Category Archives: MMP

MMP BLOG #11: MODERN MONEY THEORY AND ALTERNATIVE EXCHANGE RATE REGIMES

Posted on August 14, 2011 by | 18 comments

L. RANDALL WRAY

Floating vs fixed exchange rate regimes. The previous blogs were quite general and apply to all countries that use a domestic currency. It does not matter whether these currencies are pegged to a foreign currency or to a precious metal, or whether they are freely floating—the principles are the same. In this blog we will examine the implications of exchange regimes for our analysis.

Let us deal with the case of governments that do not promise to convert their currencies on demand into precious metals or anything else. When a $5 note is presented to the US Treasury, it can be used to pay taxes or it can be exchanged for five $1 notes (or for some combination of notes and coins to total $5)—but the US government will not convert it to anything else.
Further, the US government does not promise to maintain the exchange rate of US Dollars at any particular level. We can designate the US Dollar as an example of a sovereign currency that is nonconvertible, and we can say that the US operates with a floating exchange rate. Examples of such currencies include the US Dollar, the Australian Dollar, the Canadian Dollar, the UK Pound, the Japanese Yen, the Turkish Lira, the Mexican Peso, the Argentinean Peso, and so on.
In the following sections we will distinguish between these sovereign nonconvertible floating currencies and currencies that are convertible at fixed exchange rates.
The gold standard and fixed exchange rates. A century ago, many nations operated with a gold standard in which the country not only promised to redeem its currency for gold, but also promised to make this redemption at a fixed exchange rate.
An example of a fixed exchange rate is a promise to convert thirty-five US Dollars to one ounce of gold. For many years, this was indeed the official US exchange rate. Other nations also adopted fixed exchange rates, pegging the value of their currency either to gold or, after WWII, to the US Dollar.
For example, the official exchange rate for the UK Pound was $2.80 US. In other words, the government of the UK would provide $2.80 (US currency) for each UK Pound presented for conversion. With an international fixed exchange rate system, each currency will be fixed in value relative to all other currencies in the system.

In order to make good on its promises to convert its currency at fixed exchange rates, the UK had to keep a reserve of foreign currencies (and/or gold). If a lot of UK Pounds were presented for conversion, the UK’s reserves of foreign currency could be depleted rapidly.
There were a number of actions that could be taken by the UK government to avoid running out of foreign currency reserves, but none of them was very pleasant. We will save most of the details for a later discussion. The choice mostly boiled down to three types of actions: a) depreciate the Pound; b) borrow foreign currency reserves; or c) deflate the economy.
In the first case, the government changes the conversion ratio to, say, $1.40 (US currency) per UK Pound. In this manner it effectively doubles its reserve because it only has to provide half as much foreign currency in exchange for the Pound. Unfortunately, such a move by the UK government could reduce confidence in the UK government and in its currency, which could actually increase the demands for redemption of Pounds.
In the second case, the government borrows foreign currencies to meet demanded conversions. This requires willing lenders, and puts the UK into debt on which interest has to be paid. For example, it could borrow US Dollars but then it would be committed to paying interest in Dollars—a currency it cannot issue.
Finally, the government can try to deflate, or slow, the economy. There are a number of policies that can be used to slow an economy—but the idea behind them is that slower economic growth in the UK will reduce imports of goods and services relative to exports. This will allow the UK to run a surplus budget on its foreign account, accumulating foreign currency reserves.
The advantage is that the UK obtains foreign currency without going into debt. The disadvantage, however, is that domestic economic growth is lower, which usually results in lower employment and higher unemployment.
Note that a deflation of the economy can work in conjunction with a currency depreciation to create a net export surplus. This is because a currency depreciation makes domestic output cheap for foreigners (they deliver less of their own currency per UK Pound) while foreign output is more expensive for British residents (it takes more Pounds to buy something denominated in a foreign currency).
Hence, the UK might use a combination of all three policies to meet the demand for conversions while increasing its holding of Dollars and other foreign currencies.
Floating exchange rates. However, since the early 1970s, the US, as well as most developed nations, has operated on a floating exchange rate system, in which the government does not promise to convert the dollar.
Of course, it is easy to convert the US dollar or any other major currency at private banks and at kiosks in international airports. Currency exchanges do these conversions at the current exchange rate set in international markets (less fees charged for the transactions). These exchange rates change day-by-day, or even minute-by-minute, fluctuating to match demand (from those trying to obtain dollars) and supply (from those offering dollars for other currencies).
The determination of exchange rates in a floating exchange rate system is exceedingly complex. The international value of the dollar might be influenced by such factors as the demand for US assets, the US trade balance, US interest rates relative to those in the rest of the world, US inflation, and US growth relative to that in the rest of the world. So many factors are involved that no model has yet been developed that can reliably predict movements of exchange rates.
What is important for our analysis, however, is that on a floating exchange rate, a government does not need to fear that it will run out of foreign currency reserves (or gold reserves) for the simple reason that it does not convert its domestic currency to foreign currency at a fixed exchange rate. Indeed, the government does not have to promise to make any conversions at all.
In practice, governments operating with floating exchange rates do hold foreign currency reserves, and they do offer currency exchange services for the convenience of their financial institutions. However, the conversions are done at current market exchange rates, rather than to keep the exchange rate from moving.
Governments can also intervene into currency exchange markets to try to nudge the exchange rate in the desired direction. They also will use macroeconomic policy (including monetary and fiscal policy) in an attempt to affect exchange rates. Sometimes this works, and sometimes it does not.
The point is that on a floating exchange rate, attempts to influence exchange rates are discretionary.  By contrast, with a fixed exchange rate, government must use policy to try to keep the exchange rate from moving. The floating exchange rate ensures that the government has greater freedom to pursue other goals—such as maintenance of full employment, sufficient economic growth, and price stability.
As we continue this discussion in coming weeks, we will argue that a floating currency provides more policy space—the ability to use domestic fiscal and monetary policy to achieve policy goals. By contrast, a fixed exchange rate reduces policy space. That does not necessarily mean that a government with a fixed exchange rate cannot pursue domestic policy. It depends. One important factor will be whether it can accumulate sufficient foreign currency (or gold) to defend its currency.
Next week, however, we will take a brief diversion to examine so-called commodity money. The fixed exchange rate based on a gold standard has been a reality in relatively recent times. And during much of the past two millennia, governments issued coins with silver and gold content. Many equate these with “commodity money”—a monetary system supposedly based on precious metal, indeed, one in which money derives value from embodied gold or silver.
We will come to a surprising conclusion, however. Even coins made of gold and silver are really IOUs stamped on metal. They are not examples of commodity money. They are sovereign currencies.
I can already hear the teeth of our resident Austrian gold bugs rattling so hard their fillings threaten to shake loose.

