DIAGRAMS & DOLLARS update

By J.D. Alt *

I’m most appreciative of the comments and suggestions that followed my recent post. The comments were so encouraging I decided to expand the essay slightly and turn it into a small eBOOK available on AMAZON. I did my best to incorporate many of the commentary’s suggestions. For example, I tried to minimize the problem of reinforcing the “wrong” ideas in my effort to debunk them—a problem rightfully and forcefully pointed out not once, but twice, by Bob Eisenberg! I did not go so far as I think he would have liked, but I did incorporate a warning, just prior to the “incorrect” diagram, advising the reader not to get too enamored with it because it was INCORRECT, and the purpose of the eBOOK was to explain why.

Part one of the post was picked up by Naked Capitalism, and the commentary there had a very different and interesting flavor. By far the greatest criticism was the observation that the central premise of the diagrams was, in fact, wrong: the Private Sector does in fact create the money the FG must use! Many of the proponents of this position seemed extremely well informed, falling into two different but overlapping camps. First were those focused on the idea the sovereign government had given up its money issuing powers to the banking industry—with the Federal Reserve and Treasury, in essence, being controlled and manipulated by the private banking industry. The second perspective was that the banks in fact do create trillions of Dollars in “debt money” which are real financial assets in the Private Sector pot—so, in that sense, the PS pot does “create” its own money.

There is truth in each of these positions, but I decided not to attempt to unravel it with the diagrams. I added an acknowledgement of the “bank money” created by the reserve banking system, but noted that “bank money” is never used to pay Federal Taxes—or for Sovereign Spending. I decided that wading too far into the weeds would just confuse the basic simplicity of the description I’d developed and diminish its effectiveness as an introduction to MMT. To that end, I added the following introduction to the eBOOK:

What’s this eBOOK about?

Many economists and budget theorists are now debating the realities and implications of a new understanding about MONEY. Modern Money Theory (or MMT) is a term that pops up more and more in mainstream discussions about our current economic malaise and National Budget. On the one hand, the new understanding seems to hold out great possibilities, but on the other it seems highly improbable, if not impossible. There is a great deal of disagreement even amongst the economists themselves—and for those of us who are not economists, the topic seems overwhelmingly complicated.

This small eBOOK is an attempt to illustrate the basics of this debate for the “non-economist”. My hope is that by making the basic concepts more visible, the topic—and its remarkable implications for our National Budgeting process and collective well-being—will become more widely discussed.

The illustrations and explanation were first created for New Economic Perspectives, a website and blog at the University of Missouri KC School of Economics. Under the leadership of Dr. Stephanie Kelton and L. Randall Wray, NEP has moved to the forefront of a world-wide effort to inform political leaders, economic thinkers, and engaged citizens about the realities and possibilities of the “modern” fiat currencies we use today. Readers interested in going beyond the basic concepts illustrated in this eBOOK will do well to go to the NEP website: www.neweconomicperspectives.org

So if you want to contribute to the effort, please go to AMAZON and write a review of DIAGRAMS & DOLLARS! If it gets lots of interesting reviews, maybe a lot of people will read it.

[* Post revised to reflect new e-book cover]

26 Responses to DIAGRAMS & DOLLARS update

  1. Nice.
    Why did you decide to put that particular diagram on the cover of the ebook?

  2. ” a warning, just prior to the “incorrect” diagram”

    But the incorrect diagram is on the cover.

    • Golferjohn & Joshua: you both zeroed in on the same issue! Thanks. I was somehow not focused on the cover and the reinforcing the “wrong” while trying to debunk it issue. I think a cover-change is in order. It will take about 12 to 18 hours to go into effect. Thanks again for noticing that.

  3. I do not have kindle and I am not going to get it. I would be glad to pay 5 dollars to get a link delivered to my email address or a pdf copy sent.

  4. Will Diagrams and Dollars be available in the NOOK reader format?

    • Right now only available through Amazon 🙁 ….sorry.
      There is a free Kindle App that’s available for android phones and tablets… not sure if that works with nook.

