User:Dtellett/Modern Monetary Theory

Modern Monetary Theory is an economic theory based on the Chartalist concept of state money, post-Keynesian views of endogenous money and functional finance.

MMT aims to describe and analyze modern economies in which the national currency is fiat money, established and created exclusively by the government. In MMT, money enters circulation through government spending; Taxation is employed to establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that can only be met using the government's currency. An ongoing tax obligation, in concert with private confidence and acceptance of the currency, maintains its value. Because the government can issue its own currency at will, MMT maintains that the level of taxation relative to government spending (the government's deficit spending or budget surplus) is in reality a policy tool that regulates inflation and unemployment, and not a means of funding the government's activities per se.

Vertical transactions

MMT labels any transactions between the government sector and the non-government sector as a vertical transaction. The government sector is considered to include the treasury and the central bank, whereas the non-government sector includes private individuals and firms (including the private banking system) and the external sector – that is, foreign buyers and sellers.

In any given time period, the government’s budget can be either in deficit or in surplus. A deficit occurs when the government spends more than it taxes; and a surplus occurs when a government taxes more than it spends. MMT states that as a matter of accounting, it follows that government budget deficits add net financial assets to the private sector. This is because a budget deficit means that a government has deposited more money into private bank accounts than it has removed in taxes. A budget surplus means the opposite: in total, the government has removed more money from private bank accounts via taxes than it has put back in via spending.

Therefore, budget deficits, by definition, are equivalent to adding net financial assets to the private sector; whereas budget surpluses remove financial assets from the private sector. This is represented by the identity: (G-T) = (S-I) – NX (where G is government spending, T is taxes, S is savings, I is investment and NX is net exports). It is important to note that this identity is not unique to Modern Monetary Theory; it is an identity used throughout all macroeconomic theories, because it is true by definition.

The conclusion that MMT necessarily draws from this is that private net saving is only possible if the government runs budget deficits; alternately, the private sector is forced to dis-save when the government runs a budget surplus.

MMT therefore does not support the notion, as some Keynesians do, that budget surpluses are always necessary in periods of high effective demand. According to the framework outlined above, budget surpluses remove net savings; in a time of high effective demand, this may lead to a private sector reliance on credit to finance consumption patterns. Rather, MMT suggests that continual budget deficits are necessary for a growing economy that wants to avoid deflation. MMT only advocates budget surpluses when the economy has excessive aggregate demand, and is in danger of inflation.

Interaction between government and the banking sector

Modern Monetary Theorists emphasise the importance of reserve accounting and the operational details of interaction between government, the central bank, and the commercial banking sector.

A sovereign government will typically have a cash operating account with the central bank of the country. From this account, the government can spend and also receive taxes and other inflows. Similarly, all of the commercial banks will also have an account with the central bank. This permits the banks to manage their reserves (that is, the amount of available short-term money that a particular bank holds). So when the Federal government spends, Treasury will debit its cash operating account at the central bank, and deposit this money into private bank accounts (and hence into the commercial banking system). This money adds to the total reserves of the commercial bank sector. Taxation works exactly in reverse; private bank accounts are debited, and hence reserves in the commercial banking sector fall.

Government bonds and interest rate maintenance

Virtually all modern central banks set an interest rate target, requiring central banks to actively intervene in commercial banking operations. According to Modern Monetary Theory the purpose of government borrowing in modern floating exchange rate regimes is purely to drain excess reserves from the banking system

In most countries, commercial banks’ reserve account with the central bank must have a positive balance at the end of every day; in some countries, the amount is specifically set as a proportion of the liabilities a bank has (i.e. its customer deposits). This is known as a reserve requirement. At the end of every day, a commercial bank will have to examine the status of their reserve accounts. Banks in deficit have the option of borrowing the required funds from the central bank, where they may be charged a lending rate (sometimes known as a discount rate) on the amount they borrow, but will prefer to borrow at lower rates from other banks if possible. On the other hand, the banks with excess reserves may earn a support rate of interest from the central bank but will prefer to earn higher returns from lending offering their extra reserves to banks that are in deficit on the interbank lending market.

Banks will therefore lend to each other until each bank has reached their reserve requirement. In a balanced system, where there are just enough total reserves for all the banks to meet requirements, the short-term target interest rate will be in between the support rate and the discount rate.

