A while ago, I came across a comment from someone on r/collapse describing Functional Finance (MMT) concepts to someone droning on with the usual misinformed “we’re borrowing from the future” rhetoric. I thought those comments did a very good, succinct job of explaining some of the concepts, so I thought about posting them here.
Then I thought, in that same spirit of brevity and simplicity, what if I fleshed out those comments a bit more?
As some of you may know, Reddit has a section entitled “Explain Like I’m Five.” I wondered if there was one about MMT. There was, but it wasn’t very fleshed out.
So, I thought, here was a challenge. What you see below is the result. It’s far more wordy than I wanted, and necessarily a bit more complicated than I would have liked (maybe more “Explain Like I’m Fifteen”). I wanted it to to be no longer then a (long) Reddit comment, but I couldn’t quite do the concepts justice in that space, although, with a bit of clever cutting and pasting, it could form the basis of a suitable Reddit comment. I actually did that myself to respond to a particularly idiotic posting, and that in return helped flesh it out. Nevertheless, brevity and simplicity were the key goals here. I used more examples than I would have liked, but I really think they help in explaining the concepts.
*Plagarism alert!* A lot of this is lifted from other sources. I tried to avoid copying text word-for-word as much as possible, but there are some instances where I fell back on that because it was clearer and more accurate. I took a lot from Warren Mosler’s definitive work on the topic– “Seven Deadly Innocent Frauds of Economic Policy,” rephrasing and simplifying along the way, as well at the “Introduction to MMT” at New Economic Perspectives. I also stole a bit from David Graeber about the nature of money, along with some other authors. So don’t accuse me of plagiarism, because I admit it! Still, I hope this collection and simplification of their ideas will be of some merit. In that spirit, I hope the original authors will not object.
Of course, if anyone spots any severe inaccuracies or errors (bearing in mind that this is a simplified explanation), please be sure and point them out. I’m not an economist, nor do I even play one on TV, I’m just someone sick of all the misinformation and scaremongering I see out there.
Without further ado:
Modern Monetary Theory describes the way the monetary system works for sovereign governments who control the issuance of their own currencies. It simply describes how our international monetary system actually works and what the ramifications of that are.
The great virtue of modern, fiat money is that it can be managed flexibly enough to prevent *both* deflation and also any truly damaging level of inflation – that is, a situation where prices are rising faster than wages, or where both are rising so fast they distort a country’s internal or external markets. The trick is for the government to spend enough to ensure full employment, but no so much, or in such a way as to cause shortages or bottlenecks in the real economy. These shortages or bottlenecks are the actual cause of most episodes of excessive inflation. If the mere existence of fiat monetary systems caused runaway inflation, the low, stable rates of consumer-price inflation we have seen over the past thirty-plus years would be pretty difficult to explain.
The government has no money! It can only take money from the private sector by force!!!
The government has no money? The government neither has nor does not have money. It spends by changing numbers up in our bank accounts and taxes by changing numbers down in our bank accounts. And raising taxes serves to lower our spending power, not to give the government anything to spend. Taxes do not finance government spending. As a sovereign currency issuer, the government does not need to “get something” from the private sector first in order to spend. If the private sector has to “earn” dollars, where are they to get the dollars that they must earn?
Imagine if we had a brand new country with a brand new currency. No one has any. Then the government proclaims that there will be a property tax. How can it be paid since no one has any money? It can’t, until the government starts spending. Only after the government starts spending the currency does the population have the money to pay the tax. The funds to pay the taxes, from inception, come from government spending (or lending). We need the federal government’s spending to get the funds we need to pay our taxes.
As another example, imagine if parents wanted their children to do certain household chores, so they printed up a series of coupons and gave them to their children coupons for each task completed–mowing the lawn, taking out the trash, and so on. To create a demand for the coupons, they require each child to pay them 10 coupons at the end of the week to avoid punishment. The children can trade the coupons among themselves if they wish; thus Suzy can have Jimmy clean her room by “paying” him with one of the coupons “earned” from mom and dad.
This creates a demand for these coupons. These coupons now function as the household’s “money.”
Do the parents have to somehow get the coupons from their children before they can issue them to the children for doing their chores? Of course not! In fact, the parents need to “spend” the coupons by paying the children to do the household chores if they want to collect the coupons at the end of the week. How else can the children get the coupons that they need?
If government spends currency into existence, it clearly does not need tax revenue before it can spend. Further, if taxpayers pay their taxes using currency, then government must first spend before taxes can be paid.
If you went to the local tax office and wrote a check for $1,000 to pay your taxes, the government would deduct that $1,000 from your checking account and hand you a receipt, extinguishing your tax liability. The government did not “get” anything from you–it just transferred sums in various bank accounts. If you were to pay your taxes with all one-dollar bills, the government would also extinguish your tax liability, hand you a receipt, and toss the dollar bills into the furnace. The dollar bills in this case function like a $1,000 concert ticket – once the ticket taker takes the ticket from you, she tears it up and throws it away because it is no longer needed.
