The Primer has run its course. I did not get to cover quite all of the topics I had planned. However, for those of you who want the whole Primer can read The Book: Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems. Pre-order your copy here.
As the marketers say, if you liked the Blog, you’ll love the Book. As we went along with the blogs, I tweaked the manuscript. I incorporated a Q&A section following many of the chapters, taking account of your responses. I added topics that seemed to interest you, but that I did not have time to address in the blog. It also has an index and bibliography. And I changed the order substantially in order to make the argument more coherent. The book is in printing now so I expect you can get it by August.
This week we will wrap up with a discussion of the “nature of money”. Really that is what we’ve been getting at for approximately 52 weeks. I think this is what distinguishes what we do here at NEP from other bloggers who understand much of the basics. It is not just that a sovereign government faces no financing constraint, other than constraints it self-imposes. It is not just that bond sales are a reserve drain. It is not just that a JG provides a wage anchor. In my view, MMT is an approach that allows us to understand the nature of money in the sort of economy we find ourselves. And since money is the most important economic institution in our economy, we really cannot understand what our economic system is all about if we get money wrong.
Warning: this final blog will be more theoretical—you could even say philosophical or existential—than what came earlier. If you’re like me, that can cause eyelids to droop. Unfortunately, when you get into the nature of things, there’s no alternative. You all remember that first year college class in philosophy: “who am I and why am I here?” “If a leaf drops in the forest, does it make a sound if nobody is there to hear it?” So, what is money and what is it all about?
Since this is a rather long blog, wait until you’ve got a free hour to read it. It is not the kind of thing you can skim over.
First a quick note on the comments to Blog #51. You note I did not respond. I found many of them distressing. I presume these were mostly by a vocal minority who’ve not paid much attention over the past 51 weeks of blogs. Many were ideologically-driven. I am puzzled that one who is absolutely ideologically opposed to MMT and the JG would waste his time reading and commenting on the blogs. I certainly would not go to their blogs, much less make comments on them.
In any case, I think I can make one useful comment that is closely related to this week’s concluding blog.
Our free-marketeer friends conjure up in their imaginations a particular kind of economy with quite specific tendencies. It is mostly based on the simplest model presented in the first year economics text: a perfectly competitive economy, with no money, and with “rational” (in the selfish sense) economic agents maximizing utility. There is an invisible hand that unerringly guides these homogenous globules of desire (Veblen’s term) toward an optimal, mutually beneficial state of bliss (“Pareto optimality” as it is proudly called by economics teacher).
As I discussed in the last blog, in this simple model, words like “productivity” and “efficiency” are reasonably well-defined, and we can imagine that the invisible hand rewards productive and efficient behavior and punishes their opposites. It does this with prices that provide wages and profits to the worthy and bankruptcy and unemployment to the unworthy.
Our free marketeers and their brethren apologists among the orthodox economists pose an imaginary economy that is viewed by some as a utopian version of our own, but one that operates without money. Then they choose one commodity to serve as a medium of exchange to grease the invisible hand.
To add a patina of realism, they then imagine a transactions-cost reducing evolution toward gold-backed notes or demand deposits. But an evil government comes along, drops gold, and adopts a fiat money standard. With nothing “real” standing behind money, the invisible hand gets fooled as nominal prices deviate from real prices causing us to move temporarily away from the blissful point of market-clearing general equilibrium. As government continues to “print money” we get accelerating inflation and then finally hyperinflation.
Fortunately you cannot fool the invisible hand over the long run, so no matter how rapidly nominal prices increase, we get back to equilibrium, albeit one that is less preferred because government saps precious bodily fluids like some evil Dr. Strangelove.
Hence, best to destroy or at least to contain government, and either go back to gold or at least operate the monetary system as if we were on a gold standard (as Greenspan claimed he did as Chairman).
The best government is the one that governs least, letting invisible market forces produce maximum efficiency and productivity while punishing the weak, lazy, and imprudent. That would take us back to the time “when the ice was melting…when the weather was delightful and the mind free to be fertile of new ideas—in the islands of the Hesperides or Atlantis or some Eden of Central Asia” as Keynes put it.
