October 10th, 2012
in Op Ed
Letter to My Brother
by J.D. Alt, New Economic Perspectives
My brother, Jeff, is a very smart guy who went to West Point, got a masters degree at Purdue, had a successful career as a business man and now, in his retirement, can sometimes beat his wife at golf. I sent him the NEP link to Playing Monopolis Monopoly and the other two essays I wrote as well, Men on a Wall and New Sense Common Sense. Since then we’ve been corresponding about MMT—with me trying to get him to “see” it, and he, to his credit, actually doing his best to “see” it while also collecting a lot of other opinions on the topic. Recently he sent me one of these other opinions, which included a textbook circular flow diagram that seemed to prove that MMT was impossible.
The dialog I’m having with my brother might well be representative of other inter-family debates going on in the MMT community. It occurred to me, therefore, that it might be useful to submit my latest brotherly correspondence for comments and suggestions. Here it is:
Thanks very much for sending me Tom’s response to my essay, and the other articles. I’m pleased you are so interested in this—as I am—and want to understand the truth of it, as I do as well, even though it’s not easy to do. I appreciate the time Tom has taken to give such a considered response. His comments have been very helpful.
What I’m coming to realize is that MMT has three parts: the first is very basic logic and quite simple; the second is extremely complex banking procedures; the third is a political policy conundrum that MMT doesn’t have a silver bullet for. The last is the part I am ultimately trying to get to (because it intersects the architectural ideas I’m pursuing) but I can’t really go there until I get over the basic logic component.
The basic logic is where my NEP essays have been focused. If you don’t “see” and accept the basic MMT logic, then making “sense” out of everything else is futile. The basic logic has to do with a fundamental shift in the dynamics of money that began in 1971 when Nixon took the U.S. (and the rest of the world) off the gold standard.
Until then, you could understand money—paper currency and coins and various I.O.U’s denominated in them (bonds etc.)—as being representative of a relatively fixed amount of financial wealth (the gold and/or silver the paper was convertible to “on demand”, and which was stored around the country in vaults―most in Fort Knox, I suppose.) This relatively fixed pot of money—for convenience let’s just call it “dollars”—was shared by everyone who needed to make financial transactions: households, businesses, state and local governments, and the federal government. The banking industry essentially managed the distribution of these dollars amongst the people and entities who earned them and spent them and borrowed them. Households and businesses earned dollars by working and providing services in exchange for those dollars. Governments—state, local and federal—“earned” their dollars by levying taxes on the businesses and households. Everyone (including the federal government), if they didn’t have enough dollars to pay for what they needed at a given moment, could (if they were credit worthy) borrow dollars from somebody who was willing to lend them.
This state of affairs is illustrated in the textbook circular flow diagram that Tom provided. (Here it is).
Click on any graphic for larger image.
To be honest, I’m not sure I understand the diagram entirely, but I assume from Tom’s comments it describes the flow of money within the economy and, as he suggests, the Federal Government should be considered simply another box in the loop. For my purposes, that’s all that’s important. So here I’ve modified the diagram as he instructs, adding the Federal Government box. I’ve also added something else: the outline of a “pot” filled with blue “dollars”, representing the idea that all these boxes—including the Federal Government—are sharing the dollars within the pot.
Click on any graphic for larger image.
The dollars in this pot were printed or coined by the federal government (others who printed dollars were called counterfeiters and put in jail.) The danger was that the federal government would print too much paper currency relative to the amount of gold backing it up—which would cause the value of the dollars to collapse (everyone running to the bank to convert their dollars and there wouldn’t be enough gold, so the remaining dollars would be worthless.) To prevent this Congress passed laws controlling how the federal government could print dollars.
Even so, the pot of dollars shared by the system fluctuated because the banks were allowed—by law—to loan out more money than they had in deposits. So, for example, if a bank had $1000 in deposits, it was allowed to make loans worth $10,000. In effect, the bank “created” $9,000 out of thin air. There was, of course, some danger in doing this, because the banks were promising to convert those “created” dollars to “real” dollars on demand—which, in turn, were convertible, on demand again, to some portion of the real gold that was stored at Fort Knox. Folks being folks, if they began to get a whiff that the bank couldn’t make good on the promise, they’d all run to the bank to withdraw their dollars—even worse, try to convert them to gold. This happened over and again throughout the course of history: it was the inevitable result of everyone—including sovereign governments—sharing (and leveraging through the banking system of loans) a relatively fixed pot of financial wealth.
Everything Tom says in his letter—and the main points in the other articles you sent—assumes that the world described (and illustrated) above still exists. And, in fact, most of the “rules” that were put in place to control that world—to keep it from collapsing, so to speak—are still with us, still guiding the Fed (central bank), the Treasury and the private banking industry.
What MMT is saying is that the fundamental logic of this monetary system changed in 1971—even though the “rules” stayed the same. What changed is basically twofold: First, the federal government is no longer “sharing” the pot of dollars, but is now purely the issuer of the dollars that go in the pot. Fiat currency (which is what the US Dollar converted to when Nixon decoupled it from gold) is created by the sovereign government, and that is the ONLY way it can come into existence. (If you found a gold nugget in your back yard, you could convert it to a fiat dollar by selling it to a neighbor; but the only way that neighbor was able to have the fiat dollar to spend was because the federal government had created it.) Second, because the fiat dollars are no longer representative of a fixed amount of gold or silver, the sovereign government can, theoretically, create an infinite amount of them.
