As I noted yesterday, last evening I accepted an invitation to speak on a panel…
A simple personal calling card economy
Some readers have asked me to provide a simplified explanation of how the modern monetary economy works which is devoid of all the jargon that economists hide within. As part of another earlier blog, I did present a simple fiscal game which provides all the essential insights you require to understand how a modern monetary economy actually operates. Like all models it is stylisation. But there is nothing that I could add by way of complexity that would change the fundamental conclusions and understandings. So to make the model easier to find for reference purposes later on I an presenting it again as a stand-alone blog. Read on!
A simple fiscal game!
Here is an example to help you think about all of this economic jargon. The concepts are simple and the numbers are small which makes it easy to understand and relate to (thanks to Warren Mosler for the original idea for this heuristic).
Imagine the economy is my household which is comprised of me (the parent) and you (the kid)! As the parent I assume the role of “government” and you thus comprise the non-government (private) sector. As the government I decree that I will offer 100 of my personal calling cards per week, if you agree to tend the garden on a weekly basis. These are the cards I exchange at meetings with various professional associates outside of the household. They are normal size rectangles of cardboard.
You say, naturally: “Why would I want your worthless personal calling cards?”
I reply (reflecting my knowledge of how modern monetary systems like the household work): “because to stay living in the house I expect 100 personal calling cards a week to be paid in taxes”.
You say: “when do I start work!”
Immediately, by imposing tax obligations in the currency of issue (the personal calling cards) I have created a demand for the currency and this allows me to transfer private resources (your work in the garden) to the public sector (the nice garden). However, also note that I have to spend the 100 cards each week before you can pay the tax of 100 cards – which clearly means that the taxation can never be considered a source of revenue which “finances” or allows me to spend the cards in the first place. The cards come from no-where and I have the monopoly rights to spend them. I am never financially constrained in my own personal calling cards (the currency).
So this sort of currency is what we call a fiat currency – being made legal by legislative fiat. It has no intrinsic worth and its value is tax driven. Just like the Australian dollar!
Note that I probably would never “print” any cards. I would run some spreadsheet on the house computer and just keep “bank entries” to record all the outflows (spending) and inflows (taxation). All the transactions would just be numbers entered into relevant columns. If I slipped up and added a 0 to my spending one week, I wouldn’t have to “print” 900 new cards. You would be better off by 900 cards because it would show up as a deposit in your account. But nothing else would be required. Same as in the Australian economy.
Now under these conditions, the household ‘budget’ would be balanced each week: I spend 100 cards and you pay 100 cards. You are unable to accumulate any cards (that is, save) because you can only get access to the volume of cards that I make available via spending. Same as in the Australian economy.
What if I wanted to teach you to save as preparation for managing your own affairs when you became an adult? Well the only way you can save is if I, for example, decided to employ you more each week and offered, say, 120 cards per week as wages (government spending) yet continued to tax you only 100 cards. The same effect could have been if I reduced the tax rate and held spending constant or a combination of increasing spending and reducing taxes.
Whatever, and lets stick to the spending of 120 and the tax of 100, the fiscal position now goes into deficit of 20 cards per week. You now can save 20 cards per week because my spending (the government spending) has provided the “finance” to permit you to do that. As the weeks go by you could accumulate more and more savings (numbers in the spreadsheet would increase) and you would soon see that the non-government saving over time is the exact record of the cumulative deficits being run by me (the government). Same as in the Australian economy.
Now, you might want to make more money (cards) on your savings. The only way that can happen is if I offer you a government bond (a bit of paper saying that if you deposit your savings with me each week I will pay them back at some future time plus some interest all in personal calling cards). So the offer of a new financial asset – the household debt instrument (the bit of paper) gives you a chance to compound your saving and maybe take a holiday – not work some weeks but still pay taxes!
So the debt issuance in the household establishes a non-zero rate of interest in the household and increases your wealth. I didn’t have to issue the bond to keep running the deficits. The bond just replaced non-interest bearing savings (reserves in our “banking” system) with an interest-earning asset (the bond). Same as in the Australian economy.
Now lets say I am reading some neo-liberal literature on the Internet which warns me against running fiscal deficits. As a result I get the feeling we have to get back into fiscal surplus to be a responsible government. So I tax 100 cards but cut my spending on garden work to, say 90 cards per week.
