By Michael Hoexter
An Adjustable Liquidity Source and Liquidity Sink
While it may seem obvious and a tautology to treat money as a “liquidity source”, sometimes, especially in an area of life where there are many unexamined assumptions, it makes sense to rehearse the obvious. “High-powered” state-issued money is treated within accounting as an individual’s or a businesses “most liquid” asset but anything that functions as money confers “liquidity” on any individual who possesses that instrument or thing. Liquidity means that that object or instrument can be readily traded for wished-for goods and services. This liquidity can extend to “money-objects” other than state issued currency but the latter is in most contexts the most liquid money technology that we have.
The public monopoly of the currency provides households and businesses with a valuable public service, a more or less trusted universal exchange medium that enables transactions to occur easily and with a shared measure of value. However the currency does not simply exist outside of or as an “add on” to government. Government creates the currency and injects it into the economy by spending the currency into the private sector. In an era of electronic currencies and transactions, the creation and spending of the currency are simultaneous.
Modern fiat currencies are a sophisticated and powerful monetary technology because they enable leaders/managers of the macroeconomy to inject liquidity into the economy where and when it is viewed as necessary while also fulfilling the public mission of government, however that is dictated by the political process of the nation. These spending (and taxing) powers associated with a fiat currency can also be misused especially if they are not yoked to both a democratic political process of some description as well as a technical macroeconomic accounting process that measures, reports and analyzes variables related to social and environmental welfare accurately. These variables include unemployment, inflation and, I would add, carbon intensity, carbon emissions and other measures of environmental sustainability. In sum, a fiat currency is an instrument of great economic power that is a fact of modern life but can also be used or abused, depending on institutional and political arrangements.
In a fiat currency system, the amounts of government spending and taxation are financially independent of each other and can only be linked together by a political but not a financial or economic constraint. The spending of a fiat currency-issuing government is not dependent upon taxes collected to fund government spending as monetary units are not tied to some external limiting measure of value, like gold bullion or another metal. These precious metals are and were of course as arbitrary a measure of value as any other; they were simply an agreed-upon convention that itself was self-referential. The political right, which in many matters related to overall social welfare tries to limit the role of government, expresses nostalgia for the gold standard because it wants to use the limiting factor of a metal standard to control government’s role as a macroeconomic manager. In a fiat system, the currency is simply created by the government spending and with that spending liquidity is created in a particular sector of the economy into which the government has spent the money. The implementation of a fiat currency does not necessarily lead to inflation but it will tend to “err” on the side of inflation as the gold standard “errs” on the side of deflation.
In both a fiat and a metal standard monetary system, taxation by the central monetary authority drains liquidity out of a sector or activity of the economy, buffering the potentially inflationary effect of the money injected into the economy by government spending. The central bank affiliated with government can also continue to indirectly control the amount of money in circulation by braking or accelerating the private banking system’s drive to lend money by raising or lowering the interest rates. The division however between monetary and fiscal policy does not make sense in a fiat currency system; both the targeting of interest rates via the operations of the central bank and of fiscal policy (spending and taxation) are all part of the monetary system.
In a fiat currency system, the government also does not need to “ask the permission of” bond markets to spend more than taxes collected or “borrow” the currency from a foreign power or the domestic or international private sector. The institutional arrangements that require, for instance, the US government to issue bonds in the amount of budget deficits, creates the appearance of either “asking permission” or “borrowing” from the private sector or the rest of the world are political arrangements that are in part relics of the gold standard era where a government would have to back its currency by finding gold reserves somewhere to “back” deficit spending. This is an atavism from the gold standard era that needs to be revisited in light of our understanding of modern fiat currencies as well as the inevitable fiat element of all historical currencies. The source of the US dollar is the US government, not, for instance, the Chinese government.
To avoid excessive inflation or currency devaluation, the monetarily sovereign government also functions as a liquidity “sink” as well as a liquidity source, tamping down economic activity in a focal or more generalized way. The government can, for instance, impose higher taxes on the wealthy or on certain activities that are deemed socially harmful like financial trading or fossil fuel use. Higher taxes on the wealthy may blunt income inequality but do not solve the problem of the continual draining of liquidity from middle and lower socioeconomic strata, the people who are compelled to spend more of their money because of lower incomes. Therefore, as has resulted from the historical development of the welfare state, much deficit spending is in various social support programs like healthcare, education, unemployment insurance, and old age pensions which helps maintain effective demand for real goods and services among the middle and working classes.