Thus, the government does not need to “get” money from somewhere to give to someone else that they can then use to “spend.” The people at the U.S. Treasury who actually spend the money (by changing the numbers of bank accounts up) work in different offices than, and do not even have the telephone numbers of, the people at the IRS who collect the taxes (who change the numbers down), or the people at the U.S. Treasury who do the borrowing (by issuing Treasury securities).
Similarly, if the government owed you a tax refund of $1,000, it would simply add an additional $1,000 credit to your bank account. It doesn’t take a gold coin or a dollar bill and stick in into a computer somewhere. All it does is change the number in your bank account by making data entries on its own spreadsheet, which is linked to other spreadsheets in the banking system. Government spending is all done by data entry on its own spreadsheet called “The U.S Dollar Monetary System.”
This is often referred to as “printing” money, although hardly any money exists in physical form such as cash or coins. Most of it exists in the various accounts through which money transferred from one account to the other via keystrokes, and the government can never “run out” of keystrokes. They are adjusting the numbers in various bank accounts either up or down.
In other words, the sovereign government that issues its own currency has unlimited spending power; it owns the currency. These credits/debits are recorded in various spreadsheets, so, the government can never “run out” of money, any more than a sporting event can run out of points, or a construction site can run out of inches. If the New York Yankees score twelve runs against the Boston Red Sox, and twelve runs get added to the scoreboard, they did not “steal” those points from the Red Sox. That is, the government is not “revenue constrained” (but does face other constraints)
If taxes are not used to raise the money the government needs to function, then what are they used for? Taxes create the demand for the government’s currency. Liabilities issued by the state will be considered ‘money’ if those are also the only thing you can use to satisfy tax obligations. The government can levy a general tax obligation on all citizens, and declare what it is payable in. That is sufficient to create a demand for their IOUs as money, and will basically drive its use even in most private transactions within the country.
To prevent the government’s spending from causing inflation, the government must also take away spending power via taxation not to pay for anything, but so that their spending won’t cause inflation. “Unprinting money” via taxation makes it more scarce and valuable, and leaves enough room for governments to spend without causing inflation.
Taxes can also regulate aggregate demand, and we can use taxation to modify market behaviors by taxing what we wish to discourage (like smoking and carbon emissions), and subsidizing what we wish to encourage (like health care and clean energy). The amount of tax revenue has no effect on the spending power of the government. As previously stated, taxes function to regulate our spending power and the economy in general, and not to get the money for Congress to spend.
This is not to say that the government should just spend, spend, spend, without limit, but that the government’s budget constraint is the wrong constraint. The correct constraint is whether or not a particular budget position will raise inflation beyond an official target rate (say, 2%, which seems to be the choice of most central bankers). The objective of the government should be to provide full employment while controlling inflation. This is done by investing (to increase employment) and taxing (to control inflation). An inflation constraint provides more fiscal space than a budget constraint, but in no way does it provide unlimited fiscal space. Therefore, the government should not have deficits or surpluses as their primary objective. Rather, the conditions in the actual economy will dictate policy.
If the current economy has a lot of unemployment, than the government should invest to try and create jobs while taxing in a clever way to avoid inflation. In such a case, the government would possibly end up running a deficit. If, on the other hand, there is high employment and lost of revenue from the sales of goods abroad, then the government should tax a lot; it wouldn’t need to spend as much and might possibly run a surplus. In either case, the conditions of the actual economy determine the actions to take, not an artificial budget constraint.
The same goes for the overall amount of debt. When people say “future generations are going to pay for our debt,” they are really saying that in the future the government will be constrained and have less spending power because of the debts we run up today. This is not true; the government owns the currency and so the amount of overall debt has no impact on the government’s ability to spend. The government can always issue the money it needs to pay its liabilities.
But the National Debt is XXX TRILLION DOLLARS!!!!
The term “national debt” is deceptive, the “debt” is actually assets on the balance sheets of private entities. In the above example, are the parents, by issuing slips of paper to get their children to do their chores, in any sense “in debt” to their children by doing so? Of course not!
Similarly, in the property tax example, is the government now in “debt” as a result of issuing the coins needed to pay the property tax? Is the government how in hock to some third-party due to its “deficit spending?” Does it have to redeem those coins for wheat or pigs or anything else at some point in the future? Of course not. There’s just a bunch of money circulating out there that people can use for transactions. The treasury has made no promise to redeem those coins for anything. There’s really no reason to call those coins, or any other financial instrument the government chooses to manufacture out of thin air and swap for those coins, “national debt.” A debt that will never be paid off is a very questionable “liability.”
That’s essentially the situation with the U.S. national “debt.” The U.S. issues money by deficit spending. It puts more money into private accounts than it takes out via taxes. The private sector has more balance-sheet assets (but no more liabilities, so it has more “net worth,” the balancing item on the right-hand side of its balance sheet). The Treasury has made no promises to redeem that new money for anything (except maybe…different government-issued assets). It’s just out there. They, are only “liabilities” to the government in the most pettifogging accounting sense. If you “owed” some money that you would never, ever have to repay, would you put that on your balance sheet as a liability? Would it be anything beyond a pro forma entry designed to satisfy some obsessive impulse for accounting closure?