It’s a nice little imaginary world and we’d all (presumably) like to live in it. It bears no relation to any society that has ever existed, or that will ever exist. It is useless for developing an understanding of the world we actually live in; indeed, it is worse than useless as it is downright dangerous. Almost all the economic problems we face in our real world actually derive from the misapplication of this model to our world. I’d go further and say that most of the social problems we face (sexism, racism, ageism, and just downright nastiness) also derive from “framing” that comes out of a world view based (even unknowingly) on this model.
It is a weapon of mass destruction, and economists are shamefully implicated in unleashing it on our world.
What world do we actually live in? A world of Sabotage, as Veblen put it. But not just Veblen. Even the most mainstream texts teach this—albeit usually not until year 2 economics. But few students make it that far, after all the brain-deadening silliness taught in year 1. In year 2 we finally go beyond perfect competition.
The usual analysis of oligopolies and monopolies teaches that the business undertaker purposely restricts output and employment in order to increase profits. Veblen called it “sabotage of production” and he (correctly) predicted a coming great depression (1930s) that would result from the proclivities of the cartelized undertakers.
The “efficient” level of production for real world undertakers is always that which provides high monetary profits. No real world undertaker cares about “efficient” or “productive” undertakings in terms of “real” quantities produced—only money matters.
Likewise, in the hiring decision, no real world undertaker looks at the “real” productivity of labor power; the carpenter who can hang more doors per hour than anyone on earth is of no use to the homebuilder who cannot make money profits on the sale of finished homes.
And no real world undertaker will keep more workers employed (hanging doors or cleaning teeth) than absolutely necessary to produce the amount of goods and services that can be sold profitably.
All real world undertakers continually seek to get by with fewer workers. The “visible hand” of the undertaker is a job killer.
And here’s the final point. There are NO market forces that move the economy toward the state of bliss imagined by free marketeers. Indeed, reality is precisely the opposite. Market forces march the economy away from bliss.
Toward financial crises. Toward high unemployment. Toward low wages. Toward intolerable inequality, poverty, and suffering. Toward high crime rates and accompanying high rates of incarceration. Toward discrimination and other forms of invidious distinction.
Now, I know our free marketeers will claim that recognizing all this is “anti-capitalism”. Pointing out that our undertakers have a natural proclivity to kill jobs, not create them, is somehow anti-American. Probably Pinko!
Nay, it is Modern Money Theory; or call it Modern Money Realism if you like.
MMT is a description; it is a theory; it is an approach; and it leads to a set of policy propositions for the world in which we actually live.
It recognizes the problems and attempts to solve them. It does not condemn either capitalism or its undertakers. But whether you are for or against capitalism, MMTers believe you ought to at least understand it.
But MMT’s critics have something entirely different in mind. They want policy for a world that never existed, indeed, cannot exist. Their policy proposals are not formulated for reality, but rather for imaginary worlds. And that is true both on the right—those who want unemployment and poverty to discipline workers, especially, but also to incentivize our undertakers—and on the left—who willingly tolerate the disciplining influence of unemployment if only we will give some welfare handouts to make poverty somewhat less harsh. They formulate policy to solve imaginary problems, and impotent policy for real problems.
The Unemployed Want Jobs? Give them welfare—that is more efficient. Keep them unemployed, it builds character. Train and educate them to increase their productivity so that they might take jobs away from others.
Our Undertakers Lack Sales? Give undertakers more subsidies. Reduce undertaker regulations. Cut undertaker taxes. Encourage them to increase efficiency so that they might get by with fewer sales.
Our Economy Falters? Balance the budget. Slash trade barriers. Get the government off the backs of our undertakers. Cut wages and eliminate worker protection to destroy the market for the output of undertakers.
All that might make sense for some universe. But not for ours.
And the confusion mostly comes down to a misunderstanding of the nature of money.