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BLOG #10 RESPONSES: ACCOUNTING FOR MONEY FLOWS

Posted on August 10, 2011 by | 15 comments

L. RANDALL WRAY

Thanks for comments. I am cutting off the responses early, and will keep this short, because I am in Euroland and preparing to fly back.

Let me quickly respond to the six people who commented, and then provide a short answer to the homework question.

Neil: One imposed constraint is that banks can refuse instructions to make transfers, including transfers ordered by government that has abandoned its fiat money.

Answer: OK for individuals the bank might refuse in two cases: apparent fraud or insufficient funds. We certainly applaud any bank that refuses to shift funds out of our account if it suspects fraud! We are not quite so happy when it refuses to clear a check in the case of an overdraft, because we get charged fees. But, OK, so far. In the case of government, I’m not quite so willing to go along with your suggestion, for two reasons. First, I do not really like the term fiat money and do not know what it is supposed to mean. I use the term sovereign currency. As I will discuss in coming weeks, there are different sovereign currency regimes—from fixed to floating rates. A sovereign’s currency is, on my definition, sovereign. There are constraints on sovereign spending, including those self imposed. It could instruct its bank (the central bank) NOT to make payments when its deposits are insufficient. It might even instruct the CB to impose fees for insufficient funds! Beyond that I am not quite sure what point you are making. Even if the sovereign government did not have a “fiat currency” (whatever that means) it could decapitate any central bankers that bounced checks. This might become more clear soon.

Had ‘Nuff: Money of account can be replaced by medium of exchange; domestic currency should include demand deposits; government IOUs are not debt; currency tax.
Answer: Think of it this way: Money of account is the measure (foot, yard, inch), medium of exchange is the thing being measured (shoe, arm, earlobe). Domestic currency is the government’s IOU; demand deposits are bank IOUs—so in my view we should not mix them. They are issued by quite different entities. An IOU is a debt, so government IOUs are debts. Not sure what point you are trying to make. 
Now, why would I disagree with JKH, who claims reserves should not be included in a definition of currency? Reserves, Federal Reserve Notes (our green paper money), Treasury notes (yes, Treasury has issued paper money, too), and Treasury coins are all IOUs issued by government (either Fed or Treasury), and all commit Uncle Sam. Fed losses come out of the Treasury. If Fed goes insolvent (which it might!), Treasury will cover the losses and recapitalize it.

Functionally there is one difference in that Reserves can only be held by banks; the rest can be held by you and me. But reserves are perfectly substitutable for all the others. So why do some resist recognizing this? They want to maintain the fiction that the Fed is not part of government. Sorry, Charley, it is. Plain and simple, it is a legal creature of Congress. Finally, I have no idea what a currency tax is.

James: Treasury’s account at the Fed is not counted as money supply but rather is a Fed IOU; but Treasury spending reduces its deposit at the Fed thus taxes do “pay for” Treasury spending.

Answer: Well, I do not see how. When you pay your taxes, you draw down your bank demand deposit. A private bank credits the Treasury’s account at the bank. BUT THE TREASURY CANNOT WRITE A CHECK ON THAT. There is no way the Treasury can “spend” your tax payment. It can only write checks on its account at the Fed, and you do not have an account at the Fed. You cannot deliver to the Treasury what it needs to spend. You might say I am being picky. I say I am being precise.

Hepion: Banks keep their money at the Fed; where does the Fed store it; and who manufactures it?

Answer: The Fed hides it in caves in Kansas City. Send a self-addressed and stamped envelope with $5000 in unmarked bills to me, and I will send you a secret treasure map with an X marking the spot.

Seriously: banks don’t keep money at the Fed, indeed, banks do not have any money. Willie Sutton (google him) was wrong. Don’t bother robbing banks, because that is NOT where the money is. Banks have an electronic account at the Fed—numbers on a harddrive. I suppose the harddrive is made in China. No other manufacturing is involved. In addition, banks have a very small amount of “vault cash” in their vaults. Believe me, not worth robbing. If you really want to rob banks, do what my colleague Bill Black says: the best way to rob a bank is to own one. Then you simply credit your own bank account with bonuses. Where will you get the millions of dollars to credit your account once you own a bank? Keystrokes.

Marley: How does Fed buy back Treasuries?

Answer: You are well on your way to getting this right. Fed credits private bank (selling the Treasuries) with Fed’s own IOU, bank reserves. Fed holds the bonds as assets, offset by reserves as liabilities. So in the end, although Fed cannot buy the bonds directly from the Treasury, it buys them from banks.

Adam: (Long post…I won’t repeat it)

Answer: By Jove, he’s got it! Excellent. Grade = A.

Homework Assignment: where does the electronic “scoreboard” money come from or go to? Think of the football game, or bowling. Where do the points “come from” when you score a touchdown or knock down a pin? Where do they go at the end of the game when we clear the score board? Well, they are just “key strokes”—electronic pulses that light up the LED when points are scored, and we stop sending the pulses to turn off the LEDs. That’s all there is to it. Keystrokes.

Follow up homework? Can Government run out of keystrokes?

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MMP Post #10 — Keeping Track of Stocks and Flows: The Money of Account

