In the spirit of debate …

Readers of my blog often ask me about how modern monetary theory sits with the views of the debt-deflationists (and specifically my academic colleague Steve Keen). Steve and I have collaborated in the last few days to foster some debate between us on a constructive level with the aim of demonstrating that the common enemy is mainstream macroeconomics and that progressive thinkers should target that school of thought rather than looking within.

His blog, which carries my depiction of modern monetary theory, is HERE.

I glanced at it before I wrote this and the some of the comments are already demonstrative of the fact that people make up their minds before they understand the body of theory. Some people, who do not read my blog, clearly are still struggling with basic national accounting entities. Anyway, hopefully, this initiative will broaden the debate and bring more people up to speed on where the real enemy of full employment lies.

We will follow this initiative up with some comparative analysis (yet to be agreed) to show how the endogenous money theories that Steve propounds are captured completely within the horizontal relationships in modern monetary theory. I plan to have a session at the upcoming 11th Path to Full Employment Conference/16th National Unemployment Conference, which CofFEE hosts each year. This year it will be held on December 3-4.

Anyway, for the record this was my contribution (also repeated on Steve’s blog). Regular readers will be very familiar with the principles established below.

The fundamental principles of modern monetary economics

The following discussion outlines the macroeconomic principles underpinning modern monetary theory (sometimes referred to as Chartalism).

The modern monetary system is characterised by a floating exchange rate (so monetary policy is freed from the need to defend foreign exchange reserves) and the monopoly provision of fiat currency. The monopolist is the national government. Most countries now operate monetary systems that have these characteristics.

Under a fiat currency system, the monetary unit defined by the government has no intrinsic worth. It cannot be legally converted by government, for example, into gold as it was under the gold standard. The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.

The analogy that mainstream macroeconomics draws between private household budgets and the national government budget is thus false. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.

So statements such as “the federal government is spending taxpayers’ funds” are totally inapplicable to operational reality of our monetary system. Taxation acts to withdraw spending power from the private sector but does not provide any extra financial capacity for public spending.
As a matter of national accounting, the federal government deficit (surplus) equals the non-government surplus (deficit). In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. The federal government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment. Additionally, and contrary to mainstream economic rhetoric, the systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings.

We often read that the appropriate fiscal stance is to balance the federal budget over the business cycle. Some economists claim the goals should be to run a surplus on average over the cycle allowing for deficits in extreme downturns.

Both goals would be fiscally irresponsible in Australia’s situation where our current account is typically in deficit. If the government balanced the budget on average and the current account deficit was in deficit over the business cycle then the private domestic sector would on average be in deficit (dis-saving) over that cycle. The decreasing levels of net private savings financing the government surplus increasingly leverage the private sector. The deteriorating debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity. In other words, adopting a growth strategy that relies on increasingly leveraging the private sector is unsustainable.

The only way the private domestic sector can save if there is a current account deficit is for the government sector to run deficits up to the desired private saving. Government deficits “finance” private saving by ensuring that aggregate spending is sufficient to generate the level of output and income that will bring forth the private desired saving levels.

Unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.
How large should the deficit be? To achieve full employment net government spending has to be equal to the non-government desire to net save to ensure there is no aggregate demand gap.

Unlike the mainstream rhetoric, insolvency is never an issue with deficits. The only danger with fiscal policy is inflation which would arise if the government pushed nominal spending growth above the real capacity of the economy to absorb it.

If governments are not revenue constrained why do they borrow? We have to differentiate voluntary constraints governments impose on themselves (which reflect ideological dispositions) from the underlying mechanics of the banking system in a fiat monetary system.

In terms of the latter, while the federal government is not financially constrained it still might issue debt to control its liquidity impacts on the private sector. Government spending and purchases of government bonds by the central bank add liquidity, while taxation and sales of government securities drain private liquidity. These transactions influence the cash position of the system on a daily basis and on any one day they can result in a system surplus (deficit) due to the outflow of funds from the official sector being above (below) the funds inflow to the official sector. The system cash position has crucial implications for the central bank, which targets the level of short-term interest rates as its monetary policy position.

Budget deficits result in system-wide surpluses (excess bank reserves). Competition between the commercial banks to create better earning opportunities on the surplus reserves then puts downward pressure on the cash rate (as they try to off-load the excess reserves in the overnight interbank market). So budget deficits actually put downward pressure on short-term interest rates which is contrary to all the claims made by mainstream economics.

If the central bank desires to maintain the current positive target cash rate then it must drain this surplus liquidity by selling government debt. In other words, government debt functions as interest rate support via the maintenance of desired reserve levels in the commercial banking system and not as a source of funds to finance government spending.

However, the central bank could equally just pay the commercial banks the target rate of interest on all overnight reserves which would achieve the same end without the need to issue debt.

So there is no intrinsic reason for a sovereign government to borrow to “finance” its net spending.