When government spends without taxing, all it does is change the numbers up in the appropriate checking account (reserve account) at the Fed. This means that when the government makes a $1,000 Social Security payment to you, for example, it changes the number up in your bank’s checking account at the Fed by $1,000, which also automatically changes the number up in your account at your bank by $1,000.
The U.S. and other sovereign currency issuers operate under a purely self-imposed accounting rule: their treasuries are required to issue bonds equal to that deficit spending. This is a straightforward asset swap: the private sector gives checking-account deposits (back) to the government, and the government gives bonds in return. Private sector assets and net worth are unaffected by that accounting swap; it just changes the private-sector portfolio mix — more bonds, less “cash.” In any case, issuance of these instruments represent a desire to save on the part of the private sector, otherwise they would not find willing buyers.
It’s commonly said that the private sector is “holding government debt,” since the private sector is holding treasury bonds, but this is a misnomer. The private sector is holding assets on its balance sheet, whether they consist of bonds, “cash,” or reserves. But the “debt,” such as it is, only exists as an offsetting accounting liability on the right-hand side of the government balance sheet. It is not accurate to call these a “liability” since they will never be redeemed for anything. A better term to describe the things that we tally up on the left-hand side of our private-sector balance sheets might be “government-issued assets,” as opposed to ” government debt.” The private sector holds (owns) government-issued assets, not liabilities. And even the offsetting liabilities themselves are rather dodgy and iffy accounting entries. The government issues those assets as a public good.
The government has committed itself to issuing bonds for archaic reasons, and so it needs to roll over its “debt.” When old bonds mature, the government pays them off and issues new ones to replace them. The stock of government-issued assets grows over time, as it should and must in a growing economy. As the economy expands, the government issues more assets as a necessary lubricant, and to avoid transactional lockups for the operation of the private-sector economy (i.e. to avoid a ‘liquidity trap’). The “debt” grows over time as the economy expands. The U.S. and U.K. have been issuing debt for more than two centuries, and it has never been paid back. It cannot be, because otherwise there wold be no money. (see below)
The government should be run “like a household!!” If I ran my household budget the way that the Federal Government runs its budget, I’d go broke!!! We have to live “within our means,” so the government should too!!!!
A sovereign, currency-issuing government is NOTHING like a currency-using household or firm. The sovereign government cannot become insolvent in its own currency; it can always make all payments as they come due in its own currency.
Government debt does not have to be paid back. It almost never is. To pay back government debt, you have to run a budget surplus, and while there may be modest surpluses from time to time, they don’t add up to more than a minuscule fraction of all the accumulated debt. Governments that issue their own money don’t have to pay off their debts. They actually can’t. In fact,as we saw above, they issue money — the money that’s necessary for a growing economy to operate — by deficit spending.
We have seen that money is a credit/debit relationship, and the relationship between various sectors of the economy (public, private and foreign) must always sum to zero due to an accounting identity. If the government reduces its debt, everyone else has to go into debt in exactly that proportion in order to balance their own budgets. Debt consists of issuing liabilities that others are willing to hold as financial assets. If there were no debt, there would be no money!
You can think of this as series of interlocking balance sheets between the the major sectors of the economy: public (the government), private (business in aggregate), and foreign (balance of payments), where the total assets = total liabilities. The numbers are zero sum—a surplus in one sector necessarily means a deficit in another sector due to accounting identities.
Since income has to equal expenditure for the economy as a whole (which is the same things as saying that saving equals investment), the sums of the difference between income and expenditures of each of the sectors of the economy must also be zero—a rise in the deficit of one sector must be matched by an offsetting change in the others. These differences can also be described as “sectoral balances.” Thus, if a sector is spending less than its income it must be accumulating (net) claims on other sectors. When broken into sectors, government deficits are non-government surpluses, to the penny.
If the government declares “we must act responsibly and pay off the national debt” and runs a budget surplus, then it (the public sector) is taking more money in taxes out of the private sector than it’s paying back in. That money has to come from somewhere. So if the government runs a surplus, the private sector goes into deficit. If the government reduces its debt, everyone else has to go into debt in exactly that same proportion in order to balance their own budgets. People just assume that the government running a surplus will somehow make it easier for all of us to do so too. But the reality is precisely the opposite: the less the government is in debt, the more everybody else is.
Why does anybody have to be in debt at all? Why can’t everybody just balance their budgets? Governments, households, and corporations; everyone lives within their means and nobody ends up owing anything. Why can’t we just do that?
Because if there were no debt, then there wouldn’t be any money. Money is debt. An individual household or business needs to get dollars to pay it’s debts, that’s true. The same is not true of the economy as a whole. Your spending is my income. Your debt is my asset. Banknotes are just so many circulating IOUs. (take out a dollar bill and read what it says: “This note is legal tender for all debts, public and private”). Dollars are either circulating government debt, or they’re created by banks by making loans. That’s where money comes from. Obviously if nobody took out any loans at all, there wouldn’t be any money. The economy would collapse.
They money that we use are liabilities issued by the central government that others are willing to hold as financial assets. For most people and firms, others are only willing to value and accept our IOUs if they promise to pay something (redeemability in say, an equivalent amount of government currency) and that the extent that our promise to pay is credible (which the banks are in the business of keeping track of).
