their beliefs.

However, most people overlook that while consumer price inflation in the 2010s was low, a lot of liquidity has gone into the asset market, as witnessed by the S&P index went from 800 in 2009 to more than 2500 at the end of 2019, a rise of more than 200% and one of the best decades for stock investment. In addition, the S&P Case-Schiller Home Price Index went up from 140 in 2010 to 220 in 2020.

Using the MMT tools in the Covid-19 pandemic became fashionable and applauded worldwide. The U.S. alone ran a two-year budget deficit of almost US$ 6 trillion, or more than 30% of GDP in 2020 and 2021.

MMT was a fashionable academic topic at that time. According to Nexis Uni, there were around 5,000 mentions of MMT in the news, academic articles et al. between 2019 and the end of 2021. However, this year, there have only been around 700 mentions. The surging inflation in 2022 turned the fashionable economic idea into the emperor's new clothes.

Inflation surge from MMT:

A good portion of the U.S. Covid deficit went into excess savings of the household and depressed the willingness to work. The term great resignation aptly describes what happened to the U.S. labour market, it is tight, and people easily get new jobs with higher pay. As a result, there are two job vacancies for every unemployed person. The labour force participation[nc1]  today is 1% below the pre-pandemic level of 63.2%, and The 3.7% unemployment rate in August is close to 50 years low.

The excess stimulus also heated the asset market. For example, the S&P Home Price Index went up from 220 before the pandemic to 320 in recent highs, the best in housing history. In addition, the S&P Index went up from the pandemic low of 2300 in March 2020 to more than 4700 at the end of Dec 2021.

Dissecting the August CPI shown that the key drivers behind the 8.3% inflation rate are not so much the result of supply chain disruption caused by lockdowns or energy inflation triggered by the Ukraine War. Instead, it resulted from higher service costs, higher wages, and higher rents from high housing prices. How long will it take the higher interest rate to cool the labour market and how high should it go to turn the situation around are twin questions hanging over the U.S. economy.

The close link between inflation rate and labour market condition is well-established, and the conventional wisdom that productivity provides the solution is proven right again today. Therefore, the promise of MMT that it can be an alternative to replace productivity is simply an illusion.

The reported stress on the central bank balance sheet further doubts MMT.

Record loss at Reserve Bank of Australia (RBA):

RBA announced on September 21 that it had taken a mark-to-market valuation loss on its bond holding of A$44.9 billion (US$30.02 billion) in 2021/2022. The bonds were accumulated under a A$300 billion emergency stimulus programme from November 2020 to February 2022.

The losses eclipsed underlying earnings of A$8.2 billion and left the central bank with an accounting loss of A$36.7 billion. In addition, the RBA equity and reserve fund was wiped out and is in a negative equity position of A$12.4 billion.

All central banks in the world have their liabilities guaranteed by the government, and its legal power to create money means RBA can stay in business. However, the accounting loss still constrains the ability of RBA to pay a dividend to the government in the immediate future.

With the rising interest rate, many central banks worldwide would face similar losses on their emergency stimulus programmes. In July, the Swiss National Bank reported a first-half loss of 95.2 billion Swiss francs, the biggest since the central bank was founded in 1907.

The inability of the central bank to conduct regular monetary operations is nowhere more glaring than the Bank of Japan when it faces depreciating pressure on the yen. The yen depreciated from 115 to a dollar at the start of the year to 145 on September 29 as the country became the only economy with a negative interest rate. Many pundits posited that the whooping 270% debt to GDP ratio left many Japanese banks holding a huge amount of Japanese Government Bond (JGB) on their books. Therefore, a rate increase will likely cause huge mark-to-market loss and technically trigger bank solvency problems. That leaves market intervention as the choice to support the yen in the foreign exchange market. It is reported that BOJ and the Japanese government spent a record $21bn in their first intervention in 24 years to prop up the yen last week.

Ending a conundrum takes skill and luck

The current problem arising from excesses of MMT takes time to unravel, and the immediate task is to stop the financial conditions from deteriorating and spiralling out of control. The unusual IMF warning on the U.K supplementary budget is a good case in point; hoping a tax cut can stimulate economic growth in the face of high debt, high inflation, and low growth has not proven workable in the case of supply-sider economies of the 1980s nor the MMT recently.

Expectation plays a particularly important role in economic adjustment today. It affects consumer spending behaviour and business willingness to invest. For the economy to move away from the prolonged almost zero interest rate environment to the new rate equilibrium that anchors spending and investment decisions is not easy. One should not rely on the market alone; any misstep can paralyze the system once confidence is shaken. Therefore, policymakers should focus on building public confidence in their ability to navigate out of the unsustainable high debt & high inflation dilemma.

A misguided understanding of important economic issues like MMT often causes many excesses that tip the macroeconomic balances. It takes time to rebalance the economy, and policymakers need luck and skill.