The analogy that L. Randall Wray—the leading U.S. author about MMT—uses to visualize this transformation is that the old pot of gold-backed dollars became a “bathtub” of fiat dollars with the plumbing spontaneously evolving to reflect the new reality. The first plumbing change was that the federal government stepped OUT of the bathtub and became the spigot that, when turned on, poured dollars into the tub. Still IN the tub, sharing the dollars—earning them, spending them, borrowing them—are the U.S. households, businesses, state and local governments (in essence, everyone except the sovereign government, which is now the spigot.) The second plumbing change is that the tub got a drain which could be closed or opened, a little or a lot, to let dollars drain out of the tub.
Here is Tom’s diagram modified to illustrate this new reality.
Click on any graphic for larger image.
So now, instead of the “old” way, with the gold-backed dollars essentially being recycled over and over within the pot―with the federal government taxing and borrowing them so it could subsequently spend them to get the things and services it needed―the plumbing works in a new (modern) way: The federal government turns on the spigot and fiat dollars flow into the tub until the tub fills up to the “right” amount. When the tub gets filled up too much (too many dollars chasing a fixed amount of goods and services, as Tom pointed out) the Fed opens the bathtub drain. The bathtub drain is federal taxes. The relationship between the dollars flowing out of the spigot (federal spending), and the dollars draining out of the tub (federal taxes) is what controls the amount of dollars in the tub (and hence, inflationary or deflationary pressure on the currency.)
There are two critical things to make note of here. The first is that the MMT economists are not proposing that this is the way things ought to be; they are saying this is way things actually are happening right now.
The second thing to notice is that the only thing that can activate the spigot―adding dollars to the tub―is federal spending. The federal government can’t just “put” the dollars in the tub; there is no mechanism for doing that. To turn on the spigot, the federal government has to spend the dollars on something. It can buy services (like medical services for people on Medicare), or it can pay to build something useful or necessary (the Hoover Dam, for example), or it can purchase an asset from someone (like a Treasury or mortgage bond.) Each one of these transactions adds dollars to the tub―specifically, it adds dollars to the Private Sector bank account of the person providing the Medicare services, or the persons building the Dam, or the person or bank selling the bond.
What is called the federal “deficit” is the difference, at some particular point in time, between the number of dollars the federal government has spent INTO the tub, and the number of dollars it has drained OUT of the tub with taxes. (It is running a “deficit” when it is spending more IN than it is taking OUT.) That, by definition, is the federal “deficit”. But we can immediately see, by simple logic, three important things:
First, what we are calling the federal “deficit” are the dollars left in the tub!―in other words, the financial wealth of the households and businesses of the Private Sector. We can reduce the federal “deficit” either by turning down the spigot (reduce federal spending), or by opening the drain wider (increasing taxes), or by some combination of the two. In either case, reducing the “deficit” will, by definition, reduce the number of dollars in the tub―which directly translates to fewer dollars in the bank accounts of households and businesses. Now the ONLY reason you’d want to do this, that I can think of, is if the tub was too full of dollars (which means the currency is experiencing major signs of inflation.) This is why the debate going on now in Congress about how to reduce the federal “deficit” is political insanity!
Second, we can see that what we are calling the federal “deficit” is NOT a “deficit” at all in the same way the word would apply to me or you, or any business, or state or local government in the tub (the Private Sector.) If any of us in the Private Sector spends more dollars than we earn, we have to come up with a way to earn (or borrow) dollars to make up the difference―or, we go bankrupt. The federal government, in contrast, doesn’t HAVE to “come up with a way” to earn (or borrow) dollars to make up its “deficit” because, of all the players at the table, it is the ONLY one who can simply create dollars as needed. In fact, you could reasonably argue that the job of the federal government is to deficit spend. If it doesn’t, the Private Sector economy will slowly grind to a halt.
Finally, we can see that, by logic, the federal “deficit” is NOT a debt that the federal government is obligated to repay to anybody, at any time―now or in the future. It is, by definition, the simple balance sheet accounting of the difference between the number of dollars the federal government has spent into the tub, and the number of dollars it has drained out of the tub with taxes. The federal government doesn’t need those tax dollars to spend from the spigot. There is no “bucket brigade” that catches those dollars coming out the drain and carries them up to dump into the spigot. The draining dollars are just “cancelled”, so to speak, and new fiat dollars are created in the spigot as needed. Nor does the federal government need to borrow dollars to spend from the spigot. The Fed’s “borrowing” (selling bonds) has nothing whatsoever to do with the need to acquire dollars so it can spend them. The Fed’s bond sales are, instead, a mechanism for managing the banking and monetary system…. But this is where we get into the extremely complex banking procedures which I referred to in the beginning. To see and believe the basic logic and truth of MMT, I don’t think it is necessary to go there.
So this brings me finally to the political policy conundrum for which MMT has no silver bullet. An article yesterday in The Wall Street Journal attributed to the president of the German Bundesbank, Jen Weidmann, the following sentiment:
“Central banks exist to defend a currency against politicians’ cravings for easy money.”
This pretty much sums up the conundrum from both perspectives: If we thought pork-barrel politics and Congressional earmarks for “bridges to nowhere” were out of control before, what do we imagine will happen if Congress (and the K-Street lobbyists) get a whiff of the idea there is an infinite supply of dollars available for their pet projects? How could we possibly control the ensuing chaos? At the same time, however, Mr. Weidmann’s position (and, indeed, his actions in the Eurozone financial crisis) ensures that some major sector of society will suffer, or at least be unable to generate and take advantage of the full economic energy of which it is capable—and which, in fact, is available to it, except for the first part of the conundrum.
I personally believe that MMT is a crucial turning point in the evolution of human society. It is the critical dynamic that will enable us to create the enormous technological and infrastructural solutions that our survival and prosperity are going to depend on as the human population approaches ten billion souls on a finite planet. It is therefore essential that we not only acknowledge MMT as the new economic reality that it is, but we also figure out an effective way to manage and control it.