What is money? What is “monetary production”? Let us close this blog and this Primer with an examination of three propositions. Certainly I do not mean to argue that these three propositions, alone, are sufficient. But you’ve had 51 weeks of blogs previously, so all we are trying to do here is to tie up some loose ends in the most “efficient” manner possible.
Introduction: What is Money?
In an important sense, our task throughout this year has been to develop a theory of the nature of money. When asked “what is money”, most people respond—quite reasonably—that money is used to buy something. This gets at money’s use as a medium of exchange, which is of course the most familiar use. If pressed further, most people would also say that money is something one can hold as a store of value. Indeed, economists recognize money as the safest and most liquid store of value available—at least outside situations with high inflation, when money’s value falls rapidly. Some people will also mention the use of money to pay-down debt, with money used as a means of payment, or means of final settlement of contractual obligations.
Finally, if we ask people “how much is that worth”—pointing to just about anything—a common response would be to evaluate worth in terms of money, this time acting as the unit of account used to measure wealth, debt, prices, economic value.
These answers take us quite far in understanding what is money, each focusing on a different but widely recognized function or use of money—identifying money with what money does. But we might try to dig deeper, and ask what is the nature of that “thing” that serves these functions?
When we go to the store, we might use cash or a bank check or a plastic credit card as our medium of exchange. When we file our tax return with the treasury, we might simply make an electronic payment. We can buy books or collectible Barbies over the internet using PayPal. But we can assess the value of a used car in terms of a purely representational unit of account—much as we can guess the weight of our neighbour in pounds, kilograms, or stones, units we cannot touch.
Is Money a Physical Thing?
Many people rather instinctively believe that money must have some real physical existence, or at least it must be “backed up” by hoards of precious metals kept safely in government vaults. Some who know that is not true fear that the money we use today is somehow illegitimate, a “false” money precisely because it is “worthless” pieces of paper or electronic entries down at the bank. That is a typical response by Austrian-leaning “goldbugs”, often followers of Ron Paul (a sometime US Presidential candidate and thorn in the side of the Fed).
What we have tried to do in this Primer is to present a careful and coherent exposition on the nature of money. We have consistently distinguished between the money of account (Dollar, Pound, Yen) and money things denominated in that money of account. We have argued that all those money things, in turn, are liabilities, obligations, IOUs, of their issuer. At the same time, they are assets of the holder. The nature of the obligation of the issuer is this: one must always accept one’s IOU in payment to oneself. The bank that issues demand deposits as its liabilities must accept its demand deposits in payments on the loans it holds as assets. The government that issues currency as IOUs in its payments must accept its currency in payment to itself (for fees, fines, and taxes).
So there really is something standing behind the money things: the promise of the issuer to take them back. Issuers commonly add another promise to increase acceptability: to convert their IOUs to the IOUs issued by some entity whose liabilities are even more acceptable. That led us to the notion of a debt pyramid. Liabilities of households and firms are converted to demand deposits of banks (one promises to deliver bank liabilities in redemption against one’s debts), and bank IOUs are convertible to government currency (cash and reserves–HPM).
The “goldbugs” have mostly got it backwards: it was not gold that gave money its value but rather, gold had money value because its price was pegged in terms of money by the government authorities. This was done by promising to redeem gold for currency at a fixed exchange rate.
In any case, let’s analyse the economy we’ve got, with the monetary system we actually have. And that is one that is based on a money of account chosen by government, and almost everywhere subject to the “one country, one currency” rule. The currency is issued by a sovereign government when it spends, and received by government in payment of taxes and other payments to the government. Even if the gold standard existed at one time, and even if it operated smoothly in the manner fantasized by the goldbugs, it no longer matters in any significant way.
Three Propositions on the Nature of Money
Let us close with the three propositions:
1. As Clower (1965) famously put it, money buys goods and goods buy money, but goods do not buy goods.
2. Money is always debt; it cannot be a commodity from the first proposition because if it were that would mean that a particular good is buying goods.
