Saturday, January 7, 2017

Modern Money Theory Thought Exercises

Modern Monetary Theory (MMT)

MMT is a different perspective of a modern monetary economy characterised by a fiat currency and a flexible exchange rate. Rather than trying to explain it all at once, I'll walk through some examples that aim to explain as we go. I've not provided any sources as MMT can be easily researched through Google. Also, some conclusions are my interpretations of the exercises, so don't takes any of this as MMT canon. In at least one case I come to a different conclusion than some MMT advocates. The mistake is of course almost certain to be my own.

If I have made mistakes please let me know so I can correct them. But keep in mind that a few mistakes and oversimplifications have been made intentionally.

Minimal supply examples

Single-year closed loop

Let's imagine an unrealistically simple government and economy. The government budget is $100, which they print into existence. There is no other money in existence. The entire government consists of one man, Gary. He runs all the government operations. For ease let's say the tax rate is 50%. Gary takes a $100 salary and has $50 left after taxes. He pays it all in room & board to Phil. Phil gets $25 leftover, and pays it all to Paul for maintenance. Paul gets $12.50 leftover and buys food from Pamela. Pamela gets caught peddling dope under the table and pays her entire $6.25 to the government.

The government has spent $100 into existence, and has collected $100 in taxes (and fines). The budget is balanced, and there is no private-sector savings.

Currency is issued by the government through spending and collected through taxation. The currency has no intrinsic value. It's value derives from the fact that the currency - and only the currency, can be used to settle tax obligations imposed by the government for various economic activities. Without the political policy of taxation, the monetary system would fail because the currency would have no value.

Single-year closed loop doubled

Gary's pay is increased to $200. Gary has $100 left, and he pays it all in room & board to Phil. Phil gets $50 leftover, and pays it all to Paul for maintenance. Paul gets $25 leftover and buys food from Pamela. Pamela gets caught trafficking weapons under and pays her $12.50 to the government.

In this case the government spending doubled, and so did all incomes, and presumably prices. The effect on the economy was nil, since resources are allocated exactly the same. In the real world things aren't so simple, since there are savings to contend with, industries are affected differently by government spending, and other reasons. But the lesson to keep in mind is that what matters is the relative proportions, not the total. Whether you say the economy is worth $100 or $100 trillion, if you have half it's the same amount of wealth.

Single-year closed loop with barter

Paul makes 100 widgets, Phil makes 100 sprockets. Paul trades 50 widgets to Phil for 50 sprockets. That government determines that, because the production of widgets and sprockets was the entirety of economic production, and the money supply is $100, each item is valued at 50¢, so each owes $12.50 for the income from $25 in sale of products. Phil sells his remaining 50 sprockets to Gary for $25, the government take half, and then Phil uses the remaining $12.50 to settle his existing tax obligation. Paul does the same with sprockets. The budget is balanced, and wealth allocation is as follows:

Gary: 50 widgets, 50 sprockets
Paul: 50 sprockets, capacity to produce 100 widgets per year
Phil: 50 widgets, capacity to produce 100 sprockets per years

Note that while Gary contributes no direct economic production, he accumulates twice the wealth of Paul and Gary. I'm not sure if there is a general lesson or that is a quirk of this particular scenario.

Single-year open loop

Original scenario but Pamela wises up and doesn't get caught. At taxation time the government collects less than it spent. This is the budget deficit and becomes the national debt. The $12.50 the government is shorted equates to $12.50 that the private sector has in savings.

The government must incur a national debt for public saving to occur. 