As the government generally spends by making transfers to private bank accounts, spending more than it taxes on a given day adds reserves to the banking system. This will lead to a system-wide surplus of reserves. In that case, banks trying to offload excess reserves on the interbank lending market would force the short-term interest rate down to the support rate (or alternately, to zero if a support rate is not in place). At that point, the surplus bank will simply keep the reserves with their central bank and earn the support rate. According to Modern Monetary Theory the role of government debt is to offer banks an alternative source of return on their reserves.

The alternate case is where the government receives more taxes on a particular day than it spends, resulting in a system-wide deficit of reserves. As a result, surplus funds will be in demand on the interbank market, and thus the short term interest rate will rise towards the discount rate. Thus, if the central bank wants to maintain a target interest rate somewhere between the support rate and the discount rate, it must manage the liquidity in the system to ensure that there is the correct amount of reserves in the banking system.

The only way it can do this is by a vertical transaction – by buying and selling government bonds on the open market. On a day where there are excess reserves in the banking system, the central bank sells bonds and therefore removes reserves from the banking system, as private individuals pay for the bonds. On a day where there are not enough reserves in the system, the central bank buys government bonds from private individuals, and therefore adds reserves to the banking system. According to Modern Monetary Theory the only reason for government debt to be issued is to manage interbank lending

MMT rejects the mainstream theory of crowding out (where government spending is said to put upward pressure on interest rates), arguing that governments issue them to reduce downward pressure on interest rates and there will always be sufficient market demand for government bonds issued at any central bank target interest rate. Some Modern Monetary Theorists acknowledge that long-term bonds may not be desired by the market in times of uncertainty, therefore affecting the yield curve by pushing up interest on longer term bonds. They generally argue that this is a reason for the government to limit itself to short-term bonds.

It is important to note that the central bank buys bonds by simply creating money – it is not financed in any way. It is a net injection of reserves into the banking system. As a result, MMT necessarily implies that the central bank of a country is not able to influence a government’s spending decisions. If a central bank is to maintain a target interest rate, then it must necessarily buy and sell government bonds on the open market in order to maintain the correct amount of reserves in the system.

Horizontal transactions

MMT considers any transactions within the private sector (which includes the commercial banking system) as horizontal transactions. Specifically, MMT focuses on loan creation within the banking system.

MMT states that as a matter of accounting, loans will always necessarily create a liability and a deposit equal in magnitude. Thus the net amount of financial assets (deposits – liabilities) cannot be changed via banking actions. Of course, the deposits created certainly expand the money supply; subsequently, these deposits may flow away from one bank and into another, and this must be balanced at the end of the day to meet reserve requirements (see Interactions between government and the banking sector). But banks cannot create net financial assets without an attached liability. Only the government sector - specifically, the reserve bank - is able to do this (see #Vertical transactions).

As a result, MMT rejects the mainstream notion of the money multiplier, where a bank is completely constrained in lending through the deposits it holds, and its capital requirement. MMT does not argue that an individual bank’s reserve position is completely irrelevant to its decision to extend credit; clearly, an individual bank will weigh the benefit of lending money beyond its reserve position, and the cost of borrowing funds from the interbank market (or the central bank) in order to meet its capital requirements (see #Interaction between government and the banking sector). However, what MMT does argue (in opposition to the mainstream) is that there is no real constraint to a bank in creating any loan it likes. The decision will be based purely on creditworthiness and profitability – the reserve requirement is simply one aspect of profitability.

The foreign sector

Imports and exports

MMT analyses imports and exports within the framework of horizontal transactions. It argues that an export represents a desire on behalf of the exporting nation to obtain the national currency of the importing nation. The following hypothetical example is consistent with the workings of the FX market, and can be used to illustrate the basis of the theory:

”An Australian importer (person A) needs to pay for some Japanese goods. The importer will go to his bank and ask to transfer 1000 yen to the Japanese bank account of the Japanese firm (person B). After looking up the relevant exchange rates for that day, the bank will inform him that this will cost him 100 dollars. The bank removes 100 dollars from the importer’s account, and goes to the FX market. It finds an individual (person C) who is willing to swap 1000 yen for 100 dollars. It transfers the 100 dollars to that individual. Then it takes the 1000 yen and transfers it to the Japanese exporter’s bank account.”

Thus, the transaction is complete. What made the transaction possible (i.e. acceptably priced to the importer) was person C in the middle of the FX swap. Thus MMT concludes that it is a foreign desire for an importer’s currency that makes importing possible.

