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Modern money theory, or MMT, is a way of looking at the modern money system. Although referred to as a theory, the concept is based on actual practice. MMT was formulated by economists who study the monetary mechanics of the economy. It is based on how the money system functions in the real world vs. how it should function based on a textbook description.

Many MMT concepts run counter to the conventional wisdom. Like any economic theory, it is complicated and controversial. But, for contrary investors, there are ways to apply MMT in order to make more accurate investment predictions and better investment selections.

Making Predictions With MMT

Investors will find MMT helpful in deciding when to go long and short in the bond market, when to expect economic growth or economic decline, and when to expect inflation in the economy. For example, conventional wisdom says it makes financial sense to balance the government budget, but MMT proponents say it only makes sense at full employment. At less-than-full employment the lower spending starves the economy of need private capital, while at more-than-full employment it can raise inflationary pressures.

MMT economists point to the recession of 2001 as evidence that Clinton-era budget surpluses starved the domestic economy of private capital and lowered growth (see Exhibit 1). Investors with an MMT mindset would not have been bullish about the economy in 1999 when the surplus started, and would have prepared for possible drawdowns in financial markets.

Exhibit 1: Change in Federal Surplus or Deficit Vs. GDP. The government goes into surplus (red line, left side) in 1998 and two years later the GDP drops (blue line). In 2001, the surplus starts to decrease and the economy rebounds.

Click to enlarge images.

MMT economists believe that government austerity is deflationary. If the government is putting less into the economy and taxing more out, there will be inadequate private capital in the system to drive up prices.

Modern Monetary Mechanics

In a sense, MMT should be called "modern money practice" because it is less a theory than a way of looking at the how modern monetary mechanics work in practice. As Yogi Berra said, "In theory there is no difference between theory and practice. In practice there is." MMT is a complex subject. Investors who want to learn more can read this. The strength of MMT for investors is that it is driven by actual money flows instead of ideology.

There are two important MMT concepts that can be applied when making investment predictions and selections:

No. 1: The U.S. Government Is Self-Funding

Economics textbooks assume the government borrows money from private citizens and then spends the borrowed money. When the government does this, there is less money for private businesses to borrow. This competition for money pushes interest rates upward.

In practice, when the government spends money it issues checks and the new government checks get deposited in banks. These checks raise the level of bank reserves. Banks don't want to hold low-interest reserves, so the banks swap the reserves with the government for interest-bearing Treasury bonds. In this process, the government prints money and puts it into the economy. Then it issues a bond and sells it to the bank in exchange for the money it just spent. In completing this transaction, the government borrows back the money it just spent.

Therefore, the federal government is in practice self-funding. It pays interest to the bondholder, but through a sort of slight of hand it gets the money from itself, not from private citizens. (This applies only to governments that put their names on their currencies not to state governments or euroland governments, neither of which have their own currencies -- e.g., there is no Greek currency or Montana currency.)

Imagine going to the bank and depositing $10,000 and at the same time taking a loan out for $10,000. Now you have your $10,000 back and a loan. That's what the government does -- it prints the money, deposits it into the economy, and takes out a loan. In the past, people have complained that this makes no sense -- but that's a different story. And it is immaterial for investors because this is how we do it in our modern economy.

No. 2: Banks Are Self-Reserving

In textbooks, banks loan out a fraction of their deposits. Each loan is backed by a small portion of the banks' deposits -- a reserve. Currently, banks are required to keep reserves. But, in practice, the amount of required reserve is miniscule and there is a significant time lag from when the bank makes the loan to when it must account for the reserves.

If you borrow money to buy a car, the bank gives you a check, you give the check to the dealer for the car, and the dealer deposits the check in the bank that night. When the dealer deposits the check, new bank reserves are created. The banking system now has the money to meet its reserve. (Also, if the bank doesn't have reserves, it can borrow the money from the Fed.) In practice, banks are self-reserving. Banks can loan as much money as they have creditworthy customers to borrow it.

Contrary investors can profit from these insights in many ways. Here is one example:

Deficits Lower Interest Rates

The conventional wisdom says government borrowing puts upward pressure on interest rates by competing for money with the private sector. But if governments are self-funding and banks are self-reserving, there is no actual mechanism to cause this. In our current system there is no shortage of money for creditworthy companies, and therefore government borrowing can't crowd out private investment.

MMT economists point out that when the government writes a check to pay a government supplier, the money gets deposited in a bank, usually that night, and forms new bank reserves. Since banks don't need reserves to make loans, the banks buy Treasury bonds to get interest income. This increases bank demand for treasury bonds.

Increased demand for bonds means more reserves bidding on Treasuries. The added demand pushes bond prices up and interest rates down -- not up. This is the opposite of what is commonly believed. As evidence of the MMT point, notice the correlation between interest rates and debt level in Exhibit 1 (above) in the United States and Exhibit 2 (below) in Japan. In both cases, as the debt levels rise interest rates decline. If the government is crowding out the private sector, why aren't borrowing rates rising?

For investors, the competing theories form two opposite predictions. Facing higher government debt, a textbook investor would go short treasuries, believing interest rates will rise as private investors are crowded out of the capital market. An MMT investor would go long, believing the deficit would push rates down as increased bank reserves raise the demand for treasury bonds.

The textbook theory was behind Bill Gross' failed bet against the treasuries and forms the basis of many hedge fund manager's bets against Japanese government bonds. The Japan bet has failed on such a reliable basis that the wager is referred to as "The Widowmaker Trade."

Exhibit 2: Federal Debt (Blue) Vs. One-Year Treasury Rate (Green): Interest Rates Decline as Debt Increases

Exhibit 3: Japanese Gross Government Debt (Red) Vs. One-Year Yen Interbank Rate (Red): Notice the overall decline of interest rates and the reaction of interest rates in 2005 to the debt contraction.

Actionable Ideas

Under the MMT framework, increasing government deficits are generally bullish for long-term bonds (NYSEARCA:TLT), (NASDAQ:VGLT), (NYSEARCA:EDV), (NYSEARCA:ZROZ), and (NYSEARCA:PLW). Deceasing deficits are bearish for long-term bonds.

Government austerity driven by lower spending and higher taxes will slow the economy by limiting private capital needed for economic expansion. The reduced capital is generally bearish for sectors dependent on strong economic growth like consumer durables and discretionary items such as (NYSEARCA:XLY), (NYSEARCA:VCR), (NYSEARCA:RCD), and construction (NYSEARCA:PKB) and homebuilders (NYSEARCA:XHB).

Reduced private capital resulting from government austerity can also be disinflationary as less capital chases the available goods. This will be suggest lower allocations to inflation protected bonds (NYSEARCA:TIP), (NYSEARCA:IPE) and (NYSEARCA:TIPZ).

Disclaimer: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.

Source: How To Make Money With Modern Money Theory