On the other hand, almost everyone is willing to value and accept the government’s IOUs, because everyone needs to collect government IOUs to pay taxes. That valuation is so ubiquitous, we’re willing to hold far more of the government IOUs than we even need to pay taxes, because they’re a safe bet for holding value for the foreseeable future. So the government can issue more IOUs (cash, coins, reserve accounts, treasury security accounts) than they require back in taxes, and end up perpetually running deficits to satisfy private savings desires. Our money is the government’s liabilities; if there were no debt, there would be no money!
There is going to be a cascading hierarchy of money based on the government IOUs, such as bank IOUs (checking/savings account balances) that promise to pay government IOUs, and personal IOUs (checks, etc.) that promise to pay bank IOUs, etc. And those will all tend to be denominated in the main unit of account made up by the government (dollar, Yen, Pound, Euro, whatever).
So there has to be debt. And debt has to be owed to someone. Let us refer to this group collectively as “the One Percent.” If the government runs up a lot of debt, that means the One Percent hold a lot of government bonds, which pay quite low rates of interest. The government taxes you to pay that interest.
If the government pays off its debt, what it’s basically doing is transferring that debt directly to the public sector as mortgage debt, credit card debt, student loan debt, and so on. Of course the money is still owed to the one percent, but now they can collect much higher rates of interest. And this debt is accumulated by those least able to pay. There were three times in recent decades when the government ran a budget surplus, and each time the surplus was followed, within a number of years, by a recession. Every depression in our nation’s history was preceded by a big decline in nominal Federal debt.
The government can always print the money it needs via keystrokes to pay its obligations as we saw above. Private levels of indebtedness are a much greater concern, and a greater drag on the economy. Private borrowers (and non-sovereign-currency states like Greece and Alabama, for instance) do have to pay off their debts (or default). That’s why the level of aggregate private debt, not sovereign debt, is the big money management problem.
Government deficit spending creates nongovernment sector saving in the form of domestic currency (cash, reserves, Treasuries). This is because government deficits necessarily mean the government has credited more accounts through its spending than it debited through its taxes.
Austerity through government surplus means taxing/extinguishing more money than is created and injected through government spending. That either means increased private sector debt or reduced private sector savings. This is simply a fact due to double-entry bookkeeping.
The government has a monopoly on the currency!!
The government really has no need for legal tender laws, and many countries don’t use them. Neither do they need to criminalize issuing alternative currencies. Once you have paid your taxes, you are free to hold your money in dollars, Euros, Yen, gold coins, Bitcoins, local currencies, or exchange value directly through time banking. No jack-booted government thug will take your money away from you. However, it is unlikely the corner grocery store will accept your Yen or gold coins; most domestic transactions are denominated in U.S. dollars because it is easier, and because dollars are needed to pay the tax obligation. In fact, people trade currencies all the time and these values tend to “float” against one another. Only the Federal Reserve can issue U.S. dollars however; if anyone could “print” dollars in their basement in whatever quantity they desired, a dollar wouldn’t be worth very much, and inflation would very quickly be out of control.
We are stealing from our children!! Future generations will have to pay it all back with interest!!!
The amount of debt incurred today will not stop future generations from producing and consuming all the goods and services they desire and are capable of producing. In the future, just like today, whoever is alive will be able to go to work and produce and consume their real output of goods and services, no matter how many U.S.Treasury securities are outstanding. We will not have to send real goods and services “back in time” to pay off the debt. All things being equal, and if we do not mismanage the economy, the economy will be larger in the future than it is today. Our children will change numbers on what will be their spreadsheet, just as seamlessly as we do today. Also, future generations are not just the debtors, but also the creditors. Otherwise, who would we owe all that money to?
Currently, the U.S. economy is still running well below potential output. When we operate at less than our potential – at less than full employment – then we are depriving our children of the real goods and services we could be producing on their behalf. Likewise, when we cut back on our support of higher education, we are depriving our children of the knowledge they’ll need to be the very best they can be in their future. When we cut back on basic research and space exploration, we are depriving our children of all the fruits of that labor that instead we are transferring to the unemployment lines. This is the real “stealing from our children!”
When the cost to borrow is low, it makes sense to invest in things that will pay a greater return down the line. Every business does this, and any CEO who does not know this would be fired. Like individuals, a government can increase its means in the long run by borrowing to invest in things that will make the economy more productive, and thus increase the tax revenue. If a government invests in improving the transport system, it will make the country’s logistics industry more efficient. Or if it invests in healthcare and education, that will make the workers more productive.
More importantly, unlike individuals, a government has the ability to spend “money it does not have”, only to find later that it had the money after all. The point is that deficit spending in a stagnant economy will increase demand in the economy, stimulating business and making consumers more optimistic. If nominal interest rates are below long-run trend real GDP growth, a dollar of debt more than pays for itself in the long-run.
As we saw above, “austerity” means reducing the amount of money available and driving up the level of private indebtedness. The irony is that in order to somehow “save” public funds for the future, what we do is cut back on expenditures today, which does nothing but set our economy back and cause the growth of output and employment to decline. Currently, the misplaced fear of leaving the national debt to our children continues to drive policy, and keeps us from optimizing current output and employment.
