Modern Monetary Theory
Modern monetary theory (MMT or modern money theory), also known as neochartalism, is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money, i.e., fiat money. According to modern monetary theory, "governments with the power to issue their own currency are always solvent, and can afford to buy anything for sale in their domestic unit of account even though they may face inflationary and political constraints".
MMT aims to describe and analyze modern economies in which the national currency is fiat money, established and created exclusively by the government. In MMT, money enters circulation through government spending. Taxation and its legal tender power to discharge debt establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that must be met using the government's currency. An ongoing tax obligation, in concert with private confidence and acceptance of the currency, maintains its value. Because the government can issue its own currency at will, MMT maintains that the level of taxation relative to government spending (the government's deficit spending or budget surplus) is in reality a policy tool that regulates inflation and unemployment, and not a means of funding the government's activities per se.
- 1 Background
- 2 Vertical transactions
- 3 Interaction between government and the banking sector
- 4 Horizontal transactions
- 5 The foreign sector
- 6 Policy implications
- 7 Criticisms
- 8 Modern proponents
- 9 See also
- 10 Notes
- 11 Bibliography
- 12 External links
Georg Friedrich Knapp coined the term "chartalism" in his State Theory of Money, which was published in German in 1895 and translated into English in 1924. The name derives from the Latin charta, in the sense of a token or ticket. Knapp argued that "money is a creature of law" rather than a commodity. At the time of writing the Gold Standard was in existence, and Knapp contrasted his state theory of money with the view of "metallism", where the value of a unit of currency depended on the quantity of precious metal it contained or could be exchanged for. He argued the state could create pure paper money and make it exchangeable by recognising it as legal tender, with the criterion for the money of a state being "that which is accepted at the public pay offices".
Constantina Katsari has argued that principles from both metallism and chartalism were reflected in the monetary system introduced by Augustus, which was used in the eastern provinces of Roman Empire, from the early 1st century to the late 3rd century AD.
The prevailing view of money was that it had evolved from systems of barter to become a medium of exchange because it represented a durable commodity which had some use value. Modern chartalist economists such as Randall Wray and Mathew Forstater argue that more general statements appearing to support a chartalist view of tax-driven paper money appear in the earlier writings of many classical economists. Adam Smith, for example, observed in The Wealth of Nations:
A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money; even though the term of its final discharge and redemption should depend altogether on the will of the prince
— Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations
Alfred Mitchell-Innes, writing in 1914, argued that money existed not as a medium of exchange but as a standard of deferred payment, with government money being debt the government could reclaim by taxation. Innes argued:
Whenever a tax is imposed, each taxpayer becomes responsible for the redemption of a small part of the debt which the government has contracted by its issues of money, whether coins, certificates, notes, drafts on the treasury, or by whatever name this money is called. He has to acquire his portion of the debt from some holder of a coin or certificate or other form of government money, mid present it to the Treasury in liquidation of his legal debt. He has to redeem or cancel that portion of the debt...The redemption of government debt by taxation is the basic law of coinage and of any issue of government ‘money’ in whatever form.
— Alfred Mitchell-Innes, The Credit Theory of Money, The Banking Law Journal
Knapp and "Chartalism" were referenced by John Maynard Keynes in the opening pages of his 1930 Treatise on Money  and appear to have influenced Keynesian ideas on the role of the state in the economy By 1947, when Abba Lerner wrote his article Money as a Creature of the State, economists had largely abandoned the idea that the value of money was closely linked to gold. Lerner argued that responsibility for avoiding inflation and depressions lay with the state because of its ability to create or tax away money.
MMT labels any transactions between the government sector and the non-government sector as a vertical transaction. The government sector is considered to include the treasury and the central bank, whereas the non-government sector includes private individuals and firms (including the private banking system) and the external sector – that is, foreign buyers and sellers.
In any given time period, the government’s budget can be either in deficit or in surplus. A deficit occurs when the government spends more than it taxes; and a surplus occurs when a government taxes more than it spends. MMT states that as a matter of accounting, it follows that government budget deficits add net financial assets to the private sector. This is because a budget deficit means that a government has deposited more money into private bank accounts than it has removed in taxes. A budget surplus means the opposite: in total, the government has removed more money from private bank accounts via taxes than it has put back in via spending.
Therefore, budget deficits, by definition, are equivalent to adding net financial assets to the private sector; whereas budget surpluses remove financial assets from the private sector. This is represented by the identity:
where G is government spending, T is taxes, S is savings, I is investment and NX is net exports.
It is important to note that this identity is not unique to modern monetary theory; it is an identity used throughout all macroeconomic theories, because it is true by definition.
