Some readers have asked me to provide a simplified explanation of how the modern monetary economy works which is devoid of all the jargon that economists hide within. As part of another earlier blog, I did present a simple fiscal game which provides all the essential insights you require to understand how a modern monetary economy actually operates. Like all models it is stylisation. But there is nothing that I could add by way of complexity that would change the fundamental conclusions and understandings. So to make the model easier to find for reference purposes later on I an presenting it again as a stand-alone blog. Read on!



A simple fiscal game!

Here is an example to help you think about all of this economic jargon. The concepts are simple and the numbers are small which makes it easy to understand and relate to (thanks to Warren Mosler for the original idea for this heuristic).

Imagine the economy is my household which is comprised of me (the parent) and you (the kid)! As the parent I assume the role of “government” and you thus comprise the non-government (private) sector. As the government I decree that I will offer 100 of my personal calling cards per week, if you agree to tend the garden on a weekly basis. These are the cards I exchange at meetings with various professional associates outside of the household. They are normal size rectangles of cardboard.

You say, naturally: “Why would I want your worthless personal calling cards?”

I reply (reflecting my knowledge of how modern monetary systems like the household work): “because to stay living in the house I expect 100 personal calling cards a week to be paid in taxes”.

You say: “when do I start work!”

Immediately, by imposing tax obligations in the currency of issue (the personal calling cards) I have created a demand for the currency and this allows me to transfer private resources (your work in the garden) to the public sector (the nice garden). However, also note that I have to spend the 100 cards each week before you can pay the tax of 100 cards – which clearly means that the taxation can never be considered a source of revenue which “finances” or allows me to spend the cards in the first place. The cards come from no-where and I have the monopoly rights to spend them. I am never financially constrained in my own personal calling cards (the currency).

So this sort of currency is what we call a fiat currency – being made legal by legislative fiat. It has no intrinsic worth and its value is tax driven. Just like the Australian dollar!

Note that I probably would never “print” any cards. I would run some spreadsheet on the house computer and just keep “bank entries” to record all the outflows (spending) and inflows (taxation). All the transactions would just be numbers entered into relevant columns. If I slipped up and added a 0 to my spending one week, I wouldn’t have to “print” 900 new cards. You would be better off by 900 cards because it would show up as a deposit in your account. But nothing else would be required. Same as in the Australian economy.

Now under these conditions, the household ‘budget’ would be balanced each week: I spend 100 cards and you pay 100 cards. You are unable to accumulate any cards (that is, save) because you can only get access to the volume of cards that I make available via spending. Same as in the Australian economy.

What if I wanted to teach you to save as preparation for managing your own affairs when you became an adult? Well the only way you can save is if I, for example, decided to employ you more each week and offered, say, 120 cards per week as wages (government spending) yet continued to tax you only 100 cards. The same effect could have been if I reduced the tax rate and held spending constant or a combination of increasing spending and reducing taxes.

Whatever, and lets stick to the spending of 120 and the tax of 100, the fiscal position now goes into deficit of 20 cards per week. You now can save 20 cards per week because my spending (the government spending) has provided the “finance” to permit you to do that. As the weeks go by you could accumulate more and more savings (numbers in the spreadsheet would increase) and you would soon see that the non-government saving over time is the exact record of the cumulative deficits being run by me (the government). Same as in the Australian economy.

Now, you might want to make more money (cards) on your savings. The only way that can happen is if I offer you a government bond (a bit of paper saying that if you deposit your savings with me each week I will pay them back at some future time plus some interest all in personal calling cards). So the offer of a new financial asset – the household debt instrument (the bit of paper) gives you a chance to compound your saving and maybe take a holiday – not work some weeks but still pay taxes!

So the debt issuance in the household establishes a non-zero rate of interest in the household and increases your wealth. I didn’t have to issue the bond to keep running the deficits. The bond just replaced non-interest bearing savings (reserves in our “banking” system) with an interest-earning asset (the bond). Same as in the Australian economy.

Now lets say I am reading some neo-liberal literature on the Internet which warns me against running fiscal deficits. As a result I get the feeling we have to get back into fiscal surplus to be a responsible government. So I tax 100 cards but cut my spending on garden work to, say 90 cards per week.

Can you predict what will happen now? Well in that particular week there are not enough cards “spent” to generate the funds necessary for you to pay the tax. There are 10 cards short. The household (government) fiscal position is in surplus for that week to the tune of 10 cards. But this shortage of cards liquidity in the private sector (that is, you!) means that you will:

(a) Demand more work to earn the shortfall – noting that the household has now reduced employment levels (in hours) and there is some underemployment creeping in. If I made the example more complicated with 2 or 3 kids in the house I could have easily cut spending by not paying anything to one or more of the kids thus creating unemployment.

(b) Try to sell some of your possessions to get some cards. In this simple case, you will offer your bonds (the bits of paper) for sale to get the funds. So the surplus starts to eat away at your wealth portfolio. I would be boasting like a neo-liberal would that I was running down the government debt – “getting the debt monkey off the government’s back” – which may help me sleep better – but you would just be feeling less well off (and maybe developing insomnia!).

(c) Start to run down any savings that are not being stored in bonds. Either way you run down your wealth holdings.

But in aggregate, the fiscal surplus is squeezing your card liquidity and forcing you to run down wealth. Same as in the Australian economy.

If I kept running fiscal surpluses, you would eventually run out of assets and your labour would be severely underutilised. You might be able to persuade me to start lending you the money (I might set up a privatised bank in the household) and this would keep you afloat (paying the taxes) as long as you were prepared to accept increasing private debt levels. But this is not a sustainable option. Same as in the Australian economy.