Modern Money Systems
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Modern Money Systems
The Real Economy
Money, Government and Banking
The Role of Government Deficits
Full Employment along with Price Stability
MMT describes the workings of Modern Money Systems – floating exchange rate fiat currency systems. Such regimes are not revenue constrained when spending in its own currency. All spending constraints are necessarily politically self-imposed and can be altered at will by the government. Accordingly, taxation does not serve to raise revenue for spending but to reduce private demand to leave room for the government to spend without inducing inflation.
This is contrary to pegged currency regimes, which depend upon continued access to the foreign reserve currency, or members of the Euro-zone, which depend on the European Central Bank to issue the Euro. Nations using such systems are revenue constrained much like households and firms. Using a household analogy to understand the financial considerations of a modern money system is misleading. A country with a floating non-convertible currency can issue any amount of currency at will at any time. It can never "run out of money".
Of course, this does not mean that the government should deficit spend recklessly. That would cause inflation. Spending too little leads to unemployment.
Yet, the lack of a revenue constraint gives the government of a modern money system another degree of freedom. MMT asserts that this enables the government to calibrate its spending and taxing (in amplitude and focus) to achieve both full employment and price stability. This is something generally believed to be impossible by mainstream economists.
Modern Money Systems
Modern Money Theory, MMT, is a school of economic thought, sometimes categorized as post-Keynesian. It has been developed specifically for describing the workings of what we will call "modern money systems". In these systems, a government (or other authority) responsible for fiscal policy (taxing and spending) is also a monopoly currency issuer. The currency of issue is a non-commodity-based (fiat) floating exchange rate currency. Examples are Australia, Brazil, Canada, Chile, Japan, Mexico, South Africa, South Korea, United Kingdom and the United States. The currency is not pegged, neither to a commodity like gold nor a foreign currency.
The government plays a central role in the economy in a modern money system. As it is the currency issuer, it is the only entity that spends without revenue constraints. As monopoly currency issuer it is responsible for providing the appropriate amount of currency to the users of the currency in the economy. While maintaining the value of the currency, i.e avoiding causing inflation or deflation, it has the ability to ensure there is sufficient currency in the economy at all times to facilitate commerce. It can also accommodate the desire (or propensity) to net save in the non-government sector, to offset the drag (recession and unemployment) that otherwise results in the economy (this is discussed at some length in the article "The Role of Government Deficits").
In this sense, the monetary system is a public utility provided by the government.
Currency Issuer versus Currency Users
As a currency issuer, a modern money regime does not have any operational financial constraints when spending in its own currency. All constraints on the actual spending process are necessarily politically self-imposed. Operationally, it does not need to raise revenue before spending.
This stands in stark contrast to currency users, who are operationally constrained by having to raise revenue before being spending.
In a somewhat abstract sense, a currency issuer can be thought of as spending by issuing currency. In modern days, it is done by crediting private bank accounts, literary using keystrokes on computers (much like changing accounting entries in a spread sheet). This process is not inherently operationally dependent on preceding acquisition of revenue from taxation or borrowing.
Government spending is typically administered by its central bank. This involves procedures similar to those of regular banks. The government spends "out of an account" at the central bank. The central bank transfers funds from the government "account" to the recipients' accounts in private banks.
In most modern money systems, there are politically self-imposed constraints affecting this spending process. There can be a number of organizational rules and procedures involved. Many of these constraints made more sense during times when currencies were pegged, but are pointless for modern money systems and can sometimes unnecessarily restraint available policy options. However, since the constraints are voluntary and self-imposed rather than operational, they can be altered at will by the government of issue.
For example, in the US, the federal government is prevented from "just adding funds" to its account (the "Treasury General Account") at the central bank (the Fed). And it is also not permitted to run an "overdraft" on its account. Instead, the account must first be credited with funds by transferring funds from Treasury Tax and Loan accounts, which in turn are credited when taxes are collected and government bonds are sold to the public. Congress has also imposed a ceiling on the dollar amount of Treasury securities that the Treasury can create (the "debt ceiling").
Again, these are politically imposed rules and procedures, not operational necessities. Indeed, as a currency issuer, a modern money regime is not operationally constrained when spending. In a logical sense therefore, the ultimate purpose of taxation and borrowing can not be to raise revenue for spending.
Instead, taxation serves to reduce aggregate demand, i.e total spending power, in the economy, to "leave room" for the government to spend. This is necessary to maintain the value of the currency, i.e to avoid inducing inflation. Taxation thereby drives the value of the currency. "Borrowing" – government bond issuance – serves to manage the interest rates in the economy, which can also affect inflation.