3. Default on debt is possible, which means that credit-worthiness matters. Not all money things are created equal.
These three propositions will provide sufficient structure to dig a bit deeper into our theory of money. The following discussion will be at a theoretical, mostly logical level. This will require some reference to alternative theories and stories about money. For that reason, it will require more familiarity with the typical exposition of textbooks. Readers might want to brush up a bit on their Samuelson textbook.
Goods Don’t Buy Goods. The typical textbook story of money’s origins is by now too well known to require much reflection: because of the inefficiencies of barter, traders choose one particular commodity to serve as the money commodity. Exchange is then facilitated by using that money commodity rather than bartering directly one good for another. A hypothetical evolutionary process runs through the discovery of a money multiplier (notes issued on the basis of reserves of the money commodity, such as gold) to government monopolization of the commodity reserve and finally to the substitution of commodity money by a fiat money that is not backed by a commodity.
However, if we begin with the proposition that goods cannot buy goods then we must look elsewhere for the nature of money since there could never have been a commodity money. And we cannot presume that markets come before money for the simple reason that until money exists there cannot be “exchanges” (sales). Further, money is not something that is produced—it is not a commodity that is produced by labor (otherwise it would be a “good buying a good”), nor is it something sought to directly satisfy the kinds of individual needs or desires that motivate production of commodities. At most, we can say that we seek money because it provides access to the commodities that satisfy those desires.
It is important that money is not directly produced by labor. Imagine that we could “grow money on trees” or in the ground like corn—something your mother understood to be impossible. Workers who lost their jobs could go harvest money from trees or from cornstalks, as self-employed money producers.
Those who have read Keynes’s General Theory will recall his argument that money “cannot be readily produced” so that “labour cannot be turned on at will by entrepreneurs to produce money”, and as well his argument that “Unemployment develops, that is to say, because people want the moon; –men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off.” While it might be nice if we could grow money in window pots, our economic world would look quite different than it does now if we could do so.
And if we could grow money on trees, just how could it maintain its value? Money leaves would be harvested from trees until the amount of effort required to produce money directly equalled the amount of money one could get indirectly from other production processes (in the form of wages and profits). Leaf collection would set a low standard, indeed. Maintaining relative scarcity of money keeps it valuable, but that at the same time means that it should not be something produced by labor.
But there is a more important point to be made. Elsewhere—especially in the drafts to the General Theory—Keynes explicitly presumed that the purpose of production in a monetary economy is to accumulate money. It is this desire to accumulate money but at the same time the inability to use labor to produce it that prevents labor from being diverted to its production. Hence, Clower’s argument that “goods do not buy goods”, that money is not a commodity produced by labor, must underlie Keynes’s view. And that is why unemployment develops when people want the “moon” (money), but cannot produce it with labor.
The claim that a capitalist economy is a “monetary production economy” was also adopted by Karl Marx and Thorstein Veblen and their followers. To put it simply, the purpose of production is to accumulate money—not to barter the produced commodities for other commodities. As Robert Heilbroner argues, this provides a “logic” to production that makes it possible to do economic analysis. Indeed, our previous analysis of sectoral balances and stock-flow consistency, and even GDP accounting, itself, all rely on this “logic”.
On one level, this is obvious. We need a unit for accounting purposes to aggregate heterogeneous items: wages, profits, rents; investment, consumption, government spending; apples, oranges, and widgets. As Keynes argued there are only two obvious units of account at hand—labor hours or the money wage unit. The Classical tradition (that followed Marx) focused on the first while most of Keynes’s followers focused exclusively on the second, although some like Dillard followed Keynes’s lead by using both.
But the Marx-Veblen-Keynes monetary theory of production means to say something more than that we need a handy universal money unit for accounting purposes. Money is the object of production—it is not merely the way we measure the value of output. It is because money does not take any particular commodity form that it can be the purpose of production of all particular commodities. It is the general representation of value—it buys all commodities and all commodities buy (or, at least attempt to buy) money.
Actually, if a commodity cannot buy money, it really is not a commodity—it has no market value. Commodities obtain their value—they become commodities–by exchanging for the universal representation of social value, money. By the same token, obtaining money allows us access to all commodities that are trying to buy money.