  5. Gotta disagree with you JD, “bank Money” is most certainly used to pay taxes as it ranks equally with sovereign money created by the Government. Every loan advanced by a bank can be converted into dollar notes and coins, and the vast number of businesses that operate on borrowed money, whether it is a loan or an overdraft, use that money to pay their taxes, and that of their employees. Probably, 99% of the tax payments are electronic transactions and there is no way anyone can distinguish whether those payments are paid with sovereign money or “bank money”.

    • Stephanie Kelton

      Guggzie,

      There is only way way to extinguish tax obligations to the state, and that is by delivering state money. You may write a check to the IRS, but that check goes through a clearing process that results in the debiting of bank reserves — i.e. high-powered money — which is the only thing that will settle the payment. It isn’t as if some taxes are paid with bank money and others with sovereign money. There is nothing to “distinguish.” You can send the IRS a bag full of notes and coins or a check drawn on your account at BofA. Either way, (whether you realize it or not), you’re paying your taxes with sovereign money. You’re focusing on the stage actors and missing the action behind the curtain.

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  7. OK Stephanie, not that I agree with you, but JD has pointed out the obvious, that there is a “distinction” between “bank money” and “sovereign money”. As I have asked several times now, does anyone have actual and reliable figures for the amount of “Bank money” created by the private banks in comparison to the amount of , so called, “sovereign money” supposedly created by the Fed? It seems to me, both types of money are created by the same process, but the private banks work on the fractional reserve system and can create their “money” far in excess of the “reserves” they are supposed to hold.
    Have I got it wrong? If so, I’d appreciate getting the story “right”.

    • Stephanie Kelton

      Guggize,

      There are, of course, different measures of the US money supply. Bank money (let’s say a demand deposit) exists as part of M1. But there is also sovereign money (high-powered money), and a whole range of other money things (savings deposits, time deposits, money market funds, etc.) that get counted in, e.g. M2 and M3. Only the government — central bank + Treasury — can create high-powered money, and HPM is the ONLY type of money it accepts in payment to itself. Of course it is true that high-powered money makes up only a sliver of the entire money supply, but that has no bearing whatsoever on the fact that there is only one way to settle a tax obligation with the US government and that is by remitting high-powered money. The fact that banks are not reserve constrained does not matter in this regard. If I write a $1,000 check to the IRS to pay my quarterly taxes, that check is going to go through a clearing process, my deposit will get debited -$1,000, my bank’s account at the Fed will get debited -$1,000, and the Treasury’s account at the Fed will get credited +$1,000. It is the debiting of the reserve account (high-powered money) that allows the settlement of the liability. It is the government taking back, in payment to itself, it’s own form of money. The fact that privately created money is orders of magnitude > high-powered money is neither here nor there. I hope that helps.

  8. Not really Stephanie, if we take a fairly common situation where a person does not have the $1000 in their bank account and has to use their credit card, or use their overdraft to pay the tax. What you seem to be saying is that this “bank money” somehow, miraculously becomes “sovereign money” when it goes thru the clearing process.
    My understanding of the clearing process was to facilitate money transfers between the banks through the use of the statutory “reserve” account that each bank is required to maintain. Maybe, you are implying that this “miraculous” conversion only takes place when the “bank money” is paid to the Government. Surely, it doesn’t apply to every dollar that goes thru the clearing process? But, I still don’t have an answer to my question of the amount of “bank money” in the economy in comparison to the “sliver” of “sovereign money” created by the Government.
    It is this huge amount of interest bearing credit that is created by the private banks that is responsible for the ever growing mountain of debt placed on the shoulders of the public, not the government “deficit”.
    In reality, it is this poorly regulated supply of “fictional bank money” that is responsible for the inflationary, and deliberately derived deflationary pressures that are inflicted on society through continuous boom and bust cycles. The banks have very skilfully foisted the blame on the Government because, the Government tries to manipulate inflation through the futile adjustment of interest rates.
    The futility of this approach is amply proven by the ongoing boom and bust cycles that have occurred throughout the last century, and continue to occur today.
    It should be made very clear to people that it is not the Government that is tying the debt noose around people’s necks, but the private banking sector’s policy of loading people with easily available credit. The Governments must take some responsibility for allowing the fractional reserve system to be practiced by the banks.
    Why does MMT continue to focus solely on Government spending and ignore the real economic impact of money creation by the private banks?

