The Basics of Modern Monetary Theory

I haven’t done a post specifically about Modern Monetary Theory (MMT) for a while now, although that is the perspective from which I approach a lot of the issues I blog about. With that in mind, I thought I’d go back to basics and write a beginner’s guide to MMT as I see it. Any errors that follow will be mine alone. Please let me know if you spot one!

What is MMT? Modern Monetary Theory (MMT) is a branch of the heterodox Post Keynesian school of economics. At a basic level it is comprised of the following ideas:

1. Taxes drive money;
2. Taxes and borrowing don’t pay for government spending;
3. Countries like the UK cannot go bust;
4. Functional finance;
5. Sectoral balances;
6. Endogenous money;
7. Governments should pursue full employment;
8. Focus on real resources, not money.

So what do all these things means? In turn then:

1. Taxes drive money In theory, anyone can start their own currency. You or I could just print up some notes in our garage.  The trick though is getting it accepted. MMT posits that in order for governments to get its citizens to accept and use their currency, it is sufficient for them to impose a tax in that currency. Provided they are able to enforce the payment of the tax, people will be willing to work for payment in that currency in order to pay the tax. So the necessity to pay the tax in the government’s currency drives demand for that currency and ensures it has a value.

Further reading:

MMP Blog #8: Taxes Drive Money

Tax-driven Money: Additional Evidence from the History of Thought, Economic History, and Economic Policy

2. Taxes and borrowing don’t pay for government spending While governments do need to tax, MMT says that they do not do it to pay for their spending. Indeed, MMTers argue that government spending must come first. How can anyone pay a tax denominated in the government’s currency unless the government first spends it into the economy? So what are taxes for? We have already seen one function of tax in point 1. Taxes drive the nations currency. They also act to ‘make room’ for the governments spending, preventing that spending from generating inflation. Progressive taxes are also used for re distributive purposes to help a government meet it social aims, and taxes can also be effective to incentivise or disincentivise certain behaviours (e.g. smoking, drinking, polluting). But what about government borrowing? At the moment, if the amount of tax collected is less than the amount a government spends, it ‘borrows’ the rest by issuing government bonds. The amount it borrows is repaid with interest. MMT though, argues that similar to taxation, this borrowing is not undertaken to finance its spending, but to maintain its target interest rate. Under current arrangements, if a government didn’t match its spending to taxes plus borrowing, this would create excess reserves in the banking system, and this would drive overnight interest rates down to zero. Government borrowing also acts as a risk-free source of savings to the private sector, including pension funds.

Further reading:

Taxes for revenue are obsolete

Government bonds and interest rate maintenance

3. Countries like the UK cannot go bust In the run up to the 2010 UK General Election, it was said loudly and often that the UK was on the brink of bankruptcy, about the go the same way as Greece. We had run out of money. MMT says this is nonsense. Governments like the UK who issue their own currency cannot go bust, in the sense that they cannot run out of money. In this sense the UK differs from the Eurozone countries, who, since joining the Euro, no longer issue their own currencies. They are now currency users. This point is often missed when discussing government debts. The usual story is that when ‘the markets’ see government debts rising, they start to worry about how the debt will be repaid and so demand higher rates of interest before they will lend more. This happened in some of the Eurozone counties before the European Central Bank stepped in to stabilise the markets for these countries debt. Countries like the UK though have central banks that can always intervene if interest rates start to rise, so the risk of an interest rate spike here is low to non-existent. Interest rates on government debt are a policy choice for the currency-issuing government. To maintain the maximum flexibility over an economy, MMT recommends countries maintain their own free floating currency, and to only borrow in that currency.

Further reading:

There is no solvency issue for a sovereign government

Why do politician tell us Debt/Deficit myths which they must know to be untrue?

4. Functional Finance Functional finance is an approach to fiscal policy adopted by MMTers but first espoused by economist Abba Lerner. Functional finance has three rules:

1. The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
2. By borrowing money when it wishes to raise the rate of interest and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
3. If either of the first two rules conflicts with principles of ‘sound finance’ or of balancing the budget, or of limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.

Further reading:

Functional Finance

Functional finance and modern monetary theory

5. Sectoral balances Sectoral balances is an approach to viewing the financial makeup of the macro economy, popularised by economist Wynne Godley. It helps not to view things like the government deficit in isolation, but rather to see it in the context of what’s happening elsewhere in the economy. In the three sector version of Godley’s sectoral balances: Government balance = Private sector balance – Foreign sector balance If we apply this to the UK, we see a government deficit of 6%, a private sector balance (private sector sayings  – private sector investment) of 2% and a foreign balance (exports – imports) of -4%. MMTers argue that the natural state for the private sector is surplus, so for countries with trade deficits, a government deficit will also be the norm. If the government tries to reduce or eliminate its deficit, it will only succeed if the private sector is willing to reduce or eliminate its surplus.

