A Good Summary of How That New Fangled Money Works (with Two Minor Disagreements)

We typically don’t think of money as technology, but money is very different than it used to be. Over at the Agonist, Bolo has two very good posts about the implications of having a fiat, non-gold standard currency, and in doing so, he gives a very good summary of modern monetary theory (‘MMT’) that is accessible to non-economists (Bill Mitchell and James Galbraith are great, but they aren’t good explainers to a ‘lay’ audience; it’s frustrating). For me, this is the key implication of MMT (boldface mine):

1) The total amount of money is not constrained by some fixed amount of gold. Instead, it is constrained by the total output of the national economy. There should be enough money in circulation to run the economy at full steam and buy up every product and service available. A fiat currency moves the theoretical boundary of economic activity beyond some arbitrary threshold dictated by lumps of precious metal and pushes it out to “what the system can bear” based on actual, physical capacity.

2) Spending beyond the economy’s total productive capacity is what leads to inflation. This additional money cannot buy any new products or services (there’s no way to make them since we’re at full capacity), so it goes toward bidding on existing products and services and therefore raises their prices.
3) Your taxes do not pay for any federal government expenditures. Taxes are instead a form of private sector demand reduction. Remember, the economy can only hold a certain amount of money dictated by its maximum productive capacity. If the government wants to spend more money to purchase goods and services, it should tax more to reduce the amount of money in the private sector. If it doesn’t tax more then it risks inflation from having too much money in circulation. Likewise, if it wants to spend less, it should tax less and let the private sector do more spending. If it doesn’t tax less, then the amount of money in circulation is too low and productive capacity sits unused. The idea here is to keep the total amount of money chasing goods and services near an optimum, maximum level. Again, taxes reduce demand in the private sector to make room for government spending.

Note that this turns our normal reasoning on its head. The federal government does not tax you so that it can then spend your money on buying or providing goods and services. It taxes you so that you cannot spend as much of your money on goods and services, which then makes room for it to spend money on them instead.

One place where I have a minor disagreement is in this post:

But what about banks? Surely they make money in the form of loans? Sort of, but there are some important details here. They can make loans with money they don’t have, but those loans must be paid back (usually with interest too). If a bank makes a loan to you for +$10,000, it also creates a debt of -$10,000 that it expects payment on. These sum to zero, so that when you pay back the loan, the bank is back to where it started. Interest on your payments means that the bank acquires more money from you than it originally loaned out, but again this interest money has not been made but has instead been acquired. The bank’s new loan is shadowed by an equal amount of debt that effectively cancels it out in the long run. Simply put, the bank cannot just make money but instead must have income to match all of its spending/loans–or else it will eventually go bankrupt.

This is the “household model” of debt, where spending is restrained by income and money is simply shuffled from one household (business, etc.) to another. New money is not created for any length of time beyond what it takes to pay back a loan. Think of all the money that banks create as summing to zero, because there is always an equal and opposite amount of debt that each loan generates. Forget about credit and debt servicing and etc. for now. This is the basic dynamic that all that other stuff has been layered on top of and has obscured.

This isn’t entirely accurate. Without getting into Chartalism versus Circuitism debates, while banks can’t create money, they can induce the government to do so. This has to do with establishing lines of credit for corporations, business, and wealthy individuals. When banks lend money in an economy where more production is needed, to maintain needed reserves, they can borrow from the central bank if they don’t have adequate reserves (money) at a rate determined by the central bank–this is one way that the Federal Reserve influences the economy. When the economy isn’t running at full capacity, it makes borrowing cheap and available, and when inflation is a danger, it clamps down (usually by raising loan rates)*. While it’s ultimately up to the government to extend or not extend these loans, in practice, the central banks follow the private banks lead. Thus, loans by banks lead to deposits in borrowers’ accounts, which are backed by government increasing the money supply. The issue is who is driving the increase in money. Typically, when demand is low, it’s government (banks don’t have anyone to lend to) so government spends, and when demand is high (i.e., production needs to be increased), banks will lend since they detect profit-taking opportunities.

The other area I don’t agree with–and this is based on personal experience–is the role of local government:

There are two alternatives facing a local government that cannot tax enough. The first is financing through the private sector, which will inevitably cause problems given that local government are not profit-seeking and provide services that tend to be unprofitable but necessary. The second is stimulus from the federal level above, which could certainly work as long as necessary, but also sets up a terrible top-down dependency that erodes local autonomy over time. I believe both paths have been tried in the US–and now both local and state governments are so deep in debt or so dependent on federal handouts that they risk losing much of their authority and legitimacy.

All taxes collected should be first given to city, state, and other local governments that are, by their very nature, more accountable to the local citizenry than the national government is. They also should better know what their needs are. The federal government could then levy a tax or make payments to citizens depending on what its own spending decisions are for the year, but it will not regularly tax the same amount year after year as it does with (for example) an income tax.

First, many policies can only be adopted by the federal government: a jobs program or science-funding. Second, many local governments are ‘illegitimate’ not because of federal meddling, but because of local ineptitude. I’ve lived in many different places in the U.S. and I see no evidence that local governments are more accountable or better run–in fact, they’re often worse because people don’t keep track of local government. Obviously, we don’t want the federal government approving which particular potholes are fixed, but we do want some guidelines, especially when some localities and states will decide to repair non-existent potholes.

That aside, the two posts are a very good introduction to MMT.

*To add a complication here, this is usually the benchmark for borrowing money from other banks, which also affects the ability to acquire reserves.

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4 Responses to A Good Summary of How That New Fangled Money Works (with Two Minor Disagreements)

  1. william e emba says:

    In the early 1800s, just what was paper money wasn’t so clear. In the wilds of the Ohio River valley there were a lot of dubious banks with little specie (coinage) to back up their paper. Even more interesting, there were lots of counterfeiters. They were commonly viewed as heroes, providing liquidity that neither the states nor the feds did. During some of the trials, there would be newspaper editorials wondering what the difference was between, on the one hand, a legal but deceptive banker with a charter who couldn’t survive the smallest of bank runs and, on the other hand, an illegal but honest counterfeiter who didn’t bother with impossible promises.

  2. Kele says:

    This seems like a good source for MMT. http://rodgermmitchell.wordpress.com

  3. Kaleberg says:

    Point 3 about taxes is rather weak. The data show that higher taxes tend to raise consumer spending, so he has the sign of the relationship backwards. We saw this in the early 20s, the 30s through the 70s, and more recently in the 90s. This theory doesn’t take into account that consumer savings, that is, failure to spend all of one’s income, removes money from the economy. The government has to tax a fair bit of this difference or the economy will not be able to run at full capacity and consumer needs will be unmet.

  4. Kaleberg says:

    That’s also a rather weak explanation of how fractional reserve banking effectively creates money. It does not the importance of a statistically balanced and predictable flow, but glosses over the way that the money is actually created.

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