How our monetary system really works

Cullen Roche at PragCap.com has been my teacher on how our monetary system really works.  The school of economic thought is called MMT or Modern Monetary Theory.  I’ve written on the topic, but below is a long comment within one of his posts that gives a full description.  Keep in mind, if you have never heard these concepts before, you are likely to be scratching your head throughout.  I have written a few posts that try to keep it really basic here, and here.  But make it through Cullen’s comment and you will realize we’ve all been taking the “blue pill” and so our economy has been driven off a cliff because so few understand how our system really works.

Cullen, take the mike….

MMT is modern monetary theory. I believe the name is a bit of a misnomer as it is really just a way of describing how modern monetary systems work. The theory is all in it application (not all of us agree entirely how the govt should utilize its strengths, but we agree for the most part I think).  Learning it can take some significant time as it turns most of modern economics on its head, but I think that understanding MMT is vital in understanding how the modern monetary system works.

Start with the following link and continue on. Please feel free to ask any questions via the comment section here or email. I try to answer all questions as best I can:

http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation

The govt is not a household or a state. They do not finance spending via revenues. The US govt, as a monopoly supplier of currency in a floating exchange rate system simply spends. Think of the US govt as an alchemist. The alchemist can create as much gold as he pleases (from nothing) in order to buy up productivity and satisfy the growing monetary demands of the people he supplies currency to, but he has to be very careful not to debase his gold. Hence, there is no solvency risk for the alchemist. Only a pseudo form of default via currency collapse (hyperinflation).  He only debases his gold when he issues an amount of gold that is in excess of productive capacity (inflation).

We do not finance our spending via the bond market. Taxes do not finance spending either. We issue bonds as a form of controlling the Fed Funds rate. It’s a pure monetary operation. Not a fiscal financing operation. We issue bonds to maintain the money supply by controlling the overnight rate and control excess reserves. People think this is govt debt because Congress mandates the issuance of bonds and that’s how the system works in Europe and under the gold standard. This thinking has never changed despite the dramatic changes in the monetary system after the Nixon shock. I am quite certain that Bernanke understands this (or at least partially), but I am also quite certain that most other people in power do not (otherwise we would never have made all the policy mistakes I have been pointing out over the last few years).

Let’s understand a few things first:

1. Foreigners do not fund our spending. That is a fact.

2. The bond market is a monetary tool. NOT a fiscal financing tool.

3. We tax in order to create demand for the currency. In addition, it controls aggregate demand or effectively, the money supply.

I’ll use an example I often use. Please excuse the simplicity, but this can be a mind bending concept if you are textbook taught (trust me, I know the feeling) so I will keep it simple:

I start a new country where there is a productive economy and I invite everyone to become citizens. Rather than forcing all of us to trade with heavy gold I issue TPC notes. Now, in order to create real demand for these notes I create a tax. This makes you beholden to me via the TPC notes. You MUST have them in your account on April 15th of every year. I’ve created instant demand. This is what the US government does. In return, they spend money on public works, create jobs, supposedly spend money on furthering our nations prosperity (in theory at least) and protection of the nation (a military).  This is important to understand because I must issue notes BEFORE I can tax.  Therefore, you can see that I am not funding my spending by taxing.

How do I enforce your use of the TPC notes? I create jobs via a military and a police force and pay them well. Don’t want to pay your taxes? Say hello to officer Joe. A group doesn’t want to pay their taxes? You can protest, but if you get out of control I will introduce you to 500 men wearing body armor holding M4 carbines. In other words, don’t question the currency or else….As long an economy is productive, the sovereign nation can enforce the use of said currency, and as long as we don’t issue excessive currency there should always be demand for it. In other words, trust in the national currency is safe as long as the rule of law is maintained, corporations are productive and I maintain my ability to tax you.