Can you predict what will happen now? Well in that particular week there are not enough cards “spent” to generate the funds necessary for you to pay the tax. There are 10 cards short. The household (government) fiscal position is in surplus for that week to the tune of 10 cards. But this shortage of cards liquidity in the private sector (that is, you!) means that you will:
(a) Demand more work to earn the shortfall – noting that the household has now reduced employment levels (in hours) and there is some underemployment creeping in. If I made the example more complicated with 2 or 3 kids in the house I could have easily cut spending by not paying anything to one or more of the kids thus creating unemployment.
(b) Try to sell some of your possessions to get some cards. In this simple case, you will offer your bonds (the bits of paper) for sale to get the funds. So the surplus starts to eat away at your wealth portfolio. I would be boasting like a neo-liberal would that I was running down the government debt – “getting the debt monkey off the government’s back” – which may help me sleep better – but you would just be feeling less well off (and maybe developing insomnia!).
(c) Start to run down any savings that are not being stored in bonds. Either way you run down your wealth holdings.
But in aggregate, the fiscal surplus is squeezing your card liquidity and forcing you to run down wealth. Same as in the Australian economy.
If I kept running fiscal surpluses, you would eventually run out of assets and your labour would be severely underutilised. You might be able to persuade me to start lending you the money (I might set up a privatised bank in the household) and this would keep you afloat (paying the taxes) as long as you were prepared to accept increasing private debt levels. But this is not a sustainable option. Same as in the Australian economy.
Thanks Bill and Warren. As a non-economist, this simple thinking game is one of the most enlightening pieces of reading I have ever done on the subject.
Three times now on political opinion blogs, I have challenged a poster who asserted that the federal budget deficit must be paid for by imposing a tax burden on our children and grandchildren or borrowing money from some oil sheik etc etc and asked them “why would someone empowered to create their own currency need to tax or borrow in order to pay for spending in their own currency”. In all cases, the discussion thread has simply STOPPED. The proponents of the “fed needs to tax or borrow in order to spend” argument, have not even come back to defend their position. And I believe that one is actually an economist.
Probably because when they think hard about their own argument for more then a few seconds, they realize that it’s nonsense.
Dear Lefty
Thanks for the comment. I have noticed throughout my career that whenever a macroeconomics discussion starts with the mainstream economists they just disengage as fast as they can. They simply cannot answer the questions that a modern monetary theorist like me proposes. They don’t want to engage because they don’t recognise the challenge. They have occupied the dominant positions in my profession and have such an arrogance that they are above debate. It just happens that their ideas have now been proven to be dangerous and their day in the sun is waning fast.
best wishes
bill
Another comment I often hear is “governments cannot create wealth, only re-distribute it”. But in light of what I now know about the fundamental functioning of the modern economy, I would say that this is not only wrong, but ironically so. It seems to me that if the sovereign declines to issue enough currency through deficit spending, it is the PRIVATE sector that cannot “create wealth, only re-distribute it”, for the private sector has no power to affect any net increase in the medium of exchange. It can only shuffle it around, re-distribute it (largely to those who already have much of the wealth). It cannot truly create any net increase in wealth until the sovereign facilitates this with a net increase in spending.
Sounds roughly correct to me anyhow.
Dear Lefty
I think someone else raised this some time ago. It is a nonsensical claim. When the sovereign government net spends (runs a deficit) it is immediately creating wealth – initially in the form of bank deposits of those who are beneficiaries. The beneficiaries can then change the composition of this wealth and leverage it to their advantage. The private sector cannot create any net increases in assets denominated in the currency. For every asset created by the non-government sector there is a corresponding liability created. So the wealth can be grown but so is the corresponding burden.
best wishes
bill
Finally got more of this stuff. Thanks Bill. Looks like I am starting to understand this stuff
Dear Bill,
Perhaps you could expand on this example by creating a household with a number of children and then introduce fractional reserve banking into the equation?
The reason that I would find this helpful is that I can totally see the logic of the public sector creating net financial assets (or destroying them) but having read many of your blog posts now I can’t help wondering “What about bank-created money!?!” If banks are not constrained by reserves then they can create money whenever they wish. Yes once the money is paid back the net is 0 but surely there are drastic implications for unconstrained bank lending? After all, that bank-created money is as good as the government-created money until it is extinguished. The only control the government can have over the amount of bank-created money is by affecting the demand for it by changing interest rates.
