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Friday, November 30, 2012

The Most Marvelous Thing (MMT)

The most marvelous thing to come out of blogging is the dissemination of modern monetary theory (MMT).  MMT explains how the economy really works.  I was an economics major in college (University of Michigan, 1974) specializing in macroeconomics, but I never really learned how the economy works until I started reading the MMT blogs about 4 years.

One of my favorite blogs on the web is Kevin Drum'g blog on Mother Jones.  Kevin is a political blogger, and not an expert on economics.  Over the years I've seen him pose a number of questions about economics on his blog.  As the years went by, I noticed, to my amazement, that I was able to answer his questions, using the information I had learned at the MMT blogs.  Here are some examples:

  • What is money?
  • How do banks work?  How does money get created and destroyed?
  • Will the bond vigilantes strike against U.S. Treasury bonds?
  • How important is it to balance the fiscal budget?
  • What is the best way to manage the U.S. economy?
  • What does the Federal Reserve do?  How much power do they have?  Are they part of the U.S. government?
  • What is quantitative easing?  Will it stimulate the economy?  Can the Fed do more?  How about nominal GDP targeting?
If anybody wants answers to any of these questions, let me know.  Just don't be like Kevin Drum  and get some sort of mental block preventing comprehension of perfectly straightforward concepts.  That gets tiring.  

But read Kevin anyway.  Like I said, his blog is my favorite...

11 Comments:

  • This comment has been removed by the author.

    By Blogger John Holbrook, at 5:50 PM  

  • I'd be interested in the answers to all of them, in particular the first two. I've read your comments on Drum's blog and would certainly like to know more about MMT.

    Thanks,
    John

    By Blogger John Holbrook, at 5:51 PM  

  • Money is any object or record that is generally accepted as payment for goods and services, and repayment of debts (from Wikipedia). Per MMT (and the way the banking system works), there are two types of money which are created in two different ways:

    - The monetary base includes bank reserves and currency. This money is spent into existence by the currency issuer (e.g., the U.S. government, with the cooperation (in recent times) of the Federal Reserve).

    - Money created by commercial bank loans. This money is always offset by a liability (the debt owed to pay back the loan).

    The best way to think of the financial system is as a pyramid of liabilities, with the central bank at the top. MMT co-founder Randall Wray describes this here.

    Excerpt: "Private financial liabilities are not only denominated in the government’s money of account, but they also are, ultimately, convertible into the government’s currency."

    This concept is useful in considering so-called shadow banking.

    U.S. Treasury bonds, the so-called national debt, is more like monetary base money than it is like private debt. These bonds are the most liquid assets in the world and guaranteed by the U.S. government. They are the "gold standard" in terms of collateral for loans, including at the Fed's discount window. This fact has enormous implications in considering the fiscal budget and the "national debt".

    I'll answer question 2 in a separate comment....

    By Blogger Detroit Dan, at 2:05 PM  

  • Commercial banks are deputized by a currency-issuing government to create money (in the form of demand deposits) in exchange for collateral-backed promises to repay. Banks make money through short-term borrowing at low rates of interest and long-term lending at higher rates of interest. John Carney has a good description of this process here.

    Bank loans involve the creation of new money as demand deposits. This new money is destroyed as the loans are repaid. Banks are constrained by many factors in the creation of loans as described in the article by John Carney at the link referenced above.

    Banks can acquire base money (reserves) as necessary to make a loan, paying the Federal Funds interest rate (which is currently < 1/4% in the U.S.).

    An individual bank must acquire base money to make a loan, but the banking system as a whole does not require additional base money to support bank loans. That is because bank loans are deposited in banks, so the base money is just transferred from one bank to another (assuming the loan is not deposited back into the same bank that made the loan).

    Contrary to conventional wisdom, the banking system is not constrained in making new loans by the aggregate monetary base (fractional reserve banking). That is because the Federal Reserve will always supply additional monetary reserves upon demand (generally in exchange for U.S. Treasury bonds). This aspect of banking operations is described by John Carney here.

