This essay was written in 2018, soon after I first learned about modern monetary theory (MMT). I was using the task of writing as a way to orgainse my thoughts. In its original form, while being mostly correct, it contained a few inaccuracies that were formed from misunderstandings about the topic of macroeconomics. The version of the essay given here was updated in 2024.
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Over recent months, I've become fascinated by a way of looking at the economy which has overturned my understanding of how money works. It has been an uncomfortable discovery because if it is correct, then just about every pundit and politician who comments on the subject is plain wrong. That surely can't be? And a voice in my head keeps reminding me that highly paid commentators and politicians who discuss this country's economy on the media cannot be repeatedly making the same mistake. Yet the logic of what I've learned continually leads me to that conclusion.Is this just a mistaken notion that I've picked up? Is it a meme that is faulty, but has the necessary attributes to infect my overly receptive mind, one too eager not to question? Or is the fallacy contained in another meme that has passed like the common cold through the public and the heads of the establishment? I think it matters because if those in power are wrong about this, it has profound implications for how our economy is controlled. It means that the levers they pull do not operate how they think.
False economies
Across the UK's political and media world, there appears to be a deep misunderstanding of what money is and how it works. Across all outlets; TV, newspapers, radio and online; from politicians and pundits alike, the core message is that the UK government, of whatever hue, levies taxes to fund its spending. In other words, it has to be run like a household and can only spend what it takes in. If it wishes to spend more, then it must borrow money from somewhere else; from the banks, the money markets or maybe from other countries. The narrative maintains that if spending continues to run ahead of taxation then the size of the government's debt will only increase, burdening future generations with crippling repayments.The vocabulary used continually reinforces this notion. Any example of government expenditure is unremittingly referred to as having been paid for at the taxpayers’ expense. The need to balance the government budget is constantly driven home. Austerity must be applied to overcome earlier reckless spending. During the 2015 General Election campaign, UK Prime Minister Theresa May stood at a lectern during a televised question and answer session and told a nurse why her wages could not be raised. “There isn’t a magic money tree that we can shake that suddenly provides for everything that people want.”
I think that this narrative, which I agree sounds completely reasonable and common sense, is flawed. It is based on outdated concepts of how money is created and how it then flows through an economy. It is a myth, a successful meme that has the requisite characteristics to be passed from person to person while failing to be adequately challenged. But the mistaken assumptions that pervade this notion unfortunately lead those in power to incorrectly operate the economic levers that are available to them; operational errors that pertain equally to the political left and right. Whether this is deliberate on their part for the sake of following a particular dogma is another question.
Fiat currency
The core question that must be addressed is about the nature of money. Most of the major economies have what are described as 'fiat' currencies; that is, their money is not based on anything solid, like gold. They are also known as 'sovereign' currencies because only the sovereign power in a country has the legal right to issue them. Their value is arbitrary, accepted on perceptions of the strength of a country’s economy. As a result, the exchange rates between the various currencies can and do vary. It was not always so.Across the turn of the twentieth century, it was normal for major world currencies to have the value of their money linked to a precious metal, usually gold. For example, for a century, the US dollar could be exchanged for the yellow metal at a rate of $20.67 per ounce. Then in 1934, President Franklin D. Roosevelt revalued it to be $35 per ounce, essentially creating 40 percent more dollars out of the gold reserves that the US had in its vaults.
During WWII, the US dropped the gold standard so that it could pay for its role in the war; all the planes, ships, tanks and ordnance it wielded across Europe and the Pacific. After WWII, in an effort to stabilise the shattered economies of the world, an agreement was entered into at a place called Bretton Woods in New Hampshire, USA, whereby the exchange rates of 43 major world currencies were fixed to the US dollar, which itself was fixed to gold.
Then in 1971, President Nixon took the US off the so-called 'gold standard', and the dollar became a fiat currency. This effectively ended the Bretton Woods agreement, and it caused the other currencies to also become fiat (though many, including the UK, failed to recognise the profound change). As a result, the exchange rates between them now float (the pound sterling, the yen, the Australian and Canadian dollars being the major examples). The exchange rates between these countries depend on many factors, in particular, the strength of a country's economy, normally gauged by its inherent productivity and its gross domestic product, or GDP.
The source of money
The way a sovereign currency works, along with the abilities that it offers to its issuing government are described in what is known as modern monetary theory (MMT). This theory describes the core mechanisms of monetary systems, whether they are fiat or tied to something external; e.g. gold or anothr currency.MMT acts as a lens through which we can better understand the effects of policies within a country. It is usually most useful for a country where the government is the sovereign issuer of currency, but can also be applied where it is not; e.g. Euro countries. This pan-European currency is a recent entrant to the international currency scene. However, it breaks the link between national sovereignty and the issuance of currency. MMT can illuminate the repercussions of that change.
Most of the development of MMT has occurred in Australia and the US and so illustrations tend to be based on the Australian and US dollars. It begins with a handful of basic truths about the nature of money in a sovereign currency, and then goes on to explore the consequences that flow from those.
