Modern Monetary Theory is NOT a Theory. It’s How The System Works.

What Economics Has Got Wrong
Most economists still seem to think that money is merely a ‘means of exchange’, ‘store of wealth’, or ‘unit of account’, ignoring the fact that newly created money shifts economic activity to meet the needs of those to whom it is allocated. Which means who gets how much of the new cash is of critical importance in determining well-being… and production. The problem is compounded by an apparent lack of understanding about how the system really works: how money is created, allocated and destroyed.

Correcting The Misconception
Prof. Stephanie Kelton, in her book ‘The Deficit Myth’, along with other writings (and increasingly other economists), has been attempting to address this failure through the promotion of ‘Modern Monetary Theory’ (MMT). Which is poorly named, as it is not a theory at all. It simply describes how the monetary system works. It would be better named the ‘Modern Monetary System’.

A new film featuring Prof. Kelton, called ‘Finding the Money’, offers a clear explanation of the money system, as well as a devastating critique of global economists who clearly have no idea how the system works, as they try to explain how they think that it does!

Everyone should see it when it comes out on general release.

That said, most MMT analysis seems to ignore the real constraints on overseas borrowing (unless you happen to have a ‘reserve’ currency, like the US). These constraints are discussed separately at the end of the paper.

The majority of this paper looks at domestic ‘money creation’ from the viewpoint of MMT.

How Money is Really Created, Allocated, and Destroyed
The basic premise of MMT is that all domestic money is created ‘out of thin air’. Some by Government/Central Bank, and some by banks… via a computer entry.

Quite simply, the money itself costs the Central Bank or the banks virtually nothing to put it on their own books. Creating ‘money’ is not like creating a ‘chair’ (for example), it just takes a bit of compute power and the press of a few keys… and the people to do the pressing. Unlike chairs, the work to enter the numbers is essentially the same, whether the money created is $1 or $1 trillion.

Of course, there are costs in managing the system, both at the Central Bank level and at the level of the banks, so that overall, the system is not cost-less.

The money created by Government finds its way into the economy as it is spent to provide public goods and services, and to fund grants and welfare.

Taxes merely claw-back some, as a means of reducing the total amount of money in circulation, to protect against inflation.

Money is also created by banks, as they make loans, and is destroyed as the loans are repaid and the entries in the bank’s books are reversed.

Specifically, the bank makes two entries on its Balance Sheet: Debit Loan and Credit Deposit in the same name. The double entry keeps the bank’s books in balance, while the debit records the amount to be repaid by the borrower, and the credit records the amount of ‘cash’ the borrower can draw down.

In fact, cash is rarely taken out. Often, the borrower simply instructs the bank to ‘pay’ another party. In this case, no money goes to the payee’s bank. Just a message telling the payee’s bank to add to the payee’s bank account the amount specified by the borrower. At the same time, the borrower’s bank reduces the borrower’s deposit by the same amount. The payment also gives rise to a matching inter-bank debt that is settled via the Central Bank. It’s all done on computer.

Where cash is taken, the deposit is simply reduced by the amount of cash. Printing or the issue of notes (or coins) does not create money. It simply changes the form of money from a computer entry into cash.

The new money is then spent into the economy to meet the needs of the borrowers, further driving new economic activity.

This is the reverse of how most economists and textbooks describe it.

The Misconception and Where it Leads
Most people seem to believe that spending can only occur if Governments first raise taxes, and banks first raise deposits — because it just makes sense on a personal level, and it’s what most economists tell us. But it is not true.

This misconception leads to unnecessary angst over ‘Government Debt’, illustrated most recently by Republican Senator Mitt Romney damning US President Biden because he did not mention in his SOTU speech the ballooning US$34 Trillion Debt “that is going to burden our children and grandchildren”.

Similarly, on 8 February 2024, Elizabeth Schulze wrote on US ABC News web site that “The federal government’s record-high national debt is set to get even bigger, reaching a massive $54 trillion by the year 2034”. With Maya MacGuineas, president of the Committee for a Responsible Federal Budget, saying in a statement to ABC News:”Our debt is rising out of control, and it’s time for Congress to wake up,”

There are even ‘Debt Clocks’ that show the constantly increasing amount of Federal Debt, as well as the ‘share’ of the debt that each citizen ‘owes’… just to scare us!

We hear similar messages from politicians in every country, including Australia.

The Truth
A country with a sovereign currency (like the US or Australia) can always pay its debts in that currency, ‘at the press of a button’. Unfortunately, this gives the erroneous impression that paying debt in this way would result in massive inflation, and/or destroy the exchange rate. It does not.

