by Derryl Hermanutz
In his book, “The 7 Deadly Innocent Frauds of Economic Policy”, modern money theory (MMT) advocate Warren Mosler distinguishes between three very different kinds of money systems,
“Historically, there have been three categories of money: commodity, credit, and fiat. Commodity money consists of some durable material of intrinsic value, typically gold or silver coin, which has some value other than as a medium of exchange. Gold and silver have industrial uses as well as an aesthetic value as jewelry. Credit money refers to the liability of some individual or firm, usually a checkable bank deposit. Fiat money is a tax credit not backed by any tangible asset. In 1971 the Nixon administration abandoned the gold standard and adopted a fiat monetary system, substantially altering what looked like the same currency. Under a fiat monetary system, money is an accepted medium of exchange only because the government requires it for tax payments.”
Warren lists three kinds of money: commodity, credit and fiat. We are no longer on gold, so which type of money are we now using? Warren says we adopted fiat money in 1971. A point I have repeatedly tried to make to anyone who will listen is that, even though it legally and constitutionally could, the US government does not in fact issue fiat money and has not done so since Lincoln and Kennedy issued United States Notes. Fiat money would be United States Notes, or proof platinum coins. These forms of fiat money would be issued directly by the Treasury department as “money”, not issued by the banking system and loaned to the government as “debt”.
In a credit money system, the banking system that issues the money, and the economy (including government) that borrows and uses the money, are monetary opposites. Our money is the banking system’s liability, and our debts are the banking systems assets; our debts are our liability, and our money is our asset. What is an asset to the economy is a liability to the banking system, and vice versa.
The economy’s “debts” are “assets” to banks, because borrowers agree to pay interest on the loans of credit money in addition to promising to repay the principal. The economy’s “money” is a “liability” to banks, because they loaned that money into existence, and it is their legal responsibility to see that borrowers pay it back. And in the case of CDs and savings account balances, banks also have to pay interest on the economy’s deposits of money in the banking system.
Credit money is issued as a “loan” against an “asset”. Ultimately the asset is simply the borrower’s “promise” to pay interest and repay the loan principal, but the legal asset backing all credit money loans is the “promissory note”, duly signed by the borrower, that lays out the details of the borrower’s repayment obligations to the bank. Most notes are backed by collateral, real estate, cars, etc. that the borrower pledges against his promise to repay. If he fails to repay as per the terms of the loan, the debtor has authorized the lender to seize ownership of the collateral he pledged.
Under current operations the U.S. government writes promissory notes called bonds, bill or notes, promising to repay the principal and pay (what amounts to) interest on the outstanding loan balance, and primary dealer banks (PDs) buy these at auction. The PDs pay for their purchases in the same way that all banks buy “assets”: by creating a deposit of bank credit money for Treasury. The new bank deposits are “money” that Treasury can now spend. Treasury’s promises of repayment are “debts” to the government and the taxpayer.
Credit money is created by banking systems, not by governments (unless governments go into the banking business like North Dakota has). So governments, just like the rest of us who aren’t banks, can only spend more than we earn by borrowing credit money from bankers, and our deficit spending increases the total amount of “debt” we have promised to eventually repay to our banking system.
Compounding Liabilities and Credit Limits
All borrowers have “credit limits” or debt ceilings, which are on the one hand somewhat arbitrarily imposed by lenders or by borrowers based on estimates of our capacity to pay interest out of our present incomes and repay principal out of our future incomes; but on the other hand real limits are inescapably imposed by the exponential arithmetic of compound interest on the total stock of debt.
Applying “the rule of 72”, 72 divided by the average interest rate on the total debt, gives the number of years it takes for the debt to numerically double. So at 7.2% interest (loan interest is historically in the 6-8% range), debt doubles in 10 years if interest liability accumulates, then doubles again in 10 more years, etc. 2, 4, 8, 16, 32, 64, 128, 256, 512, 1024, 2048: you can see how after a few iterations of compound interest the borrower owes THOUSANDS of times the original principal balance, if the borrower keeps rolling over the loan principal and borrowing new money to pay old interest.
Rolled over debt grows exponentially toward infinity under the intransigent arithmetic of compound interest, and this imposes a hard ceiling on the total amount of credit money an economy can afford to borrow at interest, without going into hyperinflation.
Maintaining the Money Supply
To keep the economy’s total stock of debt, which is the total money supply, constant or rising, new borrowers must always be taking out new loans as old borrowers are repaying. It is not the same individuals rolling over old debt each year, but to maintain a constant money supply the economy as a whole must constantly keep rolling over its total stock of debt, and constantly pay interest on the total stock of debt. So debt grows exponentially and credit money is not a sustainable system, as a graph of post-WWII debt growth and the current global debt crisis should be demonstrating to everyone’s satisfaction. We have passed the limit where this kind of money can “work” in our economy, and the system is now collapsing.
Fiat Money – A System We Don’t Use
As an alternative to borrowing credit money that is created by its national banking system, the government could create its own fiat money and spend it into the economy without incurring any repayable “debt” in the process and without saddling taxpayers with escalating interest payments. As things stand today, taxpayers cannot even make payments on their private debts, let alone adding public debts to their unpayable burden. What the economy needs is additional income, not more debt.
Fiat money created by government and spent into the economy would be a net addition to the money supply that circulates in the economy, unless and until the government decided to tax some of that money back out of circulation and extinguish the money. Money that is “spent” into the economy by government becomes “income” to the people who receive the money. So fiat money offers a way to add positive money numbers into our monetary equation that is currently drowning in negative numbers.
