The 'Magic Money Tree'

An incredible 15-year winning streak... Yet this expert's unorthodox theory is often ridiculed in the financial world... The 'Magic Money Tree'... Why governments will never 'run out of money'... The true constraint on their borrowing power... An unprecedented deficit... This trend will continue no matter who's in charge...

Imagine running a hedge fund and never booking a loss...

That's exactly what Warren Mosler did for 15 years.

In 1982, Mosler co-founded the investment firm Illinois Income Investors. (Later, the company changed its name to III Capital Management.)

With Mosler at the helm, the firm went on an incredible winning streak... It didn't book a single losing trade from its inception through 1997, when he ceded control to his partners.

Despite his remarkable run, I bet many Digest readers have never heard of Mosler.

That's because Mosler never produced eye-popping returns. He lacked the 20% or 30% annualized returns that have made some hedge-fund managers – like George Soros or David Tepper – famous.

Still, Mosler's track record is impressive...

Under his leadership, III specialized in fixed-income arbitrage and produced annualized "alpha" – its returns above short-term interest rates – of around 6.5%. That may not sound like much. But if you can beat your benchmark by 6.5 percentage points a year for 15 years... you'll do very, very well.

And since the trades were hedged, III's risk-adjusted returns were astounding. Managed Account Reports Hedge – a publication focusing on the hedge-fund industry – ranked III's risk-adjusted returns No. 1 in the world for the 10-year period ending in 1997.

Mosler is a bond-market expert who understands everything about how the monetary system works. He even helped develop a theory – "Modern Monetary Theory" ("MMT") – based on the principles that guided his no-loss trading.

Yet today, Mosler's theory is often ridiculed in the financial world. Some skeptics even pejoratively refer to it as the "Magic Money Tree" because they think it implies that the government can spend unlimited amounts with impunity.

In today's Digest, I (Alan Gula) am going to explore this apparent contradiction: how one of the world's most successful investors can be derided so widely. As investors – and voters – we owe it to ourselves to understand Mosler's framework... whether we agree or not with the implications.

In 1976, at age 27, Mosler joined Bankers Trust...

The New York-based merchant bank provided financial services to companies and institutions. At Bankers Trust, Mosler was an assistant vice president responsible for the sales and trading of Government National Mortgage Association ("Ginnie Mae") securities.

Working on a "rates" desk, Mosler studied the Federal Reserve and other central banks around the world. He developed a deep understanding of the mechanics of monetary operations, which is basically the process by which central banks control short-term interest rates.

After leaving Bankers Trust, Mosler applied his insights during his time at III. And then, in the mid-1990s, Mosler sought to formalize his principles into a monetary theory.

In 1994, he met with Bill Mitchell, an economics professor at the University of Newcastle in Australia. Mitchell was one of the only economists in the world who shared Mosler's views of how the monetary system worked.

Drawing upon the work of other famous economists – such as Abba Lerner and John Maynard Keynes – Mosler and Mitchell came up with the framework known as MMT.

We'll explain the basics of MMT in a minute. For now, just know MMT was unorthodox. But it described reality more accurately than conventional macroeconomic models.

Mosler – the man who didn't book a single loss for 15 years – has said he wouldn't have made any money if he traded the markets using mainstream economics principles.

Most important, Mosler avoided the 'widow maker' trade...

In the mid-1990s, Japan's government debt surpassed its annual gross domestic product ("GDP"). And even worse, there was no end in sight for the spiraling debt load as the country started running persistently large budget deficits.

Back then, 10-year Japanese government bonds ("JGBs") yielded around 2%. Given Japan's "unsustainable" debt levels, many macro hedge-fund managers doubted the low yields would last. They believed that Japan's debt was very risky and should be higher-yielding. So they shorted JGBs, looking to profit from rising rates.

However, the trade became known as the "widow maker"... because the inexorable decline in rates continued.

Japan now has an astounding government debt-to-GDP ratio of around 240% – by far the highest level of any developed country in the world. (For perspective, the U.S. has a government debt-to-GDP ratio of 103%.) The Bank of Japan has also bought vast quantities of JGBs through "quantitative easing."

Conventional wisdom holds that Japan has long been bankrupt and is "monetizing" its debt. This should have caused the Japanese yen to collapse and rates to skyrocket.

Yet the yield on 10-year JGBs went negative for much of 2016. It was no anomaly, either... The interest rates on 10-year JGBs have been negative for much of this year, as well.

Mosler's views, which formed the basis of MMT, helped him steer clear of the widow maker.

He knew that some country's governments – like Japan – have far more capacity to run large deficits and issue debt than most people realize. Mosler was onto something...

The constraints imposed by the 'gold standard' are long gone...

Under a gold standard, when a country ran a large budget deficit relative to other countries, gold tended to leave the government coffers. This served to limit excessive spending.

As regular Digest readers know, President Richard Nixon severed the final link between the U.S. dollar and gold in 1971. At that point, the dollar became a "fiat currency" – a government-issued currency that isn't backed by anything.

Mosler recognized that a government that issues fiat currency has a much different financial situation than that of a household or corporation. As he wrote in his book, Soft Currency Economics, in the mid-1990s...

Government fiat money necessarily means that federal spending need not be based on [tax] revenue. The federal government has no more money at its disposal when the federal budget is in surplus, than when the budget is in deficit. Total federal expense is whatever the federal government chooses it to be. There is no inherent financial limit.

I'm sure that last sentence made the heads of many fiscal conservatives explode. But technically, everything Mosler said is true. The government doesn't have to tax first in order to spend. Nor does the government need to borrow money to fund its spending.