This presents the possibility of disappointment: the fruits of production enter the market but fail to buy money. There are consequences following on the failure to sell produced commodities including a decision to cease production. Labor power, itself, is a produced commodity (separate from the free laborer, of course, who cannot be bought or sold) that seeks to exchange for money but may find unemployment instead.
However, not only is the purpose of production to obtain money, but the production process itself is one of “production of commodities by means of commodities” as Sraffa put it. That is to say, one needs commodities in order to produce—one must buy raw materials, equipment, and labor power in order to produce output.
And those commodities (including labor power as well as other produced means of production) can only be purchased with money things (IOUs denominated in the money of account). In other words, the production process, itself, “begins with money” on the expectation of ending up with “more money” (M-C-C’-M’, as Marx put it—begin with money to purchase commodities as inputs, produce a different commodity, and then sell it for more money). Not only is production required to result in sales for money (things), but it must begin with money (things).
Production is thoroughly monetary, from beginning to end. It cannot begin with commodities, because the commodities must have been produced for sale for money (things). Analysis must also therefore begin with money.
Indeed it is the necessity of producing commodities and then selling them for money that underlies capitalism. If money can just be produced directly from flower pots, we would not need to market output—and most of the features of the economy we actually live in would be unnecessary.
We cannot begin with the barter paradigm. We cannot remove money from the analysis as if it were some veil hiding the true nature of production. We cannot imagine that in some hypothetical long run money will somehow become a neutral force, just as it supposedly was back in the days when Robinson Crusoe bartered with Friday. Beginning with barter sheds no light on production in a monetary production economy.
Indeed, if you think about it, if you exchange one commodity for another there is no need for money, even as a measuring unit. I’ve got coconuts and you’ve got fish; I’d rather have the fish and you want the coconuts, so we trade. We need to higgle and haggle to reach agreement on the exchange ratio—how many fish per coconut. That gives us a “relative price” measured in real things. We have no need for a unit of account. No doubt such exchanges occur all the time: I’ll wash the dishes if you cook the dinner; I’ll swap two Barry Bonds baseball cards for one Mickey Mantle.
Or two Mickeys if you’ll clean the toilet. We don’t need no stinking money!
So let us begin with a money of account in which we “price” the goods and services we buy and sell. And we use something that is denominated in that money of account—receiving it when we sell and surrendering it when we buy.
What is that “thing”? Is it a commodity, like gold denominated in Dollars? No!
Money Is Debt
Throughout this Primer, we have argued that money is not a commodity, rather it is a unit of account. A unit of measurement is not something that can ever be obtained through a sale. No one can touch or hold a centimeter of length or a centigrade of temperature. We might say that we buy money by selling commodities, but it is clear that if money is just a unit of account—the Dollar, the Euro, the Yen—that is impossible.
We can get somewhat closer if we recall our earlier analogy to the electronic scoreboard at a football game. As the game progresses, point totals are adjusted for each team. The points have no real physical presence other than as hyperactive electrons; they simply reflect a record of the performance of each team according to the rules of the game. Similarly, in the game we call the “economy”, sales of commodities for money lead to “points” credited to the “score” that is (mostly) kept by financial institutions.
While the game of life is a bit more complicated than the football game, the idea that record keeping in terms of money is a lot like record keeping in terms of points can help us to remember that money is not a “thing” but rather is a unit of account in which we keep track of all the debits and credits—or, “points”.
Recall that we said the “scores” on a bank’s balance sheet are liabilities—its IOUs are the points credited to players. We will have much more to say about the role played by financial institutions in the next section. Here we only want to focus on the “dual” debt nature of the money “scores”.
First, as discussed above, production must begin with money; and that money is a “score” that represents an IOU. Typically, it is a demand deposit liability of a bank. It is matched on the other side of the bank’s balance sheet by a loan, which represents the debt of the borrower in whose name the bank’s IOU is issued. In other words, one who wants to undertake production of commodities (by means of purchasing commodities) must issue an IOU to the bank (a “loan” held as the bank’s asset) and obtain in return a bank deposit (the bank’s liability).
