Modern Monetary Theory – An Introduction: Part 1

By Dale Pierce

Chapter One


This is Chapter One of a three-part overview of a body of economic thought known popularly as “Modern Monetary Theory” or “MMT”. The aim of this chapter is to explain the basic dynamics of our present-day “fiat-money” economy through the dual lenses of government spending and taxation. We will also explore some contested history, and examine some of the ways we need to think about money differently, now that the United States, along with the rest of the world, has gone off any version of a gold standard. The intent is to be as non-technical as possible, but some parts of the subject are, unavoidably, a little complex. In these areas, keeping the logic as step-by-step as possible will be the goal. In Chapter Two we will look at the ways money systems sometimes go haywire, through either inflationary malfunctions or through the (thankfully) less-familiar phenomenon called deflation, including “debt deflation”. Chapter Three will be about Jobs, Jobs, Jobs.

It may seem odd that a theory would call itself “modern” in 2013 when the events it is theorizing about mainly took place in the 1970s, so a brief explanation is in order. The label “Modern Monetary Theory” was coined by an Internet blogger, and it “just stuck”. Because it is not really very misleading, and because a lot of followers liked the sound of it and used it, the actual theorists of MMT decided to make a virtue of necessity and use it themselves. The theoretical work which had been done by MMT-orbit economists was previously called “functional finance”, after a term coined by Abba Lerner, and this terminology is sometimes still encountered. But if there is a difference between MMT and FF, it is too subtle to make a difference to us here, so we will stick to the more common term.

MMT explores the monetary- and fiscal-policy implications fiat-money. And this is, or should be, a politically neutral line of inquiry. We don’t have one monetary system for Democrats and another one for Republicans. However, there are few areas of policy disputation that are more hotly contested in America today than the ones MMT is most interested in exploring. The top three things that MMT seeks to explain are tax policy, the government’s budgetary and other other fiscal policies, and monetary policy. Enough said. Neutrality isn’t really an option when we will be addressing such unavoidably controversial subjects.

As always, everyone should strive to be objective. No one should say that something is true just because they’d like it to be true or because it would be a good thing if it were true. But MMT does not point out that government could quickly restore full employment for the purpose of saying that things should just stay as they are. When we demonstrate that government has no need to tax workers’ wages, we don’t then conclude that wages should be taxed anyway. There is a bias here that it would make no sense to disavow or try to minimize, so we should just make it explicit from the get-go and do our best to make it understood. In the end, it isn’t really very complicated.

The policy bias of MMT is the same as its theoretical bias and it comes from the same source. MMT is one vocal component of an even larger trend within Economics that wants to re-litigate the neo-classical (or “laissez faire”) revival of the 1980s and turn it on its neo-classical head. Keynes was right after all, and we had financial stability and a generation of shared prosperity back then. Friedman and Lucas and Alan Greenspan were all way wrong, so now we have financial-sector chaos, plutocracy and the seeds of a modern-day rebirth of feudalism. Just letting this happen is not acceptable – morally, politically or intellectually. And since economists were at the center of what went wrong, economists bear a disproportionate share of the moral obligation to help put things right. Some of us who are not economists pitch in as and where we can. It is hoped, for example, that this overview of MMT will be easier for lay people to to understand for having been written by one.

That said, neither MMT nor this overview is a Luddite manifesto against the things all economists do and have in common. I, myself, don’t know how their models work or what they do. But I damn-well know they do something. This component of Economics is a formal discipline akin to formal or mathematical logic, and I don’t doubt for one moment that it adds to humanity’s store of wisdom in some approximately parallel way. I don’t understand quantum mechanics either, but this does not make me suspicious of Ph.D. Physicists or tempt me to believe that Physics itself is some kind of academic scam. But then, there are differences to consider here too.

