"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Thursday, December 16, 2010

Modern Monetary Theory , or How the US Monetary System Really Works

This will be a series of posts that will be dedicated to Modern Monetary Theory (MMT).  I want to make one thing clear - although MMT is viewed as a theory, it is really a description of how the US monetary system actually works.

I am going to be posting essays on MMT piecemeal - baby steps, if you will.   There's a reason for that. Intellectually, it is not a difficult theory to comprehend.  the problem with understanding MMT is that we have all been lied to, or misinformed our entire lives as to how the monetary system works.   There are great misconceptions and these misconceptions have been reinforced by the media, by politicians, and by analysts.  I shouldn't be too hard on them, because honestly, most believe in what they say.

Some foundational knowledge that should help us get through this includes definitions of common concepts:

Free-floating currency:  A currency is free floating when it is openly traded and is not backed by anything or pegged to any other currency.  The US Dollar is free floating, which means that it is not pegged to the value of any other currency, and it is not backed by gold or any other commodity.  Thus, the US Dollar has no limitations on its creation.  It is therefore, free of any constraints to creation.  It is not tied to a certain weight of gold, nor is it tied to another currency.  The Chinese Yuan, on the other hand, is pegged to the US Dollar.  So the People's Bank of China needs to "manipulate" the Yuan so it retains a consistent value against the US Dollar.

Redeemable or Convertible Currency:  A currency that is redeemable or convertible is one that can be exchanged for a commodity, like gold.  Under a true gold standard, paper money was officially backed by gold or silver, and could be exchanged at the bank for those metals.  What was the effect of this?  People that lost faith in the currency could redeem it at a set price.  And government was constrained by this - it could never "print" at will for fear of a gold run - meaning, the government would run out of gold.

Here's what a redeemable currency looks like:

See where it says "In Gold Coin"?  That means you can exchange this dollar for gold. Actually, it was also called a gold certificate because of its redeemability.

Today, we have this:

It is not a certificate, but a note.  See the top phrase: "Federal Reserve Note"?  A Note is a promise to pay.  It is debt backed money, which is money created between the Federal Reserve and the US Treasury.  Thus, today's US Dollar is also described as an irredeemable or nonconvertible currency.  It is what it is, and since you have to pay the US Government in US Dollars, you don't have much choice, right?  But more on that later...

Operationally Constrained:  You will hear this phrase when we discuss the US Government's ability to create money.  What this means is that the US Government does not need to raise debt or collect taxes to spend money.  It is not "operationally constrained."  It can spend money at will, and if it has a deficit, it creates new money, regardless of "budgetary constraints."

Money Creation

I want to mention that for my EU readers, this will seem extremely strange.  The EU has a different system because it does not have a Central Treasury.  Although the ECB can create money from nothing, it is more constrained by EU member politics, and the budgetary constraints set by the Maastricht Treaty.

But for the US, money is created between the Federal Reserve, and the US Treasury. Edward Harrison of Credit Writedowns wrote on this last August:

So how does it work for government? Well, the Wikipedia entry for the Federal Reserve has a pretty good summary of how the Fed operates as the government’s bank:
In its role as the central bank of the United States, the Fed serves as a banker’s bank and as thegovernment’s bank. As the banker’s bank, it helps to assure the safety and efficiency of the payments system. As the government’s bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve, through which incoming federal tax deposits and outgoinggovernment payments are handled. As part of this service relationship, the Fed sells and redeems U.S.government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation’s coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation’s cash supply and, in effect, sells the paper currency to the Federal Reserve Banks at manufacturing cost, and the coins at face value. The Federal Reserve Banks then distribute it to other financial institutions in various ways. During the Fiscal Year 2008, the Bureau of Engraving and Printing delivered 7.7 billion notes at an average cost of 6.4 cents per note.
The banking relationship piece is pretty much the same as it is for me and you. The government has a bank through which it pays for stuff. But that bank also acts like the government’s investment bank too, offering bond deals of government debt as an investment bank does for corporate debt. So far, so good.