  9. In giving your reply some further thought Stephanie, what you are saying is that the “money” held in reserve at the Fed represents the supply of actual “sovereign money” that each private bank is required to hold as the basis for the fractional reserve system. Is that correct? If that is correct, then your claim that the Government is always paid with “sovereign money” makes sense in a convoluted way. I guarantee, nobody who has borrowed money from the bank to pay their government debt has any conception of this “distinction”.
    It seems more a case of semantics – you mentioned a list of “money things” as one would talk about apples, pears, oranges when the discussion is about “fruit”, in the same way this discussion is about “money” – and in that sense, there is only two types of “money” – “bank money” and “sovereign money”.

  10. You have provoked the grey matter Stephanie so, I am adding the following comments to the discussion. The “distinction” between “sovereign money” and “bank money”, which is really about the nation’s total money supply, raises the question as to the ratio of the Reserve funds to the amount of “money” created by the banks. The conventional ratio is often said to be 10:1, on the assumption that only 10% of the borrowers will choose to convert their borrowed money into “sovereign money” at any one time. Obviously, this huge “ponzi” scheme of fractional reserve banking is a monumental confidence trick of fraudulent proportion that should land the perpetrators in gaol. The Government/Fed try to vary this ratio according to how they wish to control the supply of credit to the people. While the Government gets the blame for the perpetual credit crisis that occur because of the abysmal record of the Central banks in trying to manipulate this ratio, and the interest rate, those Central Banks operate for the benefit of the banks and not for the benefit of their society.
    In essence, it all comes back to the Government endorsement of the fractional reserve system used by the private banks. That vast supply of “fictional money” created by the private banks is created and used entirely for the benefit of the banks.
    It is an obvious fact that, in a closed community, it is impossible to operate on a profit system without continually increasing the supply of “money”, and the Governments have defaulted on their responsibility by letting the private banks provide the increase as interest bearing loans.
    What should happen is that a nation’s money supply should be created for the benefit of the people, and Lincoln seems to be the only person in US history who got that right, when he created the “greenbacks”.
    Part of the Government’s “public purpose” must include the creation of all the nation’s money supply, not just a small “sliver” of it called “sovereign money”.
    What can happen is having the Government reverse the “ponzi” scheme. Every Government of a monetary sovereign nation is in the position to establish a genuine, honest and practical banking system based on the creation of ‘sound’ money related to physical assets. The primary objective of this system must be to serve the needs of the public in providing effective banking services.
    While the fractional reserve system is essentially a ‘ponzi’ scheme, it can be modified and properly controlled to serve the benefit of society. By reversing the current procedure, and instead of allowing the private banks to create ‘new’ money as they currently do, the Government, on behalf of the people, creates this ‘new money’ and sells it to the private banks. Obviously, the creation of this ‘new money’ would be a simple bookkeeping, or computer spreadsheet activity, exactly as it currently applies. The private banks would be set up in the same manner as presently in place, by obtaining capital from investors through the issuing of shares, debentures or bonds. As legitimate registered businesses, they would be eligible to apply for, and purchase, ‘new money’ from the government at a low enough price to allow them to “re-sell” it to their customers. The amount of ‘new money’ they request would be set as a ratio of their capital, plus money they hold in deposit from their customers. That ratio can vary depending on the economic activity of the nation. As the economy grows so would the customer’s deposits, thus allowing the banks to apply for additional ‘new money’ to support the continued growth. The necessary controlling regulations would be related to the nation’s productivity and consumption factors, which the Government would monitor as the primary determination for the creation of ‘new money’.
    Two other important factors would come into play with this type of system, one, the Central Bank would become a truly publicly owned bank responsible for funding the nation’s infrastructure and essential services, thus removing the need to borrow money from the private sector. The second factor would be that the Government would no longer be the lender of last resort – every private bank would stand on their own feet.

  11. “the Government, on behalf of the people, creates this ‘new money’ and sells it to the private banks.”

    Interesting concept. What does the government accept in payment for the ‘new money’?