The conclusion that MMT necessarily draws from this is that private net saving is only possible if the government runs budget deficits; alternately, the private sector is forced to dis-save when the government runs a budget surplus.
MMT therefore does not support the notion, as some Keynesians do, that budget surpluses are always necessary in periods of high effective demand. According to the framework outlined above, budget surpluses remove net savings; in a time of high effective demand, this may lead to a private sector reliance on credit to finance consumption patterns. Rather, MMT suggests that continual budget deficits are necessary for a growing economy that wants to avoid deflation. MMT only advocates budget surpluses when the economy has excessive aggregate demand, and is in danger of inflation.
Interaction between government and the banking sector
Modern monetary theory provides a detailed descriptive account of the "operational realities" of interactions between the government and the central bank, and the commercial banking sector, with proponents like Scott Fullwiler arguing that understanding of reserve accounting is critical to understanding monetary policy options
A sovereign government will typically have a cash operating account with the central bank of the country. From this account, the government can spend and also receive taxes and other inflows. Similarly, all of the commercial banks will also have an account with the central bank. This permits the banks to manage their reserves (that is, the amount of available short-term money that a particular bank holds).
So when the government spends, Treasury will debit its cash operating account at the central bank, and deposit this money into private bank accounts (and hence into the commercial banking system). This money adds to the total reserves of the commercial bank sector. Taxation works exactly in reverse; private bank accounts are debited, and hence reserves in the commercial banking sector fall.
Government bonds and interest rate maintenance
Virtually all central banks set an interest rate target, and conduct open market operations to ensure base interest rates remain at that target level. According to MMT the issuing of government bonds is best understood as an operation to offset government spending rather than a requirement to finance it.
In most countries, commercial banks’ reserve account with the central bank must have a positive balance at the end of every day; in some countries, the amount is specifically set as a proportion of the liabilities a bank has (i.e. its customer deposits). This is known as a reserve requirement. At the end of every day, a commercial bank will have to examine the status of their reserve accounts. Those that are in deficit have the option of borrowing the required funds from the central bank, where they may be charged a lending rate (sometimes known as a discount rate) on the amount they borrow. On the other hand, the banks that have excess reserves can simply leave them with the central bank and earn a support rate from the central bank. Some countries, such as Japan, have a support rate of zero.
When a bank has more reserves than it needs to meet the reserve requirement, banks will try and sell their extra reserves to banks that are in deficit. This buying and selling is known as the interbank lending market. The surplus bank will want to earn a higher rate than the support rate that the central bank pays on reserves; whereas the deficit bank will want to pay a lower interest rate than the discount rate the central bank charges for borrowing, which is typically high. Thus they will lend to each other until each bank has reached their reserve requirement. In a balanced system, where there are just enough total reserves for all the banks to meet requirements, the short-term target interest rate will be in between the support rate and the discount rate.
However, MMT points out that government spending has an effect on this procedure. If on a particular day, the government spends more than it taxes, then net financial assets have been added to the banking system (see vertical transactions). This will lead to a system-wide surplus of reserves. In that case, the attempted selling of excess reserves would force the short-term interest rate down to the support rate (or alternately, to zero if a support rate is not in place). This is due to the fact that when there is a surplus in the system, and all banks can meet their reserve requirements, there would not be any demand for these surplus reserves.
The interest rate the banks charge on reserves would therefore fall to the support rate—at that point, the surplus bank will simply keep the reserves with their central bank and earn the support rate. MMT therefore concludes that the mainstream theory of crowding out (where government spending is said to put upward pressure on interest rates) is necessarily incorrect. Government spending, according to MMT, drives the short-term interest rate down. MMT does, however, insert one caveat: that long-term government bonds can affect the term structure of interest rates. For example, in times of uncertainty, long-term debt may not be desired by the market, leading to high interest rates for that particular type of debt, and therefore affecting the yield curve. MMT proponents therefore tend to argue that government should limit itself to short-term bonds.
The alternate case is where the government receives more taxes on a particular day than it spends. In this case, there may be a system-wide deficit of reserves. As a result, surplus funds will be in demand on the interbank market, and thus the short term interest rate will rise towards the discount rate. Thus, if the central bank wants to maintain a target interest rate somewhere between the support rate and the discount rate, it must manage the liquidity in the system to ensure that there is the correct amount of reserves in the banking system.
The only way it can do this is by a vertical transaction—by buying and selling government bonds on the open market. On a day where there are excess reserves in the banking system, the central bank sells bonds and therefore removes reserves from the banking system, as private individuals pay for the bonds. On a day where there are not enough reserves in the system, the central bank buys government bonds from private individuals, and therefore adds reserves to the banking system.
