Last chance....
Last chance….

If you don’t know me, I’m a bit of a student of economics, though “Student” may be stretching it.  What I am intensely interested in is the overarching “whole” of how things work together to form the civilization that surrounds us.  One piece of this “whole” is economics.  “Economics” is short descriptor of a vast field of study.  Today we’re going to focus in on a particularly interesting sector of economics: Monetary Theory or How Money Works.  If you’ve managed to finish the prior sentence without closing this tab on your browser, I’ll assume that you are going to stick with me at least a little bit longer.

Every so often in our short lives we discover something that completely changes how we view a small part of our vast world. I think that happened to me not too long ago when I stumbled across Modern Monetary Theory (here forward referred to as MMT).  I was taken totally off-guard.  I started thinking that Morpheus from the “Matrix” had just entered the room and asked me which color pill I wanted to take.  I quickly downed the red pill and dove headlong into MMT.

Paradigm shift: A change in the basic assumptions of ruling theories of science

If one applies this definition to the science/art/magic of economics, there may indeed be a looming paradigm shift across the boundaries of economics.  Until then, I’ll have to content myself with my own personal shift in how I view this part of the world and how it works.  If you are still reading, then I will assume that you too have swallowed the blue pill and have prepared to open your mind just a bit.

The study of economics throughout history has often been segregated into “schools” of thought.  From Ancient to Classical to Modern, economists have tended to organize under collective banners that helped the outside world catalogue the root from which the theories of the economist spring.  The most prevalent schools today are the Chicago School, Austrian, and Keynesian.  You’ve probably heard of each of these.  We aren’t going to delve into these channels of thought and theory today, but its important we know each of these actors, because they comprise the whole of the economic matrix that surrounds us in the US today.  In a literary, scholastic and political sense, each of these schools dominate the very way we think and speak about the reality around us.  So pervasive are they that they’ve simply become part of the background, become the starting point of reference for nearly every economic and fiscal decision our policy-makers engage in.

Nearly everyone has picked their favorite.  Fierce battles are fought in the public space and in our own private conversations over which school is “right”, which one “works”, which is “best”.  I myself have always considered myself a proud if agnostic Keynesian.  Chicago Schoolers should be viewed with suspicion and Austrians with utter derision.  I spent years cementing these beliefs with research, reading and personal experience.  Then MMT came along and I found myself questioning many deeply ingrained beliefs about how things “work”.  I’m not sure whether MMT even counts as a “school”, more like a department, but let’s explore it a bit shall we? I’ll be interested to hear your feedback once you’ve read through the whole post.

The components of Modern Monetary Theory have been around since 1895, but become a cohesive “thing” in 1998 or so.  It is designed to explain how modern money works, both from a monetary and fiscal standpoint.  The theory is not especially complicated and is easily digested.  MMT is beginning to emerge as a viable alternative to conventional wisdom.  Often you’ll hear MMT described as “Chartalism” or “Post Keynesian”.  The University of Missouri, Kansas City is considered to the center of the cutting edge of MMT.

Let’s start with the basics that we need to understand and agree to before we move forward.

1. One’s financial asset is another financial liability: Simple right?  The money in your checking account is offset by an IOU at your bank.  The govt. bond you buy is offset by a liability on the books of the federal government.  Student loans, auto loans all work like this too.  A household’s financial net worth is asset – liabilities.

2. Public and Private sector: By using the agreed logic above we know both the public sector and private sector work this way too. All of the financial assets inside the private sector (all households and firms) HAVE to be offset by an equal amount of financial liabilities inside the private sector.  Right?  That goes for the Public sector (all levels of government) as well.  Agreed?  If all we do is look at this, then the net financial wealth of the private and public sector would always be zero (very important to remember).  There are also real assets, which we’ll talk about later.

