"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, February 3, 2011

Modern Monetary Theory and Why We Have a Debt Based System

I have decided to write once more a series of posts involving Modern Monetary Theory (MMT), or as I like to describe it: how the US monetary system actually works.  For those that are not familiar with this, I have written an intro titled:  Modern Monetary Theory , or How the US Monetary System Really Works.

My post yesterday contained a link from the Fiscal Sustainability Teach-In which was held last April, 2010.  That link had Economist Bill Mitchell's presentation on "What is Fiscal Sustainability."  That presentation was also followed by a question and answer session by some prominent economists.  It is not necessarily difficult material to understand.  What hinders most people in understanding MMT is the amount of disinformation, perpetuated by the media and politicians, that is out there.  We have all been conditioned to misunderstand how a modern monetary system works.

And so, I will occasionally write about my views on MMT, as described by Bill Mitchell in his presentation.  There will be several topics to be covered, and I hope this series sheds some light on what dangers, both economic and political, our current monetary system inherently contains.  No monetary system is perfect, none have shown to have a perpetual lifespan, and a monetary system is only as good as the government that controls it.  And so, we need to be mindful that there is also a distinction between theory and actual practice.

That said, I want to tackle the biggest issue we face first: Why do we have a debt based system?  And what I mean by that is why does the US need to conduct Treasury sales.  Why doesn't the US government just "print," electronically or physically, the money we use?  After all, the US government is not operationally constrained.  It creates money whenever it spends.

In his presentation, Bill Mitchell makes this point about sovereign deficits, debts, and ratios to GDP:
And what really needs to be exposed in this discussion are that all those constraints are voluntary. And in a fiat monetary system, the national government doesn’t have to issue any debt at all. And so fiscal sustainability can’t be caught – a pure concept of it – can’t be caught up and tied in with any of these voluntary constraints. 
In theory, what Bill Mitchell is saying sounds like great stuff. After all, isn't the interest on the national debt growing out of control? And to a large degree, much of the interest that the Federal Reserve receives through US Treasury purchases is returned to the Treasury anyway! But does that mean we are in the clear? And now that the Federal Reserve is the largest holder of US debt, should we feel secure knowing that most of the interest on that debt will be returned to the US Treasury?

Not necessarily.

A mistake economists make is to overlook noneconomic factors that have a tremendous economic consequences.  All too often economists and other analysts view their topics in a sterile environment, unaffected by other exogenous factors.

But there is one factor that cannot be ignored regarding the US Government's use of a Treasury market:


Bill Mitchell is correct when he says that the world's monetary system changed in 1971:
And when you think about it, the whole discussion of fiscal sustainability in the mainstream media and in our governments, in our parliaments, are all applying the logic – and what’s taught students in our universities out of textbooks – are all applying the logic that related moralists to a monetary system that ended in 1971.  
That's very true. Never before in the history if the world has the entire global economy functioned on purely fiat currency - currency that is nonconvertible. Yet we find ourselves constantly discussing economic topics in a gold standard era.

But we also need to understand what were the geopolitical consequences of the change that occurred in 1971, with the end of the gold standard of Bretton Woods under the Nixon Administration.  Up to that date, governments worldwide that accumulated surpluses through trade had three options:  They held onto the currency, or they converted that currency into gold, a pure asset, or sovereign debt denominated in that currency which paid a return: interest.

And so, the US in 1971 unilaterally told the world it would no longer exchange dollars for a fixed price in gold.  And the result was that foreign held surplus dollars would be recycled into US Debts.

Under the gold standard of Bretton Woods, the US's trading partners had an advantage.  Whenever they felt the US overstepped its bounds in money creation, they could easily exchange their dollars for gold.  As the gold was quickly being depleted, the US was forced to shut the gold window.

This represented a geopolitical advantage to the US in the medium term.  By strengthening the US Treasury market worldwide - as it became the only choice left for trade surpluses due to the new irredeemable dollar, the US could much more easily export its inflation.  Don't get me wrong, the US was able to do this under the prior gold standard, but there was a built in "opt out" clause, so to speak.  As a trading partner of the US, you could choose to exchange your US surplus dollars for gold instead of buying US debt.  Those that did got gold for $35 an ounce.  Not bad!