If debt was the problem, we should have had runaway inflation for years. We haven’t (apart from the recent bout due to supply chain problems arising from COVID, and energy shortages due to the Russia-Ukraine war).

While ‘Finding the Money’ provides a clear explanation of the money system, it could benefit from a summary in accounting terms, as there are always two sides to any transaction. For every expense there is an income; and for every debt, there is an asset.

Accounting for the Money Flows
The following diagram is not a ‘strict accounting ledger’, as it combines both the Government and Private sector in two columns. It builds on the approach outlined by Prof. Kelton to illustrate the impact of the new money flows on the Profit and Loss and the Balance Sheets of both the Government and the Private sector. See table below (author’s diagram).

The Deficit Myth (with acknowledgements to Stephanie Kelton)
As illustrated, all the focus on the Government ‘Debt Clock’ (the money owed on bonds) fails to recognise that it is matched by the Private Sector ‘Asset Clock’.

It also fails to recognise that, as a result of selling the bonds, the Government retains the cash it receives. This cash can sit on its Balance Sheet until the time comes to repay the bonds. Repayment is therefore never in doubt. The entries are simply reversed: the cash goes down along with the liability for the bonds (as they are repaid). There is zero change in the Government’s net asset position.

If in the next year, the Government continues to run a deficit, it again adds to the money supply, without any change in the level of debt. The debt only goes up if the Government sells bonds to take some money out of the economy, and increase interest rates. Again, receiving cash that it can hold against repayment upon maturity.

Nor does Government borrowing ‘crowd out’ private sector borrowing. A private individual or corporation is always able to go to a bank and get a loan based on their own creditworthiness and interest rates at the time. The bank does not have to find the money to make the loan. Like the Government, it just makes the necessary entries in its books: Debit Loan and Credit Deposit. Money at the stroke of a few keys.

The level of Government Debt has no bearing at all on interest rates. This is clear from the 40-year climb in debt, matched by a 40-year fall in interest rates since the 1980’s. This could not occur if Government Borrowing ‘crowded out’ Private Borrowing.

In fact, there is no need to issue bonds at all, except to provide a guaranteed income for the bond holders, who would otherwise have to hold their cash or invest it elsewhere. Or, to take money out of the ‘financial/property’ markets too cool demand for assets.

This understanding of money creation and debt, should eliminate any concern that ‘future generations’ will have to make any sacrifice to repay ‘our’ debts.

Under the current system, Central Bank buying and selling of securities also provides a means to provide or withdraw ‘liquidity’, and to impact interest rates. This would be unnecessary in a Monetary System based upon Central Bank Digital Currencies

The money to pay the interest does not need to come out of tax. It can be created, just the same as for all Government spending. While this new money also feeds into the economy, most gets reinvested, so it has little impact on the demand for goods and services, and hence inflation in consumer prices.

Australian financial journalist, Alan Kohler, reinforces this view that MMT is just how things work in an article in The New Daily, with his graphic showing the exponential increase in global debt reproduced above… of which the counterpart is the increase in global wealth (mostly accruing to the top 1%).

The Surplus Myth (also with acknowledgements to Stephanie Kelton)
The complementary erroneous idea to ‘The Deficit Myth’, is that a surplus is required to ‘bank savings’ — to ‘pay for a future deficit’. Yet, as the accounts show in the above diagram, if the arrows are reversed, a surplus is not ‘banked’. A surplus is just the opposite of a deficit. It takes money out of the economy, reducing private wealth, and current economic activity. That is all.

If the economy is overheating, and needs to be calmed, there are a whole host of factors to be considered. Merely putting the Government into surplus does not address them. What really needs to be considered is discussed below.

Utilizing Our Resources for the Common Good
In recognizing that Federal Debt is not a problem (at least insofar as domestic spending is concerned), we can look at each year’s spending with a fresh eye. We can consider what are the main priorities to advance community well being: health, education, housing, etc and consider the local resources available to deliver ongoing improvement.

If, for example, housing for the homeless is critical, but the private construction sector is already stretched, perhaps there is a need to consider temporary solutions (say, using hotels that may be under-utilized) until private demand softens, or incentives could be provided to build more social housing and fewer upmarket homes.

Whatever the decisions made, they should be based on the availability of resources, not the level of debt, or even the level of the deficit.

However, this decision is complicated by overseas borrowing to acquire overseas resources, both directly by the government, and indirectly through the government buying local resources with an overseas component.