In fact, MMT asserts that in a logical sense, government expenditure necessarily comes before collecting taxes, rather than the other way around. Tax payments can only be settled with base money (bank reserves or physical currency). Logically, this requires that base money previously has been issued and spent into the private sector by the government [Kelton, Fullwiler]. The base money must be issued and added (government spending) before they can be removed again (taxation).
("Base money" is the definitive currency of the monetary system. It is issued by the government, consists of bank reserves and physical currency and comprises the "monetary base". This is further discussed in the article "Money, Government and Banking".)
Revenue Constrained – To be or not to be
Firms, households and non-federal public entities such as states and municipalities in the US are, as opposed to modern money governments, revenue constrained. In order to spend they must obtain funds from revenue, borrowing, drawing down savings or selling assets. This applies also for member nations of the Eurozone and other nations using the euro, since they are not issuers but users of the currency of issue.
A pegged currency regime is revenue constrained, much like households and firms. The issuer of a pegged currency ensures convertibility to a foreign currency or a commodity (such as gold). It does so by offering to sell the object of conversion for a fixed price in the own currency. The government therefore holds reserves of the object of conversion.
A pegged currency regime thus faces a risk of not being able to defend the currency peg. By issuing and spending too much of its own currency in relation to the amounts of held reserves, the government may finally be unable to supply the amounts of reserves being demanded for conversion by the public. The regime could ultimately be forced to devalue the currency, which is equivalent to a default.
Although it may be operationally possible, short term, to issue and spend new currency without revenue constraint, the regime must therefore carefully manage the reserves of the object of conversion. This has to be taken into account when conducting fiscal and monetary policy. The result is an additional restraint on spending in the own currency. The fiscal policy space is reduced compared to that of an unpegged currency regime. 
Taxation has to serve not only to regulate private spending power, but also to defend the currency peg by removing currency from the economy, preventing it from being converted to the object of conversion.
Government borrowing similarly serves to defend the currency peg by deferring the desire of the currency holders to convert its currency into the object of conversion. The issued government bonds can be thought of as "competing" with the conversion option, with market forces determining the required interest rate. If there is a perceived default risk, the market will demand higher interest rates to compensate for the risk of holding bonds. If the currency regime does not offer a competitive interest rate, holders of currency would be prone to instead convert it to the object of conversion, thereby draining the nations reserves.
This explains the very high interest rates paid by governments with perceived default risk in fixed exchange rate regimes and Euro-zone regimes, in contrast to the ease with which a "modern money" nation such as Japan can keep rates at zero, despite large government deficits.
Using a household analogy can be useful for understanding the financial considerations of pegged currency systems.
An example of a pegged currency default is the US in 1971, that was no longer able to uphold the dollar convertibility to gold, and abandoned the gold standard in favor of a modern money system. Other examples are Russia 1998 and Argentina 2002, both of which defaulted on their fixed exchange rate currencies. There are also numerous examples of fixed exchange rate currency devaluations over the course of history.
The Fallacy of the Household Analogy
Using a household analogy to understand the financial considerations of a modern money regime is fundamentally inadequate. Any notion that such a government can involuntarily go bankrupt or become insolvent in its own currency is erroneous (although it may choose to voluntarily "default" for political reasons, for example due to political unrest, war or regime change).
It can be difficult to intuitively grasp the lack of operational financial constraints. Instead of using a household analogy, one must realize that the government can not possibly "run out" of its own money. The government does not "have" or "not have" currency to spend. Another analogy, somewhat more crude, is to think of the government as always having an "infinite fund of financial assets" (denominated in its own currency) at its disposal.
As a currency issuer, a modern money regime spends by crediting bank accounts. This is much like changing numbers on a scoreboard in a game of sports – and a scoreboard does not run out of points. The currency issuer is the score-keeper. The currency users are the players of the game, and will have to work to obtain the points.
As an example, such analogies may make it clear that it is pointless for a modern money regime to increase taxes for the sole purpose of collecting money into funds for future use. It may be reasonable to store real assets, or foreign currency financial assets. But building up sovereign funds of financial assets denominated in the own currency is nonsensical, since a "fund" of any size can be created instantaneously by a currency issuer at will.
Similarly, as has been pointed out above, the notion that the government has to collect taxes or borrow money in order "finance spending" is incorrect. Taxing serves to reduce private spending power, "borrowing" (issuing government bonds) serves to alter interest rates – and neither is done in order to "finance spending".
