Intro to modern monetary theory
by Hansi Mehrotra
6th June 2014
Being a professor in risk management, Professor Frank Ashe had to explain the biggest risk event in recent history – the global financial crisis. He went back to basics to understand the genesis of the credit bubble, in the process discovering Modern Monetary Theory and how government deficits are not as bad as people think.
With so much discussion around the US government debt ceiling and tapering of the quantitative easing, most people are led to believe that government deficits are not desirable. Indeed, people believe the unchecked rise in credit was part of the problem causing the global financial crisis. Other investors believe the current government spending is ‘crowding out’ private investments.
Was the credit bubble the real problem? For a professor in risk management, it was important to understand the root cause of the biggest risk event in recent history. However, this is easier said than done.
In the process of going back to basic economics, Frank Ashe, a professor at Australia’s Macquarie University, discovered that perhaps people’s understanding of economics is a key part of the puzzle. While most people believe that banks take deposits and then lend out for a spread, what actually happens is the other way around – banks lend first which creates deposits when the borrowers spend.
At a CFA Institute event in Mumbai, Ashe explained the Modern Monetary Theory in economics. He says that government surpluses destroy private wealth and it doesn’t make sense for them to behave as if they were on the gold standard.
Loans create deposits, not vice versa
Ashe pointed out that his observations weren’t as far fetched as they sound. Indeed the Bank of England, in an article released in March 2014, admits that banks do not lend out deposits or reserves – in fact, loans create deposits. So banks actually create money out of thin air, so to speak. The German central bank and Fed also have confirmed this previously according to various blog posts following the Bank of England release.
One blog said ‘this is an important revelation as most economists think that debt – and the real nature our money system – don’t matter.’
Even if banks don’t really loan based on their deposits and reserves, who cares? Why is this such a dangerous myth? According to Washington’s Blog, ‘because, if banks don’t make loans based on available deposits or reserves, that means:
- This was never a liquidity crisis, but rather a solvency crisis. In other words, it was not a lack of available liquid funds, which got the banks in trouble, it was the fact that they speculated and committed fraud, so that their liabilities far exceeded their assets. The government has been fighting the wrong battle, and has made the economic situation worse.
- The giant banks are not needed, as the federal, state or local governments or small local banks and credit unions can create the credit instead, if the near-monopoly power the too big to fails are enjoying is taken away, and others are allowed to fill the vacuum.
Indeed, the big banks do very little traditional banking. Most of their business is from financial speculation, according to the blog.
Modern Monetary Theory
To understand this conclusion, Ashe said it was important to understand the underlying theory, called the Modern Monetary Theory (MMT). MMT is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money, i.e., fiat money.
According to MMT, ‘governments with the power to issue their own currency are always solvent, and can afford to buy anything for sale in their domestic unit of account even though they may face inflationary and political constraints.’
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, money enters circulation through government spending. Taxation and its legal tender power to discharge debt establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that must be met using the government’s currency.
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.
When a government borrows, it basically exchanges one government obligation for another. This is neutral government transaction.
In a nutshell, when a government spends money, it creates net financial assets in the private sector and when it collects money, it destroys net financial assets in the private sector. In other words, government deficits create net financial assets and government surpluses destroy net financial assets.
Sovereign governments can always pay their bills. Default by a government is never necessary. The key point here is that government spending should be consistent with economic activity.
Ashe pointed out that sovereign states, such as the US, UK, Australia and India, issue their own money. However, Eurozone countries like Germany, France and Italy are not able to create money anymore – the European Central Bank (ECB) does. “And the ECB forgot that it can print its way out of the crisis,” said Ashe.
Ashe believes the general discussion on MMT is a good start. His ‘A Kindergarten guide to modern monetary theory’ provides a useful simple guide to the theory for lay people.
But as the blogs pointed out, the implications are quite serious. Investors and risk managers have to un-learn a lot of what they learnt about economics text books written in the gold standard age, and learn how to navigate the world in fiat money age.