Modern Monetary Theory and Mr. Paul Krugman: a way forward

By Pavlina Tcherneva

There is nothing more deceptive than an obvious fact.”
— Arthur Conan Doyle (The Adventures of Sherlock Holmes)

The fact that the U.S. government is a monopoly issuer of the U.S. currency is an obvious fact. The fact that an issuer of a currency doesn’t need to borrow its own currency from anyone else in order to spend is also an obvious fact. So is the fact that a sovereign currency nation that issues two government liabilities—government bonds and central bank reserves—can always issue such liabilities and convert one into the other ad infinitum. And yet there is nothing more deceptive than the significance of these obvious facts.
Mr. Krugman in his Friday NYT blog engaged Modern Monetary Theory on these facts and received considerable flack from MMT economists and supporters for misrepresenting MMT’s assertions. Frankly, I was pleased to see Mr. Krugman address our work and was really not surprised by some of his objections. After all, he is making the same arguments we’ve been addressing for the last two decades, since the very early days of MMT. I am surprised, however, that he has relied on hearsay or critics of MMT, rather than our own writings to do them justice. Over those decades we have elucidated our position in great detail in various books, journal articles, blogs and papers (probably the most systematic responses to MMT critiques that are accessible to non-academic audiences can be found on this blog, Bill Mitchell’s, and Warren Mosler’s). Many more amazing and intellectually curious people have engaged with these ideas, and have started their own blogs (see links on this blog). There are plenty of primary sources on MMT not to mischaracterize it!
But this is an opportunity for dialogue because we are all on the same side here. We are all convinced that poor understanding of the economy leads to bad policy. For MMT, poor understanding of the monetary system leads to especially bad policies. So if we do anything together, Mr. Krugman, let’s build one bridge and let that be a bridge of understanding of what the possibilities are under sovereign currency regimes.
Here I want to make the simple point that it is not sufficient (although it is necessary) to just recognize these obvious facts; indeed we must have a framework for thinking about these facts to move economics and policy forward. Yes, you recognize that we are a sovereign currency nation, but nevertheless conclude in your second piece on MMT that we can (at some point) become insolvent. Your argument looks at bond vigilantes’ behavior to which I will turn in a second.
It is an obvious fact that the U.S. government’s liability is unlike those of the private sector, because only the government pays by using its own liability and there is no limit to which it can issue those. This has been an important point of departure for MMT, but it has been recognized by some of your saltwater colleagues as well. And yet, they have not been able to provide the intellectual leadership to move us forward.
Let’s take Mr. Woodford, for example — a saltwater star economist, who developed the Fiscal Theory of the Price Level (FTPL), which I must admit I have criticized considerably. Problems with FTPL and DSGE models, notwithstanding, Woodford has recognized the obvious fact that sovereign currency nations cannot default on their obligations:
“A subtler question is whether it makes sense to suppose that actual market institutions do not actually impose a constraint … upon governments (whether logically necessary or not), given that we believe that they impose such borrowing limits upon households and firms. The best answer to this question, I believe, is to note that a government that issues debt denominated in its own currency is in a different situation than from that of private borrowers, in that its debt is a promise only to deliver more of its own liabilities. (A Treasury bond is simply a promise to pay dollars at various future dates, but these dollars are simply additional government liabilities, that happen to be non-interest-earning.) There is thus no possible doubt about the government’s technical ability to deliver what it has promised…” (Woodford 2000, p. 32)
Even more surprisingly, Woodford has used this logic to make the point that:
“it is possible for a government to finance transfers to an initial old generation by issuing debt that it then ‘rolls over’ forever, without ever raising taxes” (2000, p. 30).
In other words, programs like Social Security are forever sustainable! Some may wonder why an economist of Mr. Woodford’s standing would make such a claim and yet remain silent at a time when Social Security, the most popular American social safety-net, is under attack by deficit hawks. The reason is because recognizing a simple and obvious fact does not provide the tools for intellectual leadership.
Does the recognition that sovereign governments like the U.S. (he calls these Non-Ricardian Regimes) cannot possibly default on their obligations tell us anything about what fiscal policy should look like? NO, it does not. Does it give guidance on what stabilization policy must look like? Absolutely not. There is nothing in this work of use for economic policy. The reason is that the recognition of this obvious fact has been coupled with a whole series of flawed assumptions, problematic models, and dubious transmission mechanisms, which lead him to conclude that government spending is inherently inflationary.
You too made this logical leap and argued that in normal circumstances when:
“we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation”. (NYT, March 25, 2011)
There is a problem with this claim. As MMT has demonstrated through the use of double-entry book-keeping, in reality, the government always spends by crediting bank accounts, i.e., by creating ‘money’. Yet, considering the inflation data, we’d be hard pressed to make the case that government spending in the postwar era has set unsustainable inflationary processes in motion, much less hyperinflation. Inflation is not a function of too many liabilities in circulation. But both you and Mr. Woodford are assuming that this is the case.