Back to basics. With a sovereign currency, since money has no direct relationship to the value of anything solid, it begs the questions; where does it come from and what gives it value? MMT points out that a fiat currency is created by a sovereign government as the currency of that country. The denomination of the currency, be it the dollar, pound, yen or whatever, is what is known as the "unit of account." In the UK, this is the pound Sterling and no one else in this country is allowed to create pounds Sterling currency. If they do, they are committing counterfeit.
When the UK government imposes a tax or a fine on a person or a company, only the pound can be used to pay that obligation. It is possible for anyone to create or use other currencies in this country; e.g. printed vouchers, supermarket loyalty points, US dollars and Bitcoin are all examples. However, taxes to the UK government cannot be redeemed with them, for very good reasons.
Back to basics. With a sovereign currency, since money has no direct relationship to the value of anything solid, it begs the questions; where does it come from and what gives it value? MMT points out that a fiat currency is created by a sovereign government as the currency of that country. The denomination of the currency, be it the dollar, pound, yen or whatever, is what is known as the "unit of account." In the UK, this is the pound Sterling and no one else in this country is allowed to create pounds Sterling currency. If they do, they are committing counterfeit.
When the UK government imposes a tax or a fine on a person or a company, only the pound can be used to pay that obligation. It is possible for anyone to create or use other currencies in this country; e.g. printed vouchers, supermarket loyalty points, US dollars and Bitcoin are all examples. However, taxes to the UK government cannot be redeemed with them, for very good reasons.
MMT posits that for a country with a sovereign currency, the link between tax and spending is broken. It is pointed out that a sovereign government creates money merely by spending. If it requires goods or services, or if it wishes to give money away for policy reasons (think state pensions, child allowance or other benefits), it does so by instructing its central bank to credit the 'reserve accounts' of the commercial banks so that they can then mark up the accounts of companies, organisations and persons as necessary. The government might be buying anything from aircraft carriers, motorways and bridges, paying for soldiers, scientists and civil servants; or maybe just purchasing paperclips for parliamentary offices.
Though many often disparagingly describe this as 'printing money', it is a faulty characterisation. The UK government does not print money to buy what it wants. Only about three percent of the currency in circulation in the UK is in the form of printed notes or struck coins. The crediting of accounts is achieved merely with keystrokes on a computer keyboard. It is the job of the central bank to keep the score. There is no movement of banknotes or gold from one place to another. In this arrangement, money is an IOU from the government, stored on a ledger, and they can create as many IOUs as they see fit. Likewise, paying a tax involves the debiting of accounts. Again, the central bank (the Bank of England in the UK) keeps score.
The value of the money is therefore not intrinsic and the concept of a currency is merely a scorekeeping exercise of government IOUs. In the distant past, you could theoretically present banknotes to a central bank under a promise that they would exchange them for gold or silver. Now, were you to present a £20 note, all you'd get back is... twenty pounds!
The money in the system can be likened to points in a game. Is a football league limited in the number of goals and points that can be handed out during a football season? No. They are created on a league table as and when required. All that matters is that someone is keeping the score.
In the game of Monopoly, the banker dishes out money from the bank, either at the start of the game or as the game plays out. Imagine a situation where the banker runs out of cash, what with all the salaries that are paid out when the players pass Go, and with all those Community Chest payments. What happens then? The rules of Monopoly state "If the Bank runs out of money, the Banker may issue as much as needed by writing on any ordinary paper." As long as there is money in the game to keep it going, it doesn't matter that it was created out of thin air. Likewise, with a fiat currency, the sovereign government can generate money as required. Furthermore, the UK government can never go broke for it can always issue money to pay its debts. It cannot be forced into default.
A fiat currency offers a government two important abilities that suggest how economies can be better controlled by those who have their hands on the levers of power. These abilities are concerned with how governments spend and how they tax.
Government spending
With a fiat currency, a sovereign government can purchase anything that is priced in its own currency, and it can do so at will. Indeed, it is important that it does so because this is the only means by which money of a particular currency can enter the private sphere. Once there, the money can be used in transactions, either by people selling their time and labour (salaries) or by them spending the money they earn in shops and on services. All this spending is what is aggregated to a figure that states the size of a country's economy, its gross domestic product.It is important at this stage not to run away with the notion that such government spending is unconstrained. It is not. There are fundamental limits which are discussed later.
With this freedom, the government can spend on whatever it feels will best serve its purposes. By doing so, money is created that will circulate around the economy. If the government limits its spending, it will likewise limit the money that can flow through the economy.
