Modern Monetary Theory

Modern Monetary Theory (MMT or Modern Money Theory, also known as Neo-Chartalism) is a macroeconomic theory which describes and analyses modern economies in which the national currency is fiat money, established and created by the government. The key insight of MMT is that "monetarily sovereign government is the monopoly supplier of its currency and can issue currency of any denomination in physical or non-physical forms. As such the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors. Thus, insolvency and bankruptcy of this government is not possible. It can always pay".^[1]

In sovereign financial systems, banks can create money but these "horizontal" transactions do not increase net financial assets as assets are offset by liabilities. “The balance sheet of the government does not include any domestic monetary instrument on its asset side; it owns no money. All monetary instruments issued by the government are on its liability side and are created and destroyed with spending and taxing/bond offerings, respectively.”^[1] In addition to deficit spending, valuation effects e.g. growth in stock price can increase net financial assets. In MMT, "vertical" money (see below) enters circulation through government spending. Taxation and its legal tender power to discharge debt establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that must be met. In addition, fines, fees and licenses create demand for the currency. This can be a currency issued by the government, or a foreign currency such as the euro.^[2][3] 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 by itself.

Background

MMT synthesises ideas from the State Theory of Money of Georg Friedrich Knapp (also known as Chartalism) and Credit Theory of Money of Alfred Mitchell-Innes, the functional finance proposals of Abba Lerner, Hyman Minsky's views on the banking system and Wynne Godley's Sectoral balances approach.^[4]

Knapp, writing in 1905, argued that "money is a creature of law" rather than a commodity.^[5] At the time of writing the Gold Standard was in existence, and Knapp contrasted his state theory of money with the view of "metallism", where the value of a unit of currency depended on the quantity of precious metal it contained or could be exchanged for. He argued the state can create pure paper money and make it exchangeable by recognising it as legal tender, with the criterion for the money of a state being "that which is accepted at the public pay offices".^[5]

The prevailing view of money was that it had evolved from systems of barter to become a medium of exchange because it represented a durable commodity which had some use value, but proponents of MMT such as Randall Wray and Mathew Forstater argue that more general statements appearing to support a chartalist view of tax-driven paper money appear in the earlier writings of many classical economists,^[6] including Adam Smith, Jean-Baptiste Say, J.S. Mill, Karl Marx and William Stanley Jevons^[7]

Alfred Mitchell-Innes, writing in 1914, argued that money existed not as a medium of exchange but as a standard of deferred payment, with government money being debt the government could reclaim by taxation.^[8] Innes argued:

Whenever a tax is imposed, each taxpayer becomes responsible for the redemption of a small part of the debt which the government has contracted by its issues of money, whether coins, certificates, notes, drafts on the treasury, or by whatever name this money is called. He has to acquire his portion of the debt from some holder of a coin or certificate or other form of government money, and present it to the Treasury in liquidation of his legal debt. He has to redeem or cancel that portion of the debt...The redemption of government debt by taxation is the basic law of coinage and of any issue of government ‘money’ in whatever form.

— Alfred Mitchell-Innes, The Credit Theory of Money, The Banking Law Journal

Knapp and "chartalism" were referenced by John Maynard Keynes in the opening pages of his 1930 Treatise on Money^[9] and appear to have influenced Keynesian ideas on the role of the state in the economy.^[6]

By 1947, when Abba Lerner wrote his article Money as a Creature of the State, economists had largely abandoned the idea that the value of money was closely linked to gold.^[10] Lerner argued that responsibility for avoiding inflation and depressions lay with the state because of its ability to create or tax away money.^[10]

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.^[11]

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 add net financial assets to the private sector; whereas budget surpluses remove financial assets from the private sector. This is widely represented in macroeconomic theory by the national income 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.

The conclusion that MMT draws from this is that it is only possible for the non government sector to accumulate a surplus if the government runs budget deficits. The non government sector can be further split into foreign users of the currency and domestic users.

MMT economists aim to run deficits as much as the private sector wants to save and for real resources to be fully used e.g. full employment. As most private sectors want to net save and globally, external balances must add up to zero, MMT economists usually advocate budget deficits.

Interaction between government and the banking sector

MMT is based on a detailed empirical account of the "operational realities" of interactions between the government and its central bank, and the commercial banking sector, with proponents like Scott Fullwiler arguing that understanding of reserve accounting is critical to understanding monetary policy options.^[12]

A sovereign government typically has an operating account with the country's central bank. From this account, the government can spend and also receive taxes and other inflows.^[13] All of the commercial banks also have an account with the central bank, by means of which the banks manage their reserves (that is, the amount of available short-term money that a particular bank holds).

