21 February 2012

Modern Monetary Theory Explained Simply and Questioned Again

It is often difficult to get a clear and simple definition or summation of what Modern Monetary Theory is, and what its adherents actually believe.

This is because some of its proponents tend to speak disparagingly and condescendingly to those who ask what it is that they believe. And they do not like to answer simple questions, preferring to engage in lengthy theoretical explanations that speak around the answer to confuse the unenlightened.

But at least one person whose intellectual integrity I respect in other matters seems to believe in this theory, so I have continued to spend some effort to get to the bottom of it, to find out what this theory is, and how it is similar or different from other monetary theories. What makes it modern?

At last there is a Modern Monetary Theory Wiki. Although it is relatively new and underpopulated, it does at least put forward the key tenets of this theory in simple language.

Here are some extended quotes that I think cut to the heart of what MMT is. And it is about what I expected it to be. You can judge what it is for yourself.

Modern monetary theory (often, "MMT") is applicable to countries that use fiat, non-convertible currency with a flexible exchange rate.

Modern monetary theory believes that countries that issue their own sovereign currency do not ever face a risk of being unable to pay their debts (the solvency constraint) but may, under certain circumstances, face undesirable inflation if a deficit is run in excess of the needs of the economy (the inflation constraint).

The "Debt"

In contrast to the deficit, the amount of so-called debt a government has is irrelevant. Government bonds, when issued in the currency of the country issuing them, can never be involuntarily defaulted on.

The government can always create currency, at no cost, to meet any obligation. The "debt" is merely the sum of the government's previous deficits and surpluses.

This is of course different than a household or business, who cannot create currency. As currency users, rather than currency issuers, their debt must be serviced by currency raised through economic activity. This is an example of the fallacy of composition.

Because the government can always simply print currency, a country that controls its own currency does not need to sell bonds to "borrow" funds. A government's decision to issue bonds is voluntary.


Taxes serve two main purposes in the economy:

1. Creating demand for currency. The government accepts its currency, and only its currency, as payment for taxes owed. People must hold currency to pay taxes or they are faced with penalties, including prison.

2. Regulating inflation. Inflation occurs when aggregate demand exceeds the productive capacity of the economy. Taxes reduce the amount of money in the hands of the private sector, and thus reduce demand.

Countries that control their own currencies do not need to tax in order to spend. Such countries can always issue currency to purchase any good or service for sale in the economy. Taxes do not fund the government.

Some of the things that this theory says are technically true. But the devil is in the details, and what is left unsaid. True, a sovereign issuer need not endure a hard default on its obligations because it can simply print more money. But this is a de facto default as anyone who has ever read any history will know. This is the economics of Zimbabwe and Weimar.

The biggest single issue in any money system that is not tied to an external standard is: 'how does one regulate its growth, especially in situations where there are conflicting priorities?'
"Paper money eventually returns to its intrinsic value -- zero."

And there are some very good reasons for this tendency to over print money without a system of checks and balances, transparency and restraints.

Debt issuance, or the discipline of the market, is one way to do this. Import constraints are another, that is, any place where the MMT realm touches some other monetary entity not under its control.

By the way, as I have pointed out before, the debt issuance constraint which is at the heart of the US Federal Reserve System is not a hard stop. All the Fed requires is a friendly (captive) primary dealer or two, and an amenable Treasury, and through manipulating the market mechanism for the bonds they can create a fairly effective money printing machine, almost as free of constraint for quite a period of time as the issuance of money without debt.

In a sense they can loot the bondholders' accounts without leaving their offices. But like the management at MF Global, they view this as a short term accommodation, and intend to put things right at some point, with none the wiser.

The domestic constraint against inflation is a little more problematic because the MMT seems to favor or presume a closed system where the people accept the money as it is defined and no other means of exchange is allowed, ever.

So really there seems to be nothing 'new' or 'modern' about it. It does not close the loop and answer the simple questions about all money systems: who controls the issuance and growth of the money supply and how do they do it? What restrains them from exceeding the restraints?

And if it is some central authority of economists, some wise Solomons who will exercise judgement independent of special interests, watching economic metrics supplied by the government to maintain some aura of restraint, I think we have 'been there and done that' many times before.

I personally do not have a problem with going to a non-debt based system of pure currency issuance. Why should a sovereign borrow from the banks and pay them interest? But the practical issue remains that the control of the issuance of the currency is critical.

As that high priest of modern fiat currency Alan Greenspan said, the Federal Reserve's fiat money system 'works' as long as it can emulate something like a gold standard. It is the temptation to print in excess of some realistic balance of economic growth and currency demand that is the sticking point in any centralized system of economic control.

Quis custodiet ipsos custodes?

I learned long ago that if someone cannot answer simple questions then they either do not know the answers, or do not want to give the answers they have to you yet. And so it is I suspect with MMT although I retain an open mind, but not to derision or intellectual intimidation.

So, what is the scheme to prevent the over-printing of money in the MMT, and what recourse do the people have if this system fails?

We are grappling with this very question today with the global dollar reserve currency scheme, so it is not theoretical. Replacing a failed fiat currency with another similar system but with different denominations and names, reissuing the paper currency after it fails, is par for the course.

And I expect that to be the preferred government resolution this time as well. The only question in my mind is how draconian will they get in order to obtain the required obedience of the markets, and how far do they think their control needs to extend geographically in order to succeed?

And what would they do with countries who have things that they need, but who will not accept their monetary diktats?

Is this what we are talking about? Just give the Fed/Treasury more power, greater spans of control, and less restraint, and they will finally get it right?

Or at least right enough, because no one will be left to question it, and say it is wrong.