Here’s the thing though: The Fed also is there on the money creation side, as the Wikipedia quote attests. The government creates currency. It literally makes the money we use. That is an important difference between government and us. Moreover, that money is not tied to any physical commodity like gold. That’s why you will often hear MMT’ers quip that sovereign debt or taxes don’t fund the government’s spending in a fiat currency system. What they are saying is that the government creates currency – and, therefore, as it’s creator they can buy stuff with money they create without funding it first.

Taxes give the fiat currency value by forcing people to use that specific currency in order to discharge their tax obligation. From an accounting perspective, they merely expunge a liability on the government’s balance sheet ledger. They don’t fund spending per se. There is a vestigial tie to taxes as a ‘funding’ source in that the U.S. government is required to issue debt in the form of Treasury bonds, bills or notes to cover deficits But this is a relic of the gold standard mandated by Congress which has not prevented the government from deficit spending. Legal tender laws make the currency widely distributed and entrench it as the money of choice within an economy. In a fiat currency system, sovereign government debt doesn’t serve an important currency function like funding deficits.

As I wrote last year:

From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].” 
So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to. When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.
-If the U.S. stopped issuing treasuries, would it go broke?

I hope that makes it clear how few constraints there really are on government as compared to you or me.

I like to think of it this way. Imagine I am the creator of currency in our country, let’s call the currency "The Harrison," paper notes with little pictures of Benjamin and William Henry Harrison on them that I print up in my basement print shop. Now Harrisons have no intrinsic value. They are valuable only insofar as they are widely circulated in exchange for goods and services. And they retain that value only insofar as their supply remains limited. If I reel off a bunch of Benjamins to buy Treasury bonds, it will not necessarily erode the value of the Harrison if those Benjamins sit in bank vaults without being lent out.

Imagine one day I decide to buy a few tanks for a military expedition abroad. I go to my basement and reel off a gazillion Harrisons equal in value to the tanks.* I then march down the street to the Government Bank and deposit the money in my account. Then I march down to the tank dealer and give him a check written on my Government Bank account of equivalent value to the Harrisons and the tanks. He gives me the tanks. I didn’t earn the money I used through collecting taxes, now did I? Technically, I didn’t actually have to issue any debt to do this. Nothing was ‘funding’ my purchase except the money I just created.

All of this is a bit scary. I think fiat money is dangerous because the temptation to just print money is always there – and there are few constraints to this. I imagine that if people realized that governments have this much control and so few constraints, they would be worried. But that is the essence of how our fiat monetary system works.

Misthos here.  So what I wanted to accomplish with this post was to objectively describe the mechanics of the US monetary system.  I will be writing on the policy implications and my opinions as to how this system will ultimately unravel in future posts.  Included in these posts will be the creation of the Federal Reserve and the Federal Income Tax, how such a system interacts with trading partners that have a different system and buy our "debt", and the consequences of that and how the private banking system, particularly the largest banks, have hijacked the US Government.

I also want to point out, as I have mentioned in other posts, that the US does not rely on China or any other country to fund itself.  Nonetheless, politicians and many analysts frequently cite this when they speak of the national debt.

But I want to end this post with a quote and an interview, that to me, sums up the US monetary system and also shows just how misunderstood our monetary system is.

Warren Mosler, a well known MMT'er, was a candidate for US Senate, and back in June, he was interviewed on Fox Business.  In that interview he said something that threw everyone off guard.  The interviewer, honestly, or intentionally, seemed confused.  Personally, I don't think he was confused.   Here is what Warren Mosler said:
"For the US Government, government spending is not operationally constrained by revenues and therefore taxes function to regulate aggregate demand and not to collect revenue per se."


Jim Slip said...

Hi Misthos, excellent first post on MMT. My thoughts:

It seems to me that the main thing with MMT is that the government has a much firmer control on the money supply than it would have us believe (by artificially giving the impression that the government is funded by taxation and bond issuance).

