Modern Monetary Theory

[moda0306]

I've been following the interesting economic arguments of Modern Monetarists for a while now.  I figured I'd post the following link to get discussion started on this topic.  I find this an extremely interesting perspective that deserves our consideration, as just what kind of constraints a fiat currency has has been a topic of conversation time-and-time again.

http://pragcap.com/resources/understand ... ary-system

[AdamA]

Moda--

Interesting post.  I understood about 25% of it.  Hopefully, someone smart and articulate on this site will dumb it down even more for me.  

I agree that most of the popular descriptions of our monetary system are very likely to be overly simplistic, and I like how this guy makes it a point to say comparing our current system to the gold standard leads to confusion.

[moda0306]

Read the comments and other links at the bottom.  Roll it all around in your head.

[moda0306]

I'm going to throw something out there, does a currency need to have an "intrinsic value" or need to be tied to something with one to work indefinitely?  Does the mere act of issuing paper and taxing in that paper "create" a workable currency?

What if we lived in a bartar society with no gold or other usable currency, and the government that we recently hired (paid in food baskets) to defend our society, families and private property has come to us with a plan to issue a common currency.  We hear and accept that plan and the following occurs:

1) They mail out to each citizen 1,000 pieces of paper with the picture of the President on it.  People look at it and think, "what the heck is this??  I'm just going to throw all this away."  Then...

2) They see the note written on it.  "In place of your payment of food, 100 of these bills must be paid to the government every year, or we'll come pick you up and send you to jail."

3) Poof!  You have a currency.  The dollars are valuable as a get out of jail free card.  The government ends up only arresting a small percentage of the population every year, but you now have a currency with "some" value.  Can that currency ever collapse?  Well if the governments ability to enforce its tax persists, one would think that it would not collapse.  The government has the authority to raise the tax as high as it wants (but only within political reality, of course)... giving people less spending money before they start running the risk of going to jail.  That will automatically drastically increase the value of the bills they were given (prevent inflation).  The government does not need to "borrow" these bills back, but it might to help keep the "right amount" in circulation to keep up with the demands of the private sector commerce.  The government will probably continue to tax for the "value" reasons discussed above, but taxing and borrowing are simply monetary management tools, and do not benefit the government's finances one way or another.  "Debt" is not really debt (they didn't even need to issue it in the first place... they only did to pull in some of the money they'd already mailed out for free), and taxes are not really "funding" anything (they could even more easily print than collect taxes).  They are just to maintain the value of the currency. 

So basically, totally different from how a household or business would look at its balance sheet, and totally different from a currency tied to another currency (or gold).

[TBV]

So long as people exchange value for value, it shouldn't matter what they use as an intermediary device (i.e. money). But if you do all the work and all I do is create promissory notes (be they dollars, coconut shells, or whatever), you will soon tire of either a) working or b) accepting my "money."  That's the rub.  Money that is scarce is valuable.  The easier it is to create, the less valuable it becomes.  So long as some people insist on inflating it, there will be debasement.  And that is a form of fraud IMHO.

It's apparently very hard to determine what the "right" amount of money is under a given set of circumstances.  Almost as hard as determining what our present set of circumstances is, in fact.  Still harder when some see utility in promoting certain policies using fiat money, regardless of the current circumstances.  The result is always the same: inflation.  Sometimes a little, sometimes a lot.  But always some.  And always enough to absorb (and negate) what would otherwise be the beneficial effects of innovation and productive investment, i.e. falling prices.  Personally, I'd prefer sound money and falling prices.

Times were when you could see the divide between Keynesians and monetarists.  Now, they seem like different sides of the same coin, only there is no longer any "coin" to speak of.

[moda0306]

While I haven't rolled the effects of expanding the currency around in my head long enough, here's one thing I've walked away with so far...

1) First off, public "debt" as we think about it should be looked at in a TOTALLY different way than private debt... it's not even necessary, but simply a tool the fed uses to adjust terms of the money supply.  The government can simply push a button to pay its bills. Secondly, public debt is simply net private savings.  Since all private sector savings has corresponding liabilities (think corporate bonds), there is a net 0 savings in the private sector.  That is a huge point.  There are net 0 financial assets in the private sector until the government issues money.  If the government finally issues its first bonds in the amount of $1 billion, then you have a $1 billion defecit in the public sector, and $1 billion in net savings in the private sector.  That's the ONLY way to have net savings in the private sector, so all this talk about "how can the answer to an overly debt-ridden society to be to take on more debt" argument is completely missing the accounting of what's going on.  Public debt (which isn't even really debt) is NECESSARY for net private savings.  I'm still trying to digest this, not claiming it as fact... just putting the argument out there best I can.  I think the source of the US private net debt in dollars is because of foreign net assets in dollars.  What is the ONLY way of improving the US net savings?  Like I showed above, the US government MUST run a defecit and the source of that defecit must go to the U.S. citizens.  Otherwise there's NO WAY for the private sector to have net savings.  It's impossible from an accounting point of view.

