Ken Solow   |   January 18, 2012

In my book, Buy and Hold is Dead (Again), I discuss in some detail Woody Brock’s views on the logical justification for active portfolio management. Brock lays out three ways active managers can outperform. First, they can better forecast structural changes in the economy. Second, they can better forecast how investors will react to changes in the news. And third, they can exploit logical errors of inference (accepted notions about how the markets work that later turn out to be wrong).

Recently, a Pinnacle client forwarded me some excellent examples of this, listed in an academic paper. In “Understanding the Modern Monetary System,” Cullen O. Roche writes that Modern Monetary Theory (MMT) describes “a monetary system within a nation operating a fiat currency that involves an autonomous monetary system, monopoly supply of currency and floating exchange rates.” In short, it describes the U.S. monetary system. (And no, most of our clients are not reading papers like this.) While dense, Roche’s work turns accepted economic views upside down.

Here are a few pearls to ponder:

“MMTers tend to view other economists as seeing the world through a largely defunct prism – a prism based on a gold standard world that became inapplicable in 1971.”

“There is no such thing as the state becoming insolvent or not being able to meet its obligations – all of which are denominated in a currency that it alone can create.”

“[Bank] reserves have very little impact on lending operations of banks in the USA. The money multiplier is a mere myth.”

“When the citizens pay their taxes, the government doesn’t ‘have more money.’ After all, they have a computer system that credits accounts and prints up bills. It is impossible for them to ‘run out’ of money. So, from a very technical perspective, it is better to think of the government as never having money.”

“Taxation is essentially a form of maintaining control of private sector spending…. When the U.S. government wants to spend money they simply tell men and women to walk into a room and credit accounts in a computer system.”

“In the MMT, bonds fund nothing. It’s important to note that the bond market is largely a relic of the gold standard.”

And most importantly:

“A government with a monopoly supply of currency in a floating exchange rate system has no solvency risk unlike a nation such as Greece that exists in a single currency system with what is essentially a foreign central bank.”

Someone who subscribes to MMT would be much more comfortable with government debt and deficits than one might be otherwise, and you can see how investors might exploit these logical errors of inference (if the author is correct).

At Pinnacle we will continue to focus primarily on better forecasting the news and investor reactions to it. The one logical error of inference that is most important to us doesn’t involve MMT, but MPT (Modern Portfolio Theory). Unfortunately, the investment industry misuses it virtually every day.