I am writing an educational post today which will attempt to describe, in the simplest terms possible, Modern Monetary Theory (MMT) and its place in the current national conversation. I fully accept that rational thought will play absolutely no part in whatever agreement is ultimately reached in Washington, DC so that is not really at issue. This post will be neither political nor funny. I also feel obligated to provide this disclaimer. I am a member of the one percent. As a rabbit American of means, I live an exceedingly comfortable lifestyle which is seen to by my large staff. I have significant investments, including substantial holdings in carrot, kale and blueberry futures. Honestly, I couldn’t care less about the fiscal cliff because my every whim will be met regardless. I sense however, that not all of you are in a similar position. I know my staff thinks they have cause for concern. In terms of what lawmakers may decide to do, my staff is right. In terms of economics, they really are wrong. Allow me to explain.

In making my most critical, essential and earth-shattering point, I will try to be as subtle as I can.

The Federal deficit is not big ENOUGH.

There. I said it. Go back and read it again just in case you missed the emphatic nature of this statement. Got it? Oh, I see, not really. I suspected as much. Allow me to explain and to provide links to more experts on this subject than you will ever have time to read but really, really should because it is fascinating stuff. It is also important that I note here that MMT is politically neutral. It is not a proposal for fiscal policy. MMT is a description of the current monetary structure as it has been ever since the US went off the gold standard. That it is not widely understood is an understatement.

I attended the University at All-Bunny (SBUNY) and when I took macroeconomics the words “modern monetary theory” never crossed the lips of any of my professors. Later, as a grad bunny, I attended some evening lectures during which MMT was introduced but the theory was young and had not fully coalesced. I say this not because I think you care about where I first heard about MMT but because there is a reason you probably don’t know anything about it either. Either you, like me, matriculated prior to the advent of MMT or your professors, like virtually all those in the country, were not exposed to MMT during their training so they did not pass it on to you. Either way, MMT is only beginning to enter the general knowledge-base because it simply takes a while for new information to gain a footing especially in an area as staid as economics. Still, given the potentially society-changing negotiations going on in Washington right now, this seems a reasonable time to point out that no matter what they decide, they are likely to be wrong because, as anyone who has paid informed attention to the monetary crisis in Europe knows, austerity measures are a death knell for already stressed economies. Nation states that are locked into a fixed currency, like all those who participate in the Euro, have turned over the control of their economies to forces which have no interest in acting in the best interest of each individual country. But, and this is important, the United States is NOT in this position.

Fiat Currency

Once upon a time the US was the prime signatory to the Bretton Woods Monetary System wherein forty-four allied nations agreed to tie their currencies to the US dollar at a fixed rate. The US dollar was tied to gold. This acted, for a time, to stabilize world currency markets and pushed then much needed security throughout the system. Eventually though, because gold is a limited commodity, being tied to the gold standard began to seriously impinge upon the US economy so, in 1971 President Nixon, with the so-called “Nixon Shock”, took the US out of Bretton Woods and off the gold standard. This was a huge deal, bigger even than I can describe. The United States now had a pure, fiat currency (meaning that the currency does not, in itself, have intrinsic value) and that the US, as the issuer of said currency, had new and significantly increased power to make much broader discretionary decisions in terms of economic policy. But a funny thing happened. US monetary policy makers didn’t really do much with their new found freedom.

To begin to explain this I must first make something very, Very, VERY clear – a US federal budget is nothing what-so-ever like your personal household or business budget in any way, shape or form. It’s not. See – you aren’t getting this.

It…is…not…like…your…family…budget.

Period. Do you see why? You don’t do you. *sad face* Well, you are in good company. Most of the country and, to the best of my knowledge, every single member of the House of Representatives, is right there with you. Here’s a hint. You have to work for your money. A business has to produce goods, or services, or, if it is Bain Capital a vulture capital firm, steal money in order to have any. The US government is an issuer of currency. They don’t have to earn it. They print it. (Do NOT go to the “inflation” place yet. I’ll get there later.) Let’s just stay focused on the simple fact that the big difference between the US government and you or me is that they will never run out of the currency needed to cover their debts. (I KNOW. I’ll get to the inflation thing later. Stay focused.)

One of the most interesting things about fiat currency is that taxes are not actually a requirement. Neither is there a need to sell bonds or borrow currency. Do you know what happens when you pay your bill to the IRS in cash? They shred it. No joke. They make a note in their computers next to your account and then that cash is gone. Poof. The only real purpose of taxes is to drive value into the economy (see Sectors, below). Taxes are a way to move value back from the private sector into the public sector. Deficits are the opposite. Deficits are a way to leave value in the private sector. For example:

if the Department of Defense spends $100 buying a wrench than the private company that sold it to them, let’s call this company Schmoing, gets that $100. The value has transferred from the public into the private sector. If Schmoing than turns around and pays their wrench supplier, ACE Hardware, $15 for the wrench, $15 of the value transferrs to ACE and $85 stays with Schmoing. If ACE than turns around and pays the actual maker of the wrench, a firm in China called Wrenches!, $5 for the wrench than $5 of the original $100 has now moved outside of the US economy. When tax time rolls around, Schmoing and ACE both pay taxes against the profit they made on the sale of the wrench. ACE pays $1 and …now here you know this is just imaginary because in the real world Schmoing would pay nothing…but back to the story, Schmoing pays $9. So, of the original $100, the government received $10 back in taxes and $5 went out internationally (to China) leaving an $85 federal deficit but that money didn’t evaporate. It is still here, in our economy, in the private sector, which is where we all agree we want to keep the majority of the assets of the country.