It is important to note that the central bank buys bonds by simply creating money—it is not financed in any way. It is a net injection of reserves into the banking system. As a result, MMT necessarily implies that the central bank of a country is not able to influence a government’s spending decisions. If a central bank is to maintain a target interest rate, then it must necessarily buy and sell government bonds on the open market in order to maintain the correct amount of reserves in the system.
MMT considers any transactions within the private sector (which includes the commercial banking system) as horizontal transactions. Specifically, MMT focuses on loan creation within the banking system.
MMT states that as a matter of accounting, loans will always necessarily create a liability and a deposit equal in magnitude. Thus the net amount of financial assets (deposits – liabilities) cannot be changed via banking actions. Of course, the deposits created certainly expand the broad money supply; subsequently, these deposits may flow away from one bank and into another, and this must be balanced at the end of the day to meet reserve requirements (see Interactions between government and the banking sector). But banks cannot create net financial assets without an attached liability. Only the government sector - specifically, the reserve bank - is able to do this (see vertical transactions).
As a result, MMT rejects the mainstream notion of the money multiplier, where a bank is completely constrained in lending through the deposits it holds, and its capital requirement. MMT does not argue that an individual bank’s reserve position is completely irrelevant to its decision to extend credit; clearly, an individual bank will weigh the benefit of lending money beyond its reserve position, and the cost of borrowing funds from the interbank market (or the central bank) in order to meet its capital requirements (see interaction between government and the banking sector). However, what MMT does argue (in opposition to the mainstream) is that there is no real constraint to a bank in creating any loan it likes. The decision will be based purely on creditworthiness and profitability – the reserve requirement is simply one aspect of profitability.
The foreign sector
Imports and exports
MMT analyzes imports and exports within the framework of horizontal transactions. It argues that an export represents a desire on behalf of the exporting nation to obtain the national currency of the importing nation. The following hypothetical example is consistent with the workings of the FX market, and can be used to illustrate the basis of this aspect of MMT:
- ”An Australian importer (person A) needs to pay for some Japanese goods. The importer will go to his bank and ask to transfer 1000 yen to the Japanese bank account of the Japanese firm (person B). After looking up the relevant exchange rates for that day, the bank will inform him that this will cost him 100 dollars. The bank removes 100 dollars from the importer’s account, and goes to the FX market. It finds an individual (person C) who is willing to swap 1000 yen for 100 dollars. It transfers the 100 dollars to that individual. Then it takes the 1000 yen and transfers it to the Japanese exporter’s bank account.”
Thus, the transaction is complete. What made the transaction possible (i.e. acceptably priced to the importer) was person C in the middle of the FX swap. Thus MMT concludes that it is a foreign desire for an importer’s currency that makes importing possible.
MMT proponents such as Warren Mosler argue that trade deficits need not be unsustainable and are beneficial to the standard of living in the short run. Imports are an economic benefit to the importing nation because they provide the nation with real goods it can consume, that it otherwise would not have had. Exports, on the other hand, are an economic cost to the exporting nation because it is losing real goods that it could have consumed. Currency transferred to foreign ownership, however represents a future claim over goods of that nation
Cheap imports may also cause the failure of local firms providing similar goods at higher prices, and hence unemployment but MMT commentators label that consideration as a subjective value-based one, rather than an economic-based one: it is up to a nation to decide whether it values the benefit of cheaper imports more than it values employment in a particular industry. Similarly a nation overly dependent on imports may face a supply shock if the exchange rate drops significantly, though central banks can and do trade on the FX markets to avoid sharp shocks to the exchange rate.
Foreign sector and commercial banks
It follows, according to MMT, that a net importing nation will be creating foreign ownership of its currency. But it is important to note that the currency will never actually leave the importing nation. The foreign owner of the local currency can either (a) spend them purchasing local assets or (b) deposit them in the local banking system. In each scenario, the money ultimately ends up in the local banking system. (Individual banks may, however, compete to attract these funds to their specific bank by offering bank bonds to overseas investors. This is typically labelled “offshore funding”.)
Foreign sector and government
Using the same application of vertical transactions MMT argues that the holder of the bond is irrelevant to the issuing government. As long as there is a demand for the issuer's currency, whether the bond holder is foreign or not, governments can never be insolvent when the debt obligations are in their own currency; this is because the government is not constrained in creating its own currency (although the bond holder may affect the exchange rate by converting to local currency). Similarly, according to the FX theory outlined above, the currency paid out at maturity cannot leave the country of issuance either.
