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.
Notice how closely the Private Sector surplus and deficits mirror the Public Sector surplus and deficit.
The following illustrations expands this view a bit:
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
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.
“*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.