Sectors

Just as math is math, accounting is accounting. There must be balance in the balance sheet. Understanding that the balance is more macro than we commonly think is why it is so difficult for us to accept that a federal deficit is a good thing. The federal government isn’t balancing a federal budget – they are balancing an economy. These are very different things. If they were balancing a budget, like certain legislators keep insisting is a necessity, than the worry would be that income (taxes) and outgo (government spending) are balanced. This is way,WAY TOO SMALL A VIEW and it’s wrong.

Our economy is divided into three sectors and it is these sectors which need to be in balance. The three sectors are the private sector (individuals and business), the public sector (local, state and federal governments) and the non-domestic sector (foreign individuals and businesses, domestic monies which get moved into foreign tax shelters, and foreign governments). As always in accounting, one sector’s asset is another sector’s liability. This is seen in the example given above when the $90 liability of the public sector becomes the $85 asset of the private sector and the $5 asset of the non-domestic sector. MMT has, therefore, two rules: all sectors cannot be in surplus at the same time and all sectors cannot be in deficit at the same time. Accounting has these same rules. This is nothing new.

As we all know all too well, the private sector cannot last for long in deficit without the economic consequence of recession becoming apparent. Likewise, at least in the US economy, we are not going to be without a trade deficit any time soon. I’m pausing here so you can all stop on the tracks and pay attention to the gigantic epiphany train that is about to mow you down. Yes, people, if we don’t want the private sector to be in deficit and we can’t have the non-domestic sector in deficit than the only option is to have the public sector run a deficit. It’s a basic principle of accounting. It isn’t complicated.

It just isn’t what we have been taught. We have been taught to view the US budget as if it were separate of you and I, an independent entity which required internal balance. Instead, MMT proves that the public and private sectors are two of the three legs upon which this meta entity, the US economy, stands. So when you hear legislators scream about a deficit or you see a Tea Party protestor carrying a sign that says “Say NO to Socilism” on one side and “Don’t Mortage My Daugters’ Future” on the other side (after you get done laughing at the spelling) the response to this is simple – better you than me because you, meaning the US Treasury, can issue currency as you need it and I can’t.

So why are Italy and Greece in so much trouble with their deficits? That’s obvious. Neither country has control over its currency. Currency itself is, indeed, limited and has become, essentially, a commodity. In the overall European Union ecosystem, essentially, Germany has boomed at the cost of Greece and Italy. It’s that balancing thing again. Still, it’s easy to think of it this way. In the mid 1990’s, Italy had approximately X debt. They were not in crisis. They were a fully functioning economy and they paid their debts in Lira. Today, Italy also has X debt. Notice that this is the same amount. they are not any further in debt than they were but suddenly it is a debt crisis. Why? Well, it’s the Euro, of course. Italy is at the mercy of the Euro and there is no advantage to the Euro in favoring Italy so Italy is drowning under a bad debt they cannot pay with limited Euros.

What we want here in the US is what MMT theorists refer to as a good deficit. A good deficit is one which operates in an unconstrained way in terms of time and arbitrary limits. By contrast, fiscal austerity is deficit by design. Fiscal austerity directly impedes the growth of the private sector. New wealth is only created by the issuing monetary authority. Here, stand on this other train track while I explain this part. (Pay no attention to the giant locomotive that is moving in your direction.) I’ll return to the previous example.

Let’s say Schmoing sells that $85 wrench to Borthrop-Humman instead of the federal government. The value has passed from Borthrop-Humman to Schmoing but it remains in the private sector. It is not new wealth it’s just recycled. Even if Schmoing built the wrench from scratch, all the components were purchased from within the private sector and on the balance sheet the value still remains there. None of it is new. BAM! *splat* *train wooshes by* Yeah, I know. I felt that way too. I always thought that because we built the thingie we were creating the wealth. My bad. I forgot that we may be building the thingie, the wrench in this case, but it has no monetary value. There is no money to pay for the wrench unless the issuing authority has issued said currency into the system and that can only be done by taking less out in taxes and/or pushing more in with government spending.

Professor Stephanie Kelton, Research Scholar at the Levy Economics Institute and one of the leading authorities on MMT has this to say,

So, let’s focus in on a specific period of time. The period in the late 1990s and early 2000s when for the first time in decades the US government ran budget surpluses…. Many people would inherently think that would be a good thing. It shows fiscal responsibility. Not only did they balance the budget, but they put it in surplus. Meanwhile, our current account deficits were huge. The rest of the world was running large positive balances against the US. That reduced US private-sector savings. Surpluses fell. It pushed the private sector into deficit on an unprecedented scale. The private sector went from surviving above the zero line to being pushed below zero. And the private sector remained there for a period of years, spending more than its income, borrowing to do it. And it was all fueled by a massive bubble economy that ended in recession, which drove the public sector’s balance back into deficit where it belongs.