Distinction must be made between government-issued currency and the pounds that are issued by commercial banks as loans. As numbers in accounts, they appear to be exactly the same. They are not. Bank-issued pounds have a defined limited lifetime, set by the loan term. When a loan is made, not only is the borrower's account marked up by the loan amount, a loan account is also created with the same number of pounds entered into it. They are 'negative' pounds, a liability that balances the asset. When a pound is repaid, it is deleted. The government's currency has no term applied to it when it is issued. Eventually, it will be returned through taxation when it is also deleted. If the government spends more than it taxes, it will be in deficit, but the private economy will be in surplus, able to save the excess pounds.
Taxation
The legal power invested in a government gives it the right to levy taxes on its population. The population must therefore acquire the currency to pay their obligations. Given that it can create its currency at will, why would a sovereign government wish to levy taxes? It must do so to force its currency to be the dominant means of exchange in the land. As a result, most everything in the country will be priced in that currency, and this allows the government, as the issuer of the currency, to purchase whatever it needs. In other words, taxes are a means by which a government can bring a country's resources to itself. (In times past, other means included forcing people to serve, usually in the military, using conscription or more direct physical coercion.)In a gold standard arrangement, the amount of currency was limited by the quantity of gold in the government's vaults. In this arrangement, the quantity of available money was fixed and if the government wanted to purchase something, it had to acquire that money from the limited pool through taxation. This is taxation for the sake of revenue generation and the arm of the UK state that deals with taxation, HMRC, still has an R in its name which stands for revenue. The name is obsolete now that the UK has a fiat currency. When it wishes to spend, it creates the money. All that is really happening in taxation is that an IOU is being returned to the government. In a particular sovereign country, it is likely that legal contracts will also be written to use that country's unit of account which reinforces the acceptance of that currency.
As a historical note, the word, revenue, is derived from French, 'revenir' which means 'to come back'. This hints at the true meaning behind taxation, the return of the government's currency back to itself. Added to that, we still talk about filling in a 'tax return'. We are indeed returning to Caesar that which is Caesar's.
There are plenty of instances where taxation is used to raise money for spending where the taxing authority does not have its own sovereign currency. Examples of this include local councils and authorities in the UK. Add to that, the individual states of the US and the countries of the Eurozone. They do have to manage their funding in the household model and for them, taxation is a major source of income. Like you and I, or any company and business, they are users of the currency. The UK government is an issuer of the currency. The distinction is important.
With a fiat currency, since taxation is not directly required to fund government spending, what else is it for beyond legitimising the currency? At the most basic level, it is about the wielding of power. Coercion is used to force the sovereign currency to be accepted over all others, allowing the government to provision itself. Beyond that, the government can use taxation as a lever of policy. Progressive taxation of incomes can be used to reduce the gap between the richest and the poorest. Taxation can be used to affect behaviours that the government deems bad. For example, they can heavily tax vehicles and fuels that cause the emission of noxious gases, and lightly tax those vehicles that do not. Tobacco and alcohol are two widely consumed substances that cause individual damage and so are heavily taxed.
Objections to MMT always raise the examples of Germany between the wars and Zimbabwe in more recent times among others. Regular repetition on the media reinforces the impression that these cases clearly demonstrate what happens when governments print money without adding the context of each case. However, studies have shown that hyperinflation does not occur in stable democracies. Rather, it is a symptom of an economy under extreme stress.
The German example is irrelevant to MMT because it occurred during the time of the gold standard. Further, Weimar Germany was being forced to pay punishing reparations after its defeat in WWI which it could not do. It had lost the Ruhr Valley, a major part of its productive capacity, to France and Belgium. It needed that capacity to buy the gold with which it could pay. Printing money was a symptom, not the cause of its hyperinflation. It did not have a fiat currency.
The Zimbabwe case was a convergence of three powerful influences. The country's agriculture sector collapsed because the government forced land ownership to change to those who were less capable of farming it productively. Zimbabwe then saw a steep rise in imports to compensate for the drop in local productivity. Meantime, the economy was mismanaged by the government, particularly by the imposition of price controls.
In the MMT concept of fiat money, inflation is a symptom of the government's inability to properly manage the country's available resources, primarily people. It must be careful that its spending does not overstretch them. If the government buys so many goods and services that it takes up all the available labour and more, the price of labour will tend to rise. In other words, wages will rise because the private sector has to start outbidding the government for the time and energy that people have to sell; i.e. their labour. And if wages rise, then so does the cost of goods and services that were created by the labour bought with those wages. This is inflation.
In other words, inflation is a sign that a currency-issuing government has spent too much. It has put too much money into the economy, and must take some money out of the economy. This can be achieved either by taxation, which destroys the money, or by selling securities or bonds which are savings accounts that are held with the government. These can temporarily remove money away from where it can be spent.
On the opposite side of the balance is the situation where the government has spent too little. Now the country's resources are underused. Unemployment rises and the affected workforce can grow stale through lack of use as skills are forgotten, new skills never learnt and people get out of the habit of turning up for a job. Thus unemployment is a sign of a lack of investment in an economy.
The government's deficit is the difference between the amount of money that a government has put into the economy and the amount that it has taxed back out. Despite the negative connotations that are consistently applied to the concept, it is a usually good thing because the government's deficit is our surplus.