Posted on August 8, 2011 by | 10 comments
Stocks and flows are denominated in the national money of account. In previous weeks we examined the definitions of stocks and flows, as well as the relations between the two. (It might be helpful if you quickly review the previous discussion on stocks and flows, and the relation between the two: flows accumulate to stocks.) Financial stocks and financial flows are denominated in the national money of account. In this blog we will go through the details of keeping track of stocks and flows in the money of account. That will also lead us into a discussion of the relation between “money” and “spending”—how do we “pay for” things?
As discussed in the past two weeks, the money of account is almost always the domestic currency—the money of account chosen by the government. In some cases, however, the accounts can be kept in a foreign currency. For the purposes of this blog we will ignore that complication—all the record keeping discussed here will be presumed to take place in a single national unit of account. Let us begin with the case of an employee earning wages.
 While working, the employee earns a flow of wages denominated in a money of account accumulating a monetary claim on the employer. On payday, the employer eliminates the obligation by providing a paycheck that is a liability of the employer’s bank. Again, that is denominated in the national money of account.
If desired, the worker can cash the check at her bank, receiving the government’s currency—again an IOU, but this time a debt of the government. Alternatively, the check can be deposited in the worker’s bank, leaving the worker with an IOU of her bank, denominated in the money of account.
Wage income that is not used for consumption purchases represents a flow of saving, accumulated as a stock of wealth. The saving can be held as a bank deposit, that is, as financial wealth (the bank’s liability).
When it comes time to pay taxes, the worker writes a check to the treasury, which then debits the reserves of the worker’s bank. Reserves are just a special form of government currency used by banks to make payments to one another and to the government. Like all currency, reserves are the government’s IOU.
So, when taxes are paid, the taxpayer’s tax liability to the government is eliminated. At the same time, the government’s IOU that takes the form of bank reserves is also eliminated. The tax payment reduces the worker’s financial wealth because her bank deposit is debited by the amount of the tax payment.
We can conceive of a flow of taxes imposed on workers, for example, as an obligation to pay ten percent of hourly wages to government. A liability to government accumulates over the weeks as wages are earned, which is a claim on the worker’s wealth. The tax liability, measured in the money of account, is eliminated when taxes are paid by reducing the worker’s financial wealth (debiting deposits also measured in the money of account) and the bank’s reserves are simultaneously debited by government.
At the same time, the government’s asset (the tax liability owed by the worker) is eliminated when taxes are paid, and the government’s liability (the reserves held by private banks) is also eliminated.
Sometimes it is useful to compare these flows to water flowing in a river, that gets accumulated as a stock behind a dam. However, it is important to understand that these monetary stocks and flows are conceptually nothing more than accounting entries, measured in the money of account. Unlike water  flowing in a stream, or held in a reservoir behind a dam, the money that is flowing or accumulating does not need to have any physical presence beyond ink on paper or electrical charges on a computer hard-drive.
Indeed, in the modern economy, wages can be directly credited to a bank account, and taxes can be paid without use of checks by debiting accounts directly. We can easily imagine doing away with coins and paper notes as well as check books, with all payments made through electronic entries on computer hard-drives.
All financial wealth could similarly be accounted for without use of paper. Indeed, most payments and most financial wealth are already nothing more than electronic entries, always denominated in a national money of account. A payment leads to an electronic debit of the account of the payer, and a credit to the account of the payee—all recorded using electrical charges.
The financial system as electronic scoreboard. The modern financial system is nothing but an elaborate system of record-keeping, a sort of financial scoring of the game of life in a capitalist economy.
For those who are familiar with the sport of American football, financial scoring can be compared with the sport’s scoreboard. When a team scores a touchdown, the official scorer awards points, and electronic pulses are sent to the appropriate combination of LEDs so that the scoreboard will show the number six. As the game progresses, point totals are adjusted for each team.
The points have no real physical presence, they simply reflect a record of the performance of each team according to the rules of the game. They are not “backed” by anything, although they are valuable because the team that accumulates the most points is deemed the “winner”—perhaps rewarded with fame and fortune.
Further, sometimes points are taken away after review by officials determines that rules were broken and that penalties should be assessed. The points that are taken away don’t really go anywhere—they simply disappear as the scorekeeper deducts them from the score.
Similarly, in the game of life, earned income leads to “points” credited to the “score” that is kept by financial institutions. Unlike the game of football, in the game of life, every “point” that is awarded to one player is deducted from the “score” of another—either reducing the payer’s assets or increasing her liabilities.
Accountants in the game of life are very careful to ensure that financial accounts always balance. The payment of wages leads to a debit of the employer’s “score” at the bank, and a credit to the employee’s “score”, but at the same time, the wage payment eliminates the employer’s implicit obligation to pay accrued wages as well as the employee’s legal claim to wages.
So, 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”.
Your homework assignment (should you choose to accept it): Think about government spending and taxing in terms of those scoreboard electronic entries. When government “spends money”, where does it come from? When we pay taxes, where does the “money” go? In what sense does the government “spend the money it receives in tax payments?”

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WHAT IF THE POPULATION REFUSES TO ACCEPT SOVEREIGN CURRENCY: RESPONSES TO MMP BLOG #9

Posted on August 4, 2011 by | 9 comments

Another good set of comments. Either my readers are getting a heck of a lot smarter, or I’m getting better at explaining MMT. As usual, let me group responses by topic.

  1. Why is gold accepted? Well, it is bright, it is shiny, and it is the “noble element” that never changes—easy to clean-up, can be smashed into impossibly thin sheets, and looks good in ears and on fingers and in teeth (at least to some people). It also benefits from an almost mystical quality—with several thousand years at the top of the totem pole of desirable prestige goods. Oh, and yes, many countries pegged their currencies to gold in not-so-recent years. Finally, its value is maintained by fairly robust manufacturing demand as well as propensity of governments to lock most of it up behind bars. Speculators bet that governments will not release the imprisoned gold, which would instantly wipe all them out. To hedge their bets, they help to put goldbugs in government. So far as I can tell, there are no rival plausible explanations for the fascination with gold.
  2. MMT explodes heads. Probably true. Not a criticism, however. Darwin exploded heads. Newton exploded heads. Why shouldn’t the occasional economist? One of my PhD students put it much better. On the last day of class he brought in a pair of those distorting glasses for each student (and professor!) and demanded each put them on. He said that this is what MMT had done for him—his whole world view had been shown to be distorted and wrong. Then we all took the glasses off, and could see the world as it exists. There you go. Downright Kuhnian.
  3. Is government benevolent, having the interests of the population in mind? Does that belief stand behind MMT? Emphatically “NO”. Have you been paying attention to the Obama administration? Have you ever heard of a maniac named Hitler? Do you really think that when Michelle Bachmann is elected to replace Obama she’s suddenly going to turn all nice and democratic? (No, I am not equating the three politicians—two of the three are irredeemably evil. The jury is still out on the third.) MMT “works” no matter how depraved or democratic the government is. That is an entirely separate question. MMT is for Austrians, too. So long as they have not been abducted and probed by aliens. Then all bets are off.
  4. Do governments have to “finance” their deficits. Well, that depends on what we mean by “finance”. Sorry, don’t mean to sound Clintonian here. Let us save that for next week.
  5. Is all money debt? YES, all money “things” are debt. Can issue of bonds affect interest rates? No, not necessarily. Depends on central bank policy—if central bank does not want interest rates to go up, it can always prevent that. Again, a topic for detailed treatment later. Is a “debt cloud constraint” good because it constrains government spending? Well, as Paul Samuelson says, it can work like that “old time religion”—it is a lie, but he claims lies are sometimes useful. I’m a professor. I cannot lie. I will not lie to you. I will tell you the truth and you can decide whether you prefer the lies. I do think government spending should be constrained. But I believe we can tell people the truth and let them choose to constrain government. I’m in a distinct minority on this issue, however. Almost all economists—including Beltway “progressives”–prefer to lie to you. You can choose what you prefer. There are plenty of beltway progressive “think tanks” that spout the lies.
  6. Some claim fiat money is accepted because it “stores value”. What value is there in a piece of paper that says “I promise to pay you 5 pounds”? Zero. Infinite regress argument—it has value only if some poor dupe thinks it does. Or, some claim fiat money is accepted because it is backed by oil. Really? How gullible can you be? Take a dollar bill down to Treasury and demand conversion to oil. Go ahead, we will wait for a report on Geithner’s response. Really. Go ahead. Report back next week.
  7. Can we drop the FICA tax and still have a viable Social Security program. Yes. Should we? Emphatic yes. Go here. There are also many posts here at NEP that make a similar argument. Tell your “progressive” friends: Don’t hang my Social Security on the hated, job killing, regressive payroll tax! My sovereign government can always make all promised payments as they come due. Period. Then hold your dim-witted Congress-people to that promise.

