Monetary Policies for a Modern World

There is a lot of misinformation out there that simply does not reflect the current state of the world we are in, and this misinformation is correspondingly causing a gigantic misallocation of private capital to non-productive uses (especially towards speculations in precious metals and other commodities) and an overblown distrust in the government’s monetary policies.

This is actually somewhat expected, because even most of our policy makers do not have the proper educational background to understand what they are dealing with and how the fiat currency system really works. Ben Bernanke and his contemporaries are, in fact, learning on the job. It is no secret that they (as well as a lot of the doomsday prognosticators aka finance columnists out there) were educated by textbooks and schools of thought formulated during an era of gold standard with fixed exchange rates. An updated conceptual framework is required for good decision-making in a modern economy.

The best framework for describing our system of fiat currencies is the Modern Monetary Theory. MMT basically shatters everything we learned from our Macro Econ textbooks, because the old conventional thinking evolved out of an obsolete economic model. In a world where free-floating fiat currencies are the norm, the conventional model does not apply. PragCap has a good write-up on it.

The theory itself is actually not very modern – the first iteration of it was formed in the 1920s and it was called Chartalism. It is currently experiencing a quiet revival because it most accurately explains and predicts what we are now observing in our modern economies. Unfortunately it has not yet become a mainstream school of thought.

But it’s super important that it does, because in one fell swoop Modern Monetary Theory explains

  1. Why the periphery EU countries are having fiscal troubles;
  2. Why the same troubles did not occur to the Japanese government after 2 decades of extreme deficit spending and monetary easing;
  3. Why they also will not happen to the US – the US government is in no risk of default, and in fact it is debatable whether they have dished out enough stimulus;
  4. The hyperinflation/doomsday scenario is not destined to happen, therefore gold and other precious metals are in a speculative bubble.

Without being too technical, I will try to summarize the MMT basics in this article. Essentially, the following assumptions hold true for all major developed economies outside the eurozone (i.e. US, Canada, Japan, UK, Australia etc.):

  • a) Money is not physically backed by any commodity or pegged to any foreign currencies.
  • b) The government is the sole issuer of money.
  • c) The government has the power to maintain the legal tender status of money (through a functioning taxation and court system).
  • d) The fiscal and monetary arms of the government effectively work as a single unit.

Assumption (d) is VERY important and this is where it breaks down for the EU, because while they have a monetary union via ECB’s euro, they do not have a fiscal union on the “federal” level. In other words, the arm of government that spends most of the money (e.g. national governments like Ireland and Greece) does not have the power to print money (euro).

These countries cannot monetize their euro-denominated debt, which arbitrarily forces them into the same constraints that regular households and private enterprises experience everyday – the need to balance budget, the need to fund expenditures with income. In fact, MMT predicts that the current arrangement of the European Union is not sustainable, and they will have to either break-up or pursue a greater federal union in order to synchronize their monetary and fiscal policies.

However, in a true Modern Monetary System (e.g. US, Canada, Japan, UK, Switzerland), the government does not behave like a private household/enterprise. The government has no obligation to balance revenue and expense – in fact it can spend on deficit forever, with the only ceiling being the economy’s ability to produce (aka Inflation). But more on that later – first we have to see that all domestically denominated government debt is an illusion under MMT.

In economies such as US where (d) is true, the government never actually “owe” money in the traditional sense, because they are also the ones who can print money. A recent example is the Federal Reserve’s QE2, where on the surface they created money to buy US Treasuries from the private sector in the open market. When all is said and done, $600 billion of treasury bills will appear as “Assets” on the Fed’s balance sheet, and the same $600 billion is already on the US Government’s balance sheet as “Liabilities”.

In all practicality, this is a wash. It is just an accounting illusion, and the government, when view as a single unit, no longer has any real obligations. All that happened was a transfer from the government’s printing press (indirectly via the private sector) to the Treasury Department which funded the government’s spending. A government who issues debt in the same currency as the money it prints will never have a debt problem.

Naturally then, the next question is why would a society accept fiat money as a storage of value/unit of exchange, when the money can be haphazardly printed by the government and not be backed by any tangible commodity?

A fiat currency is not just backed by “faith” as some would have you believe. In assumption (c), having a stable government implies that we have an army and/or a police force strong enough to maintain a functioning tax and court system. Meaning, the government can force you to surrender a portion of your livelihood every April as taxes, and you must pay them in the form of their currency, or they jail you. This creates instant demand for the currency – even if you choose to transact all of your private businesses in gold, you must convert a pre-set percentage of your income to the currency at least once every year.

Likewise, the courts can rule that plaintiffs and defendants settle damages in the form of the government’s currency. The accused pays in money and the victim must accept money as compensation for the damages. The government has the power to make sure the courts’ rulings are enforced.

And just like that – because the government declares by fiat that their currency is legal tender , the currency has intrinsic value as long as the government is functioning and has a loyal arm force that maintains the integrity of money. This is not a matter of faith. And because of this de facto intrinsic value, the private sector also chooses to transact in money themselves, even for transactions where the government is not directly involved.

So to recap what we know so far: the government does not need to “balance their budget”, they can print money and then spend it, and the private sector accepts it because they will need it because the government has the power to tax for it. Fine, you say, but what is the upper limit of money that can be printed and spent?

The ultimate limiter is inflation. Inflation does not happen automatically when we expand the monetary base, especially when the velocity of money is declining (for example, when the private sector is deleveraging). Even if both the base and the velocity of money expand, inflation only happens when the money pushes the economy to operate near maximum capacity, such that it cannot produce more goods at stable prices. A bigger amount of money chasing a limited amount of goods causes prices of those goods to go up.

This is not happening in the developed world right now. Unemployment is high, and factories are operating at below capacity. In addition, much of the production work is being offshored to developing countries, which expands the available pool of labour and productive capacity even further. With so much slack capacity, an economy simply adapts by producing more goods to match demand when there is more money going around. Inflation will not kick in until we are at near full employment and full capacity utilization. The corollary is: the government should expand the money supply until we are closer to full employment.

It may be awkward for many people to admit, but MMS (or fiat currencies) is indeed superior to all prior monetary systems because it creates flexibilities that did not exist before, and we as a society need to accept this as general knowledge. A modern government taxes and/or issues debt primarily as instruments for injecting and removing stimulus, not as means to “finance” public expenditures or “balance the budget”. In a recession, the government can spend without regard to deficit, in order to compensate for the drop in private consumptions; in a boom, the government can curb spending and raise the cost of borrowing (reduce the money supply) to avoid excess inflation.

Ultimately, money is a man-made illusion. Our policies should be designed to control this illusion in such a way that facilitates full employment and low inflation, thus enhancing real long-term prosperity of nations.


4 Responses

  1. Also posted on Seeking Alpha:

  2. For some reason, I can’t see all of this article, the text keeps hiding? Are you utilizing javascript?

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  4. Can not believe Yahoo thinks this is news!

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