So, it could just as well be that the government sets the money supply every year, and if it experiences inflation, it just asks it's citizens to hand over their cash. Or it could adjust wages. Or it could adjust prices. So it's all about government control, and finding the correct balance so that people still believe in the system.

OK, now, what about international trade? It would appear that the main trophy for central banks of the surplus countries is, well, fiat cash, which is worthless. Although to be fair, you can purchase real stuff with fiat cash (like China is doing now), and you do gain international gravity by being a surplus country (like China has).

Another question: the US is the US, aka the world's superpower, and owner of the global reserve currency, thus it is even less constrained in it's actions. What I mean is, what would happen if every country had a free-floating fiat currency? Would these countries be constrained at all by their exchange-rate (by speculative attacks)? After all we do need the exchange rate for correcting imbalances in trade (ha!!).

There are a lot of variables to consider. Frankly, I wouldn't consider the national debts that much of a problem since all it requires for them to be solved is some international co-operation with re-balancing trade (I know it's easier said than done). But then the US could easily repay China, or Greece the German banks.. with fiat money!

Private credit is another matter altogether. It seems to me that it has been the steam-engine of growth in many western economies, but all it took for it to unravel was falling prices in the US housing market. Frankly, since they didn't have to, how could they let credit creation explode like that?

Sorry for such a long comment. -))

Misthos said...

Hi Jim,

I agree with your characterization of MMT as being a system that gives the government much more control than is let on.

That said, I think it is also important to understand MMT in two ways. One is how MMT describes the system we have - which although I don't like it, it is an accurate assessment nonetheless. The other involves what MMT's limitations are. My concern is that MMT'ers can get carried away with this - and not just in the sense that government can "over" print - it obviously has, but also in the sense that as the government takes over the private sector ability to create money (as you bring up) that we enter a different economic paradigm - the command economy.

It has already happened - why did some institutions get saved and others didn't? Who decides? What happened to the cleansing part of capitalism - which punishes malinvestment and rewards sustainable, sound investment?

The Fed is trying to save the economy from collapse - but what has happened in that process is the economy is getting distorted. The darwinistic aspects of capitalism are being either arbitrarily determined - or avoided altogether. There are severe unintended consequences to that.

Think of an ecosystem. On its own, it self-corrects between flora and fauna, predator and prey. What happens to that ecosystem when man steps in and introduces new species, or over-protects one species to the detriment of another? Imbalances occur which can not be maintained. That ecosystem, on its own, will self-correct. The greater the imbalances, the greater the self-correction.

You also mention international trade - good point. This is what MMT'ers, in my view neglect. They overly focus on domestic matter sand ignore the rest of the world.

Money determines who gets what resources; who gets to consume more than others. There are different monetary systems within the larger global monetary systems. Some countries can get away with a lot (Japan, US), others, not so much. Many self-impose limitations on themselves (EU). Others export real resources or economic output in return for questionable paper (Saudi Arabia). How long can such an inequitable system last without conflict? And I'm not talking about domestic strife - but global as well.

You also mention co-operation with re-balancing trade. Think of the recent G20 meetings. I have written on those extensively. What has transpired at those meetings to give anyone confidence that global coordination will prevail?

The global system is falling apart. Both politically and economically. That's the only conclusion I can come up with.

boatman said...

hi jim,

excellant site...i'll be here for all of it.

MMT is truly the operational desciption of fiat currency issuing governments.

t-bills n taxes do not fund the government...not to someone who can credit accounts with a stroke of keys.....taxes make the fiat currency valuable.

this was not by design, but how it ended up.

while descibing perfectly, the implementatin of it is bound to be flawed, as humans are....hell bernanke n the others do not even know MMT.

MMT knobs controlled by a perfect person would be great....that person will never exist.

the next convulsion(end game probly) the people will demand something more concrete.

its gonna be a hell of a ride.

signed, gold bug

Misthos said...

"MMT knobs controlled by a perfect person would be great....that person will never exist."

I agree boatman, and welcome to the site.

