The world changed on August 15, 1971 when Bretton Woods II came into existence. A fundamentally new paradigm was created, but recent debates have illustrated a basic lack of understanding about key facets of our monetary system. As terms such as “insolvency”, “bankruptcy” and “default” are thrown around loosely while talking about sovereign debt, it’s worth making a key distinction between monetary systems where (a) the state enjoys a monopoly over the issuance of fresh currency and (b) a floating exchange rate mechanism exists, and systems where this is not the case.
While talking about US debt recently, Alan Greenspan articulated this fundamental issue stating
The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.
The framework that best describes the monetary system of nations such as the United States is Modern Monetary Theory (MMT). The following Wikipedia summary is instructive.
Modern Monetary Theory (MMT) aims to describe and analyze modern economies in which the national currency is fiat money, established and created exclusively by the government. In MMT, (1) money enters circulation through government spending; (2) Taxation is employed to establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that can only be met using the government’s currency. (3) An ongoing tax obligation, in concert with private confidence and acceptance of the currency, maintains its value. Because the government can issue its own currency at will, MMT maintains that the level of taxation relative to government spending (the government’s deficit spending or budget surplus) is in reality a policy tool that regulates inflation and unemployment, and not a means of funding the government’s activities per se.
The theory was developed by economist G.F. Knapp in the 1920s.
While there are important philosophical issues involved in the adoption of a currency backed by nothing but faith in government, MMT is primarily a tool to understand the fiat money system when a state has a monopoly over the issuance of currency. That is, it’s essentially a descriptive theory, not a prescriptive one.
There are broadly four key facets to understanding MMT.
1) The government must spend the currency into existence:
This is the basis of modern monetary theory and of vital importance. In a fiat money system, the government must first spend money, in order to generate a currency in which it taxes its citizens. That is to say, government creates the taxes it collects through its spending. It is also to say that spending comes before funding.
This is an important way in which Bretton Woods II altered the landscape of the monetary system. Under the gold standard, bonds were issued due to revenue constraints caused by a lack of adequate reserves. Today, the primary purpose behind bond issuance is to help central banks hit their target rates. There are no revenue constraints anymore. In fact, Bretton Woods II was created for this very purpose.
2) Since GDP = C + G + I + (X – M) and GDP = C + S + T
C = Consumption, G = Government Spending, I = Investment, X – M = Net Exports, S = Saving, T = Taxes
It follows from the above equations that (G – T) + (I – S) + (X – M) = 0
Based on the equations above, it follows that under conditions where households and the private sector need to save in order to reduce leverage on their balance sheet, the government must spend more than it takes in, in taxes. MMT illustrates that by doing so it adds financial assets to the private sector.
Gavyn Davies of the Financial Times brings to light a similar relationship. Do note, Davies isn’t using the equations above in the same form. He describes the framework he uses
The financial balance of each sector is equal to its income less its total expenditure. A financial surplus indicates that the sector is a net acquiror of financial assets, while a deficit indicates that the sector is running down its net assets (or increasing its borrowing) to finance its activities. Because the three sectors cover all of the activities of the US economy, at home and abroad, their financial balances must sum to zero.
Davies argues that
(The private) sector includes both households and corporations, and in most economies it tends to record a small surplus most of the time. This was true in the US until the late 1990s, when the household sector started to run a financial deficit. Basically, rising equity prices, and then rising house prices increased personal wealth, and this induced households to reduce the amount they saved out of current income. As a result of this deficit, the private sector’s leverage ratio (the stock of outstanding debt/income) rose to record levels.
After 2007, falling house prices and the financial panic caused both households and companies to slash their spending relative to their income, and to generate excess cash. The shift in the private balance was a remarkable 14 per cent of GDP, and the consequent collapse in spending caused the recession. Meanwhile, the extra cash was devoted to paying down net debt, so the leverage in the private sector balance sheet started to decline
In order to better appreciate these relationships, modern monetary theory makes a distinction between horizontal transactions that occur within the private sector, and vertical transactions that occur between government and the private sector.
3) Horizontal Transactions
Modern Monetary Theory labels any transaction within the private sector a “horizontal transaction”. In particular, MMT analyzes the impact of banking transactions. It concludes that as a matter of accounting, loans within the private sector will always necessarily create a liability and a deposit equal in magnitude. That is to say that when a bank extends a fresh loan, a corresponding deposit is created somewhere in the banking system.
4) Vertical Transactions
MMT labels any transaction between the private sector and the government sector a “vertical transaction”. The terminology is aimed to distinguish these transactions from horizontal transactions which occur within the private sector.
When the government spends, the treasury disburses funds by crediting bank accounts. The other side of this transaction is that its account at the Federal Reserve is debited. Consequently, this is a transaction where the deposit within the banking system doesn’t have a corresponding liability within it.
The primary forms of vertical transactions include taxation and government spending. During taxation, private bank accounts are debited and hence reserves in the commercial banking sector fall. When the Federal government spends, Treasury will debit its cash operating account at the central bank, and deposit this money into private bank accounts. This money adds to the total reserves of the commercial bank sector.
The Federal Reserve and Quantitative Easing
Ever since the Federal Reserve announced its first round of quantitative easing some argued that high inflation, or even hyper-inflation were around the corner. One of the graphs that convinced people that there was no other logical argument was the following graph illustrating the dramatic growth of the monetary base after 2008.