Only economists themselves can reform their discipline. But consider the stake we all have in how that goes for them. When two quantum physicists disagree, and the wrong theory wins out, what’s the worst that can happen? At worst, (assuming everyone is wearing their safety glasses), some funding may be misallocated until the mistake is corrected. When two economists disagree and the wrong theory wins out, we are apt to get recessions, depressions, inflations, hyper-inflations, wars, world wars, tyrannies, mass starvation, genocides, and sometimes – when they really screw up – we get the occasional civilizational collapse. Or near-collapse.

So, when regular citizens – lay people – interest themselves in, and even involve themselves in, the affairs of the economics profession, we are not hobbits “meddling in the affairs of wizards”. We are not mere unlettered interlopers. Economists’ affection for the gold standard inflicted eight identifiable deflationary depressions on humanity in the period since capitalism first got cranked up in the 18th Century. Several went on for a decade or more. Bad economic policies collapsed the economy of the Weimar Republic in 1923, and helped create the climate of chaos and desperation which ultimately made a Hitler possible. At least fifty million died.

And those policies were not supported by a consensus within the economics profession *at the time*. More than a decade before he revolutionized the discipline with his “General Theory,” John Maynard Keynes published one of the most prescient and deeply humane treatises in economic or political history. In “The Economic Consequences of the Peace,” (i.e. the Versailles Treaty), Keynes pleaded for a peace that would rehabilitate Germany and the rest of Europe. Instead, politicians on both sides of the Atlantic, backed by the most influential economists of the day, imposed a modern version of the “Carthaginian” peace that Rome imposed on its defeated enemies after the Punic Wars.

In place of sowing salt on their farm fields, Germany’s coal resources were divied up with France and with the newly independent states of Poland and Czechoslovakia. The Germans were also deprived of their merchant fleet and required to build ships to be given to other nations instead. There were many other gratuitous reparations requirements, including even a state-of-the-art airship for the U.S. Navy. But what sealed the world’s fate were the hard-currency, gold-standard money reparations. These made a true German recovery impossible and directly caused Germany’s hyper-inflation episode. In the end, the crushing, humiliating and *economically unsustainable* provisions of the Versailles Treaty made another war, and some version of Adolf Hitler, all but inevitable.  

If the world had somehow found the wisdom, back then, to heed the advice of one economist instead of a different one, who knows? Fifty million people might not have been directly or indirectly killed by the most destructive war in human history. So, yes, we all have good reason to listen to our economists. But they are *our* economists. And we have reasons better still to listen to them skeptically. A sufficiently determined skepticism might have saved the world from a world war. A sufficiently determined and politically organized skepticism might have saved our own generation from so-called “Supply Side Economics.”

We are now trying to prevent that moral and intellectual travesty, and the policy regime that was derived from it, from degenerating into a neo-feudal, petro-centric paradigm whose real, though unacknowledged, agenda would be to extinguish human civilization through a comprehensive program of environmental suicide. If we want to prevent this, we must understand the economics of it all – what went right, why it went wrong, and what needs to happen next. So, we should get started.

This first chapter of our MMT overview begins with the advent of Whatchamacallit Economics – “Reaganomics”, “Supply-side Economics”, “Trickle-down Economics”, Monetarism, Friedmanism, the Laffer Curve, the “Washington Consensus”, neo-classicalism, neo-liberalism, neo-conservativism…

The whole aviary, we will come to find, is really just one species – and all of one flock.

I. The Age of Inflation


For Americans, the history the 1970s is painful history. a lot of people would just rather not think about it. But somewhere in the fourth year of a decade whose first year was all about Viet Nam, and whose final year witnessed the hostage-taking in Tehran, Richard Nixon completed the process he began with the suspension of convertibility of dollars for gold in 1971. Nixon “floated the dollar” on international currency markets. Except for people who were itching to speculate on gold, the public hardly noticed any of it. The experts said not to worry. And, sure enough, there were no noticeable effects for individual citizens – with the emphasis on “noticeable”. Behind the scenes, and in ways not even financial experts understood at the time, this change would change everything.