Despite the inflationary “bias” of fiat currency, government has some ability to anticipate as well as track inflation and if there are inflationary pressures on the economy, the government can impose taxes which drain liquidity from the economy in a systematic way. Also monetary policy, the setting of interest rates, can dampen the contribution of private credit creation to inflation, which is more typically categorized as a inflation-fighting measure in current mainstream economics.
In summary, the reason that fiat currencies exist and are superior to currencies tied to a commodity like gold or to the value of other currencies, is that they are adjustable liquidity sources and sinks. By increasing spending above the amount of taxation (so-called “deficit spending”, which I have proposed should be named government’s “net contribution”), the managers of the macroeconomy in government, spending and taxation authorities like the US Congress, the President and the Treasury can compensate for the “natural” long-term draining of liquidity from the economy within capitalism by the tendency towards concentration of wealth. A fiat currency where deficit spending is allowed to occur thus enables growth to occur, as a fixed stock of money throughout the entire economy would stagnate or shrink the economy. Additionally using the tool of the fiat currency, the leaders of the macroeconomy can compensate for trade imbalances that will leave countries with trade deficits drained of monetary resources relative to their trading partners by injecting more liquidity into the economies of net importers than their governments remove via taxation. Otherwise trade imbalances would eventually shrink or collapse the economies of both net importers and eventually net exporting nations.
Of course, the government also spends to fulfill a broader public purpose beyond maintaining the liquidity of the economy. Spending on vital services that can only be supplied by government may take precedence in times of crisis and also during some periods of history create inflationary pressures which must be countered for instance by price controls, such as often happens in wartime.
The “Conservative” Perspective of the Householder or Business Owner on Money
The notions of injecting or draining liquidity from the economy, one independently of the other, are very far from the perspective on money that a householder or a business owner generally have. Businesses and householders are “budgetarily constrained” meaning that they must operate with the notion that there exists in practical terms only a fixed amount of money in their accounts now and new money of necessity must be acquired from outside themselves or their organization: they must either borrow it or receive it in payment. While it is not critical for a currency issuing government to save its own money in a bank account from one accounting period to the next, for a household or business this activity is, besides sustaining oneself and one’s family, the point of economic activity in a capitalist economic system.
It may help then for households and businesses to then view money as if it is, in terms of physics and not politics, a conservative system, as a closed system with a limited number of items in it, which are shuffled or rearranged between a set of economic actors very much like themselves. Within the bounds of the system, matter and energy are conserved in the physical version of a conservative system and in the economic version, money is conserved, neither growing nor decreasing in amount. Households and businesses MUST “economize”, i.e. maintain their expenses below their income, in order to survive and/or to save. Conventional accounting, which is also used and sometimes misapplied for the accounting of fiat currency-issuing governments as well, operates according to this principle which recognizes only that has been taken in and what has been spent and creates from that a balance sheet. The goal of saving money and of managing a limited budget are paramount concerns for householders and businesses, all of which are predicated on the constancy and finitude of the store of money available. From the business or household perspective, the notion of money being created and destroyed in large amounts to achieve macroeconomic goals is an entirely different and, for many, an alien perspective.
The “micro”, on the ground, view of money is therefore different from that of the “macro” currency-issuing government but is no less real and it provides the individual householder or business owner with some sensible rules of thumb. Their ideas and attitudes about money are however not very helpful guides for macroeconomic managers in government to follow.
Austerity as Denial of Macroeconomic and Monetary Reality
Despite these clear differences in perspective and the differing truths that they reveal, there have always remained factions within economics and in the business community that could not accept that somehow the prescriptions for individual economic success and overall social welfare would differ. They insisted that saving was always and for every actor a virtue and that the experience of businesspeople was as applicable to government as it is to running a business. The so-called “Austrian” school, among which Keynes’s chief early opponent Friedrich von Hayek can be counted, insisted that market actors did not need the supervision of a government entity and that there were “natural” trends within markets and the pricing system which would stabilize the economy by themselves. Given a study of the history of the actual economy, the self-centered and stubborn naïveté of this view is exposed as laughable but unfortunately more widespread and influential than we would hope. Certain wealthy people, in particular, seem to feel that the route to their success is the route to the success of the entire society or, more likely, their success matters and is more important than the success of society as a whole. This is where the egocentricity of what might be called the hard-money view of government finance becomes a dangerous form of narcissistic entitlement, a malignant economic narcissism.
The austerity campaign has exploited the confusion and/or willful assertion by wealthy and powerful participants in the economy that the economic management of the economy as a whole and of individual businesses or households operates along similar principles. That neoclassical economics has no place within the structure of its main theory for money, let alone the mechanics of a fiat currency, has left an opening for austerity advocates to claim that governments should trim their deficit spending at exactly the wrong time and should attempt to “save” or accumulate money as would a household or business. The misapplication of business economics to the economics of national economies has already had harrowing effects everywhere it has been applied and there is no reason to believe that its application in the future will have any different results.