2) QE isn't really printing money the way I have been thinking about it.  I'm not saying it's "good" to do, but think of it this way.  If the Fed "buys" treasuries from the private sector banks, it usually does so in the extremely short-term (0-3 years).  But ST treasuries are almost money anyway, as they are basically CD's with the government.  If my bank were to pay me $10,000 for my $10,000 6-month cd, has this really drastically changed my position?  No, I now earn MM rates instead of 6-month CD rates.  Now I can choose to invest that in a riskier asset, yes, but it's not like I am holding onto something drastically different than I did before... especially in todays interest rate environments... a 6-month treasury and a treasury MM account are almost identical.  So QEII basically didn't so much "print" money, but simply changed the terms of the money to not much different than it was before.  This blew a hole in my head too.

Basically, I'm trying to adjust my thinking of what money really is and what debt really is.  If a society initiates its first fiat currency and issues its first billion dollars, it didn't have to tax or borrow to do so (in fact, it can't, since that money doesn't exist yet), but if then the same government allows the purchase of ST bonds from it, has it really changed the money supply?  To issue bonds it maybe collected $1 million in $$ and issues $1 million in 1 year securities.  Those securities could be freely used to buy/sell, etc.  So the government traded one kind of fiat paper for another... basically just putting a new "kind" of fiat currency out there.  Now it's likely that currency won't get circulated, as the people that buy them are looking to hold the bonds as assets, but that's kind of the point... it gives people a chance to have net savings when there's no borrowers in the private sector.  If the government didn't borrow it, it would either sit in these peoples' pockets or it would be borrowed to someone in the private sector.  And remember, if borrowing to someone in the private sector is a balanced transaction, no private net savings has happened, as the same amount of debt was taken on by another individual.

So now we're looking at a net public defecit, a net private surplus of the same size, but that private surplus is made up of a large private (including other countries) foreign surplus and a smaller domestic private defecit.  Accounting-wise (according to modern monetarists... and it's hard to escape the logic), by taxing or eliminating spending in our country, there's NO WAY that can help our domestic private sector balance sheets.  The ONLY way to help the domestic private sector balance sheets is to run a public-sector defecit by spending or tax cuts.  That's the only way to get private domestic savings to go up, as the only way there is a net private domestic savings is to either have public "debt" or foreign "debt" in our currency... the latter is not going to happen as other countries are being shipped dollars every day through our purchases, just as we're shipped yen, pesos, etc.

[moda0306]

Another illustration (not that I haven't already hit on it).

How do you tax something or issue a bond on something that doesn't even exist yet?  You have to issue a fiat currency before you tax it or offer bonds for it.  Therefore, any bonds you issue (people that want to save their $$ instead of spend it) are simply destroying the money you've already created (but since ST bonds are kind of like money (think CD's), did you even destroy anything or did you simply change the terms of it a little).   To take it even further, then, if you enact "QE," you're just recreating the money that you destroyed after you created it.  But once again, are you really creating money, or simply changing the terms on what's already out there.  Literally, the money that the recipients of QE receive is simply credited to their MM accounts at the fed, much like you or I being paid the balance of a CD we own.

Which basically brings me to a humbling question... given the mechanics of how the government "prints" money (buys up treasury bonds) how did the original money even make it into circulation in the first place?  Is there another "printing" operation I'm not aware of?

This is all very interesting, as it tends to wreak of some kind of hyper-keynesianism or hyper-monetarism (the proponents think the gold standard would NEVER work in todays economy), but its proponents also decry bailouts and the misallocation of resources that our government does so often.  I really suggest for you guys to read that link, as it is seriously changing my perspective on reserve accounting and our defecits.

[MediumTex]

There is something sort of absurd about having governmental entities like the IRS creating spectacularly complex sets of tax rules when the government could very easily simply print more money rather than chasing people around trying to "collect" it.

Most people don't think about it in these terms (least of all bureaucrats and tax practitioners), but when viewed from a distance there is something sort of silly about the whole arrangement.

Perhaps politicians in recent decades have begun to realize there is some underlying truth to what I am saying, which is demonstrated in their increasing willingness to simply print money (in the form of un-repayable debt) to be spent by the government rather than trying to collect it from the citizenry in the form of taxes.