MMT concludes that imports are therefore an economic benefit to the importing nation because they provide the nation with real goods it can consume, that it otherwise would not have had. Exports, on the other hand, are an economic cost to the exporting nation because it is losing real goods that it could have consumed. MMT does not, however, ignore the fact that the importing nation has given some of its currency to foreigners. This currency ownership represents a future claim over goods of that nation, which, as outlined above, are a cost. Similarly, MMT does not ignore the fact that cheap imports may cause the failure of local firms providing similar goods at higher prices, and hence unemployment. Most MMT commentators label that consideration as a subjective value-based one, rather than an economic-based one: it is up to a nation to decide whether it values the benefit of cheaper imports more than it values employment in a particular industry. Lastly, MMT does not ignore the effect of an over-reliance on imported goods (such as oil) with highly inelastic demand. It is consistent with MMT theory that a nation overly dependent on imports may face a supply shock if the exchange rate drops significantly. As an operational matter, central banks can and do trade on the FX markets to avoid sharp shocks to the exchange rate.

Foreign sector and commercial banks

It follows, according to MMT, that a net importing nation will be creating foreign ownership of its currency. But it is important to note that the currency will never actually leave the importing nation. The foreign owner of the local currency can either (a) spend them purchasing local assets or (b) deposit them in the local banking system. In each scenario, the money ultimately ends up in the local banking system. (Individual banks may, however, compete to attract these funds to their specific bank by offering bank bonds to overseas investors. This is typically labelled “offshore funding”.)

Foreign sector and government

According to Modern Monetary Theory governments can never be insolvent when the debt obligations are in their own currency even if the debt if held by foreigners; this is because the government is not constrained in creating its own currency..

Debt denominated in a foreign currency is a fiscal risk to governments, since the indebted government cannot create foreign currency. In this case the only way the government can sustainably repay its foreign debt is to ensure that its currency is continually and highly demanded by foreigners over the period that it wishes to repay the debt – an exchange rate collapse would potentially multiply the debt many times over asymptotically, making it impossible to repay. In that case, the government can default, or attempt to shift to an export-led strategy or raise interest rates to attract foreign investment in the currency. Either one has a negative effect on the economy. Euro debt crises in the "PIIGS" countries that began in 2009 reflect this risk, since Greece, Ireland, Spain, Italy, etc. have all issued debts in a quasi-"foreign currency" - the Euro, which they cannot create.

Policy proposals

Modern Monetary Theory implies that a fiat system is preferable to a commodity money system because it allows for government deficit spending for fiscal stimulus in ways not possible under a commodity money system. Modern Monetary Theorists support the principles of functional finance proposed by Abba Lerner, believing that the government must inject money into the economy in order to stimulate demand when the public prefers holding cash to spending it.

Prescriptions for economic policy range across the political spectrum, from left-supported job guarantees to traditionally right-supported tax cuts.

Fiscal vs Monetary Policy

Modern Monetary Theorists support the removal of any legally imposed requirements for the government to issue bonds and bills to the private sector, arguing that a sovereign government can finance any budget imbalance simply by expanding the money supply. This injection of reserves into the banking system will encourage banks to loan at lower interest rates, but theorists such as Scott Fulwiller argue the central bank could still choose to maintain a positive interest rate target by paying interest on bank reserves.

Some key proponents such as Warren Mosler favour a permanent zero interest rate. Randall Wray argues that interest rate manipulation is ineffective and a further advantage of low or zero rates is in reduce incomes accruing to rentiers.

Full employment

Various Modern Monetary Theorists have proposed that a Job Guarantee would be effective in achieving full employment and price stability. Unemployed workers are guaranteed a job by the government – typically at minimum wage. The level of government spending on the Job Guarantee fluctuates counter-cyclically with the level of unemployment in the private sector, increasing when private-sector firms are laying workers off in a recession and decreasing as workers move from the job guarantee scheme to better jobs in the private sector as the economy grows.

Tax cuts

Some leading proponents of MMT such as Warren Mosler advocate a large tax-cut or payroll tax holiday when unemployment is high and economic growth is low.

Criticism

Chartalism and Modern Monetary Theory has garnered wide criticism from a wide range of schools of economic thought. New Keynesian economist and Nobel laureate Paul Krugman has stated that the MMT view that deficits never matter as long as you have your own currency is "just not right".

The main response by MMT economists to the abovementioned criticism is to point out that the positions taken by critics betray a misunderstanding of MMT. Although critics often represent MMT as supportive of the notion that "deficits don't matter", MMT authors have explicitly stated that that is not a tenet of MMT.