I do not borrow from governments or tax to spend as I would if my currency were backed by gold. Interestingly, I can’t TAX you until I’ve credited your accounts with TPC notes. There is no money to be taxed otherwise. So, in effect, I have to SPEND in order to TAX (counter-intuitive to what you have been taught). Taxing debits your accounts (saps liquidity) and crediting is government spending. On my island, I am never revenue constrained. If you don’t pay your taxes I will throw you in jail and confiscate your money. But that doesn’t mean I can spend more when I tax. What do I care if you send me your TPC notes? I can just press a button and credit my “spending” account right after I shred your tattered looking cash. This is what the government actually does. Taxation is essentially a form of maintaining control of private sector spending. Pay your taxes in cold hard cash. The IRS will shred those dollars. They don’t put them in a bag and mail them to the Treasury so they can’t go “spend” it. The only reason they might keep the dollars is if they are pretty and in good condition so they can go back out into circulation.

So what’s the bogey here? What’s the catch? Because surely you must be asking yourself why this sounds like a free lunch.  We can just spend to our hearts content, right?  Absolutely not.  The bogey here is inflation which is constantly moving up and down with the amount of money in the system based on my tax rate, spending, etc. Thus, govt cannot just spend and spend and spend or the extra dollars in the system will chase too few goods and drive up prices. Thus, it’s important to understand that govt cannot just spend recklessly. This is important so I’ll say it again. This does not give the govt the ability to spend and spend and spend.  If they spend too much and tax too much they can create malinvestment and inflation.

In terms of the bond market, the issuance of bonds does not serve the same purpose it did under the gold standard. We actually issued bonds because we were revenue constrained (not enough gold reserves at all times to fund spending without creating massive inflation). Today, we effectively control the value of money in the banking system via bond issuance (a pure monetary operation to control the Fed Funds Target Rate). It can also be thought of as another form of government spending because a treasury bond is basically a savings account. Contrary to popular opinion, QE is actually a deflationary event because it takes an interest bearing instrument out of the private sector’s hands and replaces it with a non-interest bearing deposit. QE is a term that is used by people who want to scare you into thinking that the govt is being reckless with their money. The reality is that QE is just an asset swap. Nothing more. Debt monetization is another tool of the fear mongerers who don’t understand that debt monetization is actually impossible so long as the Fed has a target rate. It’s operationally impossible.

The US government is never revenue constrained. They are not like a household or state government. We don’t need China to buy our bonds in order to spend. China gets pieces of paper with old dead white men on them in exchange for real goods and services. They can either hold that money in a checking account at the Fed OR they can do what they wisely do and invest those pieces of paper in what is actually a savings account at the Fed. We also don’t need taxes to spend. The budget deficit is in direct inverse correlation to private sector savings. To be more precise: net household financial income = current account surplus + government deficit + Δbusiness non-financial assets.

This by no means says that the government can just recklessly spend. But it’s imperative that the government spend SOME money otherwise they are simply debiting the system each year via taxation without ever crediting accounts. Just ask yourself what would happen if the govt imposed a one time 100% asset tax? The private sector would instantaneously be without money. How would they spend? How would they invest?  The economy would collapse and the government would be “rich”.  Not a plan for economic prosperity.

Many financial theorists actually believe the Great Recession (and the Great Depression) was caused in part by account SURPLUS. You’ll notice that both events were preceded by great periods of “fiscal competence”, ie, budget surpluses. In reality, the govt had debited too many accounts and forced the private sector into deficit. This results in the private sector borrowing what it can’t actually get its hands on. The risk is full blown debt deflation due to excessive debt levels (because you borrow what you can’t actually get your hands on). I think the cause is a bit more complex than that but the fact that we are grossly overtaxed and the govt spends very inefficiently is a large contributing factor.

That’s a very rough sketch of our monetary system. Still confused? Read this: http://pragcap.com/talking-ourselves-off-the-edge-of-the-cliff

And this: http://pragcap.com/when-will-the-bond-auctions-begin-to-fail

And this: http://pragcap.com/jeff-gundlach-says-the-usa-will-default

And this:  http://pragcap.com/quantitative-easing-the-greatest-monetary-non-event

And this: http://pragcap.com/when-will-the-bond-auctions-begin-to-fail

And this: http://pragcap.com/a-fearsome-herd-of-tyrannosaurus-rex-approaches

Head spinning? Read the links in each. It will spin more….Everything you’ve learned in school is wrong….Well, most of it….

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