There is another problem with your arguments. You are saying that because government spending has to be financed by the private sector, it can be held hostage by the bond vigilantes. In other words, you argue, the government still needs someone to buy its debt before it can spend. This is not the case as we have explained in detail in our blogs. But even if we assume for a moment that this were the case, how are these bond vigilantes going to finance the government debt? What will they use to buy these bonds? The answer, of course, is reserves. The next logical question would be: how did these reserves get into the hands of the vigilantes in the first place? And since we know that reserves come from one place only – the government – they have to be spent into existence first before they can be used to buy bonds. In other words, government spending is financed through reserve creation by the Fed, not through borrowing from the private sector. We know of course that the Fed cannot force reserves on the banking system (Post Keynesians have made this point for decades, but mainstream economists have come around to understand this too). When the federal government spends, however, be that on military aircraft, Collateralized Debt Obligations, or Social Security, the Fed clears all government spending by crediting the bank accounts of Boeing, Goldman Sachs, or grandma (or anyone else for that matter who gets payments from the government, be they in the form of contracts, bailouts, or income assistance). This is how government spending creates reserves. Bond sales only drain any excess reserves from the system, to allow the Fed to hit its interest rate target, sales which are no longer needed since the Fed started paying interest on reserves (see here).
Now, many saltwater economists use Woodford’s idea that if the government injected bonds into the hands of the population without committing to raising taxes in the future to ‘repay’ these bonds, this bond injection will create net wealth in the hands of the private sector that would produce a wealth effect to stimulate the economy. The logic of this argument is completely upside down. There are two main problems: 1) ‘A bond injection’ does not increase net wealth, because households/investors give up reserves in order to buy Treasuries. Their net wealth position remains unchanged since they lose one asset (reserves) and gain another (a Treasury)—both of which are liabilities and a monopoly of the government. 2) It is a huge leap of faith to argue that more reserves or bond holdings would create a wealth effect. It might, but the transmission mechanism is highly problematic—the banking sector is bursting with reserves as we speak, yet bank lending to consumers and investors continues to be sluggish. The textbook money multiplier is completely wrongheaded and the transmission mechanism from reserves to deposits is fundamentally flawed. Putting aside Milton Friedman’s famous mea culpa and admission that the Central Bank cannot control the money aggregates (Financial Times, June 9, 2003), MMT has always said that it is loans which create deposits, and loan creation is never reserve constrained. Bank lending is based on the credit worthiness of borrowers, bank liquidity preference, capital requirements, regulation, but not on the availability of reserves. Reserves are provided by an accommodating Central Bank after the banking sector has made its loans, which have created the deposits that are subject to reserve requirements.
Note, however, that when a commercial bank makes a loan and creates a deposit, it can get reserves from the Fed (in order to meet its reserve requirement) in two ways: 1) it can borrow them (either at the discount window or through repos, i.e., through temporary OMOs) or 2) it can sell securities outright to the Fed (permanent OMOs) in exchange for reserves. When commercial banks borrow, they acquire an asset (the reserves) and a liability (borrowing from the Fed) so the net wealth position of the private sector does not change! When they sell securities to the Fed to get reserves, they lose one asset (a Treasury security) and gain another (reserves). Again the net wealth position remains unchanged.
Fed direct lending and temporary or permanent OMOs do not change the net financial wealth of the private sector. However, government spending does! When the government spends, private agents get reserves in their bank accounts. The banking sector will then convert these excess reserves into interest bearing assets—Treasuries. Bond sales are only undertaken by the Fed to drain reserves from the banking system and hit its interest rate target. Reserves come first and borrowing comes later. It is government spending that adds net new financial assets to the private sector. If you prefer to use Friedman’s analogy, helicopter drops of money are fiscal operations.
Another saltwater economist seems to get this. That is Mr. Bernanke who knows that the Fed cannot rain reserves unilaterally on the population or that the government cannot technically go broke. But he too has not provided much intellectual leadership even though he has a unique responsibility to do so.
Now, Mr. Krugman, you argue in your blog that “the rapid growth in monetary base since 2007 has taken place because the Fed is trying to rescue the economy, not because it’s trying to finance the government.” This statement is not quite correct because the Fed cannot adequately rescue the economy without financing its government’s purchases, like those of toxic financial assets. Note, the Fed has been lending to the private sector too, but this does not increase the net financial assets (NFA) in the hands of the private sector (a requirement for the saltwater economists’ presumed wealth effect). But according to Bernanke, a wealth effect can be generated, when the Fed finances government spending, (which as MMT’ers have been saying, it always does).
As I have explained in detail elsewhere Bernanke’s recipe for fighting crises and deflationary forces depends on fiscal policy (forthcoming in the Journal of Post Keynesian Economics, Spring 2011). Bernanke clearly recognizes that the Fed cannot increase the holdings of net financial assets (NFA) of the population without the Treasury. Only when monetary policy finances government spending are NFA created into existence. This is what he calls the fiscal components of monetary policy. When the Fed buys toxic financial assets from private banks, it buys worthless (or almost worthless) private sector assets on behalf of the Treasury and replaces them with reserves. Because a private sector asset is also a private sector liability, there is no net wealth created by the private sector as a whole when, for example, one private sector entity issues a CDO and another one buys it. But when the government (or the Fed on behalf of the Treasury) buys the CDO, it provides an asset – a reserve (in exchange for the nonperforming asset), while the issuer of the CDO is no longer liable for his payment. In other words a private sector liability has been extinguished whereas the toxic asset has been replaced by a default risk free asset—the government’s liability. Some private sector entity doesn’t have to pay up anymore, because the Treasury just did. So NFA in the private sector as a whole have indeed increased.