There are plenty of instances where taxation is used to raise money for spending where the taxing authority does not have its own sovereign currency. Examples of this include local councils and authorities in the UK. Add to that, the individual states of the US and the countries of the Eurozone. They do have to manage their funding in the household model and for them, taxation is a major source of income. Like you and I, or any company and business, they are users of the currency. The UK government is an issuer of the currency. The distinction is important.
With a fiat currency, since taxation is not directly required to fund government spending, what else is it for beyond legitimising the currency? At the most basic level, it is about the wielding of power. Coercion is used to force the sovereign currency to be accepted over all others, allowing the government to provision itself. Beyond that, the government can use taxation as a lever of policy. Progressive taxation of incomes can be used to reduce the gap between the richest and the poorest. Taxation can be used to affect behaviours that the government deems bad. For example, they can heavily tax vehicles and fuels that cause the emission of noxious gases, and lightly tax those vehicles that do not. Tobacco and alcohol are two widely consumed substances that cause individual damage and so are heavily taxed.
But what about inflation?
The prospect of governments spending willy-nilly raises an immediate fear in most folk because they feel certain that it would result in rampant inflation. This is a pervasive part of the accepted meme. It seems clear to people that if a government 'prints more money', then that money will obviously become less valuable and prices will increase. The narrative insists that taxes and borrowing are the only source of government revenue. But this is to think about money as if we are still in a gold standard world. We are not and haven't been for two generations.Objections to MMT always raise the examples of Germany between the wars and Zimbabwe in more recent times among others. Regular repetition on the media reinforces the impression that these cases clearly demonstrate what happens when governments print money without adding the context of each case. However, studies have shown that hyperinflation does not occur in stable democracies. Rather, it is a symptom of an economy under extreme stress.
The German example is irrelevant to MMT because it occurred during the time of the gold standard. Further, Weimar Germany was being forced to pay punishing reparations after its defeat in WWI which it could not do. It had lost the Ruhr Valley, a major part of its productive capacity, to France and Belgium. It needed that capacity to buy the gold with which it could pay. Printing money was a symptom, not the cause of its hyperinflation. It did not have a fiat currency.
The Zimbabwe case was a convergence of three powerful influences. The country's agriculture sector collapsed because the government forced land ownership to change to those who were less capable of farming it productively. Zimbabwe then saw a steep rise in imports to compensate for the drop in local productivity. Meantime, the economy was mismanaged by the government, particularly by the imposition of price controls.
In the MMT concept of fiat money, inflation is a symptom of the government's inability to properly manage the country's available resources, primarily people. It must be careful that its spending does not overstretch them. If the government buys so many goods and services that it takes up all the available labour and more, the price of labour will tend to rise. In other words, wages will rise because the private sector has to start outbidding the government for the time and energy that people have to sell; i.e. their labour. And if wages rise, then so does the cost of goods and services that were created by the labour bought with those wages. This is inflation.
In other words, inflation is a sign that a currency-issuing government has spent too much. It has put too much money into the economy, and must take some money out of the economy. This can be achieved either by taxation, which destroys the money, or by selling securities or bonds which are savings accounts that are held with the government. These can temporarily remove money away from where it can be spent.
On the opposite side of the balance is the situation where the government has spent too little. Now the country's resources are underused. Unemployment rises and the affected workforce can grow stale through lack of use as skills are forgotten, new skills never learnt and people get out of the habit of turning up for a job. Thus unemployment is a sign of a lack of investment in an economy.
Deficit and debt
When it becomes clear that, for a country with a currency-issuing government, the money must come from the government, it allows us to gain a deeper understanding of government deficit and debt.The government's deficit is the difference between the amount of money that a government has put into the economy and the amount that it has taxed back out. Despite the negative connotations that are consistently applied to the concept, it is a usually good thing because the government's deficit is our surplus.
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| UK sectoral balances. Government deficits equal private sector surpluses - to the penny! |
MMT points out that in general, a government must run a deficit in order to satisfy the desire of the private sector to save. In the big picture, the private sector does not save the money generated by commercial loans as that must,by some means, be paid back and thereby deleted.
If a government tries to reduce its deficit, it can seriously damage its economy. An example is the austerity policy applied in the UK after the 2010 General Election (two years after the 2008 crash). In that time, growth in GDP has been below typical.
Perhaps a more striking example is from the US. In an effort to appear to be fiscally conservative, the Clinton administration drove down the US government's deficit. In its final two years, it managed to turn it into a government surplus; i.e. the spending was less than the tax receipts. At first view, this appears to be a laudable achievement. However, the resultant lack of money in the wider economy caused the currency users; the individuals, households and businesses; to rely on excessive borrowing to support their spending, particularly when buying property until in late 2007, gorged on sub-prime mortgages, the lending bubble burst to begin the 2008 crash.