3. So how does the private sector accumulate wealth then?  By definition they need to accumulate assets from “outside” the private sector.  The private sector holds government currency as well as IOU’s in the form of the full range of different government debt (t-bonds, t-bills etc).  This adds to the positive side of the balance sheet for the private sector.

4. Real assets are assets that are not necessarily offset by a financial liability.  For example, you bought a car with borrowed money, but now the car is paid off.  It is now a real asset without an offsetting liability.

5. Net private wealth equals public debt – Since financial wealth above and beyond zero has to come from somewhere “outside” the private sector, typically it comes from the government.  You can accumulate this wealth in the form of Government IOU’s.  Government cannot create and distribute these IOU’s unless they are running a deficit.  Private sector debt and surpluses mirror the public levels of debt and surplus.  If government balances the budget each year, then the net growth of surplus in both sectors by definition must be zero.  Look at the chart below.   Public and Private deficits and surpluses mirror are nearly perfectly opposed.  “We” (private sector) go UP when “They” (public sector) goes down.

An interesting way to think of this is that the Governmental Deficit = Non-Government Surplus

If the Government balances its budget, unfortunately so does the private sector.

Private Surplus and Deficit v. Public Surplus and Deficit

Notice how closely the Private Sector surplus and deficits mirror the Public Sector surplus and deficit.

The following illustrations expands this view a bit:

Another example of how private surpluses and deficits mirror public deficits and surpluses.

6. Foreign assets and liabilities – As you may have noticed in the 2nd illustration, we can add a third sector; the Foreign Sector, composed of foreign governments, households and organizations.  The US Private Sector can accumulate financial assets in the form of both US Public liabilities and Foreign liabilities.

Basically what all of this boils down to is this:  All sectors CANNOT run a surplus.  Think about what this means in terms of the Budget Deficit.  We’ll come back to this.

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0

Remember 1999? The Wall Street Journal ran two stories side by side. One trumpeting the elimination of the Public Deficit, and another puzzling over the lack of Private Sector saving. Hmmm

By the way, the above equation is true of every country that controls its own currency.  For those that don’t (see Greece), things can get trickier and more complicated.

Sovereign Currency – The domestic currency of a nation (British Pound, Japanese Yen, US Dollar) is often referred to as sovereign currency, or currency issued by a sovereign government.  This government retains many special powers for itself in this area.

1. The government determines what form of currency it will recognize for purposes of financial accounting and transactions.

2. The sovereign government reserves for itself the right to issue this currency in the form of its choosing.

3.  If anyone other than the sovereign government tries to issue domestic currency (without permission) they will be prosecuted as a counterfeiter.

4. The government imposes its taxes, fines, and fees in this “money of account” and decides how it will accept payment for these items.

5. The sovereign government also decides how it will make its own payments to those it is obligated to (pensioners, bond-holders etc).  Typically a sovereign government will pay and accept payment for all of these financial transactions in its own domestic currency.

The overwhelming tendency globally is for a government to adopt its own unique currency that it performs all of its external and internal transactions with. Also typically wages are paid in this currency and the court system tends to enforce contracts and fines in the domestic currency as well.

You may be old enough to remember that the US domestic currency and indeed much of the rest of the globe’s domestic currencies were backed by gold.  Now for the most part they are not.  So why would anyone accept a nation’s domestic currency if it isn’t backed by anything?  This type of currency is known as “fiat” currency.  Fiat in this case means that the currency is not convertible to another commodity (like gold or silver) or foreign currency.  The British Pound and Euro don’t even have the words “legal tender” on them.

