Modern Monetary Theory

Pictures and Essays by Martin Hunt

Modern Monetary Theory
The way people think about how the state is financed is something like this: The state taxes citizens to pay for the stuff the state does, like build infrastructure, and support police and military and courts, and provide welfare. If the state does not collect enough in taxes then it needs to borrow to make up the shortfall. The resulting debt is called a deficit.

This deficit is seen as the same as me owing money to a friend. For the friend to lend me the money they actually have to possess it. A bank doesn't actually have to possess the money it lends. The rules are a bit complex with reserve requirements, but basically the bank creates money by just raising the borrower's bank balance. That is, numbers in ledgers get changed but the bank doesn't need to have the money in its vaults. The bank just raises the borrower's bank balance because the borrower promises to repay.

Both the borrower and the lender work with money created by the state. Here we call this the "money of account" and here we use dollars. The difference is that the state is the creator of the money that the rest of society uses. A basic mechanism here is that the state imposes taxes on the citizens and the only way those taxes can be paid is in the state's money.

The question then is how do people get the money to pay their taxes? What creates the money? It turns out that spending by the state is what creates money and taxes destroy money. This is sure against the current conventional wisdom but if you look at the history of the early USA the process is fairly clear.

Here's a passage from Modern Monetary Theory and it's Critics
(start quote . . . page 36 of my Kindle edition)
[We]...locate the origin of money with the authorities, originally religious authorities, then secular rulers, and finally down to modern democracies.[7] We have told the stories of the early clay shubati tablets, the hazelwood tally sticks, and the relatively late development of metallic coins. All the known evidence to date indicates that the authorities came up with a money of account used to denominate debts and credits (as Keynes hypothesized after reading Innes, the early money units were always based on grain weight units, reflecting record-keeping of daily allotments of foodstuff by those temple forbearers of modern states--as also documented by Michael Hudson). They then imposed obligations on subjects or citizens denominated in those money units (tithes, tribute, fees, fines, and later taxes), issued their own obligations denominated in the money of account, and then collected back their own obligations in payment of the obligations they had imposed.

Only later did markets develop - once there was a money of account as well as official price lists in the money of account, markets became possible. Money as a medium of exchange finally comes at the end of this historical process, following development of the money of account, taxes and other debts, prices, and markets. Markets worked just fine using credits and debts recorded on slate, clay, or whatever other substance proved handy for record keeping. In other words, the true history is just about the reverse of the barter-to-money story told by textbooks.[8] This alternative history is, quite simply, established beyond doubt. And it leads directly to MMT. But economists are not much better at history than they are at logic. So let's try a much more recent, simple, and clear example, one provided by Farley Grubb, the premier expert on America's colonial currency. The American colonial governments were always short of British coins (but prohibited by the Crown from coining their own) to finance their activities so they each came up with their own money of account (for example the Virginia pound or the North Carolina pound), imposed taxes in that money of account, issued paper notes in the money of account, spent the paper notes, collected those notes in taxes, and then burned their tax revenue.[9] I told you it would be simple and clear. A one-sentence history of sovereign currency in Colonial America. If you want more details, read Grubb. There are several things that I like about this example. First, it is clear that the colonies spent the notes first, then collected them in taxes. They could not possibly have collected paper notes in taxes if they had not first spent them because there were no other paper monies around. There weren't even any banks issuing notes in the colonies at the time. Second, the colonies did not spend the tax revenue received in the form of paper notes. As Grubb notes, they burned the notes. All of them. That was the purpose of the tax: in the tax laws the taxes were titled "Redemption Taxes" with the expressed purpose of "redeeming" the notes - removing them from circulation to be burned. Finally, the spending was simultaneously a "self-financing" operation as the notes were spent into existence. Taxes are for redemption, not to generate revenue "income" to be spent - as Beardsley Ruml put it.[10] Think of it this way: burning the notes was an inflation-avoidance maneuver. The point of collecting the notes was to get them out of circulation. If all the taxpayers had simply "lost them in the wash", there would have been no need to collect the notes. Alternatively, if the notes had a self-destruct code built into them (think Mission Impossible tapes) the Redemption Tax would not have been necessary for removing notes. However, no one would have accepted the notes without the obligation to pay taxes. We conclude that taxes are necessary from inception to "drive the currency" (that is, to create a demand for it) and - perhaps - to redeem the currency, withdrawing potential aggregate demand to keep inflation at bay. But not for revenue.[11]
(End quote)

I read Paul Krugman in the NYTs a lot. He's a liberal thinking Nobel Prize winning economist. He doesn't like MMT but that seems to be based on a misconception of what MMT is about. But he reinforces the basic idea of MMT; that a sovereign country that creates its money of account cannot run out of money to pay its obligations. Threats to default on government obligations are always political stunts.

So the basic idea is almost a complete inversion of conventional wisdom. It's not that taxes finance state spending. Rather it is state spending that provides the money that society uses. Taxes remove excess money so that inflation is controlled.

I must say that I have long thought that conventional economic wisdom was completely wrong. So I find MMT to be quite easy to accept and understand. I also know that an actual economy is way complex. There are many loops and convolutions not to mention loopholes and corruption; but I think the idea captures what is happening in fact.

Last night I talked about how we are a society with an incentive system that depends on tormenting unlucky people. I genuinely see this as a huge moral issue that we must deal with. And MMT shows how a UBI can be financed. I've actually explored that and I think we could create a generous UBI now that would be revenue neutral. But the UBI also addresses the problem of automation. Even now there are not enough well paying jobs for all who need them and that will get worse in the future.

I was thinking about your comment about Weimar Republic and Zimbabwe and their inflation. I think the inflation there was based on the fact that the productive capacity of the economy had collapsed. When bread is very scarce then the price of bread skyrockets. So if the price of bread goes from $1 to $100 then if there isn't enough currency then the economy breaks down altogether. I think that a vicious spiral ensued.

I lived through the inflation in the 1970s and 80s. I was pretty sure it was caused by the tax revolt that started in California and swept the world but didn't really understand the mechanism. MMT makes the mechanism clear. The tax revolt meant the state couldn't remove money from the system fast enough so you had too many dollars; bingo - inflation.