  12. A good question Golfer, but as any such radical change in concepts would involve a process for implementation, and given the current status of the banks with $2563.016 billion in reserves, almost 20 times the legally required reserve amount of $122.261 billion, they would have the funds to purchase access to the “new money.”
    The truly frightening thing is that M2 can legally, under current regulation, increase from around $11 trillion, as related to the required reserves, to around $227 trillion if applied to the excess reserves now held by the banks. If that isn’t a sure fire recipe for blowing bubbles, I don’t know that is. PS – this data comes from the erstwhile Canadian group, the Ludwig von Mises Institute.

    • So, what is the difference between the reserves and the new money? Both are obligations of the government. What is the point of exchanging them, one for the other? And where would the new money go, these days, except to excess reserves?

      M2 could increase without limit, even before QE. Bank lending is not constrained by reserves. The Fed, under normal, pre-QE conditions, must supply reserves as needed in order to maintain its interest rate target.

      • I guess we are talking about two different worlds, Golfer. I’m talking about a world where the private banks are controlled, and you seem to be accepting the status quo where nothing changes. As I mentioned earlier, we are talking about a huge educational challenge. In our current society, virtually everything is controlled by “money”, but very few people really understand how it all works (me included). If there is ever going to be a change in the system it is going to have to come from the people – those controlling the system will never initiate the change needed to convert the system to one that represents a public purpose designed to benefit the people.

  13. Ok, trying to apply the diagram to the current situation. If draining money with high taxes is used to combat inflation why is inflation now so low with taxes at historic lows? I assume it is related to the “liquidity trap” but I don’t see where this – or any interest rate setting mechanism – comes into play in the diagrams.

    lff

    • “taxes at historic lows?”

      Seems to be up 19% in 3 years, from 2009 to 2012, and will be up again in 2013. Data from FRED:

      2009 2230.1
      2010 2391.7
      2011 2516.7
      2012 2663.0

      • Revenues as a percent of GDP:
        from: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=205
        2009 — 15.1
        2010 — 15.1
        2011 — 15.4
        2012 — 15.8
        2013(e) — 16.7

        Lowest rates since 1950 — 14.4

        lff

        • The 1950’s are irrelevant to today’s problem. What matters to inflation is how taxes relate to spending and the state of the economy. Rising taxes dampen growth and inflation, if there is any of either one to dampen.

          With demand so much lower than capacity (unemployment so high), there will be no demand-pull inflation any time soon, regardless of the level of taxation. It has to do with the slow recovery, the chronic low demand, not any liquidity trap.

          The context of the statement about the purpose of taxes assumes that spending is controlled separately, according to public purpose, and without regard to deficits. The effect of government on the general price level is related to how much it spends net of what it taxes; that is, by how much its positive contribution to demand exceeds its negative contribution, and how that relates to the available capacity in the economy, given the other demand leakages: domestic and foreign savings. Since the deficit is largely endogenous, targeting it is futile, so the result is that spending is controlled by the needs of the government to provision itself, and taxing is used to regulate aggregate demand so that the leakages do not cause excessive unemployment, and not to have the government deficit be the cause of inflation.

          MMT believes that “monetary policy”, i.e., manipulation of interest rates or monetary aggregates, is relatively impotent, and works in a way opposite to how it is thought to work. Thus, there is no mention of interest rates or liquidity traps in the diagrams.

  14. Thanks. I get – and agree – with most of that. I had hoped the diagram encompassed more of the economic picture than it apparently does and even saw it as perhaps somewhat Friedmanesque with the monetary system as THE controlling factor in the economy. I saw the final diagram as descriptive rather than prescriptive for the current situation. For the current state of affairs it seems to me that demand is low precisely because the low interest rates trap liquidity in the banking system.

    BTW Since the diagram already shows the private financial balance and the government financial balance it would be nice to see it include the foreign financial balance and perhaps provide some insight into Godley’s sectoral financial balances framework.

    lff

    • It’s interesting that you call it Friedmanesque, because I also see parallels in the analytical methodologies. MMT has a different view of what constitutes “money”, and how its quantity is manipulated, but both agree on the importance of the quantity and its implications for aggregate demand.

      MMT has an answer for why demand is low: incomes are low. The “circle of life” is that sales drive employment, which provides income, which drives spending, which increases sales.