We live in a crazy world. On the one hand, we can observe how the central bank balance sheets are getting bigger and bigger, the national debt exploding and the interest rates hardly move any more. On the other hand, we have noticed that in the midst of the crisis, share prices are skyrocketing, banks are producing excellent annual financial statements and real estate prices are continuing to rise in some places. The question arises: how long can this go on? Put simply, there are three answers: “not much longer”, “unfortunately quite a long time” and “hopefully forever”. So the pessimists, the melancholics and the enthusiasts argue about the correct assessment of the situation. Optimists who believe that humanity will soon return to sustainable economic policies are conspicuously absent from the discussion. Too much speaks against the fact that things will have a happy end.
A powder keg?
Of the three answers, the first is most strongly represented. It predicts that the big reckoning will come soon, because the debt has advanced so far that a small spark will be enough to make the powder keg explode. The arguments of the pessimists are understandable. Private and public debts have risen steadily over the past few decades, and the financial crisis of 2008 impressively demonstrated that too rapid and extensive debt accumulation can have devastating consequences if a wave of bankruptcies occurs. There are many indications that the crazy must be viewed as normal for the time being. It is also right to point out that a prolonged phase of low interest rates enables enormous bad investments. In the past few years, many companies that would have gone bankrupt at normal interest rates have received extensive loans on favorable terms. The same goes for many mortgage borrowers who have bought an apartment or house that they can only afford because of the record-low interest rates. And it applies above all to those states that have not had their budgets under control for decades. Because the annual interest payments no longer matter, they can accumulate more and more debt. Nobody notices it in their wallet, at least not today or tomorrow.
The problem with the pessimistic view, however, is that the long-announced crash has to be postponed again and again into the future. The deeper reason is that the pessimists repeatedly underestimate the power of the central banks. As shown in March 2020, their interventions can stabilize the situation within a few days. The feared wave of bankruptcies among over-indebted companies did not occur. Of course, the massive injections of liquidity will make it even more difficult to reduce the glut of money of the last ten years. But the prognosis that it would only take a small spark to explode the powder keg has not come true. If even a gigantic shock like the corona pandemic could not bring the building to collapse, the system seems to be more stable than the major distortions suggest.
Where's the inflation?
This observation forms the starting point for the melancholy response. It predicts that the crazy world will unfortunately continue to exist for a long time because the phase of low interest rates will continue for a long time. Only when the inflation rate rises significantly would the rules change, because in that case the central banks would have to raise interest rates to keep inflation under control. This would in fact trigger a wave of bankruptcies, but since there are no signs of high inflation, an end to debt is not expected anytime soon. Why is there not inflation long ago when the central banks are printing so much money? The reason is that the additional money created stays in the financial system and does not flow into private or state consumption. The liquidity flows from the central banks to the commercial banks, some of which are used to buy securities and some of which are deposited in the liquidity accounts they have with the central banks. Only when the central banks directly finance current government spending on a large scale, i.e. provide the additional printed notes for the payment of wages and the settlement of bills, will inflation rise rapidly. The famous German hyperinflation of 1923 came about in this way. That is not the case today. The third group, the enthusiasts, cannot take advantage of either pessimism or melancholy. They watch the rising national debt, the low interest rates and the exploding central bank balance sheets not with horror, but with joy. Because for them the economic policy of the last ten years only marks the prologue of the fundamentally new approach to secure growth and full employment in the long term. Modern monetary theory (MMT) forms the basis of their conviction.
Beyond the textbooks
Modern monetary theory rests on two assertions. The first is that a country whose debts are denominated in its own currency can never go bankrupt because it can always finance the national deficit and debt servicing with the printing press. So we shouldn't worry about the growing national debt. We have unlimited leeway here, which we should use to achieve our political goals. The second claim of modern monetary theory is that the state can best control the economy and inflation through tax and financial policies. With deficits, the government can ensure that the economy grows and generates full employment, while with tax policy it can bring inflation under control, if it is necessary at all. So far it has been said in the textbooks that the central bank and its monetary policy are responsible for controlling the economy and inflation. At the MMT, the distribution of roles is exactly the opposite: the government is the decisive body that controls the economy and inflation by means of financial policy, and the central bank is only there to cover the national deficit. The first claim made by modern monetary theory is not entirely false. Countries that can borrow in their own currency actually have more economic policy leeway than countries whose debts are denominated in foreign currencies. But there is nothing more to be gained from the MMT, even if the number of its followers is steadily increasing. Above all, the idea that a government should be able to control the economy and inflation with its financial policy is completely unrealistic, because it was tried before in the sixties and seventies and failed terribly. The experiment led straight to higher inflation. Will modern monetary theory prevail despite its design flaw? That is difficult to imagine, because it can only be implemented if the central banks are completely disempowered. Even the Biden administration, in the vicinity of which the MMT enjoys a certain popularity, should speak out against such an experiment. Janet Yellen, the new Treasury Secretary, was formerly head of the US Federal Reserve and knows about the danger of a politically controlled monetary policy. So it seems that at the moment the melancholy can give the best answer to the question asked at the beginning: Yes, we live in a crazy world, and it can be assumed that it will not last forever. But there are many indications that the crazy must be regarded as normal for the time being.
Tobias Straumann is a private lecturer in economic history at the University of Zurich.