A critical element of modern macroeconomic management is realizing the potential of fiat currencies to inject liquidity into economies which are experiencing high unemployment, declining median wages, or where effective demand is undermined by large overhangs of private debt. The fiat currency’s independence of government spending from tax receipts enables managers of the macroeconomy in a downturn to up spending as much as needed to face any number of social and economic challenges facing the nation. Austerity advocates’ denial of the fiat reality of our currencies leads, as is currently the trend, to untold hardship and an utter failure to lead the economy out of its current socioeconomic and ecological morass.
Dear Prof. Hoexter,
Thanks for another fine piece of writing.
But “Net contribution” is I fear not vivid enough.
How about “Government Investment in the Private Sector”
shortened to “Federal Investment” or “Growth Funds for the Public”
or something of that flavor?
Ever yours
Bob Eisenberg
Bard Endowed Professor and Chair
Dept of Molecular Biophysics
Rush University Medical Center
Chicago IL
Prof. Eisenberg,
Thanks for thinking along. The only problem with “investment” is that it is associated with some form of “return on investment” and expectation of profit. The government may see a “return” on its deficit spending but that is not the point of the maneuver and nor should it ever “get its money back”. I chose “net contribution” because deficit spending is essentially an act of faith in the future of a community/nation; with contributions there is no expectation of dollar-for-dollar return, only moral benefit.
For most government spending, there is indeed something expected in return. It doesn’t matter if there is a deficit or a surplus in the year of the spending. Government spends in order to acquire and consume real resources. When you put $1 in the collection plate, that is a contribution. When government buys a fighter plane, they are not contributing, they are buying. (Neither are they “investing” in “The Public”)
You are correct that the “deficit” and “surplus” terminology is economically inaccurate and needs to be replaced.
I think it would be better to use less morally charged terms. Calling it a “contribution” or “investment” immediately alerts people that you’re in favor of it, and the more the better. It announces your intent before you even get started on your argument, and invites objections based on pre-conceived notions rather than on what you have to say.
Government spending is Government Demand. Private sector spending is private sector demand, and foreign spending (exports) is foreign demand. There are also negative components to the government (taxing) and foreign (imports) demand, so those two have Net quantities: The excess of exports over imports is Net Foreign Demand (currently negative in the US). The excess of spending over taxes is Net Government Demand. The sum of Private Demand, Net Foreign Demand, and Net Government Demand is Aggregate Demand.
This terminology removes all the morally charged language, positive and negative. It clears the way for an honest discussion about whether the level of aggregate demand is too low, too high, or about right, and then what to do about it.
Michael,
You use the term “public monopoly of the currency.” It seems to me that in reality the term ” the private banks’ monopoly of the currency” would be a more accurate. The US government does not create money, it is the banks who create the money out of thin air and then lend it to the government, who use it for deficit spending.
Of course, there is no need for any sovereign government to go into debt in order to create money. If the banks can create dollar bills, so can the US Treasury. Doesn’t it say so in the Constitution ?
The privatization of the US money supply has been a huge fraud perpetrated on the American people. How to change this is a monumental task, although there is a growing realization that we have been had.
Frank,
I would think that the US Congress by delegating its Constitutionl obligation to manage the money supply to the very banks that would have the most to gain from manipulating the money supply is akin to handing the reins of our energy policy to the corporations most vested in maintaining their monopoly over the country’s energy. These are both examples of the Right Wing myths of government. In short, they would suggest to put wolves in charge of henhouse security, just as they complain that a Labor department official is partial to Labor issues. As long as this mindset prevails on both sides of the aisle we will continue to have at best, Wall Street representatives that mean well but are closed minded to alternative solutions; and total adherents of the Austrian School at worst.
Michael Hoexter,
Thank you for this article, you have provided me in a relatively short space an overview of MMT that explains much that I was not sure about, and also confirmed much of what I had figured out on my own.
I think it is helpful to distinguish “creating money” from “creating net financial assets in the private sector”. Banks do the former, but cannot do the latter. Only government can do the latter, and it is done by spending.
Banks create money by making loans, but making a loan creates both an asset and a liability, both for the bank and for the borrower. The borrower has the money (asset), but also the obligation to repay (liability). His net financial position has not changed. The bank has an asset (the loan) but also a liability (the deposit), so its net financial position has not changed. (As has been noted, the bank also has the expectation of making a profit via interest, so that if the loan is repaid, some net financial assets have been transferred from borrowers to lenders. Without some offset to that transfer, eventually lenders will end up with all the financial assets of the economy.)