Further reading:

What Happens When the Government Tightens its Belt?

UK Sectoral Balances and Private Debt Levels

6. Endogenous Money Endogenous money is the idea that rather than the central bank determining the amount of money in the economy – exogenously, the amount of money is instead determined by the supply and demand of loans. In shorthand, MMTers (and Post Keynesians in general) would say, “Loans create deposits”. That is to say that banks create money by extending loans to customers, while at the same time creating a corresponding deposit. This runs contrary to what is generally taught to students of economics – that savings are loaned out with banks acting purely as intermediaries, or at best leveraging an initial injection of government money by a predetermined ratio.

Further reading:

The Endogenous Money Approach

Money creation in the modern economy

7. Governments should pursue full employment In the post war period up until the early 70s, Western governments were committed to the principle of full employment, and largely achieved this, with the unemployment rate averaging around 3% in the UK throughout that period. The Conservatives famous “Labour Isn’t Working” campaign poster of 1979 was powerful because unemployment had reached previously unthinkable levels of 1 million. Today, the Government start high-fiving each other when unemployment falls below 2.5 million. MMTers argue that achieving full employment again is very much a realistic and achievable goal, but it means abandoning modern notions that “governments don’t create jobs”, and accepting that capitalism left to its own devices will never employ all those willing and able to work. A key tenet of MMT is that governments should act as the ’employer of last resort’, offering work to all those who are willing and able to work, but unable to find a job.

Further reading:

The Job Guarantee: A Government Plan for Full Employment

The job guarantee is a vehicle for progressive change

8. Focus on real resources, not money While politicians tell us there is no money left, millions are without sufficient work and resources lie idle. MMT argues that we should focus on these real things – people and resources – rather than money which is just a tool for putting those people and resources to work. Governments can and should spend money into the economy when the private sector cannot or will not to maximise the potential output of the economy.

Further reading:

Modern Monetary Theory: The Last Progressive Left Standing

Scottish Independence – A Modern Money Analyisis

Those are some of the basics of MMT then, not that I can capture it all in 1,500 words. For more reading, try some of the links on my blogroll.

On tax avoidance and the purpose of taxation

A large section of the public get very worked up (rightly) about tax avoidance. Huge companies like Google or Vodafone seem to be getting away with paying very little tax despite turning over billions. At the same time, the Government are pursuing cuts to discretionary public spending. People often make a connection between the two and argue that if rich companies and individuals paid all the tax due, there would be no need for any cuts, so a ‘left’ solution to the economic crisis is to go after the tax avoiders/evaders in a big way, and all will be OK. I think this view is misguided. Here’s why.

Firstly, there is an implicit assumption that we need those taxes that have been avoided/evaded to pay for government spending, and if we don’t go after that money, then austerity is unavoidable as the Government doesn’t have enough money. As the UK has its own currency though, this cannot be true. It can create new currency at will and can never run out. There is a risk of inflation of course, as with any type of spending (public or private), but if you don’t think repatriating and taxing a sizeable chunk of money stashed offshore would be inflationary, how could creating a similar amount to spend into the economy be inflationary? The money sitting offshore is largely inert, sitting as excess savings. Money can only be inflationary if it is circulating.

This leads on to the other point I want to make which is about the reason we tax at all. If you ask most people why we have taxes, they will say “to pay for government spending on public services”, but as someone who finds myself in agreement with Modern Monetary Theory (MMT), I don’t think that is really the purpose of taxation at all.

So what is the real purpose of taxation? There are a number of, none of which are to pay for government spending (although confusingly, for a government to spend, it does need to tax):

1. A ‘Chartalist’ view of money (which MMT incorporates) argues that the imposition of a tax by a sovereign government creates a demand for a currency. So because people are required to pay tax in pounds, a minimum level of demand for pounds is assured and people will be willing to do business in pounds so they can obtain enough to pay their tax liabilities. Because pounds have value to those with a tax liability in pounds, they also have value to those who are not taxed in pounds, so it’s not necessary that all users of pounds are taxed.

2. While the government doesn’t need to collect tax before it spends, if it spends without taxing, this will almost certainly cause inflation. We can think of government spending as ‘printing’ money and taxation as ‘unprinting’ money. The tax ‘makes room’ for the government to spend without causing inflation.

3. To correct for ‘externalities’ and discourage ‘harmful’ behaviour. Externalities are costs or benefits generated by an activity which affects non-users of that activity. Examples could be pollution or second-hand smoking. So we might want to heavily tax polluting activities to the point the activity becomes unprofitable or the tax collected is equal to the cost of the clean-up. We might want to tax smoking heavily because it imposes a cost on the health services or gambling because it can lead to crime and contribute to social breakdown.

4. For redistributive purposes. This reason would be why we might wish to take on tax avoidance. Our economy is working as a giant hoover at the moment, sucking up money from the bottom to the top, increasing inequality and leading to more and more people becoming marginalised and stuck in unemployment or low-paid work. Tax is one way of trying to correct for this damaging process.