Due to a congressional mandate, the U.S. Treasury Department must sell debt to make up for any shortfall between spending and tax revenue. But it's a self-imposed requirement.

Since the U.S. government can effectively create currency out of thin air, it can't "run out of money." Neither can the government of Japan. (The countries in the eurozone are in a different situation. The euro currency union imposes fiscal constraints – similar to that of a gold standard.)

Still, MMT recognizes that governments can't spend without restraint...

Mosler explains the MMT view on taxes in his book, The 7 Deadly Innocent Frauds of Economic Policy...

The government taxes us and takes away our money for one reason – so we have that much less to spend which makes the currency that much more scarce and valuable. Taking away our money can also be thought of as leaving room for the government to spend without causing inflation.

This brings us to the crux of Mosler's monetary theory... Under MMT, inflation is the true constraint.

Basically, a government that issues a fiat currency can borrow as much as it wants as long as some slack exists in the economy. Big budget deficits aren't an issue until inflation rises, which signals that the government has reached its debt capacity.

MMT downplays the dangers of "reckless" government borrowing... After all, federal debt issuance increases the net financial assets of the private sector. Federal debt is a liability of the government. But it's also an asset held by households and corporations.

MMT also downplays the importance of monetary policy... Proponents believe that the level of short-term interest rates is far less important than fiscal policy. In other words, the Fed's influence on the economy is overstated.

You may not agree with these ideas. But it's important to understand that, in a way, the U.S. government is already embracing MMT...

We'll have deficits as far as the eye can see...

About two years ago, the U.S. government lowered corporate and individual tax rates. Tax cuts are effectively fiscal stimulus, just like increased federal spending. And it's unusual to see such strong fiscal stimulus – as the Trump tax cuts provided – after many years of economic expansion.

The unemployment rate declined from about 4.1% at the end of 2017 to a multidecade low of 3.5% in September. It moved slightly higher last month to 3.6%. So from an employment perspective, the stimulus has been successful.

Of course, the Trump tax cuts have also reduced tax revenues, which has widened the budget deficit. The chart below shows the federal budget deficit as a percentage of GDP...

You can clearly see the government surpluses from 1998 to 2000 – during Bill Clinton's presidency. Also notice that the budget deficit tends to blow out during and after recessions (the shaded areas on the chart)... and it usually shrinks as the economy stabilizes and returns to growth.

However, as the chart shows, the budget deficit is now equal to 4.6% of U.S. GDP. This is an unprecedented deficit outside of a recession (or post-recession period).

But remember, according to MMT, these budget deficits are benign since we're not seeing a rise in inflation – at least not in the government's official inflation numbers. Inflation is running at around 1.7% today. That's the year-over-year increase in the core personal consumption expenditures price index, a broad inflation gauge closely watched by the Fed.

Rest assured, MMT's inflation constraint concept will be tested if Trump should be reelected... Deficits of 5% or more will become common. And you should prepare yourself for a 10% budget deficit if there should even be a mild recession.

On the other hand, the Democratic presidential nominee will want to spend even more...

A couple of weeks ago, I attended the Grant's fall conference – a small, exclusive meeting hosted by legendary newsletter writer Jim Grant – in New York City.

Several speakers referenced MMT. Unsurprisingly, none portrayed it in a positive light.

Scott Minerd is the global chief investment officer at asset manager Guggenheim Investments. He said he sees inflation on the distant horizon due to the rising popularity of MMT and a growing laundry list of big-government programs that politicians are supporting. He said, tongue in cheek, "Let's have confidence in our politicians... in their ability to spend money."

Many politicians on the left side of the aisle have taken some of the well-reasoned principles of MMT and extrapolated them to an absurd conclusion...

The government can afford anything and everything.

"Medicare for All," universal basic income, and free college (with student-loan forgiveness). Oh, and the "Green New Deal" – a pet proposal of many Democratic socialist politicians – also calls for a government takeover of the energy and utility sectors.

The point is... no matter who's in office, outsized federal budget deficits are here to stay.

Fiscal austerity is dead, and the U.S. federal debt will continue its upward spiral.

We all better hope that Mosler's MMT is a robust model rather than just some flimsy magic... or else inflation is going to rear its ugly head sooner rather than later.

New 52-week highs (as of 11/5/19): Berkshire Hathaway (BRK-B), iShares Select Dividend Fund (DVY), JPMorgan Chase (JPM), Nuveen Preferred Securities Income Fund (JPS), New Pacific Metals (NUPMF), Invesco S&P 500 BuyWrite Fund (PBP), Invesco High Yield Equity Dividend Achievers Fund (PEY), ProShares Ultra Technology Fund (ROM), AT&T (T), TAL Education (TAL), and ProShares Ultra Semiconductors Fund (USD).

In today's mailbag, two Digest readers share their thoughts on the question we posed yesterday: Will you stay in stocks through the end of the year? As always, send your answers – or any other comments and questions – to feedback@stansberryresearch.com.

"Yes, but I am hedging my bets with covered calls suggested by [Retirement Trader] and buying discounted bonds as suggested by Stansberry's Credit Opportunities. It is difficult to know how long this bull market will last or how fast the market could drop." – Paid-up subscriber Jim B.

"Big thumbs up on stocks but also have eight bonds recommended in Stansberry's Credit Opportunities, and 10 put/call options from Advanced Options and Retirement Trader." – Paid-up subscriber Nicholas P.

Regards,

Alan Gula
Baltimore, Maryland
November 6, 2019