Also, when the government sends everyone a check in the mail (think of the Clinton or Bush Jr. tax cuts), the Fed clears them and creates what Bernanke has called ‘money financed tax cuts’. Bernanke has clearly stated that there is no limit to which the government can finance these.
“Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero… The U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” (Bernanke 2002)
In fact, Bernanke prefers money financed tax cuts to any other type of ‘alternative monetary policy measure’ (see Bernanke 1999). He prefers fiscal policy as a stabilization policy (or to use his vernacular he prefers these types of fiscal components, see here for details). Bernanke has also stated that we are not using taxpayer money to finance these fiscal components, just like we are not using taxpayer money when we lend to banks. The way the government spends or lends is by crediting bank accounts to private agents.
Scott Pelley: “Is that tax money that the Fed is spending?”
Chairman Bernanke: “It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.”
(60 minutes interview, June 7, 2009)
Why then is the Chairman appearing before Congress arguing that we have a long-term deficit problem and that Social Security and Medicare must be scaled back? Where is the intellectual leadership from this saltwater economist on issues of policy?
Mr. Krugman, you have also made this claim, namely that the government will eventually run into difficulty meeting its long-term obligations. My question is, if the Fed can clear any tax cut check that we get in the mail today, it can certainly clear the social security checks we will get in the future. If the government faced no technical limits to buying toxic financial assets, it clearly can pay for grandma’s social security today and mine in the future. More than that, the government can buy the labor of the unemployed today and put them to work on useful projects. The important question is what can we buy with these checks? MMT has always argued that we have to get past the illusion of financial constraints to start asking the meaningful questions of what the real resource constraints of our economy are and how to employ the idle resources to overcome these constraints in order to provide for the young, poor, unemployed and elderly and to increase the standard of living for all.
There are many economists who still don’t ‘get’ these obvious facts, but a number of saltwater economists do. Yet, ‘getting’ these obvious facts is not enough. We have to, indeed we must, engage in a conversation about the kind of spending we should be financing. Clearly we can finance any kind, but different types of spending will produce different real outcomes. Spending on anything politicians want without limit is absolutely the wrong conclusion to draw from recognizing the obvious fact that sovereign governments do not go bankrupt without self imposed political constraints (e.g., debt limits). Instead, we must ask the question: should the government be buying the junk of the financial sector or should it be buying the productive services of the unemployed? What type of government spending would pose greater risk of inflation than others, when would that happen, and in which sectors?
I’ve already argued that the mainstream cannot offer intellectual leadership on this last question because it assumes inflationary effects from government spending, all evidence to the contrary. MMT can and does fill this intellectual void. We have explained the problems with the traditional view of inflation and have ourselves offered policies for price stability. This work has also been concerned with true inflation beyond full employment and has offered a recipe to address it. We are worried about hyperinflation, and have carefully explained why Zimbabwe and Weimar Germany are extreme and unlikely special cases. From inception, we have been concerned with real economic problems like unemployment, and have argued that we can and must put the unemployed resources to work. We have objected to the inhumane notion economists hold that we can use unemployment to fight inflation and have provided alternatives. We have spelled out the key ingredients of what responsible fiscal policy would look like. We have offered specific policy proposals for addressing this crisis and our long term real economic challenges – policies, such as a payroll tax holiday and the job guarantee. We have argued that Social Security is not broken and that we can always make payments to the retired, but we have been very concerned with what the elderly can buy with these payments. We have always focused on the real productive capacity of the economy and whether it can generate the goods and services that the elderly will need. We have worried about the environment and have suggested specific policies for environmental renewal and sustainability. And on and on and on…..
So Mr. Krugman, let’s get past the obvious fact that sovereign currency nations are not financially constrained in their spending and start thinking about the genuine economic possibilities such systems can provide. Only then can we engage in the dialogue that we so desperately need. As I have argued before if we keep confusing solvency with sustainability, we will remain hostage to dated notions of insolvency, and will never get to ask the meaningful questions of what the government should do and how it should do it? But if we start this dialogue, I am sure that we will find a lot of common ground—and you will see that MMT has very specific proposals to prevent the government from running amuck and spending irresponsibly. We can and indeed we must challenge the current state of economic thinking and propel a new generation of economists forward—economists of the real world, not of the archaic textbooks.