But initially – who really cared? Gold and dollars hadn’t been convertible for American citizens since a Depression-era measure which was passed way back in 1935. A provision of it banned the private ownership of any more than jewelry-size amounts of gold. People were glad to see that restriction go away – it was an affront to tell people what they could or could not buy, including gold. As for whatever central banks did with the stuff – well, what did they do with, or do about, anything? Few Americans had a framework for thinking about such arcana, so not many did. There were so many bad things happening in those days, the public quickly moved on. But it wasn’t very long before one of the worst of those bad 1970s things was, precisely, accelerating inflation.

When, on behalf of Modern Monetary Theory, we praise the greater flexibility and fiscal-policy space made possible by our present-day fiat money system, we must not forget the traumatic circumstances which attended its original introduction – or the lingering effects those traumatic times still have on Americans today. Most Americans who think about it at all *blame* the Great Inflation of the 1970s on the introduction of fiat money back then. This was, after all, a core thesis of Milton Friedman’s monetarist, anti-Keynesian counter-revolution. His updated version of the Quantity Theory of Money had every conservative pundit with a working larynx intoning that “inflation is always, and everywhere, a monetary phenomenon.” Which, if you think about it, is much like saying that obesity is  always, and everywhere, a weight problem. But if anyone noticed the tautological or non-informative character of this generalization at the time, they either didn’t say so or were drowned out by the then-rising tide of Monetarism.

Friedman’s one-liner had a straightforward, common-sense appeal back then and it still does. And the monetarist story hangs together quite convincingly too, even on the first hearing. Prices are stable. Until they are destabilized by the dilution of the money supply with new fiat-dollars. Fractional reserve banking then kicks in, so most of the new dollars (up to 90%) get re-lent by banks, over and over again, as the money-multiplier does its dirty-work. In the end, a purchasing power many times as great as the original money injection is chasing the same goods that existed before – so, prices go up. Bada-bing.

Most of the people Modern Monetary Theory is trying to convince – educated Americans who think about the economy – have been exposed to, and believe, some version of this story. So, we don’t start from a level spot. We start from a situation where the conventional wisdom, for all but a few Americans, is that the Keynesian deficit-spending of immoral fiat-dollars always-and-everywhere causes inflation. And always carries the risk that it will accelerate into a hyper-inflation. 

On first hearing, it is the monetarist who sounds common-sensical and the chartalist who sounds like a fantasist. When we say that the spending of a sovereign, currency-issuing  government is operationally unconstrained, and is thus, in practical terms, unlimited, what the average person hears is, “Relax! We can print all the money we’ll ever need!” To get people to believe that this is not what we’re saying, and listen to our explanation of the limits of their own common sense, we need a powerful, readily-comprehensible one-liner to put up against Milton Friedman’s, and an equally compelling narrative to put up against the monetarist narrative.

Here’s a working example of the one-liner: A very large majority of people unconsciously fail to distinguish between what is merely financial and what is real.

And here’s one way to think about the short-form narrative:

The private sector creates wealth and value – real wealth – real goods and services. Think houses, cars, dry-cleaning, corn-on-the-cob. The public sector creates money – obviously. Who else would create it? The private sector needs the government’s money to pay its taxes. The government supplies it by fiat-spending it into the economy, which also has the effect of moving real goods and services into the public domain. A government may do these things well or badly – efficiently or inefficiently – in ways that advance the common good or in ways that do not. But under our modern, fiat monetary system, this is the way things must work. It is the way they already do work every day. We just aren’t accustomed to thinking about them in this way.

Looked at this way, it is not surprising that we usually have a budget deficit. The dollars people save up and use as a store of value “leak” from the private sector’s spending flow. In order to keep demand high enough to employ most or all who want work, the government must issue more money than it collects in taxes. If it did not, demand would fall and full employment would be a rare, “boom-time” phenomenon, frequently interrupted by recessions and even depressions. This was indeed the way all capitalist economies behaved prior to the 1930s, and the way the economy is starting to behave again since the repeal of most Keynesian-era financial regulations and controls.