The commodities to be used as means of production are then purchased by transferring the deposit (the bank debits the producer’s deposit and credits the deposits of the sellers of means of production). When the producer finishes the production process and sells the produced commodities, her deposit account is credited and the purchasers of the sold commodities have their deposit accounts debited.
At this point, if the producer desires, she can use her deposit account to “repay” the loan (the bank simultaneously debits the demand deposit and the loan). All of this can be done electronically and is rather like our scorekeeper who takes points off the scoreboard.
So we see that the debt of the producer is retired by selling the produced commodities (“realizing” the monetary value) and retiring the loan by surrendering its deposits accumulated through the sales. The bank cancels its debt (demand deposit) at the same time that it cancels the producer’s IOU (loan).
The second sense in which the producer is indebted is Schumpeterian (after the famous economist, Josef Schumpeter): the undertaker commands some of society’s means of production at the beginning of the production process before actually contributing to society. The producer’s IOU (held by the bank) represents a social promise that she will temporarily remove commodities on the condition that she will later supply commodities to society.
We can view all commodity production as social, beginning with commodities that were already socially produced in order to combine them in some manner to produce a (usually) different set of commodities. When those newly produced commodities find a market (buying money), the undertaker’s social debt is redeemed.
So, if successful, the undertaker’s debt is repaid—in both senses: The producer can retire her debt to the bank and to society as a whole. Undertaking is essentially a debit and credit affair, with the slate wiped clean if all goes as planned.
Money is debt (again!).
We conclude: money is debt. It need not have any physical existence other than as some form of record—mostly, an electrical entry on a computer. Money always involves at least two entries: debt of the issuer and asset of the creditor. Delivering an IOU back to the debtor results in its extinction: the debt is stricken, and so is the asset of the creditor.
In practice, creation of money usually requires four entries: a prospective producer issues an IOU to a bank and receives a demand deposit as an offsetting asset; the bank holds the producer’s IOU as its asset and issues the demand deposit as its liability. By convention we say that the producer is a “borrower” and the bank is a “lender”; we call the bank’s acceptance of the borrower’s IOU a “loan”, and the bank’s IOU “money”. However, that is rather arbitrary because both have borrowed and both have lent in the sense that both are debtors and both are creditors.
If money is debt, then as Minsky said, anyone can create money by issuing an IOU denominated in the social unit of account. The problem is to get it accepted, that is to get someone to hold one’s IOU. To become a debtor requires finding a creditor willing to hold the debt. But there are two sides to the equation: each must be willing to “create money” (issue an IOU) and each must be willing to “hold money” (hold the other’s IOU).
In the next section we address two issues related to willingness to hold money IOUs: liquidity and default. That will cover our third and final proposition about the nature of money: default on monetary commitments is possible.
Liquidity and Default Risks on Money IOUs
Goodhart argues that the reason that conventional economics cannot find an important role for money or for financial institutions in its rigorous (“general equilibrium”) models is because default is ruled out by assumption. All IOUs are presumed to be equally safe because all promises are always kept as all debts are always paid. (Indeed, many such models employ a representative agent who is both debtor and creditor and who quite rationally would never default on herself in a schizophrenic manner!)
This means that all can borrow at the risk-free interest rate and that any seller would accept a buyer’s IOU; there is no need for cash and never any liquidity constraint. Nor would we need any specialists such as banks to assess credit-worthiness, nor deposit insurance, nor a central bank to act as lender of last resort.
Obviously, almost all interesting questions about money, financial institutions, and monetary policy are left out if we ignore liquidity and default risk.
Let us return to the most fundamental question about debt, examined in detail earlier: just what is owed when an IOU is issued? All IOUs share one common requirement: the issuer must accept back her own IOU when it is presented. As we discussed above, the bank takes back its own IOU (demand deposit) when a debtor presents it to pay off a loan. Government takes back its own IOU in tax payments. If you issue an IOU to your neighbor for a cup of sugar, the neighbor can present it to you to obtain sugar. Refusing your own debt when submitted for payment is a default.