A government's debt is not the same as its deficit. Strictly speaking, its debt is the sum of all the securities or bonds that it has placed onto the market. These took pounds out of the system but at some time, that money will be paid back with interest. This is not a problem for a government that issues its own currency. It can always repay those securities and their interest. That's why they are considered by investors to be extremely safe investments. It is notable, however, that this debt is always characterised as a problem. It is never shown for what it is, the sum total of all our savings. In simple double-entry accounting terms, the government's debt is our surplus. The national debt is really the national treasure.
To put it in the same metaphor that Margaret Thatcher used during her rise to power, the UK government is like a household. It cannot live beyond its means. Money in and out must be the same and the books have to balance. If household spending exceeds income, the deficit must be borrowed and, at some point, the day of reckoning will come when that borrowing will have to be paid back.
MMT contends that this metaphor is flawed because the government is the sole issuer of currency which is essentially government IOUs. It can create IOUs as it sees fit and it makes no sense for it to borrow its own IOUs. The constraints that apply to a sovereign issuer of currency are not the same as those that apply to households, companies or non-sovereign states. Unlike a sovereign government, a household cannot create the nation's currency.
This undermines the political right, who insist that taking money in taxation must be minimised so as not to be a burden on the free market. They continue that if the income to the government is reduced by this action, then so should be their spending. This reduction in government spending suits a right-wing agenda because it chimes with a belief that governments tend to get in the way of personal and business freedom and ought to be scaled back as much as possible. Their assumption is that tax directly funds spending. They don't understand that it is only government spending that creates the money that the private sphere relies on to produce its profits and savings.
The political left also come unstuck through MMT, even though some think of the theory as being a leftist concoction. The left demand that taxation and government spending be used as a tool to force equality in society. They believe that the relatively rich should be highly taxed and the relatively poor, less so; even to the extent that they be untaxed. This is taken to the point where those deemed most needy are gifted benefits in the belief that these benefits are funded by money taken from the rich. If need be, the left will spend more than they gather in tax in order to cure the social problems they perceive, borrowing in the process with the hope that future economic success will pay off the debt.
The left don't realise that the government can help the needy without taking from the rich, Robin Hood style. Nor do they understand that the government ought to heavily tax the rich because money is a tool of power and if too much power goes to a few individuals, that undermines the power basis of the government, be it democratic or autocratic.
Thus both sides of the conventional politic are stuck on the assumption that taxation generates revenue that goes to fund government spending. And if the government needs to spend more than it taxes, it must borrow. This is thinking in the gold standard model and MMT shows that it is wrong.
MMT shows that government spending is not limited by taxes; that taxes are not linked government spending. The fact that MMT runs against much of the dogma of both left and right means that it is often a target for attack from the establishment. Once upon a time, the same was true of heliocentrism, the idea that the planets revolve around the Sun. We now know that despite the objections, it is true.
What has tended to happen with governments is that they insist, even to the point of legislation, on forcing government borrowing to cover any shortfall between spending and taxation. Therefore, having created money to spend, if they don't then destroy an equivalent amount by taxation, they create savings constructs and call that government borrowing (via bonds and securities). They then assume that one day, the money will have to be paid back using taxation money. It should be clear that this is a fallacy as they can pay the value of the securities any time, along with the interest because they are the currency issuer.
This has an interesting repercussion when it comes to interest rates. The raising of interest rates is always sold as a means to combat inflation. MMT points out that this is not the case. A rise in interest rates moves pounds from borrowers (generally the less well off) to savers and lenders (generally the better off). It reduces the spending power of the former and raises it for the latter. It also raises costs for businesses who often use credit as a means to fund inventory and investment. These costs are passed onto the consumer, raising prices; i.e. inflation. Further, it increases interest payments to those who hold government bonds. Effectively, it increases government handouts to those who already have pounds in proportion to how many pounds they have.
The inflows of money are from government spending but also from business investments, where money is put into the machinery of the economy in order to build things, to develop better things or on pure research. Another inflow comes from the export of goods and services, when other countries buy our stuff and they pay us in a way that is eventually exchanged to our own currency, thereby putting money into the economy where it can be spent by the population.
Money is taken out of the bath by taxes, quite obviously, but also by savings. Saving is generally seen as a good thing and at a small scale, it is. But if everyone were to suddenly decide to save far more than they do now, it would be catastrophic for the economy because far less money would be available with which people could buy and sell. The other means by which the bathtub empties is by imports. When we buy stuff from abroad, money leaves this economy and is therefore not available for spending here.
If too little money is available to the private sphere, then fewer people are buying and selling. There will be lay-offs and unemployment, and the capability of the people to do things and make stuff is underutilised. It is inefficient. Worse, continued lack of use erodes the ability of those resources to come back into use. Skills require practice, and as technology moves on, unemployed individuals fall behind in their knowledge.
If, however, too much money goes into the economy, it will overreach the country's ability to produce, buy and sell. Companies will begin to outbid each other in order to attract the relatively scarce resources. This raises the price of labour and eventually, the price of goods and services. We have inflation.