So when the government spends, the treasury debits its operating account at the central bank, and deposits 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 central banks set an interest rate target, and conduct open market operations to ensure base interest rates remain at that target level. According to MMT the issuing of government bonds is best understood as an operation to offset government spending rather than a requirement to finance it.^[12]

In most countries, commercial banks’ reserve accounts 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. Those that are 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. On the other hand, the banks that have excess reserves can simply leave them with the central bank and earn a support rate from the central bank. Some countries, such as Japan, have a support rate of zero.^[14]

Banks with more reserves than they need will be willing to lend to banks with a reserve shortage on the interbank lending market. The surplus banks will want to earn a higher rate than the support rate that the central bank pays on reserves; whereas the deficit banks will want to pay a lower interest rate than the discount rate the central bank charges for borrowing. Thus they will 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 interbank lending rate will be in between the support rate and the discount rate.^[14]

Under an MMT framework where government spending injects new reserves into the commercial banking system, and taxes withdraw it from the banking system, government activity would have an instant effect on interbank lending. If on a particular day, the government spends more than it taxes, reserves have been added to the banking system (see vertical transactions). This will typically lead to a system-wide surplus of reserves, with competition between banks seeking to lend their excess reserves forcing the short-term interest rate down to the support rate (or alternately, to zero if a support rate is not in place). At this point banks will simply keep their reserve surplus with their central bank and earn the support rate.

The alternate case is where the government receives more taxes on a particular day than it spends. In this case, there may be 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.

Central banks manage this 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 the private sector, and therefore adds reserves to the banking system.

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. 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 economists describe any transactions within the private sector as "horizontal" transactions, including the expansion of the broad money supply through the extension of credit by banks.

MMT economists regard the concept of the money multiplier, where a bank is completely constrained in lending through the deposits it holds and its capital requirement, as misleading.^[15] Rather than being a practical limitation on lending, the cost of borrowing funds from the interbank market (or the central bank) represents a profitability consideration when the private bank lends in excess of its reserve and/or capital requirements (see interaction between government and the banking sector).

According to MMT, bank credit should be regarded as a "leverage" of the monetary base and should not be regarded as increasing the net financial assets held by an economy: only the government or central bank is able to issue high-powered money with no corresponding liability.^[15] Stephanie Kelton argues that bank money is generally accepted in settlement of debt and taxes because of state guarantees, but that state-issued high-powered money sits atop a "hierarchy of money".^[16]

The foreign sector

NOTE: Some MMT economists view this distinction as misleading, regarding the currency area itself as a closed system, and do not differentiate between the external and domestic sectors. They view the world (closed system) split into several currency areas, not necessarily the size of a country.

Imports and exports

MMT analyzes 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 if there are floating exchange rates and they use different currencies. The following hypothetical example is consistent with the workings of the FX market, and can be used to illustrate the basis of this aspect of MMT:

”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 10 dollars. The bank removes 10 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 10 dollars. It transfers the 10 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.^[17]

MMT proponents such as Warren Mosler argue that trade deficits need not be unsustainable and are beneficial to the standard of living in the short run.^[18] Imports are 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.^[17] Currency transferred to foreign ownership, however represents a future claim over goods of that nation.

Cheap imports may also cause the failure of local firms providing similar goods at higher prices, and hence unemployment but 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.^[17] Similarly a nation overly dependent on imports may face a supply shock if the exchange rate drops significantly, though central banks can and do trade on the FX markets to avoid sharp shocks to the exchange rate.^[19]

Foreign sector and commercial banks

Although a net-importing nation will transfer a portion of domestic currency into foreign ownership, the currency will usually remain within 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.

Foreign sector and government

Using the same application of vertical transactions MMT argues that the holder of the bond is irrelevant to the issuing government. As long as there is a demand for the issuer's currency, whether the bond holder is foreign or not, governments can never be insolvent when the debt obligations are in their own currency; this is because the government is not constrained in creating its own currency (although the bond holder may affect the exchange rate by converting to local currency).^[20] Similarly, according to the FX theory outlined above, the currency paid out at maturity cannot leave the country of issuance either.

MMT does point out, however, that debt denominated in a foreign currency certainly 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.^[21] 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 implications

MMT claims that the word "borrowing" is a misnomer when it comes to a sovereign government's fiscal operations, because what the government is doing is accepting back its own IOUs, and nobody can borrow back their own debt instruments.^[22] Sovereign government goes into debt by issuing its own liabilities that are financial wealth to the private sector. "Private debt is debt, but government debt is financial wealth to the private sector."^[23]

In this theory, sovereign government is not financially constrained in its ability to spend; it is argued that the government can afford to buy anything that is for sale in currency that it issues (there may be political constraints, like a debt ceiling law). The only constraint is that excessive spending by any sector of the economy (whether households, firms or public) has the potential to cause inflationary pressures.