However, the argument that an expansion of the monetary base itself would lead to inflation or even hyper-inflation immediately was deeply flawed. In a recent paper on why banks are holding excess reserves, Todd Keister and James McAndrews of the Federal Reserve Bank of New York explain the basis of the fractional reserve banking system and how it relates to the central bank. They highlight the importance of the fact the Federal Reserve started paying interest on deposits held with it in October 2008. This tweaking of policy had an important impact on the behavior of banks. Keister and McAndrews make the following observations:
The total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks' lending decisions. The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly created reserves will end up being held as excess reserves almost no matter how banks react.
most central banks now pay interest on reserves. When reserves earn interest, the multiplier process stops sooner. Instead of continuing to the point where the market interest rate is zero, the process will now stop when the market interest rate reaches the rate paid by the central bank on reserves. If the central bank pays interest on reserves at its target rate, the money multiplier completely disappears. In this case, banks never face an opportunity cost of holding reserves and, therefore, the multiplier process described above does not even start.
When banks earn interest on their reserves, they have no incentive to lend at interest rates lower than the rate paid by the central bank. The central bank can, therefore, adjust the interest rate it pays on reserves to steer the market interest rate toward its target level. The Federal Reserve began paying interest on reserves, for the first time in its history, in October 2008. This action was taken to "give the Federal Reserve greater scope to use it lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.
Thus, monetary policy of this sort was designed primarily to facilitate liquidity within the banking system, but paying interest on deposits at par with target rates reduced the opportunity cost for banks holding reserves. Consequently, there was no transmission mechanism that would result in inflation.
In fact, the measures were introduced primarily to prevent the banking system from freezing up completely. Once banks lost faith in each others’ credit worthiness during the crisis, inter-bank lending came to a virtual standstill. The flexibility that allows the banking system to promote healthy credit creation wherever it occurs in the system was absent. A continuation of such a condition would have led to the undesirable outcome of loans that should have been made, not being made.
As the graph above illustrates, the Fed’s extraordinary measures did not lead to banks extending fresh credit to the private sector. The only major spike in the graph was of banks holding cash and cash equivalents. This is precisely what quantitative easing was designed to do. Reduce counter-party risk within the system, and gives banks the confidence to use the inter-bank markets and credit swaps as they usually would.
Does this suggest governments should run massive deficits to fund the private sector?
The analysis to this point presents a benign view of deficit spending. To recognize that the government spends the currency into existence is to recognize that governments holding debt don’t suffer the same kind of solvency issues that businesses and households do. It is also evident that central banks greatly influence, and usually determine the cost of credit. However, to conclude that running indefinite fiscal deficits and cranking up national debt is a sustainable solution would be to misunderstand the basis that holds the monetary system together.
The central lesson of MMT is that a fiat money based system, like any other depends on its ability to provide an incentive for people to be productive. Because of the unique influence that vertical transactions have on the system, the role of government is particularly important. However, MMT doesn’t prescribe a particular role for government.
At their best, monetary systems facilitate exchange and encourage productivity. At their worst, they radically distort the incentive structure and promote undesirable behavior. There are no grand conclusions to modern monetary theory. It is instead, a valuable descriptive tool that enables you to recognize what the monetary system is trying to achieve and to be aware of distortions, glaring imbalances and potential threats.
Understanding it is a useful point of departure while navigating a complicated global system. The uniqueness of the fiat money system as explained by Modern Monetary Theory lies in the reasonable conclusion that if inflation can be avoided or contained, a heightened debt/GDP ratio in itself is very unlikely to lead to “bond vigilantes” enforcing discipline on the bond market in the case of monopoly issuers of currency. Governments thus hold counter-cyclical powers that can be used more effectively than previous monetary systems such as the Gold standard. That very flexibility can also be extremely destructive.
It’s worth remembering that within the European Monetary Union (EMU), individual European nations can’t issue fresh Euros. They therefore aren’t monopoly issuers of currency. While currency systems such as the US dollar and Japanese Yen can employ counter-cyclical measures during deep contractions of the private sector, individual European nations enjoy no such powers. A high debt/GDP ratio is in and of itself a reason for the “bond vigilantes” to attack the bond markets of such nations.
The Economic & Monetary Union (EMU) and MMT
The European Monetary Union (EMU) employs a structure in which individual nations such as Italy, Greece or Spain can’t issue fresh currency independently. They therefore operate in a manner analogous to individual states in the US, rather than as sovereign nations. At the same time, the absence of a unified European fiscal policy leaves the currency without an effective policymaker. Therefore, even in the absence of inflation (which may cause a legitimate loss of faith in currency), individual European nations can and often do face considerable pressure from “bond vigilantes”. In fact, individual European nations hold no adequate policy response tools when they face a deflationary spiral or the threat of an economic depression. This means that default risk in individual nations can increase substantially simply in light of a perceived threat of future economic contraction. Individual nations bond markets therefore can be subjected to severe pressure and market forces have the ability to push individual nations to the point of actual default. Individual nations can turn insolvent, for all practical purposes.
It would be beneficial to conclude, on the basis of MMT that these countries would have greater flexibility if they enjoyed the power to issue fresh currency, as individual, sovereign nations.
While the focus in this article has been on the architecture of the monetary system within a country, MMT can also be used as a tool to understand the global architecture and to ponder imbalances caused when individual parts of a broader system aren’t monopoly issuers of currency and/or don’t employ a floating exchange rate mechanism.