The debt burden depends on the ratio of debt to GDP as well as the interest cost in servicing it. The way to reduce this burden is to have a combination of real economic growth, inflation and modest interest rates. If you want to show your concern for the well-being of future generations, demand macroeconomic policies that will boost demand and raise inflation a bit, consistent with continued low interest rates.
When Congress first imposed a debt limit in 1917, its intent was to limit the amount the Treasury could spend to finance America’s entry into World War I, not to control overall government spending. The basic structure of the debt limit hasn’t changed since 1940, and as a result, the debt limit is both arbitrary and static. It doesn’t take into account inflation or economic growth, and it has no relevance to the nation’s economic output or circumstances.
The Chinese “own” us thanks to deficits!!!
As a sovereign currency issuer, we do not need the Chinese to “fund” our deficits. A sovereign government does not need to “borrow” its own currency in order to spend. Indeed, it cannot borrow currency that it has not already spent! Functional Finance sees the sale of government bonds as something quite different from borrowing. As we saw above, the “debt” is nothing more than government-issued assets held at the Fed. Whether they consist of bonds, “cash,” or reserves, it is unrealistic to call the money originally spent into private accounts a “debt.”
As we have seen, government deficit spending creates equivalent nongovernment savings (dollar for dollar). Some of the savings created will accumulate in the hands of foreigners. For many years (during the Clinton and Bush II presidencies) the domestic private sector was also running budget deficits—so foreigners also accumulated net claims on American households and firms. The US current account deficit guarantees—by accounting identity—that dollar claims on government will be accumulated by foreigners.
Net savings of financial assets is held as some combination of actual cash, Treasury securities and member bank deposits at the Federal Reserve. Normally, the nongovernment sector prefers to hold savings in government IOUs that promise interest, rather than in nonearning IOUs like cash.
The commercial banks we use for our banking all have bank accounts at the Federal Reserve called reserve accounts. This is where they acquire the money they use for loans – they borrow it. Lowering the interest rate at which banks must borrow from the Fed lowers the “cost” of money and makes loans easier to get, theoretically stimulating the economy. A reserve account is nothing more than a fancy name for a checking account. It’s the Federal Reserve Bank so they call it a reserve account instead of a checking account.
Foreign governments have reserve accounts at the Fed also. Foreigners earn US dollars from selling us real goods and services. What do they do with those accumulated dollars? Just like you do with your dollars, they either hold them as cash IOU’s (reserve accounts), or stick them in a savings account (by buying U.S. Treasury securities).
Treasury bonds are sort of like savings accounts at the Fed. Just like your checking and savings accounts at your local bank, your checking account probably offers a very low rate of interest, but you can draw against it any any time (it is “liquid”). Savings accounts are typically held for a longer period of time and pay higher rates of interest. They key thing to understand is that both are methods of saving.
A U.S. Treasury security is nothing more than a savings account at the Fed. When you buy a Treasury security, you send your saved dollars to the Fed, and then some at point in the future (maturity), they pay back the dollars plus interest. It is just like a savings account at any bank–you deposit dollars and get them back plus interest.
When government sells bonds, banks buy them by offering reserves they hold at the central bank. The central bank debits the buying bank’s reserve deposits and credits the bank’s account with treasury securities. Rather than seeing this as borrowing by treasury, it is more akin to shifting deposits out of a checking account and into a saving account in order to earn more interest. And, indeed, treasury securities really are nothing more than a saving account at the Fed that pay more interest than do reserve deposits (bank “checking accounts”) at the Fed. The government simply changes numbers on its own spreadsheet – one number gets changed down and another gets changed up. It is much like a transfer from a “checking account” (reserves) to a “savings account” (bonds). This is a straightforward asset swap: the private sector gives checking-account deposits (back) to the government, and the government gives bonds in return. Private sector assets and net worth are unaffected by that accounting swap; it just changes the private-sector portfolio mix — more bonds, less “cash.” (Treasury “forces” the private sector to make that collective portfolio-adjusting swap through the simple expedient of selling bonds at an attractive price — a point or two below similar deals in the private sector.)
The government bonds take the form of an electronic entry on the books of the central bank of the issuing government. Interest is paid on these “bonds” in the same manner, whether they are held by foreigners or by domestic residents—simply through a “keystroke” electronic entry that adds to the nominal value of the “bond” (itself an electronic entry). The foreign holder portfolio preferences will determine whether they hold bonds or reserves—with higher interest on the bonds. Shifting from reserves to bonds is done electronically, and just like above, it is a transfer from a “checking account” (reserves) to a “savings account” (bonds).
If an individual bondholder needs cash for real-goods transactions or whatever else, the necessary asset-swap transaction happens with a mouse click. Likewise holders of checking-account deposits: if they want physical currency, their bank stands ready to make the swap; it’s called “withdrawing cash.” If the bank runs short on physical currency, the Federal Reserve provides it on demand in exchange for the bank’s reserves, its account deposits at the Fed.