Some MMT economists advocate a government-funded job guarantee scheme to eliminate involuntary unemployment. Proponents argue that this can be consistent with price stability as it targets unemployment directly rather than attempting to increase private sector job creation indirectly through a much larger economic stimulus, and maintains a "buffer stock" of labor that can readily switch to the private sector when jobs become available. A job guarantee program could also be considered a powerful automatic stabilizer to the economy, expanding when private sector activity cools down and shrinking in size when private sector activity heats up.^[24]

Criticisms

The post-Keynesian economist, Thomas Palley argues that MMT is largely a restatement of elementary Keynesian economics, but prone to "over-simplistic analysis" and understating the risks of its policy implications.^[25] Palley denies the MMT claim that standard Keynesian analysis doesn't fully capture the accounting identities and financial restraints on a government that can issue its own money. He argues that these insights are well captured by standard Keynesian stock-flow consistent IS-LM models, and have been well understood by Keynesian economists for decades. He also criticizes MMT for essentially assuming away the problem of fiscal - monetary conflict. In Palley's view the policies proposed by MMT proponents would cause serious financial instability in an open economy with flexible exchange rates, while using fixed exchange rates would restore hard financial constraints on the government and "undermines MMT’s main claim about sovereign money freeing governments from standard market disciplines and financial constraints". He also argues that MMT lacks a plausible theory of inflation, particularly in the context of full employment in the 'Employer of Last Resort' policy first proposed by Minsky and advocated by Bill Mitchell and other MMT theorists; of a lack of appreciation of the financial instability that could be caused by permanently zero interest rates; and of overstating the importance of government created money. Palley concludes that MMT provides no new insights about monetary theory, while making unsubstantiated claims about macroeconomic policy, and that MMT has only received attention recently due to it being a "policy polemic for depressed times".^[26]

Marc Lavoie argues that whilst the neochartalist argument is "essentially correct", many of its counter-intuitive claims depend on a "confusing" and "fictitious" consolidation of government and central banking operations.^[27]

Austrian School economist Robert P. Murphy states that MMT is "dead wrong" and that "the MMT worldview doesn't live up to its promises". He observes that the MMT claim that cutting government deficits erodes private saving is true only for the portion of private saving that is not invested, and argues that the national accounting identities used to explain this aspect of MMT could equally be used to support arguments that government deficits "crowd out" private sector investment.^[28] Daniel Kuehn has voiced his agreement with Murphy, stating "it's bad economics to confuse accounting identities with behavioral laws [...] economics is not accounting."^[29]

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".^[28]

New Keynesian economist and Nobel laureate Paul Krugman argues that MMT goes too far in its support for government budget deficits and ignores the inflationary implications of maintaining budget deficits when the economy is growing.^[30]

The chartalist view of money itself, and the MMT emphasis on the importance of taxes in driving money is also a source of criticism.^[27] 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.^[31]

Modern proponents

Economists Warren Mosler, L. Randall Wray, Stephanie Kelton, 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.^[32]

Bill Mitchell, Professor of Economics and Director of the Centre of Full Employment and Equity or CofFEE, at the University of Newcastle, New South Wales, refers to an increasing related theoretical work as Modern Monetary Theory. Scott Fullwiler has added detailed technical analysis of the banking and monetary systems.^[33]

Rodger Malcolm Mitchell's book Free Money^[34] (1996) describes in layman's terms the essence of chartalism.

Some contemporary proponents, such as Wray, situate chartalism 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.^[13][35]

Hyman Minsky seemed to favor a chartalist approach to understanding money creation in his Stabilizing an Unstable Economy,^[36] while Basil Moore, in his book Horizontalists and Verticalists,^[37] delineates the differences between bank money and state money.

James K. Galbraith supports chartalism and wrote the foreword for Mosler's book Seven Deadly Innocent Frauds of Economic Policy in 2010.^[38]

Steven Hail of the University of Adelaide is another well known MMT economist.^[39]

See also

• Money
• Deficit spending
• Demand for money
• Functional finance
• Sectoral balances
• Quantity theory of money
• History of money
• History of macroeconomic thought
• Hyman Minsky

Notes

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, M.E. Sharpe, Inc., 31 (3): 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 economics in "It’s Hard Being a Bear (Part Six)? Good Alternative Theory?" (PDF) . Introduction to modern (as of 2009) Chartalism.
• Wray, L. Randall (2000), The Neo-Chartalist Approach to Money (Working Paper No. 10), UMKC Center for Full Employment and Price Stability 
• Wray, L. Randall (2001), The Endogenous Money Approach (Working Paper No. 17), UMKC Center for Full Employment and Price Stability 
• Wray, L. Randall (December 2010), Money (PDF) (Working Paper No. 647), Levy Economics Institute of Bard College 

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
• Macroeconomic Balance Sheet Visualizer, visualizing and understanding important concepts in macroeconomics
• Modern Monetary Theory: A Debate (Brett Fiebiger critiques and Scott Fullwiler, Stephanie Kelton, L. Randall Wray respond; Political Economy Research Institute, Amherst, MA)
• Credit Writedowns, news and opinion site, from the MMT perspective
• Knut Wicksell and origins of modern monetary theory-Lars Pålsson Syll
• Evolution of Selected Economic Schools, a simplified diagram
• Modern Monetary Network