Another promise that many monetary IOUs carry is convertibility on demand (or on some specified condition such as a waiting period) to another monetary IOU or even to a commodity. For example, on a gold standard the government might promise to convert its currency (an IOU stamped on coin or paper) to so many ounces of precious metal. Or, a country on a fixed exchange rate might promise to convert its currency to so many units of a foreign currency. Banks promise to convert their demand deposit IOUs to domestic high powered money (currency or reserves at the central bank).
It is important to remember that a promise to convert is not fundamental to issue of an IOU—it is in a sense voluntary. For example, modern “fiat” sovereign currencies on floating exchange rates are accepted with no promise to convert. Many attribute this to legal tender laws, where sovereign governments have enacted legislation requiring their currencies to be accepted in payments. But there are (and have been) currencies that readily circulate without any legal tender laws as well as currencies that were shunned even with legal tender laws.
If currency cannot be exchanged for precious metal in many countries, and if legal tender laws are neither necessary nor sufficient to ensure acceptance of a currency, and if the government’s “promise to pay” really amounts to nothing (except exchanging its currency for its currency), then why would anyone accept a government’s currency?
As we have emphasized, it is because the sovereign government has the authority to levy and collect taxes (and other payments made to government including fees and fines). Tax obligations are levied in the national money of account—dollars in the US, Canada, and Australia.
Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In all modern nations, it is the government’s own currency that is accepted in payment of taxes. While taxpayers mostly write checks drawn on private banks to make tax payments, actually, when government receives these checks it debits the reserves of the private banks—reserves that are the central bank’s IOU.
Effectively, private banks intermediate between taxpayers and government, making payment in currency and reserves on behalf of the taxpayers. Once the banks have made these payments, the taxpayer has fulfilled her obligation, so the tax liability is eliminated.
We conclude that government’s “fiat” currency is accepted because it is the main thing (and usually the only thing) accepted by government in payment of taxes. It is true, of course, that government currency can be used for other purposes: currency can be used to make purchases, to settle debts, or to save in “piggy banks”. However, these other uses of currency are subsidiary, deriving from government’s willingness to accept its currency in tax payments.
Ultimately, it is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations.
We can conclude that taxes drive money.
The government first creates a money of account (the Dollar, the Pound, the Euro), and then imposes tax obligations in that national money of account. In all modern nations this is sufficient to ensure that many (indeed, most) debts, assets, and prices, will also be denominated in the national money of account. The government is then able to issue a currency that is also denominated in the same money of account, so long as it accepts its currency in tax payment.
Enforceability of monetary contracts in court is part of the reason nongovernment money IOUs are written in the state’s money of account. In addition, money IOUs are often made convertible to the state’s IOUs—high powered money. This can make them more acceptable.
Here’s the problem, however: merely agreeing to accept your own IOU in payment is a relatively easy promise to keep. But promising to convert your IOU to another entity’s IOU (especially on demand and at a fixed exchange rate—which is necessary for par clearing in a money of account) is more difficult. It requires that one either maintain a reserve of the other entity’s IOUs, or that it have easy access to those IOUs when required to do the conversion.
Failure to meet the promise of conversion is a default. Hence, there is additional default risk that arises from a promise to convert, to be weighed against the enhancement to an IOU’s general acceptability.
This gives rise to the concept of liquidity: how quickly can an asset be converted with little loss of value? Generally, the most liquid asset is the state’s own IOUs (the state promises to convert its IOUs to its own IOUs, and to accept those in all payments due to the state), so the conversion of other liabilities is often to HPM. Banks hold some HPM so that they can meet demands for conversion, but it is access to deposit insurance as well as to the central bank that makes the bank’s promise to convert secure.
Deposit insurance means the government, itself, will convert the bank liabilities to HPM at par; access to the central bank means that a bank can always borrow HPM as necessary to cover conversions.
