There is an emerging school of economic thought, Modern Monetary Theory (MMT), that describes:
“the workings of modern money systems, where a government responsible for fiscal policy (taxing and spending) is a monopoly currency issuer, issuing a non-commodity-based floating exchange rate currency”
To better understand the cause(s) of the financial melt-down of 2007, many prominent economists developed an approach, which has been called MMT or “The Kansas City Approach”, building upon the works of Abba P. Lerner, John Maynard Keynes and Hyman P. Minsky. You may or may not agree with MMT but this is interesting stuff and could be a fun exercise for the brain though some may label it arcane and boring – how is that for a yin and yang.
In my limited understanding, modern monetary theorist say that a fiat currency – the monetary unit defined by the government – cannot be legally converted into gold as it has no intrinsic worth. Its viability is ensured by the fact that it is the only unit which is an acceptable for payment of taxes and other financial demands of the government. That would be a funny thing to say to Ron Paul and his gold standard supporter.
The MMT also has few things to say to all those who continuously draw a parallel between household budgets and the national government budgets. It says such an analogy is false. I agree, though, those modern monetarists, being economists, say it much more cogently and intelligently:
Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.
MMT says that government deficits are required for the economy to continue to power forward as budget deficits result in system-wide surpluses (excess bank reserves). In some-shape-or-form, this too I believe, though I have been trying to use debt-equity based financing for a business as a model, with an appropriate debt-to-equity ratio, to come up with an explanation.
J.D. Alt, an architect and author, uses a very fascinating method employing the game of monopoly to explain it. The current discussion of United States’ debt problem and impending bankruptcy had him worried. So he dug deeper in to MMT and found;
Even more remarkable, sovereign “deficits” in the fiat currency are just the accounting record of the surpluses that have been injected into the private economy. Eliminating the sovereign currency deficit by imposing austerity will not make the economy healthier; it will, in effect, bankrupt the citizens!
Using the game of monopoly and balance sheet accounting he builds a persuasive case (I am paraphrasing) “that when someone’s individual bank account is in deficit then it is something to worry about. When a city or state government has a deficit, that’s also something to worry about because local governments do not have the power to issue the currency. But when a sovereign government, which can print money, has a growing deficit then we are badly misleading ourselves if we use the word the way we do when we think of our own bank accounts. Sovereign deficit is in fact a balance sheet accounting of a nations financial wealth. And why should one want to reduce that is a mysterious thing indeed!”
Alt’s article is interesting but it also raises many questions. For one, it assumes that there is only one fiat currency issuer. When there are multiple fiat currency issuers – other nations – then their interaction or foreign exchange rates become a factor too. If there is significant import-export or foreign investment then the government just cannot print more money when it needs without facing consequences, which sometimes turn out to be awfully negative.
Paul Krugman also wrote that Deficits saved the world
Jan Hatzius of Goldman Sachs has a new note (no link) responding to claims that government support for the economy is postponing the necessary adjustment. He doesn’t think much of that argument; neither do I. But one passage in particular caught my eye:
The private sector financial balance—defined as the difference between private saving and private investment, or equivalently between private income and private spending—has risen from -3.6% of GDP in the 2006Q3 to +5.6% in 2009Q1. This 8.2% of GDP adjustment is already by far the biggest in postwar history and is in fact bigger than the increase seen in the early 1930s.
That’s an interesting way to think about what has happened — and it also suggests a startling conclusion: namely, government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.