Too Large Deficits Lead to Inflation
The fact that a modern money regime has no operational financial constraints does not imply that it should deficit spend recklessly – or too little for that matter – without constraints at all, as per some "deficits do not matter" doctrine. It is able to do so operationally – but deficits do matter.
Over-spending leads to inflation. It is true that, starting from a point of low capacity utilization, increasing nominal spending (aggregate demand) is likely to increase real output (goods and services) rather than price levels. There is however always a limit to how much capacity utilization can increase to absorb increasing nominal spending. Effective demand will eventually exceed the potential of the real economy to expand to meet it. Demand side inflationary pressure will ultimately arise.
In combination with a collapse in the production and taxation systems (typically in conjunction with war, civil unrest or regime change), the result could ultimately be hyperinflation. This was the case with Zimbabwe and Weimar). The economy is left in chaos with an unusable monetary system.
So, governments do need to be spending constrained -- and that is what budgeting is all about. However, budgeting can be improved if the constraints are correctly understood. It is always about inflation, not affordability.
Too Small Deficits Lead to Unemployment
Government under-spending (or over-taxing) leads to an economy performing below potential, resulting in recession with unemployment and possibly even deflationary episodes.
MMT views unemployment as unnecessary and harmful, as it results in huge permanent losses every day in foregone output and income. Add to that the depreciation of human capital, increasing family breakdowns, child abuse, crime, medical costs, skill loss, psychological harm, ill health, reduced life expectancy, loss of motivation, racial and gender inequality and loss of social values and responsibility:129. The personal, family and community losses are very large and persist across generations.
Another Degree of Policy Freedom
The amount of government spending, taxing and bond issuance ("borrowing") influences inflation, interest rates, capital formation, and other economic phenomena.
But the amount of money available to the government is unlimited, completely independent of spending, taxing and bond issuance. As it turns out, this has massive implications for how government responsibilities should be formulated.
A modern money regime is released from the operational financial constraint of having to raise funds to spend, and the risk of default. The regime has no currency peg that has to be defended by raising taxes or interest rates. This frees the government from having to depend on borrowing, competing with the private sector in the bond markets, to fund deficits. That is one constraint less – and one degree of freedom added.
MMT states that this enables governments to achieve full employment along with price stability – something that is not possible under a pegged currency regime, and generally believed to be impossible by mainstream economists.
Indeed, full employment and price stability is not only possible in a modern money system, but the two are in fact natural complements to each other:122. What MMT proposes is a Job Guarantee program (JG) in which the government unconditionally offers a public sector job at the minimum wage to anyone willing and able to work.
This is all discussed at some length in the articles "The Role of Government Deficits" and "Full Employment along with Price Stability", but a compact summary is as follows. The fixed wage offer under the Job Guarantee effectively creates a peg for the currency, fixing its value in relation to the market value of unskilled labor. The government offers to purchase labor that is idle (for sale) much like a government under a gold standard offers to purchase gold that is "idle" (for sale). The government offers a fixed price -- and lets the deficit float. The deficit automatically adjusts to achieve zero involuntary unemployment, no more and no less. This stands in stark contrast to traditional Keynesian general demand stimulus, in which aggregate demand is stimulated by the government buying resources and labor on the market, potentially bidding up prices, wages and entire wage structures in the hope that demand should "trickle down" and ultimately create new jobs at the "bottom". The JG program avoids the resulting inflationary effects by instead stimulating the economy directly at the "bottom", hiring at a constant price so that market wages are not chased after in upwards spirals. It should also be contrasted with today's approach which uses a buffer stock of unemployed to control prices but results in staggering social costs. A JG program uses a buffer stock employed, which has better inflation fighting effects and is beneficial in many other ways.
Government Deficits is not a Burden
Government deficits is not burdensome for the government or the population (in any other way than potentially inflationary effects). The government in a modern money system spends by issuing government IOUs (government currency and government bonds). A government deficit simply means that the government spends more than it taxes. It issues and injects more IOUs into the non-government sector than what is being withdrawn ("un-issued", destroyed). As has been discussed in this article, government spending is no more burdensome than changing numbers on a spread sheet or a score board.
A government deficit corresponds to a non-government sector surplus -- penny for penny. The non-government Net Financial Assets increase. Without the government running deficits over the decades, the non-government Net Financial Assets would remain constant. By running carefully calibrated deficits, the government can allow the non-government Net Financial Assets to grow sustainably forever, which is the expected norm in a growing economy.