When the U.S. government does what’s called “borrowing money,” either domestically or internationally, all it does is move funds from checking accounts (the reserve accounts held by the banks) at the Fed to savings accounts (Treasury securities) at the Fed. In fact, the entire $13 trillion national debt is nothing more than the economy’s total holdings of savings accounts at the Fed.
What happens when the Treasury securities come due, and that “debt” has to be paid back? The Fed merely shifts the dollar balances from the savings accounts (Treasury securities) at the Fed to the appropriate checking accounts at the Fed (reserve accounts) – that’s it. To pay off the national debt the government changes two entries in its own spreadsheet – a number that says how many securities are owned by the private sector is changed down and another number that says how many U.S. dollars are being kept at the Fed in reserve accounts is changed up. That’s all, debt paid. All creditors have their money back. Paying off the entire U.S. national debt is but a matter of subtracting the value of the maturing securities from one account at the Fed, and adding that value to another account at the Fed. These transfers are non-events for the real economy and not the end of the world, as some fear.
As we saw, foreigners buy government bonds when they are more attractive than reserves, which pay little or no interest. Let us presume that sizable amounts of government bonds are held externally, by foreigners. What if low interest rates mean that foreigners decide they would rather hold reserves than bonds?
If the day ever comes when China demands that the Treasury securities which it holds have to be paid back, the Fed simply changes two numbers on its own spreadsheet. The Fed debits (subtracts from) China’s securities account at the Fed. And then it credits (adds to) China’s reserve (checking) account at the Fed. That’s all – debt paid! It’s essentially an asset swap. Paying off China doesn’t change China’s stated $U.S. wealth. They simply have dollars in a checking account rather than U.S. Treasury securities (a savings account) of equal dollars. China now has its money back. It has a (very large) U.S.-dollar balance in its checking account at the Fed. We will not have to sell off the Statue of Liberty or Mount Rushmore to pay off our “debt” to China.
If China then wants anything else – cars, boats, real estate, other currencies – it has to buy them at market prices from a willing seller who wants dollar deposits in return. And if China does buy something, the Fed will subtract that amount from China’s checking account and add that amount to the checking account of whomever China bought it all from. Refusing to “roll over” maturing bonds simply means that foreign banks will have more reserves (credits at the issuing government’s central bank) and less bonds. Selling bonds that have not yet matured simply shifts reserves about—from the buyer to the seller. Neither of these activities will cause pressure on the government to offer higher interest rates to try to find buyers of its bonds.
From the perspective of government, it is perfectly sensible to let banks hold more reserves while issuing fewer bonds. Or it could offer higher interest rates to sell more bonds (even though there is no need to do so); but this just means that keystrokes are used to credit more interest to the bond holders. Government can always “afford” larger keystrokes, but markets cannot force the government’s hand because it can simply stop selling bonds and, thereby, let markets accumulate reserves instead.
Now the private and foreign sector’s portfolio mix certainly has economic import (and even more so, changes in that portfolio mix). But that mix is secondary and subsequent to the total stock of various government-issued assets in play — be they bonds, checking deposits, whatever. Without a sufficient pool of those lubricatory assets, the financial economy binds up and freezes, as does international trade.
What happens if foreigners decide they do not want to hold either reserves or bonds denominated in dollars, and sell them off?
For the rest of the world to stop accumulating dollar-denominated assets, it must also stop running current account surpluses against the US. Hence, the other side of a Chinese decision to stop accumulating dollars must be a decision to stop net exporting to the US. This is not going to happen, as China is very much dependent upon exporting to the U.S. for a number of reasons.
Furthermore, trying to run a current account surplus against the U.S. while avoiding the accumulation of dollar-denominated assets would require that the Chinese off-load the dollars they earn by exporting to the US—trading them for other currencies. That, of course, requires that they find enough willing buyers to take their dollars. That is, the dollars earned by China’s export surplus have to go somewhere.
This could—as feared by many commentators—lead to a depreciation of the value of the dollar. That, in turn,would expose the Chinese to a possible devaluation of the value of their US dollar holdings—reserves plus Treasuries that total over $2trillion.
If China’s central bank ceases buying its $200 billion a year of dollar denominated assets, and if nothing shocks the behavior of other central bank or collection of private foreigners, two things will happen: (1) the value of the value of the dollar will fall, and (2) U.S. interest rates will rise. The fall in the value of the dollar will boost U.S. exports and diminish U.S. imports, and the trade deficit will shrink. And–as long as the Federal Reserve is successful in avoiding recession–the rise in interest rates will reduce investment inside the United States and also lower asset values, which will make homeowners and investors feel poorer and increase their savings. It will thus reduce the gap between savings and investment, and so diminish the capital inflow.
What happens if China says, “We don’t want to keep a checking account at the Fed anymore. Pay us in gold or some other means of exchange!” They simply do not have that option under our current “fiat currency” system. Governments do not typically ship pallets of paper money or gold bars across the ocean. If they want something other than dollars, then they have to buy it from a willing seller, just like the rest of us do when we spend our dollars. In this case, they must find holders of other currency-denominated reserve credits willing to exchange these for the bonds offered for sale. It is possible that the potential buyers will purchase bonds only at a lower exchange rate, so it is true that foreign sales of a government’s debt can affect the exchange rate. However, so long as a government is willing to let its exchange rate “float” it need not react to prevent a depreciation.