[moda0306]

How is the debt not repayable if all it takes is the push of a button?

I agree on your point on taxes... seems truly obsurd to dance to a fiscal song that's not even playing.

[moda0306]

Somewhere at the above site are examples of periods of time where the U.S. government has run surpluses, and a history of the worst U.S. recessions.  It's amazing to see how many recessions were preceded by U.S. debt reduction.

[moda0306]

I think the "collection" of taxes plays a part in giving it value.  I am not sure how fiat currencies have started in the past or if after you have an established value ceasing to tax destroys a currency, but with the threat of imprisonment associated with not paying taxes, I wonder if that plays a role in keeping the currency valuable, even if there is a net defecit being run every year.

[TBV]

“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand.”?

"A further expansion of production is possible only if the amount of capital goods is increased by additional saving, i.e., by surpluses produced and not consumed. The characteristic mark of the credit-expansion boom is that such additional capital goods have not been made available. The capital goods required for the expansion of business activities must be withdrawn from other lines of production."

---Ludwig von Mises

[moda0306]

What would you define as "credit expansion?"  If credit expansion is person A loaning money to person B, then what does the government printing money have to do with it?  Maybe the government can coerce the misallocation of resources, but that is different than "credit expansion" isn't it?  Does the mere creation of a fiat currency create "credit?" (ie, if I send out $1,000 to every member of a society as an introduction to a new fiat currency, is that an "expansion of credit?) Isn't credit merely a promise to pay in the future?  Credit generates as a perfectly natural function of the economy, does it not?  If government's enacting a fiat currency is simply a way of getting "more money" out there than gold could ever provide to manage a large economy, is that really credit?  If not, how would enough currency exist within a large economy with not enough gold to function as a currency?  If the government is not revenue constrained and its bonds are simply a way of managing the money supply, then are those bonds really credit??...I mean, they were purchased with the fiat money that I believe you are arguing is credit to begin with, so aren't we swapping credit for credit given your argument and therefore not expanding anything with QE?

I am being serious, not sarcastic.  I don't know how to fit these different ideas into our current monetary system.  TBV, you seem to want to come at my points from a totally different context from which I'm making them.  There's nothing wrong with that, as that's exactly what I'm doing, but I need to be able to connect the dots.  Your quotes and poetic, well thought out statements are well-taken, but if you could address those points you could maybe help us both (or just me) better understand credit.

[TBV]

What would you define as "credit expansion?"  If credit expansion is person A loaning money to person B, then what does the government printing money have to do with it?  Maybe the government can coerce the misallocation of resources, but that is different than "credit expansion" isn't it?  Does the mere creation of a fiat currency create "credit?" (ie, if I send out $1,000 to every member of a society as an introduction to a new fiat currency, is that an "expansion of credit?) Isn't credit merely a promise to pay in the future?  Credit generates as a perfectly natural function of the economy, does it not?  If government's enacting a fiat currency is simply a way of getting "more money" out there than gold could ever provide to manage a large economy, is that really credit?  If not, how would enough currency exist within a large economy with not enough gold to function as a currency?  If the government is not revenue constrained and its bonds are simply a way of managing the money supply, then are those bonds really credit??...I mean, they were purchased with the fiat money that I believe you are arguing is credit to begin with, so aren't we swapping credit for credit given your argument and therefore not expanding anything with QE?

I am being serious, not sarcastic.  I don't know how to fit these different ideas into our current monetary system.  TBV, you seem to want to come at my points from a totally different context from which I'm making them.  There's nothing wrong with that, as that's exactly what I'm doing, but I need to be able to connect the dots.  Your quotes and poetic, well thought out statements are well-taken, but if you could address those points you could maybe help us both (or just me) better understand credit.

Doesn't all of this start with the Fed loaning money to banks at near-zero interest rates?

[moda0306]

I will investigate and get back to you on this, as this is one point not really discussed in the MMT articles I've read.  I lean towards thinking that money really isn't "lent" to the banks as much as reserve requirements are adjusted, and the reserve interest rates are set by the fed, but I could be in gross error.

[TBV]

I will investigate and get back to you on this, as this is one point not really discussed in the MMT articles I've read.  I lean towards thinking that money really isn't "lent" to the banks as much as reserve requirements are adjusted, and the reserve interest rates are set by the fed, but I could be in gross error.

These are separate techniques, AFAIK. The reserve requirement is a more standard means of increasing the money supply because it allows banks to create "checkbook money" through deposit multiplication.  Quantitative easing is when the Fed directly adds to banks' holdings for the purpose of acquiring Treasury bonds.

