The seeds of Modern Monetary Theory (MMT) were laid a century ago and have sprouted into a formidable tree of inflation. It is a tree which the Fed wants to chop down, one which casts its inflationary shadow over the economy. But the odds of any long-term solution are low since the structure of the dollar feeds the inflationary pressures in the economy.
Controlling the effects of the political push to implement MMT, now solidly in place, will be a difficult problem. Both fiscal and monetary policy shifts of substantial magnitude will be demanded. The popularity of MMT has helped balloon the national debt to over $33T. How did this happen?
Much of the political establishment believed in MMT. In a certain way, the validity of the Magic Money Tree was confirmed by central bank policy. Under MMT the natural rate of governmental interest is zero. And much of the past few years interest rates were zero. This was explained in part by long-term trends in real rates declining over time.
The principal cause of zero interest rates was that they were politically administered rates set by the Fed, not market rates. In addition, of course a generation of economists and policymakers thought that they were living in a profoundly unusual moment when deficits didn’t matter. They simply ignored a chilling history of countries who have attempted anything like MMT. The list includes Venezuela, Zimbabwe, Yugoslavia, Hungary, and Greece at various times. And of course the Weimar Republic of Germany where a wheelbarrow of Marks bought a loaf of bread in 1923. There is nothing modern about MMT and its legacy is a stern reminder of the dangers—dangers that surround us now.
1971 was a watershed
Chopping the MMT tree down alone will not be enough, though. If we somehow overcome the MMT legacy of debt and deficits we still have to live with the inflationary bias of the dollar. The inflationary roots in our economy are deep and they begin with the dollar and are overlaid by our MMT impulse to rationalize excesses in spending.
The lessons for investors are simple. Expect long-term inflationary biases of around today’s level of inflation and stay alert for some stabilization in digital currency opportunities. A war in the Middle East is sure to exacerbate inflationary pressures even more.
Origins of the fiat currency
In the mid-1960s, the Vietnam War, was raging. Then President Nixon, finally ended any convertibility of the dollar to gold, directly or indirectly. In 1971 the “Nixon shock” terminated the Bretton Woods agreement and the gold standard.
The Nixon change was not arbitrary. There were fiscal imbalances. Economic problems then were dearly felt as they are now. But ending the gold standard didn’t solve the inflation problems. The dollar tied to gold made its use inflexible at times in monetary policy, especially inflationary periods. Without a tie to gold, the government got its monetary flexibility, an inflation issue, and a fiat dollar.
Inflation, as the Bureau of Labor Statistics (BLS) thinks of it, is the general upward price movement of goods and services in an economy. BLS measures inflation in a variety of ways.
The index typically used is the Consumer Price Index (CPI). The CPI captures the monthly change in a basket of goods and services for urban consumers (CPI-U). While its measure can be complex, there is little doubt that inflation in the late 20th Century was an enormous social problem. For those not used to seeing inflation rates in a long-term time series, the data is shocking. Inflation has slipped into higher gear since the dollar delinked from gold and became a fiat currency.
From the founding of the Republic in 1776 to 1971, the purchasing power of the dollar fell by about three and a half dollars. What cost $1 in 1776 cost approximately $4.66 in 1971. So, the purchasing cost decreased by about $3.66. The average inflation rate was 0.79% per year over 195 years of wars and panics.
If we look at the period after the dollar became a fiat currency the results look strikingly different. An item that cost $1 in 1971 cost about $7.60 in 2023, which is an increase of $6.60 over 52 years. This is an average inflation rate of 3.98% per year. This produced a cumulative price increase of about 660% from 1971 to now. This reflects the inflationary bias of a fiat currency combined with MMT. The US dollar is now a fiat currency and legal tender for the country. Its only support is from the government.
Higher for longer
The notion that the Fed will keep interest rates higher for longer, as it is now indicating, just means that inflation can be expected to be higher for longer. For investors this means that even if the Magic Money Tree is felled with fiscal and monetary controls, the likelihood of a deeper set of fiscal controls to manage the fiat currency’s bias to higher inflation seems remote at best. For investors, inflationary expectations should include the fiat currency bias. In the end, controlling inflation may require inventing different types of money like tightly regulated crypto currencies.
1. Fed unlikely to achieve 2% inflation long term.
- Zero interest rates will not return in a market economy.
3. Inflation protection is at a premium.
This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.