We’ve established that sovereign governments get to decide what unit of money they’ll accept in payment for financial transactions.  They also get to decided what unit of money they’ll use to make their own payments.  The answer to the question of why people accept currency that is not backed by anything is taxes.  Let me explain:

Taxes drive money. Because the official government currency is the only thing the government will accept in payment of the taxes it levies, to avoid fines and imprisonment, the individual or business must get it’s hands on official government currency to pay its taxes.  Essentially when we pay our taxes, we are using the government IOU (currency) to pay the tax collector. Thus domestic  currency is accepted in private financial transactions as well.  The government can’t force private entities to use dollars in payment for goods and services in the Private sector or to save those dollars either but because everyone must use domestic currency to pay their tax bill, fines, and fees, it is far more convenient to use that same domestic currency in private transactions as well.  If something costs a “Dollar”, you must use a “Dollar” to pay for it, no?

This is why reserves of metal or foreign currencies are not necessary to make people accept a domestic currency.  Kind of neat trick no?  The government imposes a liability payable only in its own domestic currency on you, which forces you to use that currency to pay the liability.

To summarize:

“*The government names a unit of account and issues a currency denominated in that unit;

*The government ensures a demand for its currency by imposing a tax liability that can be fulfilled by payment of its currency;

*Government spends by crediting bank reserves and taxes by debiting bank reserves; (They tax you a dollar, you write a check for a dollar, the bank sends a dollar to the tax collector)

*In this manner, banks act as intermediaries between government and the nongovernment sector, crediting depositor’s accounts as government spends and debiting them when taxes are paid;

*Government deficits mean net credits to banking system reserves and also to nongovernment deposits at bank.”

– L. Randall Wray – Fiscal and Monetary Policy Operations in a Nation that Issues its Own Currency – 10/2/2011

Great, so what does all this have to do with anything?  

Good question, if you are still with me (bravo!) let’s get back to our friend Conventional Wisdom.

Conventional Wisdom #1 – Governments are constrained by their budgets.  In order to spend more, they need to raise money through taxing or borrowing

Conventional Wisdom #2 – Budget deficits are inherently bad.  Not only that but they impose burdens on the economy as a whole in some manner.

Conventional Wisdom #3 – Public deficits take away savings that could be used for investment.

Conventional Wisdom #4 – We needs savings of some kind to finance the government’s deficits and investment.

Conventional Wisdom #5 – Higher deficits now mean the need to raise taxes or cut spending in the future to pay for them.

Conventional Wisdom #6 – Government deficits crown out private investments and drive interest rates up.

Conventional Wisdom #7 – Government deficits create debt that is left for our grandkids.  We have to cut taxes or reduce spending to pay down our debt.

All of these in the view of MMT are patently false arguments.

Much of the conventional wisdom is indeed true for a country that does not control it’s own domestic currency.  For a country that issues it’s own domestic currency these are not true.  Think about what this means in our everyday understanding of Congress, budgets, spending and our very national priorities.

>>>We need to be careful here.  What this does NOT mean is that the government can spend whatever it wants whenever it wants.  Too much spending would be inflationary and lead to other problems.  Nor can Treasury pay for governmental desires and obligations at whim.  That spending authority is constrained by Congress. <<<

Too much government spending can cause inflation

Too much spending could affect the exchange rate

Too much spending could take resources from private industries seeking to use these assets

Government shouldn’t do everything.  It could create reverse incentives for private entities

Budgets do provide and check and balance on government projects

As you can see there are legitimate concerns around how much and on what government spends money.  But the concern should never be insolvency.  By definition this is impossible in a country that uses a sovereign currency.

What I’ve (hopefully) done today is to establish the basic framework within MMT operates.  We’ve now established the DESCRIPTION.  In the subsequent post, I’ll try to apply MMT to specific situations occurring in our country and around the world today.  How does MMT apply to the Fed’s quantitative easing?  To the Euro crisis? To the Debt Ceiling?  To unemployment? To social programs?  This will focus on the PRESCRIPTION.

Lastly, and most importantly the final post will look back at our first two posts and evaluate what we’ve learned.  What do we agree with?  What do we disagree with?  What can we use going forward?