[moda0306]

So how is the fed "loaning money at artificially low rates" by enacting QE?  I'm pretty sure QE is simply buying back a bond that a bank owns and crediting their reserve account at the treasury for the amount that the bond(s) were worth, and that account earns whatever measly MM rate that the fed is paying at that time.

Nowhere in that do I see the fed "loaning money at near-zero rates" but simply setting up those rates for their reserves... I'm not saying it doesn't happen... just that I'm not seeing those loans within QE.

Now purchasing MBS at face value?  I can definitely see that being rotten... though I am quite sure that the MMT people are strongly opposed to propping up the housing market (and the bad bank loans) in that way.

[TBV]

So how is the fed "loaning money at artificially low rates" by enacting QE?  I'm pretty sure QE is simply buying back a bond that a bank owns and crediting their reserve account at the treasury for the amount that the bond(s) were worth, and that account earns whatever measly MM rate that the fed is paying at that time.

Nowhere in that do I see the fed "loaning money at near-zero rates" but simply setting up those rates for their reserves... I'm not saying it doesn't happen... just that I'm not seeing those loans within QE.

Now purchasing MBS at face value?  I can definitely see that being rotten... though I am quite sure that the MMT people are strongly opposed to propping up the housing market (and the bad bank loans) in that way.

If the Fed created money just to buy pre-existing Treasury securities from banks, the proceeds from which came back to the Fed as bank reserves, what would be the point (aside from lowering Treasury yields)?  As I understand it, the banks use those reserves to make loans and/or buy assets.  Due to the reserve requirement, they can create multiples of money for every dollar of reserves they hold.  This expands the money supply even more than the Fed's original act of money creation. Ben Bernanke refers to this as "credit easing", thus the relevance of von Mises' argument re: credit expansion.

[moda0306]

TBV,

This is still an act of the private sector.  If the bank has to keep $10 in reserves and can loan the other $90, that's the private sector trying to put that money to use.  If anything, the reserve requirement prevents the expansion of too much credit by forcing the bank to hold what they'd otherwise want to lend out.  I put my money in the bank, and the bank wants to do something with it.  This can easily exist without the fed, can't it?  Heck, even w/ a gold standard, the bank could say to themselves "well, as long as we keep 10% reserves in the vault we should be ok."

Otherwise the bank would probably charge you for holding your gold as opposed to paying interest... I don't know I'm trying to think through this and am stumbling a bit.

That said, I do believe after reading more that the fed "lends" money to banks... I just need to find out how much and in waht context I should be looking at it.

[moda0306]

Further, I'm quite sure that's what QE is, replacing investments in US treasuries (usually ST) with pure cash.  It goes right into their reserve account, but now they can do what they wish with that money.... including buy more of what they just sold... the whole idea, as I see it, is to change the composition of risk-free (ok, not "risk-free," but you know what I mean) return assets out there to make risky assets look more "worthwhile."  If 5 year treasuries are paying 4%, great for me, but if the fed comes along and enacts QE, all of a sudden there's less risk-free competition out there for bonds, so rates drop... now that all these recipients have QE that they can no longer get the 4% return they wanted in 5-year treasuries, they decide that it's now worthwhile to try to invest in corporate bonds or stocks instead.

That's my impression anyways.

[moda0306]

Another thing about QE... if the bank or whoever was investing before, it's not like QE comes in and says "go buy a Porsche."  It comes in and gives them cash for what was a short-term investment.  They will probably want to reinvest (obviously... QE didn't turn banks into consumers)... now they'll probably be more inclined to invest in small business loans or something.  Therefore, you don't get this huge rush of money into consumers' hands causing inflation, simply a reprioritization on the part of banks as to where the best return will be.

Just thought I'd reillustrate my impression of the effect of QE.

[TBV]

Moda:  Earlier you included this in one of your posts...
"If government's enacting a fiat currency is simply a way of getting "more money" out there than gold could ever provide to manage a large economy, is that really credit?"

It reminded me of the argument that easy money proponents have often used, i.e. that there is a shortage of money which cannot otherwise be addressed by a gold standard, due to its supposed inflexibility.  1) Since 100% reserve gold certificates can be denominated in whatever fraction of a gold gram/ounce one pleases, why should the total supply of available gold be a constraint on the expansion of money? 2) The response (by Ron Paul and others) to the original argument is that the perceived need for a stimulative monetary policy is just a symptom of the economic contractions caused by prior inflationary bubbles.  If so, then repeating the error can be like filling a room with gas, hoping that no one lights a match.  John Hussman has written about this and argues that even small increases in monetary demand can spark inflationary spirals due to the present alarming expansion of base money.

