## Sunday, December 21, 2014

### Suggestions to Enhance the Modern Monetary Theory (MMT)

Modern Monetary Theory (MMT) has a widely accepted basic premise: Government can print all the money it wishes. If we accept this, the theory should then map the pathway used for entry of new money into the economy.

MMT skeptics immediately point out that if government did print at will, the money would immediately have no value. The reply by MMT supporters is that value is provided by government taxation. People, they seem to say, work to pay their taxes. This is not a satisfying reply.

In this post, we will find a more satisfying explanation for the initial value of fiat money. We will also develop an equation and map for creating a money supply and bringing it into the economy. We will begin with the equation because the method of money creation is important to the initial valuation.

Developing an equation for money creation

An equation will be built from the widely used government budget accounting constraint "expense equals income", This can be restated as "government expenses (Exp) are met by taxation (T) and borrowing (B)" and written as

Exp = T + B.                                           (1)

Government can only tax the bigger private economy. (If there is no private economy, there is nobody to tax.) We will assume that government levies a tax on private economic transactions at a tax rate TR. The private economy is big and diverse so we will use a very general math function f(p, n) as the representative term [p is price, n is number of taxable transactions]. The private economy taxation can be  described as T = TR * f(p,n).

We will substitute the public terms into equation (1) to get

Exp = TR * f(p,n) + B.                          (2)

Equation (2) binds government as an entity to the entire private economy. This equation would be correct over all periods of time, long or short.

Finally, to arrive at an equation explaining how money is created by government, we rearrange equation (2) to write

(3)

In the simple accounting view, this equation has little to offer. In the MMT view, this equation explains how money is created. We will break it down from the MMT viewpoint.

The term Exp / TR is the normal purchase of labor and property using existing money. The term TR is a proportional vehicle. [Note 1]

The second term B / TR is puzzling and needs additional explanation. The term is preceded by a negative sign that indicates that borrowing subtracts from the payment of expenses. This means that borrowing has been used for payment but in reality, payment for expenses has not yet occurred. Instead, a promise to pay has been issued.

Equation (3) indicates that the private economy has been paid in two currencies, one currency being negative.

This completes the derivation of an equation explaining money creation [equation (3)].

Evidence of borrowing becomes fiat money

Equation (3) indicates that government may pay for expenses with borrowing but that payment has not really been made, only deferred. We can understand that any evidence-of-borrowing may itself be traded, even frequently traded.

The sequence to fiat money is straightforward. Government begins with payment in a well accepted currency such as gold with no borrowing. After a period of time, government begins borrowing the accepted currency, issuing a note of some kind to establish evidence of borrowing. [The issuance of the note will be recorded in the equation as borrowing].

As larger numbers of government notes come to be outstanding and widely distributed, government may accept notes for payment of taxes . As the notes become better accepted, the point can be reached where government expenses are paid in notes. At this point, notes can no longer be used as evidence of borrowing because any borrowing of notes would be borrowing from government itself. A new mechanism, bonds, is the answer. At this final step, the debt of government is represented by both notes and bonds. The notes have become so common that they are considered full payment for all debts despite being only another form of government debt.

Now we have the MMT model of money creation. Fiat money is nothing but evidence that government has borrowed in the past. Each unit of money is a share of the total borrowing completed since the government was initiated.

A satisfying initial valuation explanation

We have an equation that explains fiat money and we have a transition from borrowing to fiat money. There has not yet been an explanation of how value is assigned to fiat money. That explanation is very simple; the workers-for-government and sellers-of-property-to-government assign the value when they accept fiat notes as currency.

Think of money this way: Each unit of money is a share of (or can be traded for) any item for sale in the economy.  It is misleading to compare the value of money to the value of things not for sale.

Also remember that all fiat money comes from government so all new money must come from government.

Now it is easy to see that when a secretary works for government, she will think the money she receives for a day's work is the value of one day's work. Secretaries everywhere will think of one day's work as worth what government pays it's secretaries. So, if a secretary is willing to work for fiat money, that action becomes one measure of the value.

Many people work for government. Much property is sold to government. Each day's work and each sale is an evaluation of the fiat note. Once received, each holder of fiat currency has the challenge of making the notes buy as much as possible which tends to stabilize the  initial value.

MMT and destruction of money

Advocates of MMT often insist that when money is returned to government by taxation, the money collected disappears, only to be reissued again when government pays expenses. We can follow equation (3) to see that the B term in the equation may be positive in the case of bond pay-down but there would be no need to cancel note currency. (Remember, in a fiat system, the currency in use would be notes issued by the government. Bonds are the second level of debt issue used when excessive amounts of notes are already moving throughout the economy,)

In reality, it does not matter what government does with notes in it's possession. Whether government destroys the notes or recycles them is of no concern to the government worker or property seller who might become the next note owner.

Conclusion

We have an equation that demonstrates how the broad private economy interacts with the actions of government, allowing the creation of money if government decides to carry large amounts of debt for long periods. Money is seen to leave government (the right side of equation (3)) to become income to the private sector (the left side).

Fiat money can seen to be a logical consequence of continuing government borrowing, which over time, evolves into the form of notes (currency) and a second level of debt (bonds).

Valuation of the fiat currency is done at the moment of creation which is when government makes a payment in the fiat currency. A payment from government devalues the currency (by increasing the money supply) and a payment to government increases the value (by decreasing the money supply).

Fiat currency can be "as good as gold". A stable value is the result of sound government management.

Someone may need a name for this revised model of Modern Monetary Theory. I like the distinctive name Mechanical Monetary Theory (MeMT).

Note [1]. Ask yourself "If government creates new money, how much economic activity must the new money generate before the new money is all returned to government by taxation?" The answer: economic activity = new money divided by tax rate.

(c) Roger Sparks 2014

1. The Modern Monetary Theory description looks like:

L(t+1) = L(t) + D(t),

where L is the level of government liabilities, and D is the fiscal deficit.

These liabilities are then divided up, with bonds being issued to keep interest rates near a target rate.

As a result, MMT does not attach too much importance to the distinction between money and government debt. It was more of a mainstream worry whether governments "fund" spending with taxes, money creation or bonds.

I am unsure about your points about the switch from paying taxes in gold. In practice, most countries had debt-based private currencies, and they were absorbed by the state. There were mechanisms to convert debts into gold, such as coin issuance. At this point, the historical steps we arrived at fiat currencies are somewhat moot.

1. Brian,

Thanks for taking a look at the post.

Equation (3) spans 'time'. It can be applied no-matter whether the time period is one year or 50 years.

The 'B' term is borrowing .

Over 100 years (for example), the borrowing would include borrowing gold and giving notes as evidence of borrowing. In the current time period, government is borrowing notes and giving bonds as evidence of borrowing. Notes have become so common that they are used as the daily currency.

Currently, government can be described as borrowing it's own debt. That concept is behind the charge that QE is ineffective. The charge is that QE only has influence on the liquidity of the money supply.

On the other hand, we could also look at equation (3) and say that the money supply (which is government debt) is currently rapidly increasing because government still has a large annual deficit. In my view, this is fiscal policy in action.