The Government Budget Constraint Challenged
In mainstream economics there is often talk about the "Government Budget Constraint" (GBC) that governments should adhere to, often expressed as a maximum deficit-to-GDP-ratio or debt-to-GDP-ratio. An example of an implemented GBC is the European Growth and Stability Pact, which specifies such limits for the Eurozone members. Another is the debt ceiling in the US.
MMT states that government spending should be evaluated in light of its anticipated consequences, not on an arbitrarily selected numerical constraint. For example, one possible consequence is inflation, and government spending anticipated to create inflation should be avoided (unless avoiding it results in consequences that are even worse than inflation). The government should therefore indeed impose spending constraints on itself – but again these constraints should be based on the anticipated consequences of spending, not on arbitrarily erected numeric limits.
The Government Budget Constraint idea may be rooted in a belief that government deficits and debt-to-GDP ratios that rise beyond a particular level can cause the bond markets to raise interest rates (due to fear of government default) or even decide not to buy government bonds, so that the government would lose its ability to borrow money to meet its obligations (literally "running out of money").
While this is true for a pegged currency regime or a member of the Euro-zone and a pegged currency regime, it is not applicable for a modern money regime.
Deficits Per se do Not Lead to Inflation
According to conventional wisdom, government deficit spending (by currency issuance) automatically and inevitably causes inflation to occur. This popular view is incorrect, but very common. It is important to get this right.
The starting point is the simple identity called "equation of exchange", MV = Py. It states that the money spent on goods and services during a period of time (MV) equals the nominal value (money value) of those goods and services (Py) (this is a truism). M is a measure of money supply and P is the average price for goods and services.
By erroneously assuming that V and y are constants, the conventional conclusion is that if the money supply (M) increases, prices (P) necessarily increase as well. V is the money velocity – how many times each currency unit is spent on goods and services on average over the the time period in question (say a year). The variable y is the total quantity of goods and services sold (during the year). It is often assumed that y is constant at the level of full employment, which is clearly not the case. Velocity V is not constant either, but empirically highly volatile over the business cycle.
For example, in a recession people tend to spend less and hoard more due to uncertainty about the future, so that each currency unit is spent less often on average, i.e V is smaller. This is likely to correspond to a decrease in output quantity (y) rather than prices (P), as prices are "stickier" for various reasons.
If the government then increases its deficits aggregate demand increases as well, as will various measures of "money supply". But evidence suggests that firms tend to respond to increasing demand by increasing output (y) rather than prices (P) if they can.
The latter is an archetypal example of a situation where an increased money supply would not necessarily correspond to increased prices – at least as long that there is still considerable slack in the economy (with workers standing idle by machines running at half speed).
Of course, increased government deficits (so that M increases) when the economy is already at full capacity (y is at its maximum) is likely to lead to increased prices (P increases). Conventional wisdom has that right; but as discussed, the full-capacity-assumption is only a small part of the equation.
Further, when an increased money supply is observed in correlation with an increase in price levels, it can be the case that increasing prices have lead to an increased money supply, and not the other way around. For example, in the US an important inflationary episode occured during the 1970s and early 1980s. The money supply (M) rose, and largely proportionally to the increase in price level (P). This was when OPEC acted to raise oil prices, which caused costs to skyrocket for many US businesses. As the ripple effect of the OPEC price increases moved through the economy, the demand for cash by these businesses rose. Private banks and the Fed did what they could to accommodate. Loans were extended and government bonds sold by the private sector to the central bank. This raised the supply of money. In essence, the rising prices (P) led to an increase in the supply of money (M) and not the other way around.
In general, we can note that a growing money supply (M) over the decades is natural in a growing economy (y increases).
When discussing the equation of exchange, for MMT the net financial assets of the non-government sector is the preferred measure of "money", rather than traditional monetary aggregates. Also, MMT emphasizes the desire to net save within the non-government sector (some income is withheld, i.e unspent), which is akin to the inverse of the "velocity" measure (V).
- ↑ the term fiat derives from latin "let it be done", referring to that the money is established by government decree; see https://secure.wikimedia.org/wikipedia/en/wiki/Fiat_money
- ↑ Further examples are Albania, Democratic Republic of Congo, Czech Republic, Hungary, Iceland, Israel, New Zealand, Norway, Philippines, Poland, Somalia, Sweden, Switzerland and Turkey. See: IMF (International Monetary Fund). "De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks". https://www.imf.org/external/np/mfd/er/2008/eng/0408.htm. Retrieved 31 May 2011.
- ↑ Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia and Spain, "Eurozone". Wikipedia. http://en.wikipedia.org/wiki/Eurozone. Retrieved 1 June 2011.