To sum up then, I am not saying we shouldn’t go after tax avoidance. We absolutely should (although overhauling and simplifying the whole tax system would be more effective in the long run). It’s just that I don’t think it’s an answer to our sluggish economy. Those who avoid/evade tax undermine the tax system by offending people’s sense of fair play. If some are seen to be ‘getting away with it’, it makes maintaining the legitimacy of tax more difficult, and a strong tax base with efficient collection is vital for a functioning mixed economy.

While we need to do something about tax avoidance (preferably through regulation rather than appealing to amoral companies’ morals), we should not oppose austerity by saying “tax the rich more” or “tackle tax avoidance”. Austerity should be opposed on it’s own terms i.e. the government is not running out of money; the markets can’t hold us to ransom, and cutting spending in a recession is a really, really stupid thing to do.

On welfare cuts and automatic stabilisers

Cuts to welfare spending seem to be in the headlines daily nowadays. Every time a bad bit of economic news is announced (which is often), the prospect of yet more welfare cuts seems to raise its ugly head. Just this week, following the terrible Q4 growth figures, there was a story in the Independent about certain ministers who are pushing for further cuts to welfare.

There are a number of issues around welfare which are regularly discussed. These include ‘fairness’ and ‘making work pay’. A lot has been written on both sides of the arguments on this, so I’m going to focus on the likely economic impact of welfare cuts.

Now a key argument on welfare cuts is that the deficit needs to come down and everyone needs to contribute (we’re all in this together remember). Putting aside the fact that I don’t think we should try to reduce the deficit at the expense of jobs or living standards, I want to look at whether the claim that welfare cuts help reduce the deficit stand up to scrutiny.

A lot of people would say that the purpose of working-age welfare benefits is to provide a subsistence level of income for those who are either unable to find work, or unable to work altogether due to ill health or disability. While that’s true, welfare payments also serve a very important macroeconomic function. They act as an ‘automatic stabiliser’.

What are automatic stabilisers? From Wikipedia:

“In macroeconomics, automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP.”

In other words, in a boom, the government collects more taxes and pays out less in benefits which helps put the brakes on to prevent the economy from overheating. Conversely, in a slump (like the one we’re in now), less tax is collected and welfare payments soar as people lose their jobs and businesses make less sales. This acts to prevent the economy going into free-fall. The stronger the automatic stabilisers, the shallower are the slumps and the quicker are the recoveries.

In response to criticism of his economic policies, George Osborne has claimed his plan is flexible because he has “been prepared to let the automatic stabilisers operate..”. I’m not sure what he means by that. What would not letting them operate look like? I suppose you could stop paying benefits to new claimants, or make people pay the same rate of tax even when their incomes fall, but no sane person would advocate that. So in Osborne’s world, ‘flexibility’ seems to mean not taking complete leave of your senses.

In any case, the Government are not letting the automatic stabilisers operate, they are trying to weaken them all the time. Bedroom taxes, Atos reassessments, cuts to council tax benefits, these all weaken the automatic stabilisers. What does this mean? It means that income will be taken out of the pockets of the poorest (who by the way spend most of their income), who then spend less in local businesses. These businesses then make less sales, leading to the government collecting less in tax, while the businesses might decide they don’t longer need as many staff, or even go bust.

Spending is a circuit. It goes round and round the system, not stopping after its first use. The government thinks by cutting the amount it pays benefit claimants by x pounds, it will save x pounds. It’s easy to see the flaw in this logic though. If you give someone £100 less in benefits, that’s £100 less going into the economy. Someone else has lost £100 in income (unless that person’s taxes are cut by the same amount, but the Government are not proposing to cut taxes). The actual saving for the Government will not be £100, but a figure much much smaller. It could even be negative if the cuts further depress employment. The welfare bill could actually go up.

This, in a nutshell then is why cutting spending by x pounds is only cutting the deficit by (-)y pounds. This confuses all sorts of people who are starting to claim austerity is not happening because the deficit is rising.

What the cuts to welfare also mean is that the next time there is a crisis, it will be much deeper, because our new, weakened automatic stabilisers are not strong enough to stop the slide and spark the recovery.

There’s actually a strong case for strengthening the automatic stabilisers. You could do this on the tax side by perhaps linking national insurance rates to the unemployment rate, or on the welfare side by guaranteeing jobs for those who are made redundant following an economic slump.

Cutting welfare in a slump is a very dumb thing to try to do. It won’t work and will make things worse. They will be disastrous on an individual level for many families bearing the brunt of these cuts. With jobs not being created in sufficient number (no matter what the Government tries to say), there’s no possible way the cuts can act as an ‘incentive to work’, and as we’ve just seen, in macroeconomic terms, weakening automatic stabilisers in a slump is an awful idea. Dumb, dumb, dumb.