This is the MMT that Warren writes about, but it only applies to a fiat money system where governments in fact issue their own non-debt money. It doesn’t apply where governments borrow the money that they spend above government revenues.
Vertical vs. Horizontal Money
This fiat money process, where government creates its own non-debt money and spends it into the economy, would add “vertical” money into the economy, a net addition to the money supply, money that is not “owed” to anybody as repayment of a loan or a bond or any other kind of “debt”. All credit money that is issued as debt which must be repaid is, on the other hand, “horizontal money” that only exists as long as the loan balance that created it is outstanding. As the loan principal is repaid, the horizontal money is extinguished and ceases to exist.
All credit money is horizontal money. All money that is borrowed into existence and which must be repaid and extinguished, exists only as long as the borrower remains “in debt” to the lender/money creator. Only government fiat non-debt money can be “permanent” vertical money. Only government fiat money can be spent into circulation as an addition to the money supply (and an addition to the national income) without adding to the economy’s total debt to its banking system.
The Government DOES NOT ISSUE Money
But the government is not issuing any non-debt money. There are no platinum coins or U.S. Notes. Instead, the government uses the same credit money that the rest of the economy uses, money borrowed from the banking system, money that is owed as debt.
Warren’s “frauds” apply to a fiat money system where the government issues its own money. But in the credit money system that our governments actually use, the frauds become “facts”. All credit money is borrowed into existence and must be repaid according to the terms of the loan, so all of the arithmetic constraints of zero sum balance sheet credit money that apply to other private borrowers also apply to the current financial operations of the U.S. government.
The government SHOULD be a money issuer, according to us MMTers. But in fact the government behaves as a money “user”, borrowing credit money from its banking system (i.e. from the primary dealer banks who bid at Treasury auctions and buy the new Treasuries with newly created bank deposits that become the “money” that Treasury then deficit spends into the economy) to fund deficit spending.
The bonds and other Treasury securities are all acknowledgments of “repayable debts”. They are promissory notes, where the borrower (government) promises to repay principal plus interest according to the terms of the bond or security or other debt instrument against which a commercial bank created a deposit.
The Banks Issue Money
Credit money is issued as bank deposits by the banking system. Credit money is a balance sheet equation, where all of the money that is issued as “deposits” is exactly offset by “debts” that must be repaid. The money on one side of the equation is offset by the debt on the other side, so the equation sums to zero.
Zero Sum Money
Credit money is spent into the economy by borrowers and is ultimately removed from the economy by those same borrowers to repay their loans. A bank loan of credit money creates a deposit in the banking system, and a borrower repayment destroys that deposit.
Just as taxation extinguishes fiat money, so loan repayment extinguishes credit money. The loan created a positive number of money and an equal negative number of debt. When the money meets the debt in a loan repayment, the positive number extinguishes the negative number, leaving zero money and zero debt on the balance sheet.
In a credit money system, money and debt net out to zero. All of the money is always owed by its original borrower as repayment of a debt to the banking system. So even though many borrowers are spending newly loaned credit money into the economy and removing money from the economy in different timeframes, the fact remains that all of the money at all times is owed as debt to the banking system that created it as bank deposits. The total stock of money is always owed as debt to the banking system that created it.
By law, bank deposits are convertible into the central bank’s banknotes, dollar bills and $5s and $20s. But commercial banks must borrow banknotes from their central bank, so even the “cash” that is printed by a credit money system comes into circulation as a debt, because the commercial bank owes the cash to its central bank as repayment of the banknotes it borrowed.
Repeat Again – The U.S. Does Not Use Fiat Money
Neither the cash nor the bank deposits in our credit money system are issued as “fiat money” by the government. This fact, that we are not using government fiat money but are instead using private bank credit money, is the ONLY ‘deadly fraud’ we need to focus on at this point. Because unless the bankrupt and insolvent governments of the world actually start exercising their constitutional authority to issue some of their own non-debt fiat money, they truly are bankrupt and insolvent just as the Austerians claim.
Europeans are already trapped in a system that has stripped nations of fiat money powers. They have no alternatives other than to borrow more euros from euro-issuing bankers (or from hedge funds and other privately owned pools of money) or balance their budgets. If the lenders say no then these nations have NO MONEY to deficit spend, and they are FORCED by arithmetic necessity to balance their budgets, just like you and me. We have no power to print or create money, so we must live within whatever limits our incomes and our creditors impose on our spending power.
Other potentially sovereign nations, like the U.S., technically possess fiat money powers but in fact do not exercise them. If you have a fire extinguisher, but don’t use it, you still burn down. “Potential” powers don’t put out “actual” fires.
The U.S. is Insolvent ONLY if It Chooses to Be
So it may be “voluntary” bankruptcy, but that doesn’t change the essential fact that it is still bankruptcy, followed by asset fire sales of whatever the government owns and the banksters want. This has been going on all over the Third World for 50 years under IMF structural adjustment programs and other “shock doctrine” tactics. Now it’s coming home to a First World nation near you. The ONLY alternative to this Austerian bankster paradise is government issuance of its own non-debt fiat money. But if governments won’t do that, then Austerianism is what we can look forward to in the near future.
USA in 2012/2016: An Insolvent and Ungovernable Country by GEAB, LEAP/W2020
About the Author
Derryl Hermanutz has contributed (opinion and analysis) previously on topics related to theory of money and relationships between current events and economic history and philosophy.