But can the US really wipe out the US sovereign debt market and just issue currency as Bill Mitchell suggests nations are capable of doing?  Yes, but the geopolitical repercussions would be severe.  With the current debt based system, not only can the US export and control its inflation, but through debt issuance, it can also affect trade relationships.  The US can buy whatever it wants without really selling as many things of value in return!  But it's not just the US.  The US-China trade relationship can be described as a vendor financing scheme as much as the Germany-Greece relationship is.  As I have said before in other posts, fiat money allows trade imbalances to grow to dangerously high levels.  The re-balancing of such distorted trade relationships are more likely to end in disaster than in a smooth re-balancing transition.

But for the US, having the world's reserve currency requires that you run a trade deficit.  After all, as the world economy grows, more US dollars need to be printed.  If the US only exported, the amount of dollars worldwide would shrink as the US accumulates a dollar surplus.  It's the same logic that describes a government's debt is always equal to it's private sector's savings.

The US, as global superpowers are want to do, wants to maintain its superpower status.  It's debt based monetary system allows it to consume much more than many other countries.  The sustainability of such a system is another topic.  I don't think it is sustainable.

But the bottom line is that the US needs a debt based system.  The economics of such a system reinforces the geopolitical goals of a superpower.  That system, however, is being tested right now as the Federal Reserve becomes the largest owner of US debt.

To ask the US to issue money without having a Treasury Market is to ask the US to step down from its role as a world power.   Good luck with that.

And if it did, the US would have to start increasing its exports real quick, because that FIRE Economy of big banks, big law firms, hedge funds, and real estate professionals and others would come crashing down.  But that's another topic, for another day.

(Just a quick note.  There are other reasons for a Treasury market, re-capitalizing banks in a way that confuses the average person, targeting rates, etc... but I just wanted to focus on the geopolitical consequences in this post.)

1 comment:

Rajiv said...

Misthos (Gus),

You might also want to look at Peter Cooper's article - Straw Men (And Women)


The question is whether there are idle resources that people would willingly put to use if there was demand for the resulting output, and whether this additional output could be supplied in a non-inflationary manner.

No one in the MMT camp is suggesting the government should net spend more than is necessary to enable the purchase of potential output at current prices.

For everyone but the Austrians, inflation means a persistent rise in the general price level (the weighted average of all prices of final goods and services), not an expansion of broader money per se.

This can lead to differences between Austrians and non-Austrians in their assessments of whether inflation is occurring. If there is a rise in general prices, there will typically be an expansion of broader money to accommodate it unless real potential output shrinks due to a supply shock. In this case, both Austrians and non-Austrians alike will observe inflation. But it is possible for the broader money supply to expand (inflation for Austrians) without general prices rising (no inflation for other economists) whenever the economy is operating below full capacity. This means that from the Austrian perspective, it makes sense to suggest deficit expenditure will reduce the value of money even if, for other economists, there is no inflation.

Differences such as this can be discussed as part of a healthy debate. What is more annoying is the practice of creating straw-man arguments, such as the suggestion that MMT economists are advocating mindless spending out of all proportion to the actual demand deficiency. The tactic often appears to be deliberate, in that there is a wilful misinterpretation of the argument to make it easier to ridicule or criticize. No matter how many times the point is clarified, the wilful (and convenient) misinterpretation will be repeated as if nothing has changed.

As a practical matter for foot soldiers, we need to balance the need to deal with such mischaracterizations with the need to develop the argument further for those not thrown by the mischaracterizations. At some point, it is probably best to assume that intelligent readers have been provided with enough clarification to make up their own minds about the merits of the straw-man argument, and just get on with advancing the discussion.

MMT – and heterodox approaches, in general – seem more susceptible to this kind of straw-man treatment because its proponents have to make the running. In debates with critics or skeptics, the aim of the MMT proponent is usually to explain why the current dominant understanding of the economy is lacking, and why an alternative may offer an improvement in understanding.

A skeptic who is only interested in a better understanding of the economy has no motive to mischaracterize MMT arguments. But when a skeptic or critic is more interested in defending a preconceived view of the world – possibly for psychological, political, or careerist reasons – their motive may not be to understand but to obfuscate, sidetrack, or otherwise hold up the discussion enough to make it difficult for others, trying to understand without prejudging positions, to separate nonsense from valid argument, particularly if untrained in economics.

Consider journalists, for example. It is hard to blame them for erring on the side of the orthodoxy when in doubt if they don’t have sufficient confidence in their own understanding. When in doubt, it is surely safer to go with the view of a Professor from an Ivy League university over the views of a heterodox economist, even if the heterodox position makes more sense.

Opponents of the heterodox position can take advantage of this, knowing that they do not have to win arguments, or even engage in them in many cases

Also you may want to allow for blockquotes, and increase allowable length of comment