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MMP Blog #9: What If the Population Refuses to Accept the Domestic Currency?

Posted on July 31, 2011 by | 19 comments
By LR Wray

In the last two weeks we asked, and answered, the question: why would anyone accept a “fiat currency” that has no intrinsic value without precious metal backing? We have argued that legal tender laws, alone, are not sufficient because it is generally too difficult for government to enforce them. Further, we know that “fiat currencies” are often accepted even where their use is not required (ie: where there are no legal tender laws, or at least none that are applicable).

We concluded that “taxes drive money”: if a sovereign has the power to impose and enforce a tax liability, it can ensure a demand for its currency. This is the one transaction that government can ensure its “fiat currency” is used: in payments made to itself.

We also concluded that other kinds of obligations will work: if you need the currency to pay fees, fines, or tithes, you will demand at least enough currency to make those payments. And, finally, we argued that an authority that monopolizes a needed resource (land, energy) can “name the price”, i.e., dictate what must be delivered to obtain it. So that, too, could drive a currency—and, again, it is because the authority can choose the form in which the payment is made.

The best kind of payment is an obligatory one—one that must be made to stay out of prison, or to avoid death by thirst. An obligatory payment that must be made in the sovereign’s own currency will guarantee a demand for that currency.

And we argued that even if one does not owe taxes (or fees, etc.) to the sovereign, one might still accept the currency knowing that others do have tax liabilities and thus will accept the currency. But how much currency will be accepted? Can the sovereign issue more than the tax liability? How much more?

Imposing and enforcing a tax liability ensures that at least those subject to taxes will want the domestic currency, in an amount at least equal to the tax liability that will be enforced. In the developed nations, the population is willing to accept more domestic currency than what is needed for tax payments—typically government does not find sellers unwilling to sell for its currency.

The normal case—let us say, in the US or the UK or Japan—is that anything for sale is for sale in the domestic currency. These sovereign governments never find that they cannot buy something by issuing their own currency.

To be clear: if there is something for sale with a US Dollar price, it can be bought by delivering US currency. (We will just note a caveat here, to be explained more fully later: sometimes, especially for payments made by mail, paper currency and coins are not accepted. But when a payment is made by check, there is a transfer of bank reserves—a kissing cousin to sovereign currency.)

However, the situation can be different in developing nations in which foreign currencies might be preferred for “private” transactions (payments that do not involve the sovereign). To be sure, the population will want sufficient domestic currency to meet its tax liability, but the tax liability can be limited by tax avoidance and evasion. This will limit the government’s ability to purchase output by making payments in its own currency.

We can get a rough idea of the limit imposed on a government whose population prefers foreign currency. Let us say that the government imposes a tax liability equal to one-third of measured GDP. However, because the informal sector escapes accounting, let us assume that GDP only represents half of the true level of output.

Further assume that government is only able to collect half of imposed taxes due to evasion. This means that collected taxes equal only one-sixth of measured GDP and only one-twelfth of true output and income. (Hello, Greece! Just kidding, but that is one of the claims frequently made.)

At a minimum, in such a situation government will be able to move one-twelfth of national output to the public sector through its spending of the domestic currency (since those who really do have to pay taxes need the domestic currency to meet their obligations).

In practice, the government will probably be able to capture more than one-twelfth of national output because some “private” entities (domestic and perhaps foreign) will want to accumulate domestic currency as well as other claims on government (such as government bonds)—recall from previous discussion that government deficits allow accumulation of net financial wealth in the form of government IOUs. Hence it is likely that government will be able to purchase somewhat more than a twelfth of GDP, while collecting taxes equal to a twelfth of national income, with some households or firms (or foreigners) accumulating the rest of the currency spent as net financial wealth.

(These calculations are necessarily approximate because we are ignoring possible effects of taxing and spending on the behaviour of the population. For example, imposing a tax can drive more production into the “grey market”, leaving measured GDP and taxable income lower.)

To capture a larger per cent of national output, government needs to pursue policies that will a) reduce tax evasion and b) formalize more of the informal sector. Both of those actions would increase taxes on the population and would allow government to obtain more output.

If taxes are at just one-twelfth of national output, it might not be effective for government to simply increase its spending to try to move more resources to the public sector—this could just result in inflation, as sellers would accept more domestic currency only at higher prices (as they already have all the currency they need to meet the tax obligation they think will be enforced). And beyond some point, government might not find any sellers for additional currency.

While it would be incorrect—for reasons explored later—to argue that taxes “pay for” government spending, it is true that inability to impose and enforce tax liabilities will limit the amount of resources government can command.

The problem is not really one of government “affordability” but rather of limited government ability to mobilize resources because it cannot impose and enforce taxes at a sufficient level to achieve the desired result.

Government can always “afford” to spend more (in the sense that it can issue more currency), but if it cannot enforce and collect taxes it will not find sufficient willingness to accept its domestic currency in sales to government.