MMT does point out, however, that debt denominated in a foreign currency certainly is a fiscal risk to governments, since the indebted government cannot create foreign currency. In this case the only way the government can sustainably repay its foreign debt is to ensure that its currency is continually and highly demanded by foreigners over the period that it wishes to repay the debt – an exchange rate collapse would potentially multiply the debt many times over asymptotically, making it impossible to repay. In that case, the government can default, or attempt to shift to an export-led strategy or raise interest rates to attract foreign investment in the currency. Either one has a negative effect on the economy. Euro debt crises in the "PIIGS" countries that began in 2009 reflect this risk, since Greece, Ireland, Spain, Italy, etc. have all issued debts in a quasi-"foreign currency" - the Euro, which they cannot create.
MMT claims that word "borrowing" is misnomer when it comes to a sovereign government's fiscal operations, because what the government is doing is accepting back its own IOUs, and nobody can borrow back their own debt instruments. Sovereign government goes into debt by issuing its own liabilities that are financial wealth to the private sector. "Private debt is debt, but government debt is financial wealth to the private sector."
This means that sovereign government is not financially constrained in its ability to spend; it can afford to buy anything that is for sale in currency that it issues (there may be political constraints, like a debt ceiling law). The only constraint is that excessive spending by any sector of the economy (whether households, firms or public) has the potential to cause inflationary pressures. MMTers argue though that generally inflation is caused by supply-side pressures, rather than demand side.
Realization that a sovereign government's ability to spend is not limited by its ability to raise revenue has led to some rather unorthodox policy conclusions. Abba Lerner's functional finance is an integral part of the MMT. This is the idea that a state uses its fiscal policy purposefully as a stabilizing mechanism for macro-economy. Warren Mosler put it this way: "for any given size government, there is a ‘right level’ of taxes that corresponds with full domestic employment". Abba Lerner said that: "government should adjust its rates of expenditure and taxation such that total spending is neither more or less than that which is sufficient to purchase the full employment level of output at current prices."
MMT also advocates replacing NAIRU unemployment (unemployment that is purposefully maintained to achieve price stability) with job guarantees that would achieve price stability by employing people in labor buffer stock. That would get rid of involuntary unemployment, as well as achieve better price stability because employers like to hire people that are already employed. A job guarantee program would also be a powerful automatic stabilizer to the economy, expanding when private sector activity cools down and shrinking in size when private sector activity heats up.
MMT has garnered wide criticism from a wide range of schools of economic thought. New Keynesian economist and Nobel laureate Paul Krugman argues that MMT goes too far in its support for government budget deficits and ignores the inflationary implications of maintaining budget deficits when the economy is growing, though MMT authors argue that "deficits never matter" exaggerates their position.
Austrian school economist Robert P. Murphy states that "the MMT worldview doesn't live up to its promises" and that it seems to be "dead wrong". He observes that the MMT claim that cutting government deficits erodes private saving is true only for the portion of private saving that is not invested, and argues that the national accounting identities used to explain this aspect of MMT could equally be used to support arguments that government deficits "crowd out" private sector investment. Daniel Kuehn has voiced his agreement with Murphy, stating "it's bad economics to confuse accounting identities with behavioral laws [...] economics is not accounting."
Murphy also criticises MMT on the basis that savings in the form of government bonds are not net assets for the private sector as a whole, since the bond will only be redeemed after the government "raises the necessary funds from the same group of taxpayers in the future". In response to this, MMT authors argue that the repayment of bonds does not necessarily have to occur from taxes; a central bank attempting to hold an interest rate target must necessarily purchase government bonds. These purchases occur through the creation of currency, rather than taxation.
Economists Warren Mosler, L. Randall Wray, Stephanie Kelton, and Bill Mitchell are largely responsible for reviving the idea of Chartalism as an explanation of money creation; Wray refers to this revived formulation as Neo-Chartalism.
Bill Mitchell, creator of the Centre of Full Employment and Equity or CofFEE, initially at the University of Newcastle, New South Wales, and now at the Charles Darwin University, Australia, refers to an increasing related theoretical work as Modern Monetary Theory. Scott Fullwiler has added detailed technical analysis of the banking and monetary systems
Rodger Malcolm Mitchell's book Free Money (1996) describes in layman's terms the essence of Chartalism.
Some contemporary proponents, such as Wray, situate Chartalism within post-Keynesian economics, while Chartalism has been proposed as an alternative or complementary theory to monetary circuit theory, both being forms of endogenous money, i.e., money created within the economy, as by government deficit spending or bank lending, rather than from outside, as by gold. In the complementary view, Chartalism explains the "vertical" (government-to-private and vice versa) interactions, while circuit theory is a model of the "horizontal" (private-to-private) interactions.