Overseas Borrowing
A country that issues its own currency only needs to borrow overseas currency to finance excess imports (over and above its exports). Though the constraints are much less for a country that has a Reserve Currency (like the US), as it can buy overseas goods and services using its own currency.

Regardless, while the underlying productive capacity of a sovereign country remains strong, the currency will remain strong, despite a sizeable import deficit.

This paper is applicable to the US, but also discusses the constraints that do not apply in that case (at least not to the same extent).

Of course, it’s not ‘the country’ making the import decisions, it is individual government and private sector entities.

We can presume that any private importer will only borrow to import if they can sell for a profit. If (say) due to a loss of exports, the current account was to grow and the exchange rate fall, and perhaps interest rates rise, this would make it harder to import at a profit, putting a natural brake on the importer.

On the government front, they too would be faced with financing any overseas imports using overseas borrowings. However, because there is no immediate natural brake, governments (politicians) can make unwise decisions, putting the country into hock to overseas lenders.

Of course, the ability of the government to borrow overseas will be constrained in the long term by its future credit rating, interest rates, and exchange rates, which will depend upon any future shortfall on the country’s international accounts, which will in turn depend on its own manufacturing and software complexity to sustain its needs for goods and services, and/or an abundance of natural resources that remain in demand!

In my view, MMT does not offer a solution, what it offers is an explanation for why Governments seem to get away with profligate spending.

Though they complain about ‘the deficit and borrowings’ in opposition, when in power, politicians know there is a wide margin when it comes to incurring debt, including overseas debt. Possible problems can usually be kicked down the road, if there is enough political support for a favoured project (political support is not the same as community support).

Nevertheless, over time, excessive and wasteful overseas spending will make it harder and harder to borrow as credit ratings deteriorate and the exchange rate falls, leading to a rise in interest costs, also payable in overseas currency, adding to the burden.

This suggests that, rather than focus on total government debt, the focus should be on total overseas borrowings by the government directly, and indirectly via local goods purchased by the government with an overseas component. We need to know how much is borrowed and what it is for, and the likely impact on the country’s credit rating vs. potential benefits.

This can be made easier if a country adopts a Central Bank Digital Currency that enables all domestic spending to be funded by the Central Bank. Though it may also require some new series of statistics to gather the necessary data.

Managing Economic Downturns
This understanding of the money system also allows us to ignore any accumulated domestic government debt and to expand the deficit as needed to return the economy to full capacity in the event of a downturn, without worrying about the need to ‘repay the deficit’ at some future date.

The reason is that once the money has been spent and the resources brought into production, the resulting deficit remains just a number on the Government/Central Bank accounts. It can have no further economic impact.

Tax cuts are the usual cry of the right… to stimulate the economy. Clearly, any cuts will increase the deficit, which as the above analysis shows, drives up the private sector ‘asset’ clock… increasing wealth at the top end.

Another approach would be to leave taxes as they are, and instead pay the same total amount as a stimulant to all people equally. As the bulk of the money will go to those you will need to spend it to survive during a downturn, the money will naturally flow through the businesses where it is spent, circulating up to the wealthy, increasing their wealth much the same as the tax cut. But, with a major difference. Along the way, it will ensure that the rest of the population has their basic needs met.

This raises the prospect using the ‘deficit’ money to fund a ‘Job Guarantee’ for those who can do paid work, as well as a ‘Basic Income’ set to keep the labour market in ‘dynamic balance’.

The fairest and most effective way to underpin all people (not just those able to do paid work) is to pay individuals an equal amount of ‘new money’, so they can spend it to meet their basic needs.

Both Job Guarantees and a Basic Income are separately discussed in the paper: A Universal Basic Income That Underpins Well-being.

This assessment will become more complicated, the higher the level of overseas debt and the size of any shortfall on the international account, both relative to the domestic economy. Again, indicating the need to place greater focus on the effect on imports, of any proposed countermeasures.

Managing Inflation
If inflation does become a concern, a decision then has to be made: to cut back government spending, and/or bank lending, and/or to raise taxes, and in what areas.

Generally, there should be no need to try to mitigate imported inflation, as the inflation itself cannot be restrained domestically, while the rise in price will be a natural brake on imports.

That said, inflation should never be a reason to cut back payments that people rely on to survive. Indeed, MMT shows that the real value of these can be maintained, and so they should be maintained. It would mean switching more resources to meeting basic needs and less on other spending while keeping the economy at full capacity. But that’s also a whole other discussion.