Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems

by L. Randall Wray

Is all money debt? A: Yes, all money “tokens” are records of debt.

money of account is the measure (foot, yard, inch); medium of exchange is the thing being measured (shoe, arm, earlobe).

The question is: where did that money come from? Well, the purchaser of your property issued an IOU to a mortgage lender; the loan had to be a wee bit bigger to cover the extra property value due to the workshed you built.

demand deposit (the bank’s IOU, held by the depositor).

So all purchases with demand deposits have a loan somewhere in the background.

To sum up: real assets can get monetized when someone goes into debt.

bank IOU to her (demand deposit)

When government spends, it creates “net financial assets” for the nongovernment sector in the form of reserves or treasuries or cash.

Note that by double entry bookkeeping, every item is entered twice – once as “owned” and once as “owed”.

The government’s IOU goes up and that is exactly equal to the credit to the retiree’s demand deposit.

What we are getting at is that the private sector does not need to “go into debt” to get “money”, but only so long as the government supplies it.

What about real wealth? The government owns lots of real assets: bridges, roads, parks, public buildings, bombs, aircraft carriers, and so on. Those add to the total national net wealth.

Or, say that the buyer already has a sufficient credit to his demand deposit. Well, that is another infinite regress; it came from a loan.

In other words, the gold cannot become financial wealth unless there is a debtor to a bank, allowing the gold to be monetized through a sale.

also resist assigning monetary values to things like caring for your own children – something economists are wont to do.

is there a maximum government deficit ratio that is sustainable?

And many worry about the sustainability of the US trade deficit.

Anything carried to a logical absurdity is unsustainable. As you will see, this is the rigged game used by deficit warriors to “prove” the US Federal budget deficit is unsustainable.

To rig the little model to ensure it is not sustainable, all we have to do is to set the interest rate higher than the growth rate –

Remember, that is a big part of the reason that the GFC (Global Financial Crisis) hit: an over-indebted private sector whose income did not grow fast enough to keep up with interest payments.

The GFC is the equivalent to an explosion of Morgan that would prevent him from growing to an infinite size.

Galbraith shows that even a persistent (and “high”) primary deficit is sustainable if the interest rate is low enough, because the debt ratio will eventually stop growing.

Here are some possible consequences of a persistent deficit that grows fast enough to imply rising interest payments and debt ratios:

Inflation:

In other words the (nominal) growth rate will rise above the interest rate,

Austerity: government can try to adjust its fiscal stance (increasing taxes and reducing spending to lower its deficit).

The private sector will adjust its flows (spending and saving) in response to the government’s stance.

That is usually called the “wealth effect”. In other words, government debt is private wealth and as private wealth grows without limit this will eventually cause spending to rise relative to private sector income, reducing government deficits as tax revenues rise.

It takes two to tango and the likely result is that tax revenues and consumption will rise, the government’s deficit will fall, and the private sector’s surplus will fall.

to avoid an exploding debt ratio all the government needs to do is to lower the interest rate it pays below the economic growth rate.

To put it simply, there is a “flow” of Dollars abroad due to the current account deficit that is matched by the “flow” of Dollars back to the United States due to her capital account surplus.

Here is an interesting point: even though the United States is the “biggest debtor on earth”, the factor payments (interest and profit) flow in her favor (at least, so far).

Its interest rate is set by the Fed, which can always set the rate below the US growth rate (and, indeed, as Galbraith points out, the US inflation-adjusted interest rate is often below the “real” growth rate).

This does not normally raise great fear because the other side of that coin would be that the US could produce output to replace declining imports (most economists would celebrate that, as it would mean more US jobs).

Countries with huge Dollar holdings – like Japan and China – know that dumping Dollars would probably cause the Dollar to depreciate, meaning capital losses on their holdings.

They are sustainable. They will be sustained until the rest of the world decides not to accumulate more Dollars and Americans decide they really do not want the cheap commodities and environment-destroying oil produced by the rest of the world.

All “modern money” systems (including those of the “past 4000 years at least” as Keynes put it) are state money systems in which the sovereign chooses a money of account and then imposes tax liabilities in that unit.

This is the necessary and fundamental promise made: the issuer of an IOU must accept that IOU in payment.

It can be forced to default on its promise to convert if it does not.

This “promise to accept in tax payment” is sufficient to create a demand for the currency: taxes drive money.

In either case, the bank IOU is converted to a government IOU.

Lots of cash could increase the attractiveness to bank robbers, but the main reason for minimizing holdings is because it is costly to hold currency.

however, more important to banks is that holding reserves of currency does not earn profits. Banks would rather hold loans as assets because debtors pay interest on these loans.

This also leads to a discussion of “pyramiding”: in modern economies that leverage liabilities, it is common to make one’s own IOUs convertible to those higher in the debt pyramid.

To hit its interest rate target, the central bank must accommodate the demand for reserves – whether the ratio is 1 percent (about where it was in the United States

(Note: the required reserve ratio in Canada is a big zip, zero! That is the most advanced way to run the system.)

Higher reserve ratios do act like a tax on banks – they must hold a very low earning asset.

in an asset that earns a very low interest rate (the support rate paid by the central bank on reserves).

Will that affect lending rates earned (what they charge borrowers) and deposit rates paid (what they pay depositors)? Banks earn revenue on the spread between those two; that is how they cover costs and make profits.

Tax payments destroy monetary base (L1 + L2 declined), that is, the amount of central bank money tokens held by the public and banks.