In this era when there are many undocumented and misguided views on monetary policy, there is one that’s really infuriating: modern monetary theory science fiction.
One of its main principles is based on a fallacy: “A country with monetary sovereignty can issue all the debt it needs without default risk.”
First, that is untrue. A report by adviser David Beers at the Bank of Canada identified 27 monetary sovereigns involved in local currency defaults between 1960 and 2016.
Beers explained: “A long-held view by some investors is that governments rarely default on local or domestic currency sovereign debt. After all, they say, governments can service these obligations by printing money, which, in turn, can reduce the real burden of debt through inflation and dramatically so in cases like Germany in 1923 and Yugoslavia in 1993–94.
“Of course, it’s true that high inflation can be a form of de facto default on local currency debt. Still, contractual defaults and restructurings occur and are more common than is often supposed.”
A country with monetary sovereignty can’t issue all the debt it needs without default risk. It needs to issue in foreign currency because few trust their monetary policies. Most local citizens are the first ones to avoid domestic currency exposure and buy U.S. dollars, gold or cryptocurrencies, fearing the inevitable.
Most governments will try to cover their fiscal and trade imbalances by devaluing their currency and making all savers poorer.
“A country with monetary sovereignty can issue all the currency it needs” is also a fallacy.
Monetary sovereignty isn’t something government decides. Confidence and use of a fiat currency aren’t dictated by government, nor does it give said government the power to do what it wants with monetary policies.
There are 152 fiat currencies that have failed due to excess inflation. Their average lifespan was 24.6 years, and the median lifespan was seven years. In fact, 82 of these currencies lasted less than a decade, and 15 of them lasted less than one year.
Given that the world of currencies is a relative one, the average citizen of the world will prefer gold, cryptocurrencies, U.S. dollars, or euros and yen, rather than their own currencies.
Why is this? When governments and central banks worldwide try to implement the same mistaken monetary policy of the United States and Europe or Japan, but without their investment security, institutions and capital freedom, then they fall into their own traps. They weaken their own citizens’ trust in the purchasing power of the currency.
The modern monetary theory answer would be, all that is needed is stable and trustworthy institutions. That doesn’t work either.
Too Much Spending
The first crack in that trust is currency manipulation to finance bloated government spending. The average citizen may not understand currency debasement but certainly understands that their currency isn’t a valid reserve of value or payment system. The value of a currency is not dictated by the government, but rather by the latest purchase agreements made with such means of payment.
Governments always see economic cycles as a problem of lack of demand that they need to “stimulate.” They see debt and asset bubbles as small “collateral damages” worth assuming in the quest for inflation. In addition, crises become more frequent while debt soars and recoveries weaken.
The imbalances of the United States, eurozone, or Japan are also evident in weak productivity growth, high debt and diminishing effectiveness of policies.
Countries don’t borrow in foreign currency because they ignore modern monetary theory science fiction. They borrow because savers don’t want government currency debasement risk, no matter the yield. The first ones that avoid domestic currency debt tend to be domestic savers and investors because they understand the history of purchasing power destruction of their governments’ monetary policies.
Some 48 percent of the world’s $30 trillion in cross-border loans are priced in U.S. dollars, up from 40 percent a decade ago, according to the Bank of International Settlement. Again, this isn’t because countries don’t want to issue in local currency. It’s because there is little real demand.
As such, governments can’t unilaterally decide to issue “all the debt they need in local currency” because of the widespread lack of confidence in the central bank or the governments’ perverse incentive to devalue at will.
As reserves dry up and citizens see that their government is destroying the purchasing power of the currency, the local savers have to listen to politicians talk about “economic war” and “foreign interference,” but they know what really happens. Monetary imbalances are soaring, and they run away.
Inflation isn’t solved with more taxation.
Many modern monetary-theory proponents solve this equation of inflation caused by monetary excess, denying that inflation is always a monetary phenomenon. They say that inflation could be solved by taxation. Isn’t that a fantastic idea?
The government benefits from new money creation, massively increases its imbalances, and blames inflation on the last recipients of the new money created, savers and the private sector. It solves inflation created by government by taxing citizens again. Inflation is taxation without legislation, as Milton Friedman said.
First, the government policy makes a transfer of wealth from savers to the political sector, and then, it increases taxes to solve the inflation it created. Double taxation.
How did that work in Argentina? That is exactly what governments implemented, only to destroy the currency, create more inflation and send the economy to stagflation.
These two factors—inflation and high taxation—negatively impact competitiveness and ease to attract capital, invest and create jobs. They relegate a nation of enormous potential, such as Argentina, to the final positions of the World Economic Forum index, when it should be at the top.
Excessive inflation and high taxes are two almost identical factors that hide an excessive public expenditure that has acted as a brake on economic activity. It isn’t considered a service to facilitate economic activity but as an end unto itself.
The consolidated public expenditure reached 47.9 percent of GDP in 2016, a figure that is clearly disproportionate. Even if we consider primary public expenditure, that is, excludes the cost of debt, it doubled between 2002 and 2017.
The idea that a country’s debt isn’t a liability, but simply an asset that will be absorbed by savers no matter what, is incorrect since it doesn’t consider three factors:
- No debt is an asset because a government says so, but because there is a real demand for it. The government doesn’t decide the demand for that bond or credit instrument; savers do. Savings aren’t unlimited, hence deficit spending isn’t endless, either.
- No debt instrument is an attractive asset if it is imposed on savers through repression. Even if the government imposes the confiscation of savings to cover its imbalances, the capital flight intensifies. It’s literally like making a human body stop breathing in order to conserve oxygen.
- That debt is simply impossible to assume when the investor and saver knows that government will destroy purchasing power at any cost to benefit from “inflating its way out of debt.” The reaction is immediate.
The socialist idea that governments artificially creating money won’t cause inflation and the supply of money will rise in tandem with supply and demand of goods and services is simply science fiction.
Government doesn’t have a better or more accurate understanding of the needs and demand for goods and services or the productive capacity of the economy. In fact, it has all the incentives to overspend and transfer its inefficiencies to everyone else.
As such, like any perverse incentive under the “stimulate internal demand” fallacy, the government simply creates larger monetary imbalances to disguise the fiscal deficit created by spending and lending, without real economic return. That creates massive inflation, and economic stagnation as productivity collapses, impoverishing everyone.
Currency strength and real long-term demand for bonds are the ultimate signs of the health of a monetary system. When everyone tries to play the Fed without U.S. economic freedom and institutions, they only play the fool. Monetary illusion may delay the inevitable—a crisis—but it happens faster and harder if imbalances are ignored.
However, when it fails, the modern monetary-theory crowd will tell you that it wasn’t done properly. And that it’s you, not them, who don’t understand what money is.
Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.