When the Treasury sells a bond, it is a swap of financial assets between the government and the non-government sectors. The net financial assets of both parties are unchanged. Likewise, when the Fed buys a government bond, it is also a swap of financial assets, and neither party’s (not their sectors’) net position is changed. As long as the government’s credit is unchallenged, no money is created in these transactions, because the bond trades at par with cash. (BTW, it doesn’t matter if you consider the Fed to be part of the government or not. Either way, there is no movement of net financial assets between sectors.)
When government taxes, it removes financial assets from the private sector. When government spends (whether that spending is “covered” by taxing or by borrowing, or not covered at all), it is a swap of financial assets to the private sector in return for real goods and services transferred to and consumed by the government, for the “public purpose”. Unlike bank loans, these activities do change the net financial position of the private sector. Selling real goods and services to the government is one way for the borrowers in the private sector to gain the money they need to pay the interest on their bank loans, and, indeed, for them to become net savers and lenders themselves.
golferjohn1,
There seems to be 1 iteration immediately obvious to me that your response has missed. What is the case when taxes are paidto the government and used not on spending, but on paying the principal and interest on the bonds. It would seem to me that paym,ent on the principal reverses the earlier transfer, but the interest paid to the bond purchaser is a transfer that soley benefits the purchaser similar to the instance of a bank loaning money.
Paying the principal of the bond is just the reverse of selling it, an asset swap.
Paying the interest is just like any other transfer payment spending, adds financial assets to the non-government sector. The only difference between transfer payments and other spending is that transfer payments (SS is the biggest) don’t purchase real goods and services for the government.
It matters not whether the money for either of these came from taxes, or borrowing, or neither. In fact, they say “money is fungible”, so you can’t really tell which of several sources was used to pay for anything.
Having said that, according to MMT taxes don’t pay for anything. Money received in taxes is destroyed, money to spend is created from keystrokes. Accounting for it is just accounting, not economics.
Frank,
There are two sources of money in our society but only one of actual “high powered currency”. Banks create money out of thin air by making loans, but they do this in the national unit of account, in the US dollar. There used to be in the 19th Century banks that created their own currency but not anymore. Banks and economy require federal spending and the operations of the central bank combined with the Treasury to create a pool of the most liquid money. Also the net profits of the banks, the interest which they gain on their loans, must eventually come from money spent into the economy by the government. Banks are not in the business of increasing the pool of money, of liquidity, available to society so the economy can grow; that is the role of governments if they choose to pursue a pro-growth policy.
Actually my last sentence should say “in the medium and longer term”. Banks in the short term provide liquidity to businesses but their loans must be repaid with interest, so they drain liquidity from the real economy in net.
In short, both banks and the US government create money out of nothing. Banks do it by issuing loans. The US government does it by spending. Both create money on keyboards.
People like Frank (above) erroneously think that ALL money comes from bank loans. Popular writer Ellen Brown thinks this as well, as do her numerous followers. They are flat wrong.
Frank (above) also feels that private banks are evil, and that we have given them too much power to issue money (as loans). I agree with this, but I think the real issue is that there are some industries (e.g. banks and prisons) which should never have a profit motive.
Instead of “Government Demand,” how about “Public Demand”?
I like “government demand” better. In the sectoral balances, it’s called the government sector. “Public” has multiple meanings, one of which is “ordinary people”, which is a different sector. In other contexts, the “public sector” includes more than just the Federal government, which is the only part of government that is monetarily sovereign, which is what matters. The other parts of the public sector can’t create money and so are limited in their budgetary actions.
The word “demand” does not capture the notion that government is supplying liquidity by spending above the amount of taxes collected. Government is creating something new and also is unique is this regard relative to other sources of “demand” which cannot supply their own liquidity. Also the supply/demand pair anchors economics in the neoclassical paradigm. I think we need to move beyond it in understanding how economies actually work.
Just a comment from a non economist. It does not seem immediately obvious to me that an increase in the interest rate can curb inflation. I could, for example, be perfectly willing to borrow at a higher rate if I expected a profit? In fact, during a bubble, like housing or tech, the future is always brighter to those inside the bubble. You are obviously relying on the belief that at least some will not borrow at the higher rates. But people have purchased houses at increasing rates of interest, for example. Bankers too would try to loan more money at the higher rates. So once the bubble is in bloom, interest seems not to be a restraint. Taxes or reduced spending, though, could dampen the enthusiasm, especially with tougher regulations. I would appreciate some further comment. Thanks.
“I could, for example, be perfectly willing to borrow at a higher rate if I expected a profit?”