Put simply, the population will find it does not need additional domestic currency if it has already met the tax liability the government is able to enforce (plus some accumulation of currency for contingency purposes). In that case, raising taxes would increase demand for government’s currency (to pay the taxes), which would create more sellers to government for its currency.

Until government can impose and collect more taxes, its spending will be constrained by the population’s willingness to sell for domestic currency. And that, in turn, is caused by a preference for use of foreign currency for domestic purposes other than paying taxes. While this is not a big problem in developed countries, it can be a serious problem in developing nations.

In this blog, we have presumed government spends and taxes using currency (notes and coins). In practice, governments use checks and increasingly use electronic entries on bank accounts. Indeed, government uses private banks to accomplish many or most transactions related to spending and taxing.

In coming weeks we will provide a more “realistic” account of taxing and spending using bank accounts rather than actual currency. This does not change anything of substance—but it does require some understanding of banking, central banking, and treasury operations, discussed in the following blogs.

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RESPONSE TO BLOG 8: MORE ON TAXES DRIVE MONEY

Posted on July 27, 2011 by | 22 comments
By L. Randall Wray
Thanks again for well-focused questions and comments. Here we are concerned with why government “fiat”currency is accepted. The short answer was that “taxes drive money”: since you have a tax liability that must be cleared by delivering the government’s own currency back to government, you want to obtain government currency. So in that sense, it is the tax liability that drives the desire to obtain government currency.
I did leave a couple of teasers, which some touched on in their comments. First, does it have to be a tax? Clearly the answer is “no”: if government imposes a fine on you in the form of five Dollars, you need five Dollars in the form government is willing to accept to pay your fine—sovereign currency. Until the 20th century, taxes were relatively less important; what mattered more were fines and tithes and fees.
To go further, let us say government monopolizes the water supply (or energy supply, or access to the gods, etc); it can then name what you need to deliver to obtain water (energy, religious dispensation, etc). In that case, if it says you must obtain a government IOU, then you want government IOUs—currency—to obtain water in order to avoid death by dehydration. In early 19th century England, almost all activities necessary to keep your family alive were illegal by dictate of the crown. You had to pay a fine after you killed game to feed your family. You needed the crown’s currency to pay the fine—hence “fees drove money”. You get the picture.
All you need to drive a currency is a more or less involuntary obligation to deliver the currency—and that can be a tax, fee, fine, or even religious tithe. Or a payment to obtain water or any other necessity. We can go into this later, but at UMKC students need buckaroos to pay a “tax” to pass their courses—that drives the buckaroo currency—it creates a demand for buckaroos (the sovereign currency at UMKC).
That answers the question: yes it is not enough to impose the obligation (fee, fine, tax); the obligation must also be enforced. A tax liability that is never enforced will not drive a currency. A tax that is only loosely enforced can create some demand for the currency, but it will be somewhat less than the tax liability for the simple reason that many will expect they can evade the tax.
We can next move on to the second teaser: why would those who do not have tax liabilities also be willing to accept currency?
That leads us to the Tobin, “snowball” point: if some segment of society owes the tax (or fee or fine) denominated in the currency, others will accept it. Note this is not an infinite regress argument. It is the tax standing behind the currency. But it is not necessary for every individual to owe the tax.
Let us say that Bill Gates owes $1.5 trillion in taxes. I’d be happy to accept Dollars since I know Gates will accept them when I purchase Microsoft software. And that explains why foreigners want dollars—not because they owe taxes, but because a sufficient number of Bill Gates do.
From inception we know that if the total tax liability in dollars is, say, $100 billion, the taxpayers will want a minimum of $100 billion. (How much more? $120 billion? $180 billion? We will investigate that later.) Government can spend into the economy at least that amount.
How much will the Dollar be worth? Well, that depends on what must be done to obtain it. We will have much more to say about that in coming weeks.
A commentator did hit on this point: what if the tax liability is too low? Let us say the tax liability is $100 billion but government tries to spend $1000 billion. This is ten times what the taxpayers need to cover their liabilities. It is possible—even probable—that government will not be able to find takers for the $1000 billion. It can bid the price it is willing to pay (for labor, finished output, or resource inputs) up, but still find no takers. We could register “inflation” and still find government cannot spend as much as it wants.
A better solution—obviously—is to raise the tax liability toward $1000 billion, rather than to increase the price government is willing to pay. Again, that is something we will come back to, but it also sheds some light on what determines the value of the currency. As I said last week, we need to separate the willingness to accept currency from the value of the currency. Raising the tax liability will increase the desire to obtain currency although that does not tell us exactly how much the value of currency (in terms of labor or other resources) will rise.
Valuing something like a bridge is very difficult—especially if we are talking about a bridge already in place. Fortunately, it is also a question that is not very important, so long as the bridge is public—not owned by some profit seeking entity. There really is very little reason to value public infrastructure once it is in place, except perhaps in terms of all the pleasure it provides to the population. That is probably something that cannot be and should not be measured in money terms.
But, yes, raising the tax liability while holding government issue of the currency constant is likely to lead to what we might call unemployment: those willing to work to get the currency in order to pay taxes, but who cannot find work or demand for output to obtain the currency.
We will later go through the accounting to answer the question raised by a commentator: what about the reserve effects of tax payments? But, briefly, yes, paying taxes will all else equal reduce outstanding bank reserves. In practice, if the central bank targets overnight interest rates, it will replace lost reserves if they were desired or required—by lending at the discount window or through open market purchases of treasuries.
There were several questions/comments that were not comprehensible to me: what about interest, which requires one to repay more than what is owed. I do not see the relevance to this week’s topic. What about issuing money with no offsetting debt? Well, all money “things” are IOUs hence are debts, hence there is no possibility of issuing money that is not a debt. What about socio/political ramifications of who pays the tax? Yes very important, but I do not see the relevance to the topic at hand.

OK I hope I have covered the main comments and questions. More next week.

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MMP BLOG #8: TAXES DRIVE MONEY

Posted on July 24, 2011 by | 24 comments

By L. RANDALL WRAY

Last week we raised the following question: Where currency cannot be exchanged for precious metal, 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 more than exchanging one 5 Dollar note for another 5 Dollar note, then why would anyone accept a government’s currency? This week we explore the MMT answer.

Taxes drive money. One of the most important powers claimed by sovereign government is 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, Yen in Japan, Yuan in China, and Pesos in Mexico. 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.