Doesn’t all the aggregate money supply information (like M3) show a constantly increasing money supply in almost every nation? Is this from constant deficit spending? Constant expansion of debt creation by banks? Both? Which one is the greater contributor to the money supply?
If reserve requirements are now 0 do we not now operate in an era of zero-reserve banking and not fractional reserve banking? What about the capital requirement on banks? Banks increase their capital by charging interest but when they do this doesn’t this interest have to come from either net financial assets in the economy or other debt-money?
Would you say that the economy is too unbalanced towards debt-money and it is this reliance on debt-money that exacerbates booms and busts and indeed caused the current depression?
I think from the questions I have asked it is clear I lack a good understanding of the interaction of the banks ‘debt-money’ and the governments circling of money (spending then taxes). I think this is true for most people! Anything you can write to shed some light on all of this would be much appreciated 🙂
I hope you’re having a Merry Christmas and a Happy Holidays.
All the best,
Alex
Dear Bill,
One more thing… why do so many people equate savings with what banks can lend out? It seems that banks require savings to satisfy certain accounting requirements but that (in a growing economy anyway) savings are not required to make loans… what role do savings in a fractional reserve system really play?
I am not an economists but I thought that the role of money was not to pay taxes but was kind of an IOU to make a claim on the resources of the society. For example if the garden is growing 50 potatoes, 40 potatos, and 10 Tomatoes, those 100 business cards would be used up to buy the food. In this example the tax that the farther requires might be 50 business cards and and then the father and the son could negotiate over the prices of the different food items. In this way the son could reduce his food intake and also save money so he could take a vacation and still have some money left over to pay his taxes. But if the father then starts adding more than 100 business cards to the game there will be more units of IOUs without a corresponding increase in the number of units of food therefore it would seem obvious that in the negotiations over the food more business cards will be offered to get that food driving up the price.
Dear Curt
Thanks for your comment.
Adding further business cards will only drive up prices if there is no extra work that can be done for a given saving desire by the kids.
best wishes
bill
Hello Bill,
I checked back so fast under the assumption that you might be in Australia, and it would be late in the afternoon there now, not very early in the morning. Dont know where I got such a funny idea from. Odds are that if you were down there you would also be way over there not relatively close as in Perth.
In any case it would seem to me that no matter how much work was to be done as long as the outputs, in this case the food, stayed the same, the prices for those food items would go up. If more work was being done in the mean time we would have a case in which household productivity was dropping. Of course the dad could make the propoganda claim that prices are not rising that new wealth is being created like when the government claims new wealth is being created when people pay to send their children to day care rather than have the children’s grandmother watching the children. In one case GDP gets added because money changed hands in the other case no money changing hands no GDP increase. But in our current example food is the only item traded in a cash economy.
Of course if the extra work in the garden did create extra food then the prices for food would not necessarily go up.
So this brings me to the point at which I would say HOW deficit spending is spent might have something to do with how inflationary it is. The idea of that where deficit spending is spent may also have some relationship to this problem popped in to my head just now although I have never thought about this before. Also yesterday I had the idea that the velocity of money might play a role but then after reading another comment I sort of dropped that idea but now I think that I should reconsider it.
With friendly greetings,
Curt
One huge inaccuracy in your article is that base money isn’t issued by government spending, but by central bank open market operations. When it wishes to increase the money supply, the central bank will buy bonds and other forms of long-term debt from the private economy in exchange for its short-term obligations (freshly-issued money). If the central bank is buying government bonds, which is pretty standard, then this would make it easier for the government to borrow money and run a deficit, but the government running a deficit by itself in no way constrains the money supply. If the government had no debt, the central bank could buy other forms of long-term debt from the market when creating the money supply.
What your article does illustrate quite clearly is why the central bank needs to operate independently of the government, although usually because a government in charge of the printing presses would print tons of money to run huge deficits causing inflation, not, as you suggest, because it wouldn’t print enough money, causing deflation.
http://en.wikipedia.org/wiki/Central_bank
Dear Ryan
How much of my work have you read?
best wishes
bill
Bill, I’ve only read this blog post.