Depreciation of the dollar would increase the dollar cost of China’s exports, making them more expensive, and lower the value of China’s dollar-denominated assets. US exports would become more competitive globally, which would be a boost to domestic industries, lowering the trade deficit and boosting domestic employment. For these reasons, a sudden run by China out of the dollar is quite unlikely. A slow transition into other currencies is only possible if China can find alternative markets for its exports.
The Job Guarantee
One ramification of the above is that a currency-issuing government can purchase anything that is for sale in its own currency, including the labor of every last unemployed person who is looking for a job. This is known as the “job guarantee.”
The government already creates millions of jobs, from combat soldiers, to IRS accountants, to elevator inspectors, to U.S. Congressmen (who enjoy benefits denied to most citizens). It also purchases goods and engages the labor of numerous private sector entities to accomplish various things that suit the public purpose, from building roads and bridges, to protecting the country, to basic research and development.
One key factor is that the job guarantee would hire “from the bottom,” not from the top to ensure that such programs don’t create real resource bottlenecks by competing with the private sector for highly-skilled or specialized labor. The job guarantee could also put a floor under domestic wages without costly regulations. Whether the job guarantee makes fighter planes or wind turbines makes no economic difference–the workers employed by it will spend their wages on the same things other workers buy. When you hand money over to a convenience store cashier to purchase goods, do they ever squint or turn the dollar bill sideways and ask, “Are you sure this money came from work that was performed in the public sector?” They don’t, because the money governments pay to public employees is the same money everyone else gets paid in.
What matters, economically, is whether there are sufficient real resources and labor available to produce these goods and services in line with the increased demand for them. If there are, no additional government intervention is necessary in order to mobilize them. The same private profit motivation which induces a company to produce one widget can be relied upon to produce the production of another one. If there are enough real resources available to produce the goods and services that are equal in value to the government’s job guarantee spending–if they are not already being used to produce something else–then the increased demand that results from the payment of job guarantee wages will not be inflationary, regardless of what they go to produce.
The only time the American economy ever achieved an extended, years-long period with zero unemployment, low, well-controlled inflation rates and with no significant financial aftershock at the end was the World War II era – broadly defined to include the Lend-Lease buildup of 1940 and 1941. This solution to the problem of mass unemployment worked in the 1940s and it would work today. In the 1940s, of course,the jobs were almost all war-related. But, economically, this makes no difference. Increased government spending is what ended the Great Depression, not the War per se. The former British politician Tony Benn regularly noted that if you can have full employment killing Germans, then there is no reason why can’t you have it doing other socially useful activities.
But Weimar Germany! Greece!! Venezuela!!! Zimbabwe!!!!
It should be noted that the above applies only to sovereign governments with control over the issuance of own currency. A user of the currency who does not control its issuance has no such prerogative; it needs to procure the currency from another source. Greece, as a member of the Eurozone, does not have control over its own currency. Its currency, the Euro, is used by a number of other countries with different economic conditions and is not allowed to “float,” Regulation of the currency is controlled not by the Greek government, but by the European Central Bank.
In Weimar Germany, the government was forced to pay extremely large war reparations in foreign currencies which it didn’t have, so it had to aggressively sell its own currency and buy the foreign currency in the financial markets. This relentless selling continuously drove down the value of its currency, causing prices of goods and services to go ever higher in what became one of the most famous inflations of all time. By 1919, the German budget deficit was equal to half of GDP, and by 1921, war reparation payments represented one third of government spending. On the very day that government stopped paying the war reparations and selling its own currency to buy foreign currency, the hyperinflation stopped.
In Zimbabwe, the conditions for hyperinflation were caused by the destruction of nearly half of the country’s domestic food production via misguided land reforms, plus a civil war which eliminated much of the economy’s productive manufacturing capacity. In response to food shortages, the Bank of Zimbabwe used valuable foreign exchange reserves to buy imported food, leading to a lack of foreign currency to purchase essential raw materials. Manufacturing output collapsed, but the government used much of the remaining foreign exchange to dole out political favors, rather than adding to the country’s productive capacity. The end result was inflation and then hyperinflation.
A sovereign-currency issuer might “have” to pay back their debt if they have committed to redeem their money for something else. For instance Argentina (dollar-denominated debt) and whole host of other countries who were on a gold standard had promised to give gold in return for their money. If they can’t or won’t do so, that is a default on their promise. The U.S. and the U.K. (among others) do not face that situation.
Yes, once the economy gets to full employment, then extra government deficit spending can start driving up prices, but with high unemployment and unused yet functioning factories all across the country, there is plenty of room to cut taxes and/or increase spending to get us to full employment. This is true no matter what the size of the federal deficit. Ultimately, inflation (and then hyperinflation) is about competing distributive claims over real resources, such as oil, gas, water, etc.