Single-year closed loop with bonds

Same as before, but Pamela uses her $12.50 to buy a government bond. The balance sheet of the government is 0 at tax collection, and the amount of money in circulation is 0. But, the government owes an IOU to Pamela, which entitles her to $25 after some maturation, say 7 years. Assume nothing else in the government budget changes, nor does the underlying wealth of the economy. In 7 years, the government issues the normal $100. There are two scenarios here.
  1. The government uses $25 of it to pay Pamela. That means $75 is used to pay Gary, who took a large pay cut. Gary can only pay $37.50 to Phil, who pays 18.75 to Paul, who pays $9.38 to Pamela. Now Pamela has 34.38% of the $100 economy, as opposed to her earlier %12.5. All other participants have lost wealth.
  2. The government spends the normal $100, but spends an extra $25 into existence to pay off Pamela. Gary still gets $100, Phil $50....Pamela $12.50 plus her $25. She now owns $37.50 out of a $150 economy, or 25%. All other plays lose market share, but not as much as scenario 1, and the currency has been inflated.
The second scenario would appear to be more preferable, because it causes a smaller transfer of wealth for the same effect. But the effect would also be that it would decrease the profitability of the bonds, meaning the rates would have to be increased to attract investors and leading to additional transfer of wealth towards bondholders.

Capital investment

Year 1

Gary spends his excess $50 to buy sprockets from Paul. Paul pays $25 in taxes, spends $15 in expenses (ultimately taxed), but keeps $10 and uses it to buy sprocket machinery. The budget is balanced.

Year 2

Because of Paul's investment, the value of the economy is 10% higher than the previous year. The government has two choices.

  1. Issue the same nominal $100. Because the value of the economy is greater, this means each dollar will have more value, so there is deflation of the currency.
  2. Issue $110 in currency, to keep the real value of the currency steady.
Governments will always choose the second option, because they avoid deflation. Thus economic growth must be matched with increased spending, or some other tool to expand the money supply.

Capital investment with savings

Year 1

Paul wishes to make a capital investment, but he needs credit to do so.

Gary pays his $50 tax and buys $40 in sprockets. Paul pays $20 in taxes, spends $20 in expenses, and invests $10 in machinery thanks to his bank loan. The government is running at a $10 deficit, so they sell a bond to Gary for $10.

Year 2

The government issues $110 in currency. $10 is used to repay the bond paid, and joins the other $100 in liquid currency. But that's not enough, because Gary demands interest for his bond, so another dollar is issued. Now there are $111 in currency, so the currency has inflated. This example over simplifies, but the result of the inflation will be a transfer of wealth to the bond seller from everyone else. 

Let's add to this scenario that Pamela has cash saved. From her perspective, the government's decision to run a deficit to provide the savings needed for capital investment is effectively a tax.

This scenario follows from MMT theory that there must be sufficient private savings for capital investment to occur. They observed that historically, periods of government austerity resulted in economic depressions. They have determined that the economy cannot reach its production potential if the money supply is tight.

Excess money supply scenarios

The budget is $100, and there is $100 already in circulation.

Steady economy

They government issues $100, and collects $100 in taxes, so the budget is balanced. However, since there is an extra $100 in circulation, we know there is a national debt. The debt was financed with bond purchases, and interest is due. The government has two choices:

  1. Allocate 5 dollars of the hundred to the debt, and reduce Gary's salary to $95.
  2. Spend an extra 5 dollars to pay the debt. The money base is now $105, and has been inflated, resulting in an effective transfer of wealth.
In response to bond financing, the government must decide whether to reduce non-finance spending or to inflate the currency. 

Foreign investment

The government has sold $100 in bonds to Elbonia to finance the debt. The budget consists of $100 to Gary, and $5 to Elbonia in interest. The government takes in $105 in taxes.

The economic production consists of Paul cranking out 105 widgets a year. When Elbonia get their interest payment, they use it to buy 5 widgets. Thus ~5% of productive capacity is diverted to a foreign entity to finance the national debt that is required to maintain a liquid monetary supply.

Foreign financing causes wealth to leave the country. (This is practically a tautology).

Bondless scenarios

The question quickly arises: why use bond financing at all? Can't the governent just spend money into existence and tax without the need for trading bonds?

Financed debt

The government budget is $100. There is an additional $100 in circulation, backed by $100 in bonds. The government has pledged to run a balanced budget.

 The hundred dollars that the government spends has obvious value. It is given value because that same $100 will be used as legal to settle tax debt owed to the government, and there is no other way to settle the debt. People need those dollars to stay out of jail, and they will give you things to acquire the dollars they need. 

