Do you remember MMT? Modern Monetary Theory was supposed to be the solution to everything. Just imagine an economy run by the government backed by limitless resources from the central bank. No challenge would be too large, from climate change to poverty, we could solve it all.
Well, that didn’t last. As H L Mencken put it, ‘Democracy is the theory that the common people know what they want, and deserve to get it good and hard’.
No sooner had MMT caught on, with some of its policies being adopted during the pandemic, did the consequences become obvious. Inflation being the most topical, but there are others.
Now we know what a government controlled economy looks like…
But this sequence of events isn’t new. You can sum up the evolution of monetary orders as ‘It’s all fun and games until someone gets inflation’. Then you get some of the worst financial market returns in history, as we have now.
Today, we explain why this is the case. Why is inflation such a problem?
The way our financial system works is that, whenever there’s a problem, central banks and governments try to solve it.
Bankruptcies, unemployment, recession, sovereign debt defaults, bank runs, and anything else — it’s all the government and central bank’s problem.
As I told the audience at one of our conferences many years ago, ‘Is there any crisis that central banks cannot fix?’
You might’ve thought the pandemic was one. But oh ye of little faith!
Within months of the pandemic breaking out, stock markets, real estate markets, and bond markets were at record highs thanks to central bank and government rescues. Bankruptcies hit record lows instead of highs, and employment broke records too.
In a system of arbitrary money under the thumb of the central bank and government, there need not be any failure. The system can simply be flooded with so much money and so many government guarantees and spending programs that an epic recession barely results in any consequences.
To some, the history of the world seemed to have changed in 2020. We appeared to have uncovered an economic holy grail, with no more economic suffering necessary in the future.
If you take a step back, the pandemic was only the peak moment in this realisation. The past few decades have been all about a gradual realisation of just how powerful the printing press is in solving all our problems.
As each crisis got larger, each government response got larger and they all worked…unless they were to small, as in 2008.
Politicians, central bankers, and every investor (except Lehman Brothers counterparties) slowly realised that there was no real risk of anything going drastically wrong in the economy or financial markets. Especially since the failure of Lehman Brothers would make policymakers think twice about letting the free-market sort things out for a few decades.
And so the presumption that, at the slightest sign of trouble, central banks and governments would just rescue the system was priced into markets. Hence impossibly high share, real estate, and bond prices.
The only fly in this ointment is that, once you overdo it, you get inflation. That is the consequence of relying too much on monetary and fiscal bailouts.
Inflation is so dangerous because it constrains the ability of governments and central banks to continue to bail everyone out. And that’s why markets are off to their worst start to a year since the Great Depression or 1970, depending on how you do the maths.
The rescue mechanism of our financial system may or may not be in operation during the next crisis because policymakers will have one eye on inflation.
But don’t worry, this uncertainty isn’t set to continue. History has another lesson for you.
When push comes to shove, central banks and governments don’t allow inflation to side track them from their true purpose of bailing out the banking system and the government. They always choose to continue inflation over causing a crisis.
The reason why is simple. Consider the incentives they face.
If they tighten monetary policy, we get a depression, political instability, a government default, and plenty more. Sure, inflation comes down, but that’s a rather steep price to pay.
If central bankers keep the government funded, unemployment low, nominal GDP growing, and the political system stable, but inflation rises, is that preferable?
Weimar German central bankers certainly thought so…
What about the ‘70s, then? Wasn’t inflation slain by tight monetary policy back then?
Yes, but this only works at much lower levels of debt. The amount of pain that would be dished out by double-digit interest rates today only proves the impossibility of doing it…without some rather extreme consequences.
I’m a big fan of the public choice school of economics. Ironically, given its name, public choice’s key tenet is that individuals make decisions, not institutions.
The Reserve Bank of Australia (RBA) and Russia don’t do diddly squat. Philip Lowe and Vladimir Putin, however, do. Alongside all the other individuals in those places. Their collective actions might make it appear like an institution, government, or company is taking action. But this is a façade, especially if you want to predict what decisions will be made.
As impossible as it may seem, central bankers respond to the incentives they face as individuals, just like you and I do — not to ‘the greater good’, or institutional mandates, or some other rationale.
So, if you want to know what the RBA will do next, look at the incentives its leaders face, not the institutional structure or the law. It doesn’t matter what the RBA is supposed to do, or is tasked with. It matters what individuals in those institutions face.
Of course, mandates with consequences for breaking them matter to individuals’ incentives. And we like our reputations to be good. But the idea of public choice economics is that you should look at the individuals in charge and the incentives they actually face, not the theory or the law.
‘Show me the incentive and I’ll show you the outcome’, explained Charlie Munger, summing up public choice economics in one sentence.
So, what incentives do central bankers face?
Do they get into any sort of trouble when inflation gets too high?
What about when their tight monetary policy triggers a recession?
As far as I can tell, there are no consequences for inflation. Except the Bank of England’s famous statutory requirement to formally explain away high inflation in a formal letter…
Causing a financial crisis and the insolvency of the government that hired you, and the bank that will hire you after your tenure at the central bank is over, is, on the other hand, not a very good incentive…
My point today is that all incentives point towards keeping governments funded, banks liquid, and employment high. If inflation is the price we pay, well, it’s the lesser of the two evils…as far as the central bankers are concerned. And that’s what matters.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