23 responses to “Modern Monetary Theory and Mr. Paul Krugman: a way forward

  1. "how are these bond vigilantes going to finance the government debt? What will they use to buy these bonds? The answer, of course, is reserves. The next logical question would be: how did these reserves get into the hands of the vigilantes in the first place? And since we know that reserves come from one place only – the government – they have to be spent into existence first before they can be used to buy bonds."From my reading of MMT the above quote represents its central error. The private sector creates money too, lends it into existence. Private people and businesses become indebted to banks, not to CBs, a mechanism or process MMT claims "nets to zero." That assertion gave me no end of trouble.After much pondering, I have come to see it like this. Interest is owed on those private-sector debts, and repayment of them is, in the messy money-scarcity generated by the uncreated-but-owed-interest, as well as in the general melee of the economy, 'asymmetrical.' That is, it is not the case that the famous 10 people all loaned $1,000 at 10% repay equally successfully what is owed, such that only one of them defaults. Maybe three default and five do just about ok while two do very well indeed in the hot economic competition purposefully ignited by the money-scarcity. In this way new 'money' is created by banks via very unequal success in the economy; perhaps of that created $10,000 dollars the banks only 'retrieve' $7,000 (of which some will be 'profit' from interest), but the 'missing' $3,000 are now owned (not owed) by the two successful firms, and held on account in the very banking system that extended the loans. A kind of upward-spiraling leap-frog with casualties. Since the $10,000 didn't exist in the first place, this is a 'win' for the banks. How else can it be that the money supply expands ahead of and beyond what the CB injects (I'm thinking of Steve Keen's "The Roving Cavaliers of Credit" here)?Also, the mentioned reserves are fractional. The percentage of money loaned by banks relative to those reserves, while it should be this or that amount, seems always to be a mystery. As I recall, Ben Bernanke even suggested the reserve requirement should be abolished completely. And what are these reserves anyway? Are they really notes and coins alone? Or are they also 'assets' acquired somehow, maybe houses, or shares, or derivatives, or businesses, or works of art, or whatever? Furthermore, such assets have no scientifically provable value, so who is to say what banks can lend into the economy? And who can ensure they stick to reserve requirements? Not 'who is supposed to.' Who can.In short, the private sector banks and private sector money creation seem to me to be the blind spot in MMT theory, the 'leak' if you will. If I am wrong on this, I am happy to be proven so.Another question-set. How is it that money, which is nothing more that addition and subtraction with percentages, is so controversial? Why is it that economists can't agree on how it works? What more important part of economics is there? That's the really important mystery, the one that must be solved.