We can see that through judicious taxation and spending, a wise government can tune the economy to remain at the point where the resources of the country are, to all intents and purposes, fully utilised but not any more than that. Taxes must be levied as necessary to give legitimacy to the currency. Beyond that, they can be used to control the amount of money in the economy; a way to counter the pressures that might cause inflation. They may also be used as policy tools to control behaviour and address problems within society; essentially to tax the bad things like atmospheric pollution, alcohol, cigarettes, environmental damage; whatever. An important point to take from this is that revenue generation is not the purpose of taxation for a currency issuing government.
A wise government can use its ability to spend its sovereign currency to supply things we might need, like roads, sewage infrastructure, defence, environmental protection, health care, education and investment in knowledge and culture. But they must do so only insofar as they use up spare capacity in the economy. Essentially, they should spend to ensure that there is almost full employment.
Since then, the current UK government has used the size of the deficit as an excuse for a policy of austerity whereby government spending is cut back wherever possible. They explain that, like a household that has splashed out a bit too much on holidays, the latest large screen TV and Christmas, they must tighten their belt to reduce the deficit. Thus, taxes are kept high, grants to local authorities are squeezed and the wages of those in jobs which are financed directly or indirectly by the government (nurses, firefighters, etc.) are prevented from rising even with inflation.
MMT shows the folly of this approach. By cutting back on government spending, the government is reducing the amount of money in the economy. In doing so, they are throttling it, depriving it of the ability to drive the buying and selling that is the very hallmark of a healthy economy. In their attempt to balance the government budget, they fail to appreciate that it is the economy that should be balanced, not the budget. A carefully controlled government deficit is a good thing because if the government is in deficit then the private sphere must be in surplus. Except for exports and imports, that's where the government's money went; into the private sphere.
One of the major proponents of MMT has suggested that a suitable policy for ensuring nearly full employment is to guarantee a job to all comers; the Job Guarantee scheme. This recognises that unemployment is merely an indicator that resources are being unused. In this arrangement, the government would find things to do for anyone who wants a job. It would only pay around minimum wage levels in order not to outbid the private sector and would include rules to insist on attendance on pain of losing the job. The job guarantee doesn’t address the issue of whether the jobs being offered are in any way desirable employment for the money offered.
As an alternative to this scheme, a government can simply choose to buy goods and services on the open market to achieve the goals to which it aspires. It can then play the market like any other customer and can do so to the point where full employment is achieved.
This is comparable to the Apollo programme to land on the Moon whereby companies across the US were hired to build the machines and facilities required for the task. 400,000 people were involved and the programme pumped a huge amount of money into the American economy. The stimulus helped the US to maintain its economic strength well beyond the achievement of the goal. The technological payoffs are still being felt. But it is then incumbent upon those in government to properly manage the contracts involved, something for which politicians are not renown.
Finally the government can directly employ people, paying them from the public purse to supply a service. In the UK, members of the armed forces are paid this way via the Ministry of Defence. As above, those in power must manage this use of resources, though this will be without the mechanisms of the market. Again, politicians are not known for their skill in large-scale management, except perhaps in times of war. However, they can set up agencies to manage projects on their behalf.
Perhaps a more striking example is from the US. In an effort to appear to be fiscally conservative, the Clinton administration drove down the US government's deficit. In its final two years, it managed to turn it into a government surplus; i.e. the spending was less than the tax receipts. At first view, this appears to be a laudable achievement. However, the resultant lack of money in the wider economy caused the currency users; the individuals, households and businesses; to rely on excessive borrowing to support their spending, particularly when buying property until in late 2007, gorged on sub-prime mortgages, the lending bubble burst to begin the 2008 crash.
A government's debt is not the same as its deficit. Strictly speaking, its debt is the sum of all the securities or bonds that it has placed onto the market. These took pounds out of the system but at some time, that money will be paid back with interest. This is not a problem for a government that issues its own currency. It can always repay those securities and their interest. That's why they are considered by investors to be extremely safe investments. It is notable, however, that this debt is always characterised as a problem. It is never shown for what it is, the sum total of all our savings. In simple double-entry accounting terms, the government's debt is our surplus. The national debt is really the national treasure.
Political push-back
The mechanisms of money described by MMT run counter to the dominant narrative that is heard throughout the media and from all wings of the political establishment. This narrative contends that, in essence, government spending is directly dependent on money flowing from taxation. It is as if tax money flows into a bank account which the government can access when it wishes to spend.To put it in the same metaphor that Margaret Thatcher used during her rise to power, the UK government is like a household. It cannot live beyond its means. Money in and out must be the same and the books have to balance. If household spending exceeds income, the deficit must be borrowed and, at some point, the day of reckoning will come when that borrowing will have to be paid back.