We will examine in more detail in coming blogs exactly how payments are made to government. While it appears that taxpayers mostly use checks drawn on private banks to make tax payments, actually, when government receives these checks it debits the reserves of the private banks. Effectively, private banks intermediate between taxpayers and government, making payment in currency (technically, reserves that are the IOU of the nation’s central bank) 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 are now able to answer the question posed earlier: why would anyone accept government’s “fiat” currency? Because the government’s currency is the main (and usually the only) thing accepted by government in payment of taxes. To avoid the penalties imposed for non-payment of taxes (that could include prison), the taxpayer needs to get hold of the government’s currency.

It is true, of course, that government currency can be used for other purposes: coins can be used to make purchases from vending machines; private debts can be settled by offering government paper currency; and government money can be hoarded in piggy banks for future spending. However, these other uses of currency are all subsidiary, deriving from government’s willingness to accept its currency in tax payments.

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. The government cannot readily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes.

For this reason, neither reserves of precious metals (or foreign currencies) nor legal tender laws are necessary to ensure acceptance of the government’s currency. All that is required is imposition of a tax liability to be paid in the government’s currency.

What does government promise? What does a government IOU owe you? The “promise to pay” that is engraved on UK Pound notes is superfluous and really quite misleading. The notes should actually read “I promise to accept this note in payment of taxes.” We know that the UK treasury will not really pay anything (other than another note) when the five Pound paper currency is presented. However, it will and must accept the note in payment of taxes. If it refuses to accept its own IOUs in payment, it is defaulting on that IOU. What was it that President Bush said?

“There’s an old saying in Tennessee — I know it’s in Texas, probably in Tennessee — that says, fool me once, shame on — shame on you. Fool me — you can’t get fooled again.”

Forgive him as he probably listened to Roger Daltry a bit too much back in his partying days. What he meant is that the sovereign can fool me once—shame on government—but it cannot fool me again. (That, folks, is what led to the creation of the Bank of England! A story for another day.)

This is really how government currency is redeemed—not for gold, but in payments made to the government. We will go through the accounting of tax payments later. It is sufficient for our purposes now to understand that the tax obligations to government are met by presenting the government’s own IOUs to the tax collector.

Conclusion. We can conclude that taxes drive money. The government first creates a money of account (the Dollar, the Tenge), 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.

(Note the asymmetry that is open to a sovereign: it imposes a liability on you so that you will accept its IOU. It is a nice trick—and you can do it too, if you are king of your own little castle.)

The government is then able to issue a currency that is also denominated in the same money of account, so long as it accepts that currency in tax payment. It is not necessary to “back” the currency with precious metal, nor is it necessary to enforce legal tender laws that require acceptance of the national currency. For example, rather than engraving the statement “This note is legal tender for all debts, public and private”, all the sovereign government needs to do is to promise “This note will be accepted in tax payment” in order to ensure general acceptability domestically and even abroad.

Ok we need a cliff-hanger. Here are two questions to ponder for Wednesday:

  1. Does this work only for taxes? Could other obligatory payments work? Like what?
  2. What if you do not, personally, owe taxes? Why would you accept the government’s currency?

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WHY IS CURRENCY ACCEPTED? RESPONSES TO COMMENTS ON MMP BLOG #7

Posted on July 21, 2011 by | 21 comments
By L. RANDALL WRAY
So the Telenovela trick worked: many good comments and questions, with no one destroying the plot line.
Let me briefly address them by grouping them into six general areas. And then on Monday we will give an answer to the question: why would anyone accept a sovereign currency? On the comments page I already addressed two questions so will not repeat my answers to those here.

  1. Can gold be money? No. Never. If gold could be money, why not silver? Copper? Coconuts? Fish? Domestic services? A fuller answer will have to wait. In my view, money can never be a “commodity”. For our economistic friends, recall the line from Clower: “goods buy money, money buys goods, but goods never buy goods.” If a commodity could be money, we have a case of “goods buying goods”. There is not, never has been, such a thing as a “commodity money”.
  2. Money is a “custom”, “law”, “norm”, “rule”. Ok, not specific enough for my taste. What is the nature of that custom, law, norm, rule? I do think that referring to “law” is on the right track. In my view, “custom”, “norm”, “rule” does not pin it down. This should be clear from the blogs I have posted the last two weeks. (Hint: why did I use the term “sovereignty”?) Veblen skewered the “leisure class” for its customs and norms—I love his explanation of the development of the custom of growing long fingernails (mostly, but not exclusively, on women—to prove that one is not and cannot be productive). These things are important. But they do not shed much light on money. Laws? Yes, you are getting hot (remember the game you played with your mum?–hide the thimble). But not legal tender laws—nothing but a “pious wish”, as Knapp put it.
  3. Why would those outside the US be willing to use dollars? Very good question. And, yes, it is related to a wish to “join the party” put on by the biggest economy in the world. But it really does beg the question, no? Certainly it must be related to willingness of Americans to accept dollars. But we do not want a “hot potato” or “infinite regress” argument (which Ramanan accuses us of, continuing to misstate the MMT position—her/his “MO”, unfortunately, and she/he does know better). So….why do Americans want dollars? Ah, yes, that is the question.
  4. Are all debts denominated in money, such as the schoolyard debts amongst children? No. For an excellent, and I mean really, truly excellent, book on debt broadly defined, please read Margaret Atwood’s “Payback: debt and the shadow side of wealth”. She documents that chimps keep careful records of debts and credits. If Chimp A helps defend me against an attack but I do not “payback” next time Chimp A is attacked, I cannot count on her when I need help. Yes, we are cousins of chimps, and yes we keep careful track of debts and credits. But many or most of these are not denominated in money terms. So far as we know, Chimps have never come up with the concept of a unit of account. But remember, if a chimp does you a favor, you’d better pay up.
  5. Does it have something to do with accounting systems of credits and debits, denominated in dollars? Bingo. We are onto something here. Credits and debits. Measured in a money of account. Keep that in mind for next week. Ponder this: if currency is related to the sovereign government, what debit/credit relation do we have with that sovereign? Remember the chimps. What do we owe our sovereign chimp?
  6. Soddy: the value of money is determined by the wealth given up when money is accepted. Except for some unfortunate terminology, we’ve again “struck gold”. The value of a currency depends on what we have to “give up” to get it. Be careful here—the value of the currency is not quite the same thing as willingness to accept it. Just because I am willing to accept a currency does not determine its value. “What am I willing to do to obtain it?” That is not the same as: “Why am I willing to accept it?” (Soddy was brilliant and came up with the Soddy principle: debts tend to grow faster than incomes due to compound interest, which is why we need the Year of Jubilee when all debts are forgiven. But we adopted the Roman view of time—abandoning the circular view of time that all previous societies accepted—so that we can never “go back”, debts can never be forgiven because property rights are sacrosanct, including the creditor’s right to squeeze blood out of an orange. So we have to have bankruptcy court, debtor’s prisons, and IMF sanctions. Ain’t Roman civilization grand?)  So I need dollars (why?) and am willing to “give up something” to get them (how much?). Those, as our Hamlet might say, are the key questions about money: why, and how much?