What Inflation Isn’t

Every day, the monetarist narrative on inflation is contradicted by the empirical evidence – as it has been for the past three decades and more. For if there is one thing absolutely everyone understands about the spending of the U.S. government today, it is that it spends vastly more than it collects in taxes. That is what deficit spending is. If the rate of consumer-price inflation really was, in any way, a straight-line function of the size of the government budget deficit, the inflation rate for 2008 and 2009 should have been spectacularly higher than in 2006 or 2012 – and much lower in 1998, when the Clinton administration ran the largest of its famous surpluses. The rate was about the same in all five of these years, and has rarely either exceeded four percent or been less than two percent in any year since the Great Inflation’s high-water mark in 1982.

People deal with the 30-years-and-counting absence of any significant amount of consumer-price inflation in a variety of ways. Some say monetarism just “worked”, and, for some reason, only had to work once. Some claim that the government is hiding the real inflation rate through accounting gimmicks or that T-bond sales somehow make the fiat dollars so illiquid, the deficits aren’t “monetized” (as if it was difficult or labor-intensive to sell a T-bond). Other people single out oil or some other commodity where monopoly power and speculation are the real price-drivers. Some then point to artificially created monopolies like health insurance and various forms of access to the telecommunications infrastructure. Even if the reason why a price goes up is monopolist power – or because Congress has granted rent-extracting opportunities to some well-connected lobby – many people will still lump that in with every other increase in their personal cost of living and label it “inflation.” And blame it on deficits, Keynesians and the national debt.

In America, at least, because of the persistence of these harmful myths, there is no alternative to re-litigating the revisionist history most people have internalized. And this starts with acknowledging that the inflation of the 1970s, *initially*, really was caused by excessive deficit spending. And, since money is fungible, spending is spending. Spending on the Viet Nam war had the potential to be – and was – inflationary. So was spending for the War on Poverty, spending on the programs run under the aegis of “The Great Society”, and every other kind of government spending, from Social Security to mowing the White House lawn. It is important to emphasize that *all* government spending has the potential to be inflationary. This for the purpose of understanding why some is and some isn’t. For it is never, ever the “deficit-ness” that is inflationary. It is always, and everywhere, the excess.

Spending in excess of what? In excess of the overfall economy’s ability to increase the production of real goods and services without causing shortages or bottlenecks which lead to higher prices. Within these real and really-binding constraints, governments that issue fiat money and float it on international currency markets really can spend as much of it as they please without causing inflation. Governments which spend in excess of these binding, real-economy limits will always create inflationary pressures – which will always go on to cause actual inflation unless the country’s real terms of trade lie sufficiently in its own favor. (For, clearly, if other countries are supplying yours with goods and services that have more value than the ones your country is sending them in return, that may put enough downward pressure on prices to let you avoid at least some of the inflation you would otherwise experience. Call it the Walmart co-efficient.)

The monetarist Quantity Theory of Money (“QTOM”) is a fallacy, in part because it assumes that a country’s economy is always producing as many goods and services as it possibly can. Advocates of this theory also assume that no worker who doesn’t want to be is *ever* unemployed. So, sure, at full employment, and with a zero percent real output gap, it’s perfectly true that almost any kind of increase in domestic spending would create inflationary pressures. But, even then, this would not be because the QTOM accurately describes the real world. It doesn’t. In the first place, it does not even accurately describe the financial operations that happen when the federal government spends money. And, just as importantly, the so-called “money-multiplier” is an outright myth – one which fundamentally mis-states the way banks and bankers do business.

Bankers don’t cool their heels waiting for depositors to stroll through the revolving door with new deposits for them to lend out. Nor do they limit their lending based on regulatory reserve requirements. They aggressively seek out deals which feature a credit-worthy borrower and a plausible repayment model. If a loan that meets these objectives causes a reserve imbalance, the bank manages that problem separately and after-the-fact. Banks can always obtain reserves from the central bank. So while excessive government spending at full employment is definitely inflationary, its inflationary effect is not “multiplied” in the way monetarists and other neo-classical economists claim. Claims to the contrary are mainly political and mainly intended to discredit the inclusion of full employment as a co-equal goal (or “dual mandate”) of fiscal and monetary policy.