Austrian economist Robert P. Murphy states that "the MMT worldview doesn't live up to its promises" and that it seems to be "dead wrong". Daniel Kuehn of the Urban Institute has voiced his agreement with Murphy, stating "it's bad economics to confuse accounting identities with behavioral laws [...] economics is not accounting."

Murphy's critique specifically employs a hypothetical example of Robinson Crusoe living in a world without a monetary system, and shows that it is in fact possible for Robinson Crusoe to save by foregoing income, thereby illustrating that despite what MMT economists argue, government deficits are not necessary for individuals to save. However, MMT economists have pointed out that the central tenets of MMT theory only aim to describe the economy of a society with a monetary system, that employs a fiat currency and floating exchange rate.

Murphy also criticises MMT on the basis that savings in the form of government bonds are not net assets for the private sector as a whole, since the bond will only be redeemed after the government "raises the necessary funds from the same group of Taxpayers in the future". In response to this, MMT authors point out that the repayment of bonds does not necessarily have to occur from taxes; a central bank attempting to hold an interest rate target must necessarily purchase government bonds. These purchases occur through the creation of currency, rather than taxation.

New Keynesian Brad DeLong has suggested MMT is not a theory but rather a tautology. Still others have said MMT "ignores the lessons of history" and is "fatally flawed."

Economist Eladio Febrero argues that modern money draws its value from its ability to cancel (private) bank debt, particularly as legal tender, rather than to pay government taxes. However it is unclear how this is a critique, since banks rely entirely on the monetary services of the state and its chosen currency, via the central banking system.

Proponents

Economists Warren Mosler, L. Randall Wray and Bill Mitchell are largely responsible for reviving the idea of Chartalism as an explanation of money creation; Wray refers to this revived formulation as Neo-Chartalism.

Modern Monetary Theorists form a distinct minority within academia, with many based at the University of Missouri - Kansas City, The Levy Institute and the Centre for Full Employment and Price Stability at the University of Newcastle, Australia.

Rodger Malcolm Mitchell's book Free Money (1996) describes in layman's terms the essence of Chartalism, while Scott Fullwiler has made significant contributions to MMT via his expertise in banking operations and the monetary system.

Some contemporary proponents, such as Wray, situate Modern Monetary Theory within Post-Keynesian economics, while Chartalism has been proposed as an alternative or complementary theory to monetary circuit theory, both being forms of endogenous money, i.e. money created within the economy, as by government deficit spending or bank lending, rather than from outside, as by gold. In the complementary view, Chartalism explains the "vertical" (government-to-private and vice versa) interactions, while circuit theory is a model of the "horizontal" (private-to-private) interactions.

James K. Galbraith has publicly advocated the use of functional finance and wrote the foreword for Mosler's book Seven Frauds in 2010.

See also

• Demand for money
• Functional finance
• Metallism
• Quantity theory of money
• History of macroeconomic thought

Bibliography

• Innes, A. Mitchell (1913), "What is Money?", The Banking Law Journal
• Febrero, Eladio (2009), "Three difficulties with neo-chartalism" (PDF), Journal of Post Keynesian Economics, 31 (3), M.E. Sharpe, Inc.: 523–541, doi:10.2753/PKE0160-3477310308
• Lerner, Abba P. (1947), "Money as a Creature of the State", American Economic Review
• Mitchell, Bill (2009), The fundamental principles of modern monetary economicsin "It’s Hard Being a Bear (Part Six)? Good Alternative Theory?" (PDF) {{citation}}: External link in |postscript= (help)CS1 maint: postscript (link)

  Introduction to modern (as of 2009) Chartalism.

• Wray, L. Randall (2000), The Neo-Chartalist Approach to Money, Center for Full Employment and Price Stability {{citation}}: External link in |publisher= (help)
• Wray, L. Randall (2001), The Endogenous Money Approach, Center for Full Employment and Price Stability {{citation}}: External link in |publisher= (help)
• Wray, L. Randall (December 2010), Money, Levy Economics Institute of Bard College {{citation}}: External link in |publisher= (help)CS1 maint: date and year (link)

External links

• MMT Wiki, the Modern Monetary Theory interactive encyclopaedia
• Bill Mitchell's blog (Chartalism is denoted as "Modern Monetary Theory", there)
• Warren Mosler's blog
• New Economic Perspectives website
• Credit Writedowns, news and opinion site, from the MMT perspective