The reality is, however, that the neo-liberal era has forced the governments to adopt voluntary constraints on its fiscal activity which are tantamount to those that operated during the gold standard period. So the federal government now issues debt to the private markets via an auction system $-for-$ with net government spending (deficits). This allegedly imposes “fiscal discipline” on the government (it is totally unnecessary from a financial perspective) because the rising debt becomes a political issue.

In conclusion, much of the deficit-debt hysteria that defines the current macroeconomic debate is based on false premises about the way the monetary system operates and the financial constraints on government spending.

Modern monetary theory provides a sound basis for understanding the intrinsic opportunities available to governments in a fiat monetary system and exposes most of the constraints that are imposed on the conduct of fiscal policy as being of an ideological origin.

This Post Has 16 Comments

  1. Great news that you and Steve are working together – looking forward to your collaboration.

    I’m no economist but I’ve been following your blog (and Steve’s) for a while. I think I sort of follow what you are both saying and I’ve been wondering whether you are really in disagreement.

    I’ve been wondering what the impact of Australia adopting a Chartalist perspective might be, in a world where everyone else is still neo-classical. Could we be punished by the finance market and if so how?

  2. Hi Bill

    Nice post, as usual.

    Wish I could make it to CofFEE this year, but will have to wait till the little one’s a bit bigger to travel so far. In lieu of that, doing my best to help out on Steve’s blog. You characterized the early comments rather well.


  3. So, if I get this correctly, the US has not been selling debt to China to “finance” its spending, but to mainain the currency peg and keep interest rates at a certain level?

    The Fed’s direct purchases of Treasuries are not inflationary because: 1) the liquidity isn’t print – it is going to the banking sector, 2) any government spending is buying goods (and labor) for which there isn’t private demand. Is this more or less in line?

    Also, fractional banking, while allowing banks to issue credit, also creates an offset with the Central Bank, so that private lenders have a debt to the bank, and the bank has a debt to the Central Bank which is offset by the funds created. If the Fed were owned by the public, then private banks would have obligations to the public in the amount of private lending emitted.

    This will be a very valuable discussion. Thanks,

    PE Bird

  4. “We will follow this initiative up with some comparative analysis (yet to be agreed) to show how the endogenous money theories that Steve propounds are captured completely within the horizontal relationships in modern monetary theory.”

    Look forward to this debate between you and Steve. When I was reading about this on Steve’s blog yesterday, I came to the above conclusion in that the government is necessary to get the fiat game going in the first place, so it must be foundational with respect to explanation. While private banks can create money by extending credit, why would anyone accept IOU’s to private banks if they were not commodity-backed, e.g., by gold reserves or highly secured by property and law, which would be unworkable in a modern economy. They would lack “moneyness.” On the other hand, governments are in a different category because they have the power to tax, along with enforcement capability. It seems that trust in moneyness has to come from either commodity-backing or credible security. So Chartalism seems logically prior to Circuitism.

    Of course, governments can loose credibility through profligacy resulting in hyperinflation, which accounts for the goldbugs. For example, the inflationistas are now scratching their heads about why the bond vigilantes aren’t demanding higher rates on Treasuries, given the amount of QE and monetization by the US. But your account explains the relationship between high government deficits, increased bank reserves, and the prevailing ultra-low short terms rates. Nor is the bond market anticipating inflation in the 10 yr or 30 yr bonds, much to the consternation of many neoliberals.

  5. In the US, there is an institutional impediment to adoption of rational monetary policy. The financial structure of the Federal Reserve System is based on Federal Reserve Banks receiving income from their asset base, which they use to cover their costs, with the surplus returned to the Treasury account.

    This is how the Fed escapes the “power of the purse” of the House of Representatives and Senate – as a side effect of its normal reserve bank operations, it free rides off the interest payments by the Treasury that are required pro forma.

    Since it tends to be very difficulty to persuade someone of a proposition when their livelihood depends on believing the opposite, there is a sense in which the whole infrastructure for the various state-supported schools of monetary theory require misunderstanding the nature of money in order to ensure that the state-sponsorship of monetary theory continues without being subject to Legislative interference.

  6. bill, it’s a good move. The great thing about steve’s blog is that he is always willing to take time out and explain, time and again and in the very best of humour, basic concepts to his mostly layman readership.

    It’s a tedious business no doubt, however in my view it’s a pre-requisite to establishing the crucial insights that heterodox economists such as yourself and steve are offering into mainstream debate on political economy.

    On that note, I greatly appreciate the efforts you and scott (and JKH, whoever he or she is) have made to answer my questions. Unfortunately for you I have many many more however hopefully as a result of all this those questions that remain will be more pertinent.

    All the best, scepticus.

  7. Bill

    Great Post! I havent read that much of Steve Keen. But my first feeling is that he just talk about the horizontal part and completely ignores the vertical transactions. I also want to thank Scott for all his efforts and patience to reply to all questions on Steve’s blog.