    New monetary base money is created via federal budget deficits and central bank operations. The U.S. federal governments pays for deficit spending by issuing U.S. Treasury bonds. As noted above, these bonds are near-money, and can be used as collateral by commercial banks to obtain new base money from the Federal Reserve (central bank). Also, the Federal Reserve frequently exchanges reserves for Treasury bonds (and vice versa) as part of it interest rate setting function (aka Open Market Operations). Quantitative Easing is an extension of the Fed's Open Market Operations to U.S. bonds of longer duration (in an attempt to lower longer term interest rates).

    By Blogger Detroit Dan, at 2:55 PM  

  • An important thing to note is that, absent intervention by the currency-issuing government, the monetary base always stays the same. But bank money, created by loans on top of the monetary base, will rise and fall depending upon the demand for loans, and the willingness of banks to make loans. Without government intervention in the form of guaranteeing bank money, the system of bank money would be unstable since bad loans can cascade throughout the system.

    Again, see Randall Wray's description of the pyramid of liabilities.

    The monetary base plus the stock of Treasury bonds (the "national debt") constitutes the net financial assets of the private sector (private as used here could include foreign and local governments).

    By Blogger Detroit Dan, at 3:09 PM  

  • Also, note that the net financial assets of the private sector (monetary base + Treasury bonds) are equal to the cumulative fiscal deficits. If the there had never been a deficit, there would be no monetary base and no Treasury bonds...

    By Blogger Detroit Dan, at 3:22 PM  

  • The essence of MMT consists of the realization that Treasury bonds are functionally interchangeable with the monetary base. In other words, Treasury bonds function like high powered money.

    This is an empirical observation, based upon the way the banking system works in modern countries with their own currencies...

    By Blogger Detroit Dan, at 4:40 PM  

  • Thank you, Detroit Dan. Very helpful. I'll probably have to return to the comments and links above a few times as I continue to make sense of this.

    Given all this, is it ever a good idea for the government to pay down its debt?

    Thanks,
    John

    By Blogger John Holbrook, at 12:37 PM  

  • Thanks John. Let me know if you have any follow up questions, or check out Randy Wray's writing on the subject at http://neweconomicperspectives.org/.

    With regard to the government paying down its debt, that might be advisable if high interest rates are generating too much inflation. In the short term that could cause currency depreciation, and consequent inflation in the prices of imported goods. But in the medium and long term, it would decrease the fiscal deficit and therefore be disinflationary.

    This is perhaps the problem with QE2 (monetization of government debt). While it's intended to be inflationary, it can have just the opposite effect (disinflation or deflation).

    The above assumes the debt would be paid off by the central bank via monetization. To have the Treasury pay off the debt with fiscal surpluses would put a real squeeze on the private sector, which could generate a financial crisis. This could, I suppose, be undertaken in a country with a large trade surplus to cut inflation...

    By Blogger Detroit Dan, at 2:09 PM  

  • Heterosensible over at Kevin Drum's blog points out this column by Rob Parenteau at NakedCapitalism that contains a fine graph showing the relationship between fiscal balance, trade balance, and private domestic sector balance: Parenteau: On Fiscal Correctness and Animal Sacrifices (Leading the PIIGS to Slaughter, Part 1)

    By Blogger Detroit Dan, at 2:24 PM  

  • I thought of another way of describing the banking system...

    There are 2 kinds of money:
    - Government money
    - Bank money

    Government money is created (by the federal government of course) via fiscal deficits. It may take the form of base money (currency plus reserve accounts) or Treasury bonds. The Treasury bonds are technically not money, but function in much the same capacity as they are extremely liquid and readily convertible to money by either the Federal Reserve or the private financial system.

    Bank money is created via private loans. Much bank money is government guaranteed (FDIC), and banks are subject to government regulation.

    As an example of how these two types of money coexist, consider the case of Bank A creating a $10 million loan for Customer Frank. Suppose that Frank requests that his loan take the form of a demand deposit account in his name at Bank B. In theory, Frank takes possession of government money (reserves) from Bank A. Frank then deposits that government money at Bank B, and receives his demand deposit account in return for his deposit of the actual government money.

    In practice, the government money (reserves) are transferred from Bank A to Bank B, and never leave the banking system. The amount of government money (aka monetary base) is unchanged. The amount of bank money is increased by the $10 million checking account that Frank now owns. Of course, Frank also owes Bank A $10 million, and this new bank money will be liquidated as Frank repays his loan.

    By Blogger Detroit Dan, at 7:41 AM  

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