It is perfectly true that a poorly managed monetary system, or one which is experiencing something like an oil-price shock, can experience inflation. But people today simply don’t realize how much bigger a problem the opposite condition can be. A little bit of inflation is useful and normal. It discourages people from hoarding money and encourages healthy levels of consumption and investment. It promotes growth, provided that a country’s fiscal and monetary authorities manage it properly. Under the gold standard, and largely because of the gold standard, the capitalist world endured eight different deflationary slumps severe enough to be called “depressions.” Since the gold standard was abolished, there have been none.
The dollar is not “backed” by anything!!! Fiat currency is not “real” money!!!
Many people are unnerved by the thought that money isn’t “backed” by anything anymore – backed by gold, for example. They’re afraid that this makes money a less reliable store of value. Hasn’t money always been gold or silver, or at least backed by it? Nope. In primitive societies, people typically participated in gift exchanges, where the receiver was placed under obligation to the giver, who would then receive something back in return at a later date. Such reciprocity has even been observed in non-human primates. As societies grew larger and more complex, and more interaction was between strangers, this relationship became more formalized. Writing was invented to keep track of these relationships. Historical studies confirm that credit/debit relationships recorded on clay tablets were the earliest known form of “money.”
Coinage was invented much later as a way of raising large armies and paying mercenaries. Governments found the easiest way to provision soldiers was to issue them standard-issue bits of gold or silver and then demand everyone else in the kingdom give them one of those coins back again. Because soldiers have the coins which everyone needs to pay the tax, trade with soldiers becomes a necessity. These coins started circulating as money. Promissory notes, which recorded an obligation on the part of a third party (an IOU), passed from hand to hand in the Middle Ages as an early form of paper money. Tally sticks, upon which were recorded a farmer’s tax obligations to the crown, also circulated as money throughout medieval Europe.
The Bank of England was created when a consortium of forty London and Edinburgh merchants — mostly already creditors to the crown — offered King William III a £1.2 million loan to help finance his war against France. To this day, this loan has never been paid back. It cannot be. If it ever were, the entire monetary system of Great Britain would cease to exist.
One problem with defining the value of the dollar in terms of gold is that gold’s value fluctuates relative to all other goods and services as the supply or demand for gold changes. When economic growth was not accompanied by an increase in the supply of gold, it put downward pressure on prices. The result was deflation and rising real debt burdens. For example, news in April 1893 that the government was running low on gold was followed by the Panic in May and a severe depression involving widespread commercial and bank failures. As a result of the panic, stock prices declined. 500 banks closed, 15,000 businesses failed, and numerous farms ceased operation. The unemployment rate hit 25% in Pennsylvania, 35% in New York, and 43% in Michigan. Soup kitchens were opened to help feed the destitute. Facing starvation, people chopped wood, broke rocks, and sewed in exchange for food. In some cases, women resorted to prostitution to feed their families.
Functional finance emphasizes the role of money as a”unit of account,” and a “store of value,” rather than as a “medium of exchange.” Money is primarily a credit/debt relationship and always has been. There would scarcely be enough gold bars in the world to run a modern industrial economy. Besides, even though gold and silver have a long history of use as a medium of exchange, it is still a social convention based upon “faith” that gold and silver are valuable–rarely do people need actual gold or silver for anything, any more than they need pieces of paper. In fact, commodities used as a medium of exchange typically do not have very many practical uses, otherwise they would be far too valuable as commodities to be used for money!
Money is primarily a social tool that we use to mobilize real resources to ensure our collective long-term health and prosperity. It is not a “thing” that is inherently scarce like diamonds or gold bullion. It is not something for the rich and powerful to hoard in their bank accounts, or to hide in offshore tax havens. It should be noted that the reverse is also true: no amount of money creation can substitute for actual resources which do not exist in the real world. Used wisely, however, it can allow us to manage our existing resources more carefully, including making the best use of our natural and human capital.
To sum up, sovereign, currency-issuing countries are only constrained by real limits. They are not constrained, nor can they be constrained, by purely financial limits because, as issuers of their respective currencies, they can never “run out” of money. This doesn’t mean that governments can spend without limit, or overspend without causing inflation; or that governments should spend any sum unwisely. The government cannot mobilize resources that do not exist. What it does mean is that no sovereign government needs to tolerate mass unemployment because of the state of its finances–no matter what that state happens to be. Nor does it require foreign entities to finance its deficit. What this further means is that a prolonged slump or depression is, ultimately, a political choice.
(I encourage you to read the original texts at the following locations):
The 7 Deadly Innocent Frauds of Economic Policy (PDF)
What is Modern Monetary Theory, or “MMT”?
Britain is heading for another 2008 crash: here’s why
‘Living within our means’ makes no economic sense. Labour is right to oppose it
MMP Blog #24: What if Foreigners Hold Government Bonds?
Martin Wolf On Wynne Godley’s Sectoral Financial Balances Approach
Isn’t it Time to Stop Calling it “The National Debt”?
The Meme that Refuses to Die: Government Debt Must Be Paid Back
4 Ways to Fix the Debt Limit – Forever
Crisis Chronicles: Gold, Deflation, and the Panic of 1893
Randy Wray: The Value of Redemption (Debt Free Money, Part 3)