- ↑ Andorra, Monaco, Montenegro, San Marino, and Vatican City, "Eurozone". Wikipedia. http://en.wikipedia.org/wiki/Eurozone#Non-member_usage. Retrieved 1 June 2011.
- ↑ "Warren Mosler critiques Paul Krugman's "MMT, again"". http://mikenormaneconomics.blogspot.com/2011/08/warren-mosler-critiques-paul-krugmans.html. Retrieved 16 August 2011.
- ↑ 6.0 6.1 "MMT AND ALTERNATIVE EXCHANGE RATE REGIMES: RESPONSES TO MMP BLOG #11". http://neweconomicperspectives.blogspot.com/2011/08/mmt-and-alternative-exchange-rate.html. Retrieved 20 Aug 2011.
- ↑ 7.0 7.1 Mosler, Forstater - The Natural Rate of Interest Is Zero
- ↑ "Tom Hickey on MMT". http://moslereconomics.com/2010/04/04/tom-hickey-on-mmt/. Retrieved 1 June 2011.
- ↑ "Nixon Shock". https://secure.wikimedia.org/wikipedia/en/wiki/Nixon_Shock. Retrieved 14 May 2011.
- ↑ "Russia another pegged currency victim". https://modernmoney.wordpress.com/2011/01/24/russia-another-pegged-currency-victim/. Retrieved 14 May 2011.
- ↑ "Argentina Inflation due to pegged currency". https://modernmoney.wordpress.com/2011/01/31/argentina-inflation-due-to-pegged%C2%A0currency/. Retrieved 14 May 2011.
- ↑ "Solvency and Value, Insolvency and Debasement". http://traderscrucible.com/2011/03/29/solvency-and-value-insolvency-and-debasement/. Retrieved 16 May 2011.
- ↑ [|Mosler, Warren] (2010). 7 Deadly Innocent Frauds. http://moslereconomics.com/2009/12/10/7-deadly-innocent-frauds/. Retrieved 24 May 2011.
- ↑ "To challenge something you have to represent it correctly". http://bilbo.economicoutlook.net/blog/?p=15683. Retrieved 16 August 2011.
- ↑ 15.0 15.1 "Zimbabwe for hyperventilators 101". http://bilbo.economicoutlook.net/blog/?p=3773. Retrieved 26 May 2011.
- ↑ "Paul Krugman Still Gets it Wrong: Modern Money Theory". http://www.economonitor.com/lrwray/2011/08/16/paul-krugman-still-gets-it-wrong-modern-money-theory/. Retrieved 20 August 2011.
- ↑ 17.0 17.1 Wray, L. Randall (1998). Understanding Modern Money. Edward Elgar Publishing Limited. ISBN 978 1 84542 941 6.
- ↑ Bill Mitchell, The Daily Losses from Unemployment. http://bilbo.economicoutlook.net/blog/?p=7308
- ↑ (unless the currency is "pegged" to "unskilled labor" which is what MMT advocates with its Job Guarantee proposal)
- ↑ This does not imply that this policy would cause any particular price index to remain constant. What is being claimed is that the proposed policy would not generate the sort of inflationary pressures that many economists believe must result from high employment.
- ↑ and the same is said about Quantitative Easing
- ↑ This section draws heavily from: John T. Harvey – Money Growth Does Not Cause Inflation! http://blogs.forbes.com/johntharvey/2011/05/14/money-growth-does-not-cause-inflation – See that article for a more thorough discussion.
- ↑ Blinder, Alan S.; Canetti, Elie; Lebow, David (1998). Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation Publications. ISBN 978-0871541215.
- ↑ For example, in developed economies the two dominant sectors are manufacturing and services. In these sectors, firms typically operate with a degree of planned excess capacity. This enables them to respond to positive demand fluctuations by increasing output at current prices. There is a competitive imperative for them to do this. If they can’t, they risk losing market share to firms who can. This feature of manufacturing and services sectors gives developed economies a considerable degree of supply elasticity. From Peter Cooper; Parable of a Monetary Economy; http://heteconomist.com/?p=658
- ↑ Scott. T. Fullwiler. "Scott Sumner Agrees that MMT Policy Proposals Are Not Inflationary". http://neweconomicperspectives.blogspot.com/2011/07/scott-sumner-agree-that-mmt-policy.html. Retrieved 16 August 2011.
- ↑ See also the discussion by Eric Tymoigne. "Two Theories of Prices". http://neweconomicperspectives.blogspot.com/2011/07/two-theories-of-prices.html. Retrieved 16 August 2011.