OK, so the suspense is killing you. Four long days to wait for the answer to be revealed. Plot spoilers: go ahead and do your damage.

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MMP BLOG #7: WHAT BACKS UP CURRENCY, AND WHY WOULD ANYONE ACCEPT IT?

Posted on July 17, 2011 by | 19 comments

Last week we introduced the concept of a sovereign currency. When I first started teaching, most students thought the US Dollar had gold backing—that it was valuable because Fort Knox was filled with gold, and if they drove to the Fort with a stash of cash, they could load up their car trunks with gold. (They were shocked to find out there had not been any gold backing since they were babies.) Today, very few students entertain such beliefs—they have all learned that our currency is “fiat”—it has “nothing” backing it up. Well, maybe “something”—but we don’t necessarily want to see what is behind Alan Greenspan’s “curtain”:

So, this week, let us take a peek behind the currency. Is there anything there, other than the Fed Chairman’s—how shall we put it—family jewels?

What “backs up” domestic currency? There is, and historically has been, some confusion surrounding sovereign currency. For example, many policy makers and economists have had trouble understanding why the private sector would accept currency issued by government as it makes purchases.

Some have argued that it is necessary to “back up” a currency with a precious metal in order to ensure acceptance in payment. Historically, governments have sometimes maintained a reserve of gold or silver (or both) against domestic currency. It was thought that if the population could always return currency to the government to obtain precious metal instead, then currency would be accepted because it would be thought to be “as good as gold”. Sometimes the currency, itself, would contain precious metal—as in the case of gold coins. In the US, the Treasury did maintain gold reserves, in an amount equal to 25% of the value of the issued currency, through the 1960s (interestingly, American citizens were not allowed to trade currency for gold; only foreign holders of US currency could do so).

However, the US and most nations have long since abandoned this practice. And even with no gold backing, the US currency is still in high demand all over the world, so the view that currency needs precious metal backing is erroneous. We have moved on to what is called “fiat currency”—one that is not backed by reserves of precious metals. While some countries do explicitly back their currencies with reserves of a foreign currency (for example, a currency board arrangement in which the domestic currency is converted on demand at a specified exchange rate for US Dollars or some other currency), most governments issue a currency that is not “backed by” foreign currencies. In any case, we need to explain why a currency like the US Dollar can circulate without such “backing”.

Legal tender laws. One explanation that has been offered to explain acceptability of government “fiat” currency (that has no explicit promise to convert to gold or foreign currency) is legal tender laws. Historically, sovereign governments have enacted legislation requiring their currencies to be accepted in domestic payments. Indeed, paper currency issued in the US proclaims “this note is legal tender for all debts, public and private”; Canadian notes say “this note is legal tender”; and Australian paper currency reads “This Australian note is legal tender throughout Australia and its territories.” By contrast, the paper currency of the UK simply says “I promise to pay the bearer on demand the sum of five pounds” (in the case of the five pound note). And the Euro paper currency makes no promises and has no legal tender laws requiring its use.

Further, throughout history there are many examples of governments that passed legal tender laws, but still could not create a demand for their currencies—which were not accepted in private payments, and sometimes even rejected in payment to government. (In some cases, the penalty for refusing to accept a king’s coin included the burning of a red hot coin into the forehead of the recalcitrant—indicating that without such extraordinary compulsion, the population refused to accept the sovereign’s currency.) Hence, there are currencies that readily circulate without any legal tender laws (such as the Euro) as well as currencies that were shunned even with legal tender laws. Further, as we know, the US Dollar circulates in a large number of countries in which it is not legal tender (and even in countries where its use is discouraged and perhaps even outlawed by the authorities). We conclude that legal tender laws, alone, cannot explain this.

If “modern money” is mostly not backed by foreign currency, and if it is accepted even without legal tender laws mandating its use, why is it accepted? It seems to be quite a puzzle. The typical answer provided in textbooks is that you will accept your national currency because you know others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an “infinite regress”: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will probably take it. What a thin reed on which to hang monetary theory!

Personally, I’d be embarrassed to write that in my own textbook, or to try to convince a sceptical student that the only thing backing money is the “greater fool” or “hot potato” theory of money: I accept a dollar bill because I think I can pass it along to some dupe or dope.

Now, that is certainly true of counterfeit currency: I would take it only on the expectation that I could surreptitiously pass it along.

But I’m certainly not going to try to convince readers of this Primer of such a silly theory. Next week: a more convincing argument. See if you can anticipate the answer.

Like a good Mexican soap opera, we need to leave you hanging. I know many readers already know the answer, and you’ve got your hands high in the air, saying “call on me, I know the Butler did it”.

But remember that this is a Primer and not all of your classmates know the answer (yet). So, please don’t give away the plot line. In the comments, let us stick to the “gold standard” vs “fiat money” or “legal tender” and “hot potato” theories of money. I am sure we’ve got at least a few “goldbugs” out there. You probably cheered when Ron Paul asked Bernanke whether gold was money. Is gold money? Can it be money? If gold no longer backs money, why does the Fed hold it? Could a currency be backed by nothing more than “trust”—the expectation that someone, somewhere, will take it?

Have fun pondering.

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SOVEREIGN CURRENCY, MEDIUM OF EXCHANGE, AND SECTORAL BALANCES: Response to Comments on MMP Blog #6

Posted on July 14, 2011 by | 5 comments

Thanks for comments. As you may have noticed, I kept the blog shorter this week so that we could focus on a smaller range of topics. That seems to have helped—the comments this week are also well-focused. I think I can hit the main concerns by addressing three topics.