Cute, superficially amusing, anti-establishment, vaguely cool, intellectually middlebrow, like one of those sophisticated children’s books, and am trying but cannot find in all the cleverness here the reason you did not simply assert a posture on currency and taxation, and inherent problems with, in a paragraph or two.
George, this is a simple model for non-economists to understand how a modern monetary economy works. Here is some follow up fleshing it out.
Barnaby, better to walk before we run
Some neighbours arrive
A modern monetary theory lullaby
Questions and answers 2
See also Stock-flow consistent macro models
Describe this scenario if no private savings takes place.
Dear Dwight Kellams (at 2010/11/19 at 3:11)
You asked:
The parent (“government”) would run a balanced budget to keep activity (household task production via the transfer of real labour services from the “private sector”) at the level it desired and all spending would be taxed (in this example). The real world is a bit more complicated because there are banks and government spending has multiplier effects. In this simple model, private consumption is not visible. But the “private sector” in this model would not be able to “risk manage” in the situation you posit.
best wishes
bill
This model assumes that kids are not at full employment. If the kids are already at full employment then paying them more (increasing the money supply) by running a deficit erodes the value of the “savings” they make through inflation to zero (An exercise for the reader).
Since in this model you have created a totalitarian state, you block the effect of inflation by controlling prices, which in this case only consists of taxation.
The only thing this model says is that in a totalitarian state, deficits create savings and surpluses destroy savings when you control prices.
This model is nothing like the Australia economy. Also in the real world I don’t see how taxes creates a demand for money, tax is levied after money is earned not before. The need to exchange goods and services creates a demand for money. In pre-industrial times where people wanted to pay tax in chickens and pigs, requiring tax be paid in currency would create a demand for money but not today.
The wealth created by deficits is illusory; the only real wealth is that produced when somebody expends energy and creates value for someone else who is prepared to pay for that value. Wealth=value, the more value you create for others in exchange for currency the more wealth you have as measured by currency. Of course you need to factor in the hidden erosion to currency wrought by governments.
I’m going to have to agree with the previous poster. The deficits in this example clearly create inflation. People do not save because they want savings–they save because they can either gain an income from the savings (in real value, not nominal) or because they want to consume later.
For example, if you rack up the deficit, that is essentially money you owe to your son. So, after 5 weeks of paying $120 for your son’s services, your son may choose not to provide the services and may still be able to pay your taxes. However, productivity for that week has fallen. All you are doing is raising the price of your son’s services, not creating wealth. As we know, rises in prices are the same as inflation.
Likewise, when you pay your son less, you are instituting an authoritarian deflation. So, in the world of a separate public and private sector, increases in the money supply will necessarily create inflation, and decreases in the money supply will necessarily create deflation. The only rise in actual value–what we would call growth in the economy–would occur if there was a rise in productivity from you or your son. Likewise, deficit spending (either funded by increases in the money supply or increases in the sovereign debt) will necessarily increase the amount of productivity that you owe your debtors (either funded through inflation, interest on the credit you take out, or taxes imposed later on).
I saw another smart comment on here that directly related these comments to the price of goods grown in the market. This is your reply–
“Dear Curt
Thanks for your comment.
Adding further business cards will only drive up prices if there is no extra work that can be done for a given saving desire by the kids.
best wishes
bill”
But, as we see, it has already driven the price of your son’s labor up by $20. You will have to offset this by either an increase in taxes or the possibility that your son does not work later on (and is still able to maintain tax payments). This example seems almost disingenuous because the government (parent) is instituting a form of authoritarian inflation to its own detriment!
This illustration does seem to clearly show that debt spending will have long-term consequences–either by inflation felt in the private market, or an increase in taxes. I hope this isn’t really an explanation of MMT–this is only the beginning of my reading on it–but, perhaps, you can provide another simple model as such that explores more of the nuances of the theory? I will be reading more on this and other sites, but this was the first extremely accessible model that I found. Thank you,
Pat
Bill,
In your household economy, you say that governments do not need to issue bonds which I understand. If so, is there a reason why governments do issue bonds in the size that they do. It seems to be that not issuing bonds would clear up a lot of the misunderstandings out there.
Thanks
TokyoJez
What if the business cards are spend overseas? How would you incorporate foreign debt in the theory? Maybe we should ‘print some cards’ to create/encourage/subsidise locally made produce….