  2. Wouldn't it be great if the economic advisers to TPTB could understand the the points which Pavlina has presented? Should that could occur, maybe the politicians could at least be informed that their misguided political ideas have no sound economic defence. Of course, the politicians might continue to wreck the USA for the benefit of their oligarchic (military-industrial complex, banksters, resource exploitation/energy barrons, etc.) patrons, but without endorsement by the economists or by the majority of rational/responsible citizens.

  3. Great article!"When the Fed buys toxic financial assets from private banks, it buys worthless (or almost worthless) private sector assets on behalf of the Treasury and replaces them with reserves."Isn't that a crime – stealing? Anybody in jail?Why then they didn't do the same with Lehman Brothers?

  4. This reflects outstanding scholarship. This piece and "Bernanke's Paradox" do a great service to the profession by connecting common ideas and themes found in mainstream and post-Keynesian literature. Thank you for taking on this intellectual leadership in such a timely fashion. It's remarkable how quickly you (and others) have been able to respond to Prof. Krugman's comments in such a comprehensive and persuasive manner.

  5. TBP blog: QOTD: As QE II Wraps Up . . . Article would have been a great link at the beginning of my blog post (below):——QE should really stand for Questionable EthicsQE I was really Bank Back Door Bailout I (BBDB I) – FED buys toxic MBS assets that the private market would not touch at price levels that would keep the banks solvent. The FED did the toxic asset purchase that TARP was supposed to do, but without congressional approval and under the guise of Monetary Policy (QE).QE II – Wizard of OZ II – Pay no attention to the wizards (BB & Timmy) behind the curtain. Creates continuous distraction and debate while gaming the system.* enables record deficits by effectively circumventing the law that the UST can’t have an overdraft at the FED* keeps interest rates low as FED will meet all bond demand (essentially infinite demand)* effective interest rate on bonds held on FED balance sheet – zero, as FED remits profits back to UST, these profits come from UST paying interest on bonds (and through the fog of deception the FED has the gull to claim that record profits are returned to the UST).* Provide backdoor gift from the FED/govt to the banks/PD for ‘laundering’ the bonds between UST and FED – front running for the xx basis point spread.* Provide backdoor gift from the FED/govt to banks by paying 25 basis point Interest on Excess Reserves (IOER)* QE does nothing to provide liquidity for bank loans – banks loan on the capital base, they can convert bonds and other collateral to loan deposits and access reserve requirements via repo, interbank borrowing and the FED window if necessary. It is not capital or liquidity that prevent banks from loaning money, it is lack of loan demand, tighter lending standards and delevering (either through payback or default) that is occuring.On the bright side, if folks would understand what is really going on. The more the FED buys bonds and held on the FED balance sheet the less effective interest rate is on the national debt. This could be considered a dry run for eliminating the bond market and FED. This perverse QE activity is validating that fact the gov’t spends independent of the bond market. This is shattering the facade that the US Bond market is an open market process to set interest rates and control gov’t spending. We are seeing that the FED sets the rates through systemic manipulation and gov’t spends unconstrained by either the “bond market” and “virtual” debt cap.Proposal for QE III — Quick End III: The New Beginning* End debt based money regime, change from Federal Reserve Notes (FRNs) to US Dollar* US Dollar spent into existence by the gov’t, issued by the UST* Shut down the US Bond market – Interest on outstanding bonds paid in US Dollar, as bonds mature the principal paid in US Dollar* All inter government trust funds, convert bonds to US Dollar. Trust fund managers invest in private market investments and/or State, Muni, etc.* Convert all reserves to US dollar* Replace existing FRNs with US Dollars as they flow into the system or UST* Repeal the FRA 1913 and all subsequent laws – End the FED; absorb operational, economic monitoring, research and statistics into the UST* End TBTF doctrine – return to competitive free market principles of failure = bankruptcy – No gov’t bailouts.* Establish a neutral inflation/deflation policy for fiscal budgets (target balance) and tax policy* Repeal 16th amendment to eliminate corp and personal income taxes, replace with consumption tax and capital gains tax on speculative gains– consumption tax (e..g provides built in stabilizer tied to GDP dynamics – economy heats up, higher taxes and vice versa– capture capital gain when realized

  6. If you wonder why economists have such a bad name, here is the answer. The polemic between economists is so opaque and convoluted that the economists don't even understand each other. A normal well-educated politician, businessman or scientist does not stand a chance. Could somebody please explain in plain language what MMT stands for, why it is important, what it can do and what not. I remember from the book "This time is different" that nations do default time and time again, something MMT does not allow. Was that on their own currency? Best wishes, I hope you all get well.