Nearly all of this information came from a few key MMT resources:

A particularly important source is  http://neweconomicperspectives.org/p/about.html – A MMT blog

 http://www.youtube.com/watch?v=cUTLCDBONok – A great video featuring MMT heavyweight Warren Mosler 

 http://www.youtube.com/watch?v=-i7O791RkvU – Great resource featuring University of Missouri KC MMT’er Stephanie Kelton

“Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems” – L. Randall Wray

“The Perfect Fiscal Storm” – L. Randall Wray  http://www.epicoalition.org/docs/perfect_fiscal_storm.htm

“The Fundamental Difference Between Austrians and MMT’ers – Cullen Roche  http://pragcap.com/the-fundamental-difference-between-austrians-and-mmters

Lastly please enjoy this excellent video on how modern money works.  I for one am a visual learner and this helped me immensely.

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NoManIsAnIsland
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NoManIsAnIsland

Funksands,

When I see or hear the word “economics,” ordinarily my eyes glaze
over and I fall into a trance (it sounds nicer than “stupor, doesn’t
it) of non-comprehension.

But to my surprise — and slight unease — I read the first part of
your treatise on MMT all the way through without becoming stuporous,
was able to understand it, and agreed with it. I’m going to read the
rest of your series as soon as I can.

Full disclosure: to the extent of my knowledge of economics, I’d also
call myself an “agnostic Keynesian,” although I don’t think of it in
terms of pride. All this said, if it may be stretching it to call yourself a “student” of economics, it may also be stretching it a bit to call Mohandas K. Gandhi a “Mahatma!”

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Dbos
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Dbos

Having studied with Dr. Milton Friedman thru an NDA grant in Economics; he and I argued Monetary Policy; the Chicago School called such because he was a professor at The University Of Chicago . Our arguments were centered around Government spending and Inflation; example government injected money moves faster than privately injected money causing greater inflation . Here’s the tricky part and even Dr.Friedman agreed with me when money is being taken from the economy ; off shored now; not when we discussed this aberration, when approaching deflation we must have the government spend more to create the phenomenon and argument that a little bit of inflation is necessary at certain junctures in our economy . The American people have been lead to believe that all inflation is evil ;NOT TRUE;just as the American people have been pounded with the idea that progressives and liberals are evil. Dr Freidman agreed with me that government spending and inflation are necessary when the private sector fails to inject enough money to move the economy where more jobs are created than lost. Plain and simple right now we need jobs and we need government spending to create the money in the economy to create jobs;we need inflation and not spending cuts ;Dr.freidman is rolling over in his grave at tis time in our history

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Nirek
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After watching the video I’m more confused, Funk.
Is the debt what we owe because the legislature spent more money on programs than they had?

Or is that the deficit?

Maybe you will get to that stuff in a future post.
Otherwise , HELP!

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kesmarn
Admin

funk, thanks so much for introducing a school of economic thought that I’d never even heard of. Economics is a field that I find baffling and interesting at the same time.

For starters — (be prepared for weirdness here, of the kes kind) — I have always wondered why some “laws” of economics are called that. “Laws.” As if economics is an exact science. Is the field of economics really based on science — the way math and physics are? It seems so “emotional” to me. The common saying is that greed and fear are what make Wall Street tick. That doesn’t seem scientific to me. It seems pretty lizard brain, frankly.

For instance, take the example of the “Law of Supply and Demand.” How is it really a “law”? If something is in short supply, do suppliers have to raise prices? I know it must be irresistibly tempting to do it. But will they go to jail if they don’t? (Or at least be thrown out of the Kiwanis club?) So, to me, the law of supply and demand feels more like a matter of choice. A totally understandable one, but still a matter of human free will.

So far, I’m the only person I know, though, who’s ever questioned this alleged law. 😉

Also — could an argument be made that the notion that the job of the government is not only to regulate inflation — but (possibly much more importantly?) to redistribute wealth (via taxes) and to regulate capitalism (which is a bone-crushing, flesh-eating monster if it’s not controlled)?