MMT contends that this metaphor is flawed because the government is the sole issuer of currency which is essentially government IOUs. It can create IOUs as it sees fit and it makes no sense for it to borrow its own IOUs. The constraints that apply to a sovereign issuer of currency are not the same as those that apply to households, companies or non-sovereign states. Unlike a sovereign government, a household cannot create the nation's currency.
This undermines the political right, who insist that taking money in taxation must be minimised so as not to be a burden on the free market. They continue that if the income to the government is reduced by this action, then so should be their spending. This reduction in government spending suits a right-wing agenda because it chimes with a belief that governments tend to get in the way of personal and business freedom and ought to be scaled back as much as possible. Their assumption is that tax directly funds spending. They don't understand that it is only government spending that creates the money that the private sphere relies on to produce its profits and savings.
The political left also come unstuck through MMT, even though some think of the theory as being a leftist concoction. The left demand that taxation and government spending be used as a tool to force equality in society. They believe that the relatively rich should be highly taxed and the relatively poor, less so; even to the extent that they be untaxed. This is taken to the point where those deemed most needy are gifted benefits in the belief that these benefits are funded by money taken from the rich. If need be, the left will spend more than they gather in tax in order to cure the social problems they perceive, borrowing in the process with the hope that future economic success will pay off the debt.
The left don't realise that the government can help the needy without taking from the rich, Robin Hood style. Nor do they understand that the government ought to heavily tax the rich because money is a tool of power and if too much power goes to a few individuals, that undermines the power basis of the government, be it democratic or autocratic.
Thus both sides of the conventional politic are stuck on the assumption that taxation generates revenue that goes to fund government spending. And if the government needs to spend more than it taxes, it must borrow. This is thinking in the gold standard model and MMT shows that it is wrong.
MMT shows that government spending is not limited by taxes; that taxes are not linked government spending. The fact that MMT runs against much of the dogma of both left and right means that it is often a target for attack from the establishment. Once upon a time, the same was true of heliocentrism, the idea that the planets revolve around the Sun. We now know that despite the objections, it is true.
Borrowing
Since the unit of account in a currency (the pound, dollar or whatever) is essentially a government IOU, the government cannot borrow its own IOUs. It may appear to do so; it takes money as bonds and national savings and pays a guaranteed interest rate, but it can do so merely because it has the ability to pay 'interest' at any time using its own sovereign currency. The receipts taken as bonds or national savings are a bit like taxation, except they are voluntary. Like taxation, they take money out of the private sphere and as long as someone keeps the score, the government can repay the same amount, plus the interest. In fact, under a fiat currency, the issuer cannot go broke for they can always write more IOUs. That's not to say that they should try to go broke, but it illustrates the fundamental difference between a sovereign currency issuer and a household.What has tended to happen with governments is that they insist, even to the point of legislation, on forcing government borrowing to cover any shortfall between spending and taxation. Therefore, having created money to spend, if they don't then destroy an equivalent amount by taxation, they create savings constructs and call that government borrowing (via bonds and securities). They then assume that one day, the money will have to be paid back using taxation money. It should be clear that this is a fallacy as they can pay the value of the securities any time, along with the interest because they are the currency issuer.
This has an interesting repercussion when it comes to interest rates. The raising of interest rates is always sold as a means to combat inflation. MMT points out that this is not the case. A rise in interest rates moves pounds from borrowers (generally the less well off) to savers and lenders (generally the better off). It reduces the spending power of the former and raises it for the latter. It also raises costs for businesses who often use credit as a means to fund inventory and investment. These costs are passed onto the consumer, raising prices; i.e. inflation. Further, it increases interest payments to those who hold government bonds. Effectively, it increases government handouts to those who already have pounds in proportion to how many pounds they have.
The Bathtub
Proponents of MMT use a metaphor of a bathtub to help explain their thinking. The bathtub represents the economy in terms of the private sphere; companies, individuals etc.; not the government. The water in the bath represents the money that is swilling around the economy, essentially the GDP of a country. There is a level within the bath which represents the point where the available resources, primarily labour, are being fully utilised.
The inflows of money are from government spending but also from business investments, where money is put into the machinery of the economy in order to build things, to develop better things or on pure research. Another inflow comes from the export of goods and services, when other countries buy our stuff and they pay us in a way that is eventually exchanged to our own currency, thereby putting money into the economy where it can be spent by the population.
Money is taken out of the bath by taxes, quite obviously, but also by savings. Saving is generally seen as a good thing and at a small scale, it is. But if everyone were to suddenly decide to save far more than they do now, it would be catastrophic for the economy because far less money would be available with which people could buy and sell. The other means by which the bathtub empties is by imports. When we buy stuff from abroad, money leaves this economy and is therefore not available for spending here.
If too little money is available to the private sphere, then fewer people are buying and selling. There will be lay-offs and unemployment, and the capability of the people to do things and make stuff is underutilised. It is inefficient. Worse, continued lack of use erodes the ability of those resources to come back into use. Skills require practice, and as technology moves on, unemployed individuals fall behind in their knowledge.