  7. Toby,Here’s the way I look at it. But I certainly could be wrong:The private sector creates liabilities at will by making loans and crediting the accounts of their customers, but it doesn’t create money at will. These actions only lead to the creation of money if the lending institution is short of reserves and the Fed – ultimately -ends up creating more reserves in response and credits lenders' accounts through discount window loans. (They might credit the account of the lending bank’s account directly, or they might end up crediting other banks’ accounts who supplied the first bank’s needs through Fed funds loans.) The Fed routinely does this, but it doesn't have to do it for any given institution. Not everyone is too big to fail. So while the private sector is the main driver of money creation with its lending behavior, the Fed has to sign off on this money creation, so to speak.Yes, the total amount of promised money, liabilities, in the system is greater than the supply of base money in the system at any time. But that doesn’t mean that the money has already been created by these promises. As more goods and services are produced and the economy grows, money will correspondingly be created by government operations. But one possible government response to overleveraging, an excess of promises, is to put the breaks on support for some lending, and thus to raise the level of default.

  8. Krugman does is not arguing with MMT theory. He is arguing with MMT rhetoric. MMT shoots itself in the foot by going around proclaiming that 'the government budget constraint does not exist' and 'the US can never default'. But in Krugmans language, excessive deflation IS default/insolvency – they have the same meaning to him and others in positions of influence.You see, MMT may be theoretically correct, but it uses rhetoric that sounds too much like Dick Cheney's 'deficits don't matter'.Economists and others like having fear of 'government default' as a big rhetorical stick to beat the government with when they don't like how government spending is being allocated.

  9. Pavlina,Bernanke and Woodford are friends, former colleagues, and co-editors ("Inflation Targeting").So obviously they are very familiar with each other's research. Why do you think Bernanke rejects Woodford's FTPL? Why is a money-rain "non-ricardian" but a bond-rain "ricardian" in Bernanke's model but not Woodford's?

  10. The problem is that people go around saying they understand MMT and then make claims that are in direct conflict with MMT. Comments like banks loan money into existence is fundamentally flawed and if you understand MMT you would understand why. Or Krugman's deficits never matter which I challenge anyone to find in any credible MMT material. Additionally the statement that the US can never default is not what MMT says. What it does state is the operationally there is no way a sovereign monetary system can default. There are obvious political ways such as the enforcement of a debt ceiling. There is a great deal of published information available about MMT by some very credible authors. My suggestion would be to start with either or

  11. DanF, why can the US default while MMT states that operationally there is no way a sovereign monetary system can default?

  12. @DanF"Comments like banks loan money into existence is fundamentally flawed and if you understand MMT you would understand why."MMT states that private 'money' or loan creation nets to zero. I've yet to see anything in the literature that explains this to my satisfaction, so I'm asking that question here. Your statement does not bring me closer to seeing my error, if indeed I am in error. If we say the 'money' lent into existence is not money but credit that will 'disappear' from the economy when repaid, fine, but this is not the whole story. That 'money' is untraceable and is usable elsewhere in the economy by whoever received it as payment for whatever. This person deposits it in her account where is becomes her money, money she might not owe to anyone. From my point of view that is money lent into existence to affect exchange. That money is then a bank's reserves for further lending, and so on. Fractional reserve banking.If 'real' money is notes and coins, then it is approx. 3% of the total money supply, depending on how we define money. Via fractional reserve lending a bank 'issues' new 'money' into the economy. The debt must be repaid (expunged), + interest, and seeing as the interest is not created with the loan, either the govt is creating this 'interest' money via its spending in sufficient quantities, or it is not and we have money-scarcity in terms of debt-repayment. If money is sufficiently there, and if private credit-money nets to zero, why the debt crisis, how come so much domestic debt, how come bail outs? If that 3% figure is correct, then loans at 3% across the board (fat chance of that!) would mean the banks sucking up that 'real' money via interest payments. What they do with that money is up to them. They seem to enjoy gambling nowadays. i.e. not reinvesting it into the 'real' economy of things.MMT really attracts me as a systemic analysis of what money is and how its quantity might be controlled. I've read plenty of articles on it at Bill Mitchell's blog, as well as here, and at Naked Capitalism, but find the 'net to zero' part of the theory to be flawed. Far closer to reality, in my view, is the work of Professor Franz Hoermann, who envisages a far more radical money system, which takes the best of MMT's insights and goes beyond them to something truly revolutionary. I'm still learning about it though, so can't spell out the details here.