The political purpose of the “money multiplier” and other economic myths is to keep the unemployment rate permanently elevated so that job insecurity will help hold down wages. Framing the fiscal policy debate within this economic construct – one that systematically over-predicts inflation – pre-empts policy-makers from using the real properties of fiat money to end recessions and restore full employment.

Of course, for the purposes of the policy discussion we should really be having right now, the assumptions of the QTOM seem bizarrely counter-factual. Are *none* of the 23 million Americans who can’t find full-time jobs really looking? Are *all of them* merely exhibiting a newly-discovered preference for leisure-time activities? Neo-classical economics invites us to believe that the unemployed are really just on vacation, and that the massive decline in America’s economic output since the housing crash was caused, not by the crash or the recession, but by a real diminution of the country’s real production-capacity. What from? No one appears to know. But it’s what the models say, so it must be true. And besides – just look – all of those people are still on vacation!

Uncle Sucker

What actually happened in America, after the real but relatively mild inflation of the late 1960s was that the Nixon administration decided to wage an economic war on the rest of the world. It was a war with many fronts – trade terms, exchange rates, and the “gold window”, to name some major ones. There was even a geo-political decision to engage in massive economic co-operation with the communist world – both Russia and China – in large part for the purpose of preserving American leverage over its ostensible allies in non-communist Europe and Asia. Nixon’s trade war, and the rest of America’s economic imperialism since then, has been depicted through yet another thoroughly fictitious narrative as “the adventures of Uncle Sucker”, in which the U.S. was repeatedly bamboozled in trade and currency deals by smaller, weaker nations. In truth, the Nixon administration relentlessly devalued the dollar, imposed arbitrary trade quotas that other countries were coerced into calling “voluntary”. Nixon also proceeded to simply default on America’s tacit gold pledge and let exchange-rate chaos reign. (For a comprehensive account of these events, see Michael Hudson’s “Super-Imperialism“).

At the time, the arab oil embargo and the OPEC price hikes of 1974 and afterwards were spun as acts of “greedy oil sheiks” trying to destroy Israel and cripple the U.S. economy. Because – well, because they hated Israel and the U.S. economy. But no matter how sincerely OPEC leaders hated Israel (no one doubts they did), the U.S. was still their biggest customer and also their real protector – both from internal dissent (cue the C.I.A.) and from communist-bloc ambitions as well (cue Henry Kissinger and the U.S. State Department). So while the original oil embargo really was a political act in aid of the arab combatants in the Yom Kippur war, the price hikes were defensive economic acts of sheer self-preservation.

Nixon’s dollar devaluations were enacted at a time when the world price of crude oil was set by an obscure committee meeting somewhere in the state of Texas. And, as with everything, the real policy of the United States was to exclusively promote its own domestic-economy self-interest. So while the value of the dollar was arbitrarily made variable, and subjected to massive downward pressure by an administration desperate to lessen its trade deficit, the dollar-price of oil was, equally arbitrarily, fixed in place. And since the U.S. had stipulated that the international oil trade be conducted exclusively using dollars, the real purchasing power oil exporters were getting for their oil went down right along with the dollar. And no one – certainly not Richard Nixon – was in any hurry to do anything about it.

The OPEC oil-price shocks, starting in 1974, were defensive in nature. They were unexpected and unintended consequences of the gold-default three years earlier, and of the trade- and exchange-rate chaos that then ensued. The effects of the oil-price shock were massive and global, setting off waves of succeeding increases in the price of everything that was produced with or transported using oil – which, of course, was everything. Even today, the industrialized world remains highly dependent on fossil fuel, and especially petroleum. But in 1974, the world’s industrial processes and transport infrastructure were vastly less efficient than now. The assumption of cheap-oil-forever was baked into every country’s budget and every company’s business plan. The worldwide surge in consumer-price inflation that raged on through the seventies and into the eighties was not caused by Keynesian deficit spending anywhere. It was caused by one country’s decision to off-load the costs of global overlord-ship onto those whom it lorded over – and the differential capacity of some countries to turn the tables and protect their own interests.

