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MMT works until it doesn't

Modern Monetary Theory assumes that the Fed can purchase all Treasuries with no consequences. But the risk-free asset is used to price all private sector assets such as the S&P500, IG, and HY credit. Put differently, the result of the Fed buying all Treasuries – and now also IG and fallen angels – is that the Fed ends up controlling all asset prices. As a result, pricing in stock markets and bond markets no longer reflect the true default risks of individual assets. And if prices of government bonds, credit, and equity are no longer a correct reflection of the true default risk in these asset classes, then it ultimately increases the likelihood that investors, including foreigners, no longer want to buy any public or private sector asset in the country doing MMT. Looking at it from the finance textbook, MMT assumes that undermining the assumptions about what a risk-free asset is will have no consequences for the currency and demand for private sector assets. As we know from history, countries that have monetized their debt have not only seen consequences for government bond interest rates but also for demand for private sector equity and credit, including from foreigners. In short, if you assume that investors don’t care about whether the price of Treasuries, credit, and S&P500 is a true reflection of the underlying default risks, then MMT works. Or rephrasing the old IMF saying about countries growing government debt levels: MMT works until it doesn’t.

Deutsche Bank