It seems that the government is the only entity powerful enough to control capitalism’s rapacity. Which is — of course — why the right wants to drown it in a bathtub. They (the right) seem to see government as valuable only to the degree that it acts as a conduit. An XL pipeline that funnels the people’s tax dollars into the pockets of corporations — whether they be private prisons, charter school chains, insurance companies, Blackwater or Halliburton.

Government’s other job, in their view, is to maintain a military large enough to protect their interests any where, any time. And to suck up enormous amounts of cash at the same time. Win-win.

So every dollar that is “wasted” on frivolities like SNAP, unemployment compensation, Head Start, or health care for poor people is highly offensive and wasteful, in their cynical view of things. That part of government is the part that needs to go down the bathroom drain along with the scrubbing Wall Street bubbles.

But what I’m too dumb to figure out is how — or even if — any of this fits into MMT.

I’m anxiously awaiting further developments in your series of articles, funk. And forgive me if I’ve muddied the waters with my own brand of Voodoo Economics.

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Nirek
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Funk, I have always gone by the saying “buy low sell high” with my investments. Then I see these adds for buying gold. They say “buy gold to hedge against drops in stocks”. But gold is at or near all time highs. So why would anyone buy gold at these high prices?

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Nirek
Member

Funk, that was eye opening to me. Thanks for the article. I learned a lot from it. I used to worry about the deficit, remember the “deficit clock” spinning out of control.

For myself and my wife, we have savings. We did without for years to build our nest egg. Now we are living off Social Security and our IRA. We don’t have to scrimp now but we are still careful about what we spend our money on.

The charts you posted show that the rich are getting richer as our debt goes up. At least that is what I saw (correct me if I’m wrong).

All and all Your article is excellent and I will read it again to reinforce my understanding.
Thanks again.

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AdLib
Admin

Funk, can’t tell you how much I really appreciated this primer on MMT. It really is a revelation to realize that public debt is exactly mirrored by private assets and vice versa. It seems so intuitive once you read it but my assumptions were that there was more dilution and diversity to debts and assets…though how could there be? Kind of the theory of matter, something can’t be created from nothing so assets can only be created from deficits and back the other way.

So would it be correct that the imbalance of wealth restricts the flow of this system since assets are being concentrated in the 1% who are not returning assets and taxes to the federal government as much as the rest of the 99% would if they had a larger share of those assets? Because of that, the government is being choked off from having more assets to circulate through programs and initiatives to the 99% and for the welfare of the nation as a whole…which would be transferring those assets to the 99% which then would reciprocate.

So, the more billionaires that are made, the wealthier they get and the less taxes they pay, the more the flow of assets are restricted in their cyclical flow to and from government and the public.

And instead of taxes being the relief valve to keep inflation at bay since they have been reduced so much (until recently with the expiration of the Bush Tax Cuts for the wealthy), isn’t the siphoning of wealth from government and the 99% by the 1% acting as an anti-inflationary factor? That is, if 99% of the public isn’t getting more money, just the wealthy, then the price of products that 99% of people buy can’t practically inflate?

And if the wealthy escape paying taxes, hide their money overseas and keep downward pressure on the incomes of 99% of Americans (stagnant wages impacted by annual levels of inflation equate to less income), isn’t this a withering system that is unsustainable in this form for the long term?

Lots of thoughts percolating in my head thanks to your fascinating article!

What is kind of amusing is that if the Repubs got their way on slashing the federal deficit, they would be decimating the assets of the wealthy (as public deficits fell, private assets would as well) and possibly stoking up inflation to terrifying heights since a slashing of taxes would harm its function as an inflationary relief valve.

Their economic theories were proven wrong and destructive in the Bush years and seeing their response, it’s clear that they aren’t open to learning from their mistakes, their views of economics are faith based and can’t be altered by even definitive proof of how false and misguided they are.

Looking forward to your follow up article with “inflated” interest.

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