When an economy is already in recession what it needs most desperately is new wealth and, with a fiat currency, that can only come from the issuing authority.

Inflation, Currency Exchange Rates and Unemployment

When was the last time your foot hat the flu? That’s because the flu is systemic. When one part of your body has it, your whole body has it. When an economy is in recession, it is systemic. Everything is effected. It is a meta problem. The odd thing about the US is that we have made choices to try to resolve our crisis without using the single most powerful weapon we have at our disposal. With any fiat currency there are only three things to watch for and none of them are deficit spending. The three economic delimiters are inflation, exchange rates and unemployment. As you can see, these things relate, directly, to each of the sectors.

In the past, deficit hawks and doves alike have tried to assail MMT theorists with the inflation argument. Just within the last three years some of the biggest names in economics, including some of the leading economic advisors to the US Department of Treasury and the Fed, have come to realize what MMT theorists have long known. If you are the issuer of the currency, you do not have to be at the mercy of bond vigilantes. As I said many paragraphs back, the US does not need to sell bonds or borrow currency in order to spend. These are habits and levers we employ as part of fiscal policy but they are not a necessity in terms of financing expenditures. It is interesting to know that the Secretary of the Treasury can order to be struck the currency of his choosing and deposit it in the federal accounts. Just like that. Congress would melt down in a fit of apoplexy, but it would be legal. The money gets injected into the economy and people go back to work. In fact, it would be easy and fast to open up the spigot and return the economy to “full” employment (approximately 3.7% unemployment) within the next two or three years at the most. An economy only gets inflationary, too hot, if new wealth continues to be pumped into the economy after the employment goal is achieved. Up until that time, provided there are no exigent commodity constraints, the supply remains in excess of the demand so inflation does not become a factor.

Again, from Professor Kelton,

Cash registers don’t discriminate. When you spend money in the economy there isn’t someone on the other end saying, ‘will that be public or private today?’ A dollar spent is a dollar spent. The federal government could SAFELY lower taxes, increase government spending, allow aggregate demand to increase.

Inflation is when demand outstrips supply. In the 1970’s this was because there was a sudden commodity shortage. The supply of oil was choked down to a trickle by the newly formed OPEC. Every product that used petrochemicals was effected. Trucks used to transport food needed expensive gas to get cheap lettuce transported across the country. The price of carrots went through the roof. Americans, with their huge gas-guzzling cars, waited in lines for gasoline. The economy could not take the shock. Unemployment rose at the same time prices spiked. Stag-flation was the new buzzword. This period is a classic example of what is called “demand-pull inflation.”

Money is not a commodity. It is not intrinsically limited. It is in no way comparable to oil (or gold). There is no reason that the US government should not be spending money to drive employment. The US dollar is not at risk of major devaluation and both short and long-term bond rates are at or just barely above zero. In other words, no one anywhere thinks the US economy is at risk of not being able to make its loan or bond payments. This is because all the investors, foreign and domestic, know that we are in full control of our currency. They are not at risk.

Final Thoughts

We have all become comfortable with viewing the federal budget just as we would view one small part of a much larger elephant. We each imagine that the “wall” or the “rope” that is in front of us is the whole thing. We each think it looks much like our personal budget only on a bigger scale. In fact, the meta whole is orders of magnitude larger and that entire pachyderm is sitting on a train that is, once again, headed right for you.

Over the next few weeks and months, the President and legislators from both Houses are going to be fighting over an imaginary “crisis” they have dubbed the fiscal cliff. This battle is entirely unnecessary. Our leadership is so used to thinking in terms of the gold standard that they still don’t know that a whole new age has dawned. The emphasis of MMT is in the power of the State to move within a substantially increased policy space which is largely unconstrained by monetary limitations.

For my part, I’ve told you about it. For your part, please pass this information on to your legislators and to anyone else you know. Post it on your Facebook page. Design a bumpersticker. Just don’t stay quiet.

I’ve digested quite a bit on MMT in recent weeks. I even read some of it before I ate it. A lot of what read really gets down into the weeds but some was quite accessible and can be found in the following places:

Professor Stephanie Kelton manages the New Economics Perspectives website and is on Twitter as deficitowl . The quotes above were from her excellent interview for Meidaroots. You can also download the truly fabulous podcast she did last week on The Majority Report with Sam Seder.

The Modern Monetary Theory Primer by Dr. L. Randall Wray is a bit weedy but essential for all those interested in MMT. This is the beginnings of what appears to be on its way to being a textbook.

Joseph Firestone who blogs on DailyKos as LetsGetItDone and at Corrente.com in their MMT blog does a commendable job of drawing all the big concepts together.