If, however, too much money goes into the economy, it will overreach the country's ability to produce, buy and sell. Companies will begin to outbid each other in order to attract the relatively scarce resources. This raises the price of labour and eventually, the price of goods and services. We have inflation.
We can see that through judicious taxation and spending, a wise government can tune the economy to remain at the point where the resources of the country are, to all intents and purposes, fully utilised but not any more than that. Taxes must be levied as necessary to give legitimacy to the currency. Beyond that, they can be used to control the amount of money in the economy; a way to counter the pressures that might cause inflation. They may also be used as policy tools to control behaviour and address problems within society; essentially to tax the bad things like atmospheric pollution, alcohol, cigarettes, environmental damage; whatever. An important point to take from this is that revenue generation is not the purpose of taxation for a currency issuing government.
A wise government can use its ability to spend its sovereign currency to supply things we might need, like roads, sewage infrastructure, defence, environmental protection, health care, education and investment in knowledge and culture. But they must do so only insofar as they use up spare capacity in the economy. Essentially, they should spend to ensure that there is almost full employment.
Austerity
In the years that followed the 2008 global economic crisis, the UK governments (of both political tendencies) pumped tens of billions of pounds into the banking system to prevent major UK banks from going bust. The pounds were created out of nothing using computer keyboards to increment the accounts held by those banks at the central bank. This action increased the national deficit because that money was not directly balanced by taxation. As an aside, since much of that money ended up in property, it did little to stimulate the economy.Since then, the current UK government has used the size of the deficit as an excuse for a policy of austerity whereby government spending is cut back wherever possible. They explain that, like a household that has splashed out a bit too much on holidays, the latest large screen TV and Christmas, they must tighten their belt to reduce the deficit. Thus, taxes are kept high, grants to local authorities are squeezed and the wages of those in jobs which are financed directly or indirectly by the government (nurses, firefighters, etc.) are prevented from rising even with inflation.
MMT shows the folly of this approach. By cutting back on government spending, the government is reducing the amount of money in the economy. In doing so, they are throttling it, depriving it of the ability to drive the buying and selling that is the very hallmark of a healthy economy. In their attempt to balance the government budget, they fail to appreciate that it is the economy that should be balanced, not the budget. A carefully controlled government deficit is a good thing because if the government is in deficit then the private sphere must be in surplus. Except for exports and imports, that's where the government's money went; into the private sphere.
The tools
Once it is understood that a government with a sovereign currency is not restrained in its spending by its tax intake, then the inevitable question comes up; how should it spend government money?One of the major proponents of MMT has suggested that a suitable policy for ensuring nearly full employment is to guarantee a job to all comers; the Job Guarantee scheme. This recognises that unemployment is merely an indicator that resources are being unused. In this arrangement, the government would find things to do for anyone who wants a job. It would only pay around minimum wage levels in order not to outbid the private sector and would include rules to insist on attendance on pain of losing the job. The job guarantee doesn’t address the issue of whether the jobs being offered are in any way desirable employment for the money offered.
As an alternative to this scheme, a government can simply choose to buy goods and services on the open market to achieve the goals to which it aspires. It can then play the market like any other customer and can do so to the point where full employment is achieved.
This is comparable to the Apollo programme to land on the Moon whereby companies across the US were hired to build the machines and facilities required for the task. 400,000 people were involved and the programme pumped a huge amount of money into the American economy. The stimulus helped the US to maintain its economic strength well beyond the achievement of the goal. The technological payoffs are still being felt. But it is then incumbent upon those in government to properly manage the contracts involved, something for which politicians are not renown.
Finally the government can directly employ people, paying them from the public purse to supply a service. In the UK, members of the armed forces are paid this way via the Ministry of Defence. As above, those in power must manage this use of resources, though this will be without the mechanisms of the market. Again, politicians are not known for their skill in large-scale management, except perhaps in times of war. However, they can set up agencies to manage projects on their behalf.
In summary
The takeaway points from this essay are:- When it comes to budgeting, governments with sovereign currencies are intrinsically different from households, companies and non-sovereign states.
- A government with a sovereign currency cannot go bust as it can always pay it debts.
- For a sovereign currency, money is a scorekeeping exercise and as in a game, points (units of account) can be created and destroyed at will.
- Taxation is necessary for a currency to have legitimacy and as a device to control the economy.
- Taxation does not directly fund government spending. It can be used as a policy device, to help control undesirable behaviour.
- To the penny, a government deficit is a private surplus. For the private sphere to be in surplus, the government must be in deficit because it is the government that spends money into existence.
- Only the government can create money. If anyone else does so, it is counterfeit. A commercial bank that lends money must balance that lending with a loan account - a balancing liability.
- A government with a sovereign currency has the power to spend in order to maximise the use of a country’s available resources. It is then incumbent on them to do so responsibly as excess spending will cause inflation. But if the resources are available, it can do it.