Much earlier in the Primer we introduced the concept of a pyramid of liabilities—IOUs issued by other institutions and households are convertible to bank liabilities. These other entities then work out arrangements that make it more likely that they can meet demands for conversion, such as overdraft facilities. Everything is then pyramided on the state’s IOUs—we can think of that as a leveraging of HPM.
All promises are not equally valid, however—risk of default varies on the IOUs. There is another fundamental principle of debts: one cannot pay one’s debt using one’s own IOUs.
But the sovereign state is special. As discussed, when the sovereign is presented with its own IOU, it promises to exchange that IOU for another of its IOUs or it allows the presenter to “redeem” it in payment of taxes.
The state makes its own payments—including redeeming its debts—using its own IOUs. To be sure, the state can retire its liabilities—by running a budget surplus—but it does not have to pay them down by using another’s IOU. So the sovereign state really is special. All other entities must provide a second party or third party IOU to retire debt. For most purposes, it will be the liability of a bank that is used to make payments on one’s debt.
Default risk on a bank’s IOUs is small (and nonexistent in the case of government guaranteed deposits), hence bank liabilities are widely accepted. Banks specialize in underwriting (assessing credit-worthiness of) “borrowers”—those whose IOUs they hold. Not only do banks intermediate between government and its taxpayers but they also intermediate by accepting borrowers’ IOUs and issuing their own bank IOUs such as deposits.
The IOUs they hold generally have higher default risk (except in the case of government debt) and are less liquid than the IOUs they issue. For this service, they earn profits, in large part determined by their ability to charge a higher interest rate on the IOUs they hold than the rate they must pay on their own. Again, the image of a debt pyramid is useful—those lower in the pyramid use the IOUs issued by entities higher in the pyramid to make payments and to retire debt.
This leads us to the interest rate, which as Keynes said is a reward for parting with liquidity. Since government-issued currency (cash) is the most liquid asset, it does not have to pay interest; bank demand deposits can be just as liquid and for many purposes are even more convenient than cash, so they do not necessarily need to pay interest (in some cases banks charge fees for checking accounts; in others they do pay positive interest—this has to do with regulation and competition, issues we will not address here).
Other IOUs that are less liquid must pay interest to induce wealth-owners to hold them. In addition, interest compensates for default risk; this is in addition to the compensation for illiquidity of the asset.
Keynes goes on to explain how the desire for liquidity constrains effective demand and results in unemployment—topics beyond our scope today although they were touched on above (unemployment results because people want “the moon”).
We return to Goodhart’s argument that conventional economics has no room for money because there is no default risk in rigorous models. For Keynes, conventional economics lacks a plausible theory of money holding precisely because there is no fundamental uncertainty in the models, which is necessary to explain why liquidity has value. The two arguments are related, and explain why financial institutions are important: they issue liquid IOUs with little (or no) default risk. This is the reason why their IOUs are frequently classified as “money” while the money IOUs of others are not. Hence, as Minsky claimed “everyone can create money”; but he goes on: “the problem is to get it accepted” (ibid).
This brings us back to Clower’s dictum: money buys goods and goods buy money, but goods do not buy goods. That surprisingly insightful statement has led us on a long path through theory, institutions, and even a bit of monetary history and law.
To be sure, we just barely scraped the surface of many of the issues of what turns out to be a complex and contentious topic. Indeed, “money” is arguably the most difficult and controversial subject in macroeconomics—what is money, what role does it play, and what should policy do about it are the questions that have busied most macroeconomists from the very beginning.
The three basic propositions examined in this concluding blog have allowed us to construct the beginnings of answers to these questions.
This has been a long and difficult blog. You might need to read it twice. Or three times. And maybe you want to buy the book (which contains a longer discussion and as well a proper conclusion), to read through at your leisure.
Thanks to the many participants who (mostly) made this a fun endeavour. Sorry that I had to truncate the Primer by about six weeks—I had wanted to run it right up to the book’s publication date. We did not get to cover quite all of the topics I wanted to do. However, they are in the book.
Have a good summer. The Primer blogs will stay up, but I won’t be posting any new ones. You’ll see me back on NEP’s front page from time-to-time. And at Great Leap Forward.
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