Any thoughts on this?

In partial reply to what you just wrote while I was writing the above......The reserve requirement allows the banking system to create money by deposit multiplication.  As deposits become loans which come back as yet more deposits, the net effect is the expansion of credit and the money supply.  As we have seen before, this usually occurs faster than the economy can produce corresponding goods and services.  The result being a dislocation of the economy and (more often that not) inflation.

[TBV]

Another thing about QE... if the bank or whoever was investing before, it's not like QE comes in and says "go buy a Porsche."  It comes in and gives them cash for what was a short-term investment.  They will probably want to reinvest (obviously... QE didn't turn banks into consumers)... now they'll probably be more inclined to invest in small business loans or something.  Therefore, you don't get this huge rush of money into consumers' hands causing inflation, simply a reprioritization on the part of banks as to where the best return will be.

Just thought I'd reillustrate my impression of the effect of QE.

Your description is similar to how Bernanke explained why his approach is different from what Japan did.  He stressed that this is not simply a means of financing government debt, but rather a more-market oriented stimulus.  Perhaps so, but it would sound more convincing if the Treasury were not simultaneously piling up unprecedented amounts of debt.

[moda0306]

Gold can be further divided, yes, but I think we're fooling ourselves if we think gold is "as valuable as we need it to be as money."  I'm not talking about "stumulus," but simply enough money to function.

There is a natural rate of ??% of currency needed as "grease" in the economic gears for every dollar of GDP or dollar of wealth, would you not agree (think of a V-8 needing more oil than a 4-banger)?  Well I think the idea that gold can just be divided smaller and smaller through the use of notes and function as a currency in a huge economy is ridiculous.  Think of it, if we used just gold in our economy it would probably have to be worth tens if not hundreds of thousands of dollars an ounce.  One ounce of gold would could you an oil rig or a farm or maybe even an entire company someday (sarcasm... kind of).  Ron Paul may have the confidence that gold will act as a store of that much value, but there's only SO MUCH value a shiny yellow metal can store.  I guess maybe this is getting back to the argument of what exactly a monetary metal can accomplish in a global economy, but I hold to the idea that gold can only be worth so much, and therefore can't work once the world economy's need for a certain amount of currency goes beyond the value of gold in the world.  Some believe the value of gold is "whatever it needs to be" and I just can't see that as being the case.

[TBV]

Gold can be further divided, yes, but I think we're fooling ourselves if we think gold is "as valuable as we need it to be as money."  I'm not talking about "stumulus," but simply enough money to function.

There is a natural rate of ??% of currency needed as "grease" in the economic gears for every dollar of GDP or dollar of wealth, would you not agree (think of a V-8 needing more oil than a 4-banger)?  Well I think the idea that gold can just be divided smaller and smaller through the use of notes and function as a currency in a huge economy is ridiculous.  Think of it, if we used just gold in our economy it would probably have to be worth tens if not hundreds of thousands of dollars an ounce.  One ounce of gold would could you an oil rig or a farm or maybe even an entire company someday (sarcasm... kind of).  Ron Paul may have the confidence that gold will act as a store of that much value, but there's only SO MUCH value a shiny yellow metal can store.  I guess maybe this is getting back to the argument of what exactly a monetary metal can accomplish in a global economy, but I hold to the idea that gold can only be worth so much, and therefore can't work once the world economy's need for a certain amount of currency goes beyond the value of gold in the world.  Some believe the value of gold is "whatever it needs to be" and I just can't see that as being the case.

We live in a country where the "dollar" (a mere legal construct) has no intrinsic value, nor does the government know what it will be worth tomorrow, next month, or next year.  Yet, we can still assert with confidence that the value of gold (a real commodity) cannot be equally flexible. Really?  Why not?

When new forms of money are introduced, old money is exchanged and phased out, just like the Euro or the greenback.  When that happens in gold, the issuer decides what amount of gold the monetary unit will command.  Just because we've grown accustomed to numbers in the billions and trillions in the last few decades doesn't mean we need to keep doing so. Pennies and dimes might once again be worth something.

Let's not forget that the USA became the world's greatest manufacturing power, built a national railroad grid, established an electricity grid, and invented the very framework for modern cities worldwide.......all while on a gold standard.  And Britain built the world's largest economy for its time (complete with the industrial revolution) using hard currency as well.

IIRC, Murray Rothbard argued against exchange rates to explain how many dollars an ounce of gold was worth.  He thought money should simply be denominated directly in units of gold.  That would dispense with the need for anything called a dollar, and also dispense with government's tendency to manipulate the ratio of dollars to gold.