  13. If politicians pass a law that stops payments from the US government then those payments are in default.It is not because the US could not make the payment it was because the politicians choose not to make the payments. This can be imposed by creating a debt ceiling and not allowing payments to be made if the debt reaches a certain amount.Here is a link on the topic:

  14. Jon, MMT doesn't say any such thing. But basically no fiat currency has ever defaulted (40s Japan & maybe 90s Russia are extreme exceptional cases). Default is a legal/political matter. If a country goes insane, of course it can default. US debt is protected against default by extremely strong and well-tested constitutional protections.The simple central idea of MMT (& allied economic sects) is that all money is a form of credit/debt, and that the most fundamental kind nowadays is government money = government debt = government liabilites, the value of, the demand for which is driven by the government's demand for taxes. Money is definable as transferrable, assignable credit/debt.DanF & Anonymous, banks can create money "at will" – they can create "bank money" – bank liabilities. As Minsky said, "anyone can create money [credit], the problem is getting someone to accept it [as money]". People accept bank money as money, and it is money for almost all purposes, except for final settlements between banks and the government. Bank money is money because the government stands behind it – it says bank money is as good as government money when it accepts bank checks as payment for taxes, or equivalently, it gives banks discount window access. The Fed must do this – it isn't because the banks are TBTF, but because checks can be used for taxes.

  15. Excellent post. Clear, concise, precise, and well-documented. Keep' em coming.

  16. The U.S can default, but only voluntarily. It can't be forced into default against its will. Only by abiding by self imposed limits.This holds for all states/countries sovereign in their own currency (i.e they control a fiat currency without a fixed exchange rate to anything).A country that has a fixed exchange rate actually "defaults", in some sense, every time it devalues its currency, since a devaluation constitutes a failure to "pay up what was promised". (Right?)But even though the U.S (and other sovereign currency countries) can't involuntarily default, inflation can certainly occur. The currency does not lose it's value in one blow, but rather in a more continuous fashion, over time. Anonymous above (March 30, 2011 6:12 AM) states that Krugman calls this (inflation) "default" even so. Ok, whatever. But inflation is not "default" in the sense of "failing to pay up what was promised", but rather "money losing value".Anyway, inflation is a real (potential) problem, "default" isn't.(Have I understood MMT reasoning correctly? I think I have..)

  17. Hello and thanks for all comments. TO TOBY, MMT is completely consistent with private money creation. I urge you to look at Wray’s paper “The Credit Money, State Money, and Endogenous Money Approaches”. Bank loans create deposits (at the stroke of a pen/they do not NEED reserves to lend) and deposits create reserves when the Fed accommodates the banks' need for reserves, in order to maintain its interest rate target. The private sector can extend to itself more credit to pay interest on past debts and on and on. It’s a problematic process which Michael Hudson also explains very well. The Fed as the lender of last resort is the watchdog and must regulate what these private lending practices are and what systemic risk they may pose. Obviously the Fed didn’t do that. When the Fed provides reserves through OMOs, they only take eligible collateral, no questions asked about the overall health of the bank. But when they lend through the discount window they can look at the borrowing banks books (frequent discount window borrowers are subject to audit). We’ve said many times that the Fed doesn’t understand the power of its discount window.In any case, MMT is completely consistent with private debt creation processes. Whenever private debts evolve from Hedge-to Spec-to Ponzi finance (see Hyman Minsky) and we have crises, the Fed saves the day by purchasing (or lending against) those private debts and replaces them with reserves.To KNAPP:Bernanke disagrees with Woodford because he knows that the Govt can’t sell bonds to the public if they have not provided somehow the reserves first. Somewhere he says (I have it in my Levy paper 539) something to the effect ‘Woodford and I differ, but the message is the same ‘too many government liabilities cause inflation’,' which of course is the problematic assumption. I emailed Woodford to ask him how 'his bond drop' gets financed and he said “Ultimately the liabilities that matter for the purposes of my analysis are “both gov’t debt and the monetary base”. The exact quote is in the same paper. So it seems that Woodford too gets it, but his original formulation of the ‘bond drop’ takes place in a ‘cashless’ Dynamic Stochastic General Equilibrium (DSGE) Model. Go figure! An economic model without money! By the way, all DSGE models have no money, any if credit is extended at the beginning of the period, it is completely repaid at the end of the period, because we have perfect foresight, rational agents, and complete markets. That is, they have no default, whatsoever! Now how in the world can DSGE model provide anything of use to understanding the real world with these assumptions?!Thanks to everyone for the comments.Pavlina R. TchernevaP.S.: and, no, ‘inflation’ and ‘default’ are not the same thing. And, yes, sovereign currency nations can default voluntarily (for political reasons), but not technically/operationally. Nations can also default if they are not sovereign—have no control over their currency, have currency pegs, currency boards, monetary unions etc. And, yes, deficits DO matter in terms of their impact on inflation, income inequality, employment, etc…. But they can always be financed under modern money regimes.