Exactly. And the higher the interest rate, the fewer are the projects that expect enough profit to overcome the higher cost. In a bubble, expectations are unreasonable, so people do deals that seem unreasonable in retrospect. But with lower interest rates, there would have been even more people willing to do that.
The history is that when the Fed gets spooked about inflation, they raise rates to the point of inverting the yield curve, and a recession follows, and inflation drops. That is not to say that there are not other things that correlate, higher tax receipts for one, but it seems to me that the discouragement of borrowers (and encouragement of savers) reduces economic activity more than the higher interest rate increases private sector incomes. MMT differs on this point, saying that the thing that matters is that government is a net interest payer, so higher rates make for more net financial assets coming to the private sector. It is difficult to quantify behavioral effects in such an uncontrolled environment as a large economy.
John, I can see what you are saying. But if this is the textbook answer, it still leaves me cold. Until the bubble bursts there will be those who borrow and those who lend since it is profitable. And, meanwhile, some people get to pay higher rates on mortgages while the top 1% rake it all in. In fact, as we saw, people continued to buy houses into the bubble with crazy mortgages with rising rates (Greenspan raised the fed rates and didn’t seem to help much!) . So, textbook or no, it is not satisfying. Maybe the answer is to get ” just a little” pregnant?
Ps I recall this fella Volcker who also raised rates. Did it help?
Yes, borrowers and lenders will borrow and lend, always. Banks stand ready to lend always, at their chosen rate, to creditworthy borrowers. There are always borrowers at any rate, some times more borrowers than at other times. Interest rates are one of the factors that influence their decision to do it more sometimes and less other times. 1980 and 2006 are examples of the Fed raising short rates above long rates, and both times recessions followed. Lenders can lose when rates rise, too, if they lend long and borrow short. People with fixed-rate mortgages (and jobs) made out like bandits when inflation went way up. It’s not always one way.
I think the solution is MMT. Keep the risk-free rate at zero, and throttle inflation with taxes, not interest rates.
Agreed!
Money acts as an “instructor” by allowing labor to be instructed to interact with “resources” to produce the goods and services a society needs or indeed to go to the marketplace and purchase goods already produced by this process. Accordingly we have the creation from nothing of “Federal Instruction” and “Private Bank Instruction.”
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So many people think goverment is depentant on private sector for financing, I think this phenomenom deserves a name. How about calling it “private money delusion” (PMD) from now on. 🙂
Because underneath all the lies and misunderstandings, is, essentually, a state money system.
I find Modern Monetary Theory similar to New Math : Construct a new vocabulary and a set of procedures to perform the same operations that were done previously…. In the process of establishing this new “paradigm”, historical experience and institutional knowledge is obscured. Its no coincidence that Romer & Rheinhart chose “This Time is Different” as the title for their opus on banking crises.
I support STATISM principally in control of the monetary system… Money AND Liquidity should only be issued proportionally to the real growth of the economy. That, of course, requires close regulation of currency issuance, bank reserves, and securitization underwriting. Its a shame that the US equates “Democracy” with subornation.
MMT isn’t confusing. The U.S. Treasury’s “overdraft privilege” was revoked for good reason. The Treasury-Reserve Accord of March 1951 is prima facie evidence.
This brings the “Scorpion and the Frog” fable to mind. Treasury-Federal Reserve collaboration exists in its present state, because whenever in the past the FED’s responsibilities were subordinate to the Treasury’s, this country experienced intolerable rates of inflation.
And that’s too bad as MMT could eliminate debt’s “bogeyman” – the compounding of interest expense.
“Greenspan raised the fed rates and didn’t seem to help much”
Bernanke never eased & Greenspan never tightened (neither did Volcker). Dec. 2007 should have been one of William Bretz’s “Juncture Recognition” points.
In Dec. 2007 the roc in MVt incontestably projected that its path would inevitably lead to a recession in the 4th qtr of 2008. Then in July 2008 the unregulated, prudential reserve, money creating, Euro-dollar banking system (not the ECB system) started to contract. As U.S. gDp started falling, the BOG introduced the payment of interest on reserves – to offset its liquidity funding facilities’ growth on the asset side of the Central Bank’s balance sheet. This was the 3rd time it literally withdrew liquidity from the financial markets.
If people understood this there would be all sorts of conspiracy theories – anti-semitism (Friedman, Greenspan, & Bernanke are Jewish…Bernanke would be assassinated, etc.).
There’s no controversy…just censorship – just like McCarthyism. Academic freedom is a barbarous relic.
The atmosphere at the Fed has always been one of arrogance & ignorance.