So why does the extra $100 floating around have value? Because the government has a legal obligation to pay off its bonds. The extra money is the legal tender that will be used to pay the bonds. The interest paid on the bonds serves 3 functions:
  1. It incentivized the sale of the bonds in the first place
  2. It reaffirms the government's obligation to the contract.
  3. It provides incentive for the government to pay off bonds, to lower the interest burden.

Unfinanced debt

The government runs up a $100 national debt as before, but doesn't sell bonds to cover the rest. The government pays no interest on bonds, but reaps the benefits of a liquid money supply. It sounds ideal, but I'm sure you're catching on to the issue at hand.

Gary gets $100 from government salary, Paul has $100 stuffed under his mattress, and Phil produces 100 beautiful widgets. Gary pays $50 in tax, and $50 for widgets. Phil pays $25 in taxes, and pays $25 to cover his expenses, which is ultimately returned to the government in taxes. At this point the government is whole. It has received $100 and there are no more outstanding tax debts.

Now suppose Paul wants some of those widgets. He offers to buy $50 worth. Phil thinks about it, and realizes that there are no more tax obligations out there. So if he takes the cash, is there anyone out there willing to give him things in exchange for the currency? They have no specific need for it. Phil ponders keeping the money to pay off his taxes next year. But in our scenario there is only income tax, so for Phil to owe money he would have made more than enough to cover it. And what if all taxes get settled again next year and he gets stuck holding the bag of unneeded paper? Phil tells Paul to come back next year before taxes are settled to buy widgets.

MMT advocates state that the value of money stems from being the sole legal tender in state-enforced taxation, yet some also advocate the removal of bond financing. These ideas appear to be contradictory. It must be concluded that interest payments are a feature, not a bug, of fiat currency. Interest payments are the cost of keeping a fluid money supply, and there is inherent inefficiency.

Overfinanced debt

The budget is $100, the money supply (i.e. national debt) is $100, and the interest rates are 10%. Thus 10% of currency must be allocated to interest payments. This is the cost of keeping a healthy money supply under a fiat currency. Many citizens will complain that the 10% going to financiers would be better served on social programs or in tax breaks, and they will have a good point.

Let's say spending gets out of hand. The budget is $100, but the money supply is $500. At 10% interest, half of the budget is allocated towards financing interest. People realize there is not way the government can tend to its responsibilities, and make the interest payments, and pay off the bonds. That is, the promise the underlies the value of the money supply, the bond contract, comes under question. People will begin to suspect that the national debt will never be repaid. They lose faith in the currency and invest in commodities like gold. We run into effectively the same scenario as in the unfinanced debt scenario: people lost faith in the value of the money supply.

The government has an option: they can increase spending. MMT theorists love to say that a sovereign nation that prints its own currency can never default on debt.

The government massively increases spending. Say up to $500 per year. The government is able to easily start buying back bonds. But the financiers are pissed. The government just drastically slashed the value of their bonds. The government credit rating tanks, making it harder and more costly for the government to finance in the future. And remember what we saw before: finance is absolutely necessary to the fiat currency.

Also angry are citizens holding savings, as their value has been slashed as well. on top of their growing distrust of the monetary system. They exert great pressure on the political establishment, and may end up rejecting it entirely. The only people happy are those invested in gold, lead, and steel.

MMT advocates tell us that a sovereign nation that issues fiat currency can't default on its debt by principle. But that doesn't mean the system can't be driven to catastrophic failure. The monetary system does not exist in isolation, and the fiat currency requires finance, a complementary political structure, and the trust and faith of the citizenry.

Their counter-argument, I'd bet, is that I've concocted a ridiculously extreme example. The argument is basically, "well they'd never really let it get that bad." I'd be skeptical of the assertion. Even in our own country we're reaching the point where many people believe exploding national debt can never be repaid.

Central banking

I've been speaking of "the government" or "the state" in monolithic term, but in reality there are two entities. The central bank handles monetary policy, and the political system handles fiscal policy. I've not created any instructive scenarios yet because I'm not certain that understanding the central bank is necessary to understand the basics of MMT.