  18. Thank you for your response Pavlina.I never claimed MMT was not consistent with private debt creation, I claim private debt creation does not net to zero. As for private banks creating credit, getting into difficulties, and the Fed being able to 'absorb' or buy up crap, that goes without saying, though I am not sure the Fed has saved the day. That they have to 'save the day' strongly implies there's no netting to zero.I shall read the recommended article in due course, and hope this comment, my third on this thread, makes it through the filters this time.

  19. Why doesn't MMT view the gold standard as a self-imposed constraint?

  20. Why doesn't MMT view the gold standard as a self-imposed constraint?Because the concept "self imposed constraint" is used to signify a constraint that is there only as a self imposed legal constraint that can be undone. It is imposed by the legislator but can also be adjusted, changed or undone by the legislator. The constraint is nobody elses business. This is not the same as a financial constraint, which has external stakeholders and cannot be undone by the legislator.A corresponding household example: Bill Gates might "decide" that he may only spend $100 on beer every week — no more, that's it, dammit. Note that this is not a financially imposed constraint — just a self regulation. If a nation voluntarily enters a gold standard, that action would be "self imposed" for sure, but when that constraint is there there will be no way to remove it without "defaulting" — i.e breaking a financial constraint, a promise to pay up — lot's of people are going to get angry (like I believe France was in 1971 when the U.S "defaulted" and exited the Bretton-Woods system — the Nixon chock).This is like if Bill Gates would give all his money away. It becomes not just a self imposed constraint that can be undone, but rather a real financial constraint that can't be undone. But if a nation just changes its own self imposed laws regardning budget deficits etc, that doesn't mean that external financial obligations will be unmet. No promises to "pay up in the future" will be broken. This is like Bill Gates taking back his self-promise to only drink beer for $100 a week, perhaps expanding it to $200.

  21. Thank you for this post Pavlina. I read Krugman's blog often and find that he is much in line with PK thought, it is frustrating that he doesn't understand MMT. Do you think you could respond to this more recent post: you!

  22. Pingback: | New Economic Perspectives

  23. Jerry Hamrick

    I stumbled onto the ideas of MMT just a few years ago when I was talking with some friends about some economic ideas discussed by my father and some other veterans just returned from WWII. They talked a lot over several years about many things concerning America’s future, and they often returned to economics. One of my friends told me that I should read about MMT and I have read a lot, and I have purchased some of the books. The ideas of MMT are indeed similar to those of my father and his friends back in the late 1940’s, but their method of describing how their ideas would be applied to help the common man were easier for me to understand than the discussions offered by MMT experts including yours in this post. The reason is obvious, while those veterans from six decades ago talked about real world economics you MMT experts talk about academic economics. You let the current powerholders who disagree with you dominate the discussion. Time after time I see MMT defenders start off by making common sense, but in a little while they start to argue with the economists who disagree with MMT while using economic jargon, and while arguing against an economic system that they know to be virtually worthless. I have made this observation to many other MMT writers and I have been ignored. But I will try again.

    You folks are going about this thing the wrong way. Nothing economic happens in this world until somebody sells something to somebody else. You are trying to sell MMT (I think) and you are failing. Your message is incoherent and causes an interested listener to turn away. Real people need real solutions that they can really understand. The disciples of MMT may have the solutions but they cannot explain them and therefore they cannot sell them. So if you feel that you are not being heard it is because your message is overpowered by self-induced static.

    Furthermore you need to ask yourselves who are your customers. Are they the economists you like, the economists you hate, the IMF, the Fed, schools of economics at various universities, government agencies, bankers, traders, or the ordinary citizens of the United States of America. Let me be direct. I have been reading the pleadings and complaints of MMT proponents for some years now and I must wonder just how stupid you must be to continue to do the same old futile thing…