Hyman Minsky seemed to favor a Chartalist approach to understanding money creation in his Stabilizing an Unstable Economy, while Basil Moore, in his book Horizontalists and Verticalists, delineates the differences between bank money and state money.
- Demand for money
- Functional finance
- Quantity theory of money
- History of money
- History of macroeconomic thought
- Modern Money Theory: A Reply to Critics
- "Soft Currency Economics" Warren Mosler, January 1994
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- Knapp, George Friedrich (1924), The State Theory of Money, Macmillan and Company, p. 32
- Knapp, George Friedrich (1924), The State Theory of Money, Macmillan and Company
- Stephanie A. Bell and Edward J. Nell, ed. (2003). The State, the Market, and the Euro: Chartalism Versus Metallism in the theory of money. Edward Elgar. ISBN 1843761564.
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- Foreign Exchange Transactions and Holdings of Official Reserve Assets, Reserve Bank of Australia
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- http://www.youtube.com/watch?v=4J0j5VwnD7I "Q:Why does government issue bonds? Randall Wray: Sovereign government really can't borrow, because what it is doing is accepting back its own IOUs. If you have given your IOU to your neighbour because you borrowed some sugar, could you borrow it back? No, you can't borrow back your own IOUs."
- http://www.levyinstitute.org/pubs/wp_603.pdf Does Excessive Sovereign Debt Really Hurt Growth? A Critique of This Time Is Different, by Reinhart and Rogoff by Yeva Nersisyan, L. Randall Wray, p. 15
- Krugman, Paul (25 March 2011), "Deficits and the Printing Press (Somewhat Wonkish)", The New York Times, archived from the original on 17 July 2011, retrieved 17 July 2011
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- Murphy, Robert P. (9 May 2011). "The Upside-Down World of MMT". Ludwig von Mises Institute. Retrieved 17 July 2011.
- Kuehn, Daniel (9 May 2011). "Murphy on the MMTers". Retrieved 17 July 2011.
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- Febrero, Eladio (27 March 2008), "Three difficulties with Neo-Chartalism", Jornadas de Economía Crítica 11
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- Mitchell, Rodger Malcolm: Free Money - Plan for Prosperity, PGM International, Inc., paperback 2005, ISBN 978-0-9658323-1-1
- "In the spirit of debate...my reply" Bill Mitchell, 28 September 2009
- Minsky, Hyman: Stabilizing an Unstable Economy, McGraw-Hill, 2008, ISBN 978-0-07-159299-4
- Moore, Basil J.: Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge University Press, 1988, ISBN 978-0-521-35079-2
- Mosler, Warren: Seven Deadly Innocent Frauds of Economic Policy, Valance Co., 2010, ISBN 978-0-692-00959-8; also available in .DOC
- Innes, A. Mitchell (1913), "What is Money?", The Banking Law Journal
- Febrero, Eladio (2009), "Three difficulties with neo-chartalism", Journal of Post Keynesian Economics (M.E. Sharpe, Inc.) 31 (3): 523–541, doi:10.2753/PKE0160-3477310308
- Lerner, Abba P. (1947), "Money as a Creature of the State", American Economic Review
- Mitchell, Bill (2009), The fundamental principles of modern monetary economics in "It’s Hard Being a Bear (Part Six)? Good Alternative Theory?" (PDF)
- Introduction to modern (as of 2009) Chartalism.
- Wray, L. Randall (2000), The Neo-Chartalist Approach to Money (Working Paper No. 10), Center for Full Employment and Price Stability
- Wray, L. Randall (2001), The Endogenous Money Approach (Working Paper No. 17), Center for Full Employment and Price Stability
- Wray, L. Randall (December 2010), Money (Working Paper No. 647), Levy Economics Institute of Bard College
- MMT Wiki, the modern monetary theory interactive encyclopaedia
- Bill Mitchell's blog (Chartalism is denoted as "modern monetary theory", there)
- Warren Mosler's blog
- New Economic Perspectives website
- Macroeconomic Balance Sheet Visualizer, visualizing and understanding important concepts in macroeconomics
- Modern Monetary Theory: A Debate (Brett Fiebiger critiques and Scott Fullwiler, Stephanie Kelton, L. Randall Wray respond; Political Economy Research Institute, Amherst, MA)
- Credit Writedowns, news and opinion site, from the MMT perspective
- Knut Wicksell and origins of modern monetary theory-Lars Pålsson Syll
- Evolution of Selected Economic Schools, a simplified diagram