Fractional reserve banking

Mortgage scenario

$100 budget, $100 excess money supply, ten of which is in the bank, and $90 Paul keeps in a fire-proof safe in his steel-reinforced SHTF bunker. Pamela wants to buy a $100 house, so she goes to the bank and they loan her the $100, using the $10 in deposits as the reserve. (Fortunately they neglected to perform a criminal background check.) The economy now has $100 from spending, $100 from the excess money supply, and the $100 of bank credit.

Up to now I've been modeling the dynamics in such a way that individual actions affect the amount of tax collected. In this example it would be tempting to imagine that the $100 created by bank credit will enter into the economy and be absorbed through taxation. Thus the government would collect $200 in taxes. However in reality individuals don't have such an effect. A person's decision to save or spend is insignificant in the whole, and if there are large trends of people in changing their savings habits, the government will alter its fiscal policy. Thus we can conclude that the amount of tax collected is determined by the government, not by the private sector.

The created currency remains in circulation, but it's value is backed by the debt obligations of the loan. We now have a total money supply of $300, so inflation has occurred. Paul's $90 cash stash will buy far few widgets that it would have before.

Year 2

Pamela works hard mugging little old ladies and acquires the $100 in bank credit floating around. However, she must acquire an additional $10 to pay her interest charges. She sells some bulk ammo to Paul and he gives her $10 of his bunker bucks, which she uses to settle with the bank. The total money supply goes back to $200, and Paul's disaster dollars regain their previous purchasing power.

I had intended this scenario to lead to the conclusion that these debt-based transactions would demonstrate long-term inflation of the currency and the requirement for the underlying economy to always be growing in value. Instead the exercise indicates that bank credit is not inflationary and that the total effect of the borrowing was that the house was transfered to Pamela (in exchange for her labor), and some of the money supply was transfered to the bank and their shareholders.

While the transaction was not inflationary in the long run, in the short term there was. In the real world there are many small transaction cycling continuously, rather than a single event that doubles the money supply. Instead the money supply is increased by bank credit, but it does so at a fairly steady state, so it does not drive inflation.

Bondless lending

Earlier we decided bonds were necessary to provide the excess money supply needed for the functioning of the economy. But we just saw that the money supply can be grown through lending. So we should be able to use that ability to remove the inefficiencies of bond financing. Let's see how that would play out.

The budget is $100. There is no excess money supply (or it would have to be backed by bonds). Gary puts $10 in a bank account. The banks makes a loan for $100 and the house is purchased. The government comes to collect $100 in taxes. Gary withdraws his $10 from the bank, but now the bank is violating the reserve requirements. In the real world the bank would borrow the reserve and pay interest, but there is no one who can lend.

The bank can't loan money is if there isn't excess money supply created by the government bond-financing a national debt. It would work if the reserve requirement was removed, but that would quickly drive the value of money to zero. The conclusions is that, even though the central bank can expand the money supply by making it cheaper to create bank credit, it is leveraging excess monetary supply that can only exist through bond financing and an accumulated national debt.

Notes, Conclusions, Caveats

  • MMT only applies to governments that issue their own fiat currency. It does not apply to local governments or states that don't issue their own currency, such as countries operating under the Euro or the US dollar.
  • The monetary system does not inherently cause inflation, but bond financing does.
  • I have not confirmed that the US money supply reflects the national debt, or explained away any differences. I don't know what the "high-value" money supply is, i.e. the size of the money supply that does not include bank credit.
  • The government spending equates to 20% of GDP and tax collection is 17%. By that account new bond should be at 3% of GDP, and its resulting inflation as well. (This is not the same as 3% inflation). I have not been able to confirm the numbers fall in line.
  • I will follow up in another post analysing the current US fiscal and monetary environment in the view of my entry-level understanding of MMT.
  • I will also follow up on why my thought process took me to the conclusion that bond financing is necessary, which runs counter to the position of many modern money theorists.

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