  8. As I understand it Chartalism says that private banks cannot create money because the money they create must be paid back. Of course that is the rule but that ignores time. If a bank creates money then the money is “released” into the financial system and it is indistinguishable from any other money. If the loan is paid back then money is taken out of the system but the reality is that the money is not paid back but is rolled over. So the reality is that banks do create money and are the main mechanism for money creation.

    The problem appears to be that money can be created by banks using money as backing for new money creation. That is, we have a mechanism where banks can create money ad infinitum – which they seem to have done.

    The real issue appears to be that we have far too many loans and hence too much money and the system continues to want more and more loans because there is a difference in interest rates between borrowing and lending hence the people who can create the money have a vested interest in continuing to create more and more loans. After some time the amount of debt collapses because there are not enough real assets to support the total amount of debt.

    The creators of (temporary) money do not have an interest in creating more and more productive assets because what is done with the money is of little concern to them if they have a security of existing assets for the money.

    The current system thus has two major operational problems. It allows loans to be backed by other loans and hence allows money creation to pyramid and at the same time it does not allow money to be lent against future assets but requires finance for new assets to be obtained from savings.

    If we make loans for the creation of new assets and we make those loans more attractive than loans against existing assets then we may solve both problems and reduce the amount of debt.

  9. “As I understand it Chartalism says that private banks cannot create money because the money they create must be paid back.”

    No chartalist ever said such a silly thing. I don’t even konw where all this stuff comes from, but many people seem to believe it. As I noted, we need to stop using terms like “money.” “Money” is always someone’s liability. Whose liability are you referring to (?) is the question that must always be clearly explained in the analysis.


  10. Dear Prof. Mitchell,

    I have read your post “In the spirit of debate…” with great interest. I also follow Prof. Keen’s blog, by the way.

    Although I have not yet formed a clear picture of chartalism (neither of Prof. Keen’s ideas), and I am no expert, I would like to ask a few questions. I ask your patience, though, if I am completely misunderstanding you.

    In this sentence you appear to be thinking of an economy without foreign sector: “The federal government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment”.

    Yet, in this sentence you are talking about a foreign sector: “If the government balanced the budget on average and the current account deficit was in deficit over the business cycle then the private domestic sector would on average be in deficit (dis-saving) over that cycle. The decreasing levels of net private savings financing the government surplus increasingly leverage the private sector”.

    Am I right to understand then that the expansive or contractive effects of fiscal policy are contingent upon the direction of the balance of trade (i.e. superavit or deficit, respectively)?

    This conclusion: “Unemployment occurs when net government spending is too low”, is meant in the case (like Australia’s) that there is current account deficit. Is this right?

    I understand that there’s nothing in chartalism precluding the banking system from creating liquidity. Then I suppose this system is largely compatible with Prof. Keen’s idea of endogenous money formation. Would this also apply to Minsky’s Financial Instability Hypothesis?

    Is it possible that a contraction of the money supply (due to increased taxes) could be offset by increased bank lending? Or is this necessarilly precluded by falling bank reserves following your reasoning here (but in the opposite direction!): “Budget deficits result in system-wide surpluses (excess bank reserves)”.

    Thanking you in advance,


  11. Marco,

    It all makes more sense if you keep it simple rather than attempt to solve it all in one hit.

    Forget about the external sector for the moment until the basics are all fully understood.

    Wrt the money side of things it’s also important to differentiate between Money Supply and Money Stock.

    The government does not have a budget constraint in terms of its own money. There is no need for a governments deficit to be financed by the private sector either – it’s merely a political choice. As long as people are willing to accept the governments money in exchange for the goods and services they can provide that’s enough to keep the ball rolling.

    By enforcing laws whereby the private sector must meet its tax obigations to the government using the same high powered money the government (RBA) issued the private secotr has little choice other than to play ball.

    Cheers, Alan

  12. Thanks Alan, for both the answer and the patience.

    Ok. No external sector for the moment. Let me think about it all and I’ll get back to you.



  13. Dear Marco

    If you read my work carefully (not just the 1000 words on Steve’s blog) you will see that modern monetary theory explicitly accounts for the foreign sector. It starts with government and non-government but recognises that the latter is the sum of domestic private and external sectors. In fact, much of the dynamics within the non-government sector are distributional but I have written explicit papers and sections in books about the external sector specifically.

    The reason we start with government and non-government is to generate an understanding of how net financial assets in the currency of issue enter and leave the economy. Once you disaggregate the non-government sector there are interesting questions but you need to understand the initial point first.

    So do not think we exclude the external sector. That is totally without foundation.

    best wishes

  14. Dear Prof. Mitchell,

    I apologize if in any way I seemed disrespectful. It was entirely unintentional.

    I am not an economist. And I am just trying to understand why we are in the current situation.

    Alan was kind enough to try to guide me. That was all.



  15. Dear Marco

    Nothing you said was disrespectful. I just didn’t want you spending time thinking out a situation that wasn’t part of what we think.

    Your input is welcome and valuable.

    best wishes

Leave a Reply

Your email address will not be published. Required fields are marked *

Back To Top