Deficits Matter

If you've been following along with the last couple economics posts, you may have noticed a contradiction between the two. In the first one, I claimed that modern fiat currencies are not inherently inflationary: it is merely the tendency of the governments who issue the currency to inflate. In yesterday's post, I suggested that the same currencies actually are inherently inflationary because the money supply must be borrowed. Let's dive in a bit and resolve that contradiction.

The notion that governments spend money into existence comes from Modern Monetary Theory (MMT). This blog took a look at the subject a year ago. (See here and here.) In large part, MMT is an answer to the question, if money is no longer backed by gold, what gives it value? Their answer: taxation. Money has value because governments require taxes to be paid in their issued currency. Someone who owes the government taxes will be willing to exchange goods and services to acquire the currency to avoid jail. Thus, value. (The first link above gives a pretty thorough treatment of this idea.) When we pay our taxes, we imagine the government is collecting the money and then routing it to whatever boondoggle program needs funding. Actually, the program is funded up front, and tax collection only serves to give value to the currency. Sure, the point is moot in our day-to-day lives, but when thinking about how our monetary system works it is very important and almost no one understands this.

Some do though. But that's a problem too, because MMT doesn't tell the whole story. It's not a complete model, which we'll get to in a second. This naive understanding causes many in power to make very faulty assumptions. Most notable was Dick Cheney's "deficits don't matter" assertion. Under pure MMT deficits don't actually matter. The government spends money into existence, and taxes it back out. The extra amount that remains in circulation is "debt" on the government balances, but is necessary to provide the money supply. Because the government can inflate or deflate the currency at will, the debt doesn't really matter. The government can reign in the money supply, thus reducing the debt, at its discretion. The whole thing is counter-intuitive, but MMT people tell us it's all sound. Well, they're sort of ignoring the white elephant in the living room.

The reality is that spending money into existence and taxing it back out won't actually provide us with a usable money supply. Imagine the government budget is $100, and it is balanced. (Like, really imagine.) In the examples given last year, we imagined the government as spending the money into existence at the beginning of the year and collecting it at the end. That would work, except what would happen at the end of the? All currency would be returned to the government. Thus all savings accounts would have to be zero, no dollars left under the mattress, etc. Which isn't feasible. We need extra money in circulation for the economy to actually function. Where does the extra money come from?

One theory you might be tempted with is the notion that the government just spends the extra money into existence. For instance, if the government spends $150, but only collects $100 (this should be easier to imagine), then there's an extra $50 floating around to facilitate transactions, savings, etc. There's your money supply! It gives our politicians a nice out too. They aren't being fiscally irresponsible...they're wisely providing needed liquidity! Unfortunately, that violates the fundamental tenet of MMT, that taxation gives money its value. Think about it. In that year, the government only collects $100. So only $100 of the currency should have value. What gives the remaining $50 value? Why nothing at all. It's just paper at that point. For taxation to give money value, it must be a closed loop. So deficits don't give us a money supply, as nice as that would be for our elected heroes.

MMT provides an answer to the question of the missing money supply, but they only get it half right. They tell us the extra money comes from fractional reserve banking. Banks can take the money the government issues through spending (call it primary currency) and can use that as backing to loan additional money into existence. Let's call the loan-created money leverage currency. [Note: I'm taking liberty with terminology. The MMT experts use different terms for this.] In the US the reserve requirement is 10%. So the banks can issue $900 of leveraged currency. So that must be the money supply! The mystery is solved.

But there is a problem with that too. There never really is $100 in primary currency floating around. It's all accounted for by taxation, and can't really be used as reserve. Bank reserves don't fall to zero at the end of the year. They'd have to call in all their loans every year to comply with the reserve requirement. If we instead imagine government as continually spending money into the economy and continuously collecting it (which is closer to how things really work) we are no better off. In fact, worse, because there is never so much as a dollar in liquid primary currency. Ten times nothing is still nothing. So something is missing. There must be extra money somewhere, in addition to primary currency, that provides liquidity; at least enough for the banks to make their reserve requirements.

This is where, from what I can tell, MMT stops. They stop there, I reckon, because if they go further they risk invalidating their theory, at least as far as the actual economy goes.

Note that we've shown two different ways that money is created and given value. One is through spending/taxing. The other is through bank script. Clearly, we can't just say that taxation gives money value. Even in MMT that would only apply to 10% of the money supply. The concept can be generalized. Contracts give money their value. Taxation is a legally enforceable contract. Bank loans are legally enforceable contracts. Money is born in a contract. But the contract also represents debt. The two are married like matter and anti-matter. Eventually, they will meet each again - at the conclusion of the contract - and will annihilate each other just like matter and anti-matter, although probably less spectacularly.

So we've identified two forms of currency, both enforced by legal contracts. We're looking for a hypothetical third. It must exist, or our theory of things is invalid. The source of the missing currency is (drumroll)...... taking on debt. Well, that sounds like a tautology at this point, right? We just said that currency necessitates debt. The government borrows money to provide a money supply. They must. What other way could there be? The government sells debt to individuals, corporations, foreign governments, and the central bank. In exchange, they can issue currency. But there is, as always, a contract. And the contract is that the government will pay those debts back, plus interest. That is the source of inherent inflation we're talking about. Say the government needs to borrow $100 to provide the money supply. We'll call this secondary currency. They promise to pay back $200 dollars in 7 years (the terms of a savings bond). Well, how do they have $200 in 7 years? They must borrow that, also. So yes, inflation is definitely built right into the system.

There is plenty to chew on if this is all true. [And it's all so counter-intuitive that we have to suspect it's not true. Then what's our error?] First, there must be some debt to provide the money supply. But deficits still matter. Just because the government borrows so it can issue cash, doesn't mean it still can't borrow recklessly in the normal way. They can still buy a cheeseburger today with promises to pay tomorrow. The big question I have is, even if governments were responsible, and only borrowed the minimum amount to provide liquidity, isn't the whole thing still insolvent in the long term? If you've read all along this far and haven't quite grasped the arguments I'm making, just picture a dog chasing its own tail. That image is all that really needs to be conveyed.

I guess I have one other big question: how else could it be done? There's something strange about the government, which issues the currency, having to first borrow it at interest. What sense does this make? The issue we'll explore next in this series will be whether there is a contract-based monetary scheme that isn't inherently inflationary. In the meantime, I have to wonder if resource-based currencies aren't the better solution. Yes, I've been beating up on goldbugs and cryptocultists, but maybe the deflation spiral is ultimately more favorable than the inflation explosion.

In conclusion, where does that leave us with the initial contradiction that fueled this whole post? Well, there is no contradiction. Under MMT, fiat currencies aren't inflationary. But in the real world they are, because MMT is an incomplete model of modern fiat currencies.

Thanks for following along. If you're bored to tears with the economics posts...well there's still going to be some more coming to slog through!