In America, none of this was acknowledged, much less understood. Bashing arabs over gas lines and high oil prices was a politically convenient dodge for both parties. They would soon add bashing Japan for their textile and auto exports, bashing Korea over steel exports and bashing all of Europe for imposing exactly the same kind of agricultural tariffs America had been imposing since 1933. The United States systematically deprived most of the developing world of food self-sufficiency in order to boost American agricultural exports. Rice from Arkansas displaced locally-grown rice in Haiti. A big effect of the infamous NAFTA treaty was that American corn displaced locally-grown Mexican corn in Mexico. As a result of these policies, third-world peasants in their millions crowded into squalid urban slums, or else resorted to desperate measures to try and emigrate. Tragedies involving over-crowded boats and rafts proliferated. Human trafficking surged. The southern U.S. border assumed the character it still retains today.

By the early eighties, a one-sided, dollarized world economy had emerged, in which the sheer bulk of the American economy was the global financial anchor. America provided stability by growing more-or-less predictably, and by providing access to its vast domestic market. Other countries were more-or-less free to compete for a share of this market – it being clearly understood that their claims on the U.S. were, and would remain, financial only, not real. No strategically important U.S. corporation was for sale, nor would foreign capital be allowed to buy one. What other countries were allowed to accumulate were real estate holdings, media companies and  dollar-denominated financial assets – mainly T-bonds. The U.S. economy’s vast size and inertia gave U.S. financial assets their stable, long-term staying power. Which, for the moment, they still retain.

Through both threats and actual cases where access to U.S. markets was selectively blocked or limited for certain products and countries, successive U.S. governments secured agreements that were labeled “free trade” pacts. But in reality, it was American financial capital – and agricultural exports – that were “freed” to penetrate and ultimately dominate markets around the world. Big U.S. corporations had already determined that closing U.S. plants and outsourcing jobs to other countries was the easy way to play the globalization game. Their sales and profits continued to grow even after real wages in the U.S. became stagnant and stayed that way. Technological progress continued to boost U.S. labor productivity – firms just stopped sharing the higher revenue with workers.

There was no real resistance from Democrats, liberals or what little was left of the U.S. labor movement by the 1990s. Real liberalism and progressivism was a long-spent force in America by then. The institutions of the New Deal and the Great Society lived on. Social Security and Medicare continued to be sacred political cows (until quite recently). But the economic theory behind these practical experiments was more-or-less quickly abandoned – in the wake of a disastrous Carter presidency and with the ascent of Reaganism. This theoretical framework was soon all but forgotten. A revisionist economic history had been long since prepared and was already circulating in academia – Milton Friedman’s “The Monetary History of the United States.”

In it, and other books like it, Big Government caused the Great Depression – not speculators or Wall Street financiers. And the banks all failed because the Fed mishandled the money supply. Corruption and non-regulation had nothing to do with it. According to this literature, Roosevelt’s New Deal policies never really put anyone back to work at all. And the programs that did – the Lend-Lease military buildup of 1940 and 1941 – somehow did not count. This deficit spending somehow was not Keynesian, and so, it was claimed, proved nothing. As for the post-war, generation-long Keynesian boom, with its widely shared prosperity and its short, mild recessions, well it wasn’t as good as it should have been. Because all those depression-era regulations limited the creativity and inhibited the “animal spirits” of financiers and capitalists everywhere. Should-a been a lot better. Just let us de-regulate the big banks and we’ll show you how much better!

And, see – look how many more millionaires and billionaires there are now! What more proof could anyone possibly need? And if poverty, misery and homelessness are all going up even as long-term unemployment sets records not seen for a generation – so what? We break eggs to make omelets. Someone just forgot to tell the little people that unregulated capitalism’s destructiveness always serves some greater, more glorious and creative purpose.

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