And for those that need proof that such a person will never exist, one only needs to look at how Wall Street was bailed out. With easily expandable fiat money.

That wasn't the case during the Great Depression, and so Wall Street suffered and was easily re-regulated as a result.

I know some will say: "But do we really need to go through a Great Depression to be able to regulate Wall Street?

That's not the issue, in my view. My response is it's unavoidable. We'll get there with a currency crisis, and the result will be worse than the Great Depression.

FSK said...

Another important point is what I call the Compound Interest Paradox (also called the Debt Virus).


In a debt-based monetary system, money is created via debt. Only the principal is created and not the required interest payments. This guarantees exponentially-growing debt.

Misthos said...


Thanks for the link. I agree with your conclusion.

And so debt needs to constantly be created in order to service the existing debt repayment with interest. This is what Fed Officials fear the most: If the money supply isn't expanded by the private sector, the Fed needs to do it or else the system starts collapsing into debt default deflation.

It's nearly impossible for the system to stay in a stable state. It needs to grow, or it shrinks. But it can't grow forever, and each additional dollar of debt is creating a diminishing rate of GDP growth.

stanislaus2 said...

Do you believe there is a national debt?
I'm an MMT follower and I've concluded there isn't.
My reasoning: Treasury issues securities to borrow money from banks to cover deficits of Congressional spending. Securities are sold at public auction and some banks buy them. The banks send money to Treasury, and their reserves are equally reduced.
Banks take a big hit in their reserves in buying these particular securities. So, they take the securities back to the auction and put them up for sale. The Fed buys them with money it creates out of thin air and deposits in the banks' reserves. Fed gets the securities in return. What has resulted?
Fed has redeemed the debt of the U.S. to the banks.
Banks have new money equal to what they lent the Treasury.
Treasury now has debt free money it is spending.
The Fed has the securities.
Does the Treasury owe the Fed for the securities?
No. The Fed is also government like the Treasury
(in these transactions). It has been established by the Federal Reserve Act of 1913 as amended.
It has bought the securities using power to create money out of thin air with no constraints, which is exclusive government power. So this is an act by the government to redeem the debt of the United States.
So there is no national debt.

The debt ceiling is now meaningless.
The monetary system is equivalent in its results as if Treasury had issued its own money as U.S. Treasury notes. But a difference is the use of the securities to control inflation and fight deflation. Fed sells securities to banks to drain money out of banks. Fed buys securities to put new money into the economy.
Fed has to get securities by buying them from banks. Treasury has to borrow to sell securities to banks.
There is no national debt at the Fed. The Fed has redeemed the debt on ever security it buys.

Misthos said...

Hi Stanislaus2, thanks for posting.

I have debated the issue with MMT'ers on this site and others, mostly Pragmatic Capitalism.

I agree with your description of the monetary system. However, there is one catch that I think MMT'ers miss. The US is not the only country in the world. There are other countries and other currencies.

We live in an economically integrated globalized world of floating exchange rate currencies.

For several decades now, the US Dollar has been the #1 global reserve medium of exchange. But such situations are not static, they are dynamic.

Without going into too much detail, the gist of my argument is that due to Triffin's Dilemma/Paradox, there are limits to what the US can do, just as there are limits for small countries whose currencies are not held as reserves - they are forced to accumulate reserve currencies for trade purposes (GBP, Yen, Dollar, etc..)

MMT on its face is a wonderful concept. But in the end, we are merely using our reserve currency status to export inflation to the rest of the world.

The rest of the world is aware of this, and they are not happy with it. Hence the recent public questioning of the US Dollar's reserve status by China, Russia, Brazil, and many others.

Yes, the debt ceiling is meaningless as you describe. But even though the US can never go broke, unless it wants to, (because it is a currency issuer) there are still constraints.

I know Japan has been used as an example, but that's another story. They too will face constraints eventually.

I have yet to find a persuasive argument by an MMT'er on the Triffin Dilemma and its constraints on the issuing country.