  1. Relation between the sovereign currency and the medium of exchange: We first introduced the money of account: the Dollar in the US and the Pound in the UK. This is a unit of account, a measuring unit like the “inch”, “foot” and “yard”. It does not exist even as an electronic entry; not even a bloodhound could sniff it out. It is representational, something only a human could imagine. Next we introduced the concept of “money things”—denominated in the money of account. (Similarly, our unit used to measure length cannot be sniffed by dog, but it does have physical things that can be sniffed and measured: the inch worm is an inch in length, my foot is a foot—more or less, and the football field is 100 times the distance from Henry the first’s nose to thumb. Probably more, actually, as we know those kings exaggerated the size of their anatomical features, like rap stars today.) This can include paper, notes, and electronic entries. We’ll say a lot more about the nature of those things that get measured by the money of account. This week we introduced the sovereign currency—the national money of account adopted by a sovereign government. While a money of account could—in theory—be created and adopted by private entities, the sovereign currency is adopted by the sovereign government; and the sovereign currency is usually at least the primary money of account if not the only money of account used within a sovereign nation.

    The word “currency” is frequently used to designate not only the money of account adopted by sovereign government, but also to designate a money thing issued by the sovereign government and denominated in the money of account. In the US it is the coin issued by the Treasury and the note issued by the Fed. In other words, we use the term “Dollar” to indicate both the sovereign currency (money of account) and the money thing (paper note or coin) issued by the US government. We have not yet got to the “medium of exchange”. Most textbooks begin with the medium of exchange (Crusoe and Friday look about for handy sea shells to function as convenient media of exchange). I reject that story and purposely wait to introduce the concept. But to jump ahead a bit, yes the “money thing” currency issued by government generally functions as a medium of exchange. Other privately issued money things also frequently function as media of exchange. That is a function of money things, and really does not help us to understand much about the nature of money. When you walk into a relatively new diner or any other “mom and pop” firm, there usually is a frame hanging on the wall, with a Dollar bill and some sort of statement like “the first dollar we ever earned”. Here, money functions as a memento—reflecting the pride of the owner of the establishment. Two decades ago, there were lots of stories of Wall Street traders using hundred Dollar bills functioning as cocaine delivery devices. I don’t think it is useful to put undue emphasis on the various functions of money. Let us at least first try to understand its nature.

  2. That leads us to the question about “bank money”. Again, we will get into this in detail in coming weeks. However, to break the suspense, banks (and other institutions as well as individuals) can issue IOUs denominated in the money of account. We do not call these “currency”. They are not issued by sovereign government. They are “money things”. Yes, some are more “special” than others: the IOU of the Bank of America (a private bank—not Uncle Sam’s bank) is more “special” than the IOU that you issue. Yes, it can function as a medium of exchange. The reasons for the “specialness” will be examined later. But an obvious one is that to some degree Uncle Sam stands behind BofA—for example, he guarantees demand deposits (your checking account).

    So, yes I do understand the worry that Uncle Sam has essentially licensed BofA to “counterfeit” Dollars—if the bank goes bust, Uncle Sam will pay out nice new Dollar bills to depositors. This raises many issues of concern, and some of those are directly relevant to the global financial crisis we are going through—in which Uncle Sam has effectively done just that. But for right now, that really would take us too far afield. Please be patient.

  3. Currencies and balances. Recall that we have discussed (briefly) unsold inventories. Suppose it is the end of the year 1974 and we are Ford motor company and we produce 1000 Ford Pintos (remember those—the ones with exploding gas tanks?) that we cannot sell. Unsold inventory gets counted as investment. Ford carries the inventory at its market price—let us say, the average price of Pintos that it actually did sell in 1974. Assume it cannot sell them in 1975, either (deep recession, bad publicity about the tanks, and so on). How to value them? All things equal, Ford would prefer not to book a loss of value—it carries them at original value, otherwise, the value of its inventory declines impacting 1975 profits and net worth. Now in 2011 it is still carrying those Pintos in inventory. You see the problem. We have to assign a dollar value to them.

    Now let’s address the problem of dual currencies. Suppose Ford produces cars in America but sells them in America and Japan. It imports all the electronic components from Japan. It can keep two sets of books—one for Dollars and one for Yen. It has income and outgo in each currency. Clearly it could run a deficit in one and a surplus in the other (or surpluses in both, or deficits in both, etc—you get the picture). All other firms, households, and levels of government can do the same in Dollars and Yen. Adding up all the sectors, we get to our three balances in each of the currencies. But Ford’s shareholders do not want to know that it has a surplus in Dollars of 1 billion and a deficit in Yen of 1 trillion—it wants the overall balance for Ford’s income. Just as we have to convert Pintos to Dollars, we have to convert those Yen to Dollars. We need an exchange rate. Yen and Dollars float—changing every day in relative value. It is going to make a huge difference what exchange rate we use.

    So, yes I am sympathetic to “Tobinesque’s” comments. The cleanest way is to keep the accounts separate and there will be sectoral balances in each currency that do balance. But, yes, a government as well as a firm needs a budget in one currency (generally it is going to be the domestic currency) and so if income and outgo occur in more than one, exchange rates must be used to get everything into that currency of denomination. This is true even if the government/firm/household actually has bank accounts denominated in the foreign currency. This complicates matters because now the sectoral balances will not balance (exactly) unless everyone uses the same exchange rate all the time—which would happen if we pegged.

    This issue has come up before—there are variations in estimates of the three balances. One reader pointed out that one of the graphs I used showing—say—the private deficit during the Clinton years differed a bit from a later one I showed here on the MMP. The reason was due to updated data and different sources (the older one came from Wynne Godley and the later one from Scott Fullwiler). As they say, economics is not an exact science!

    More seriously, you should not think that aggregate economic data like GDP or the CPI (consumer price index), or the sectoral balance are measured precisely. These are estimates, using data that is constructed. What is important is consistency. I know this always shocks students the first time they hear it. But the CPI does not come from heaven. It is constructed, it is revised, and it is subject to great debate among wonky people with thick glasses. And believe it or not, it does matter exactly how these data are constructed. But do not get misled by that. Certainly at the level of logic, the three balances do balance. If we could measure things exactly, they would balance in practice. Knowing that they should balance, the statistician who puts them together ensures they do balance—by construction. This is not easy; a “statistical discrepancy” is added to ensure they do—and if you need a big one of those, that is not good. And, yes, dealing with valuing those inventories is a big headache—I can remember when Wynne Godley used to fret over that, and I didn’t understand why. Now I do.

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