I am going to fill in a few posts for Yves while she is away on conference. Here’s one that is a thought piece I wrote last week at Credit Writedowns. It is a mental model of the economy I am toying with based on some comments the modern monetary theory folks have made to me.
This post is intended to be a hopefully brief synopsis of how the monetary system works using an Austrian framing with MMT terminology. If you don’t know what that means, you’ll see what I mean as I proceed.
MMTers like to say that money is like points and the government is just a scorekeeper. I have never really liked that analogy because the money unit of account is not just about keeping score it is also a government IOU. The government then owes its citizens something every time it issues an IOU. It is indebted to us in some capacity. So the money represents not just a ‘point’ but a debt too, even if that debt is only in fiat currency. This is the inherent problem with fiat currency for me; the promise the government makes to repay in something it can create in unlimited amounts makes that promise somewhat irrelevant.
Nevertheless, the scorekeeper/point analogy has some utility in terms of our institutional arrangements. So I am going to try to use it here.
The amount of money or credit in the system does not change the productive capacity of a society at one point in time. A country can produce whatever it can produce based on the available physical and human capital. As Andy Xie noted money contracts introduce a distribution problem, but they do not change the inherent productive capacity of a society.
So money is the way that we measure that productive capacity and set prices for wages, consumer goods and services and assets. In most monetary systems including in the euro zone, government has been tasked with setting the currency unit of account to make that measurement. If we were to simultaneously increase the price level of wages, consumer goods and services and assets by 1000-fold, all that we have done is change the nominal amounts, not the actual capacity to produce. The ‘points’, as MMTers would call them, are now worth one one thousandth in productive capacity of what they previously were.
The problem therefore is debt. See, debt introduces a money distribution problem because debt contracts are almost always agreed in nominal terms. If the government were to decree a 75 percent decrease in all prices for wages, goods and services and assets, all would be the same except the debt. The debt would be four times as onerous for debtors in real terms and four times as beneficial for creditors.
Our credit-based monetary system and its contracts signed in nominal money units of account create a need for price stability in relative terms as well as in absolute terms. For example, if the price of labour rises less rapidly for the average worker than the value (price) of output, as it has for the last three decades in the US, you have a distributional problem. Suddenly, people can’t afford stuff and the economy slumps unless it is creating more debt – (so-called Ponzi finance). That’s why all central banks are tasked with maintaining price stability.
Here’s where I get Austrian using MMT language. Recession is the way our economic system restores these points (the money unit of account) to real value. Often, the scorekeeper (government) creates so many points that the economy bumps into the whole distributional problem where prices for wages, goods and services and assets have gotten out of whack in relative and/or absolute terms. Businesses have overestimated how many points their customers have to buy stuff with and they ratchet back production, cut back staff and so on – classic business cycle stuff. The vast majority of the downturn comes from reducing inventories and output to recalibrate for how many points people actually have.
But, governments don’t like ‘recalibrations’. So they lower the price of the points to spur greater demand for them, promoting a greater distortion in the relative and absolute number of points available. Put simply, the scorekeeper has padded the score artificially, creating distortions due to the fact that debts are contracted in nominal terms.
Remember, however, that the government is just a scorekeeper here. They are not a player. They create the points, put them up on the scoreboard. And the scorekeepers can never run out of points. They can put up points in infinite quantities limited only by how fast they can bang out the keystrokes it takes to change the score.
Now, the government can change the score on the sly in two ways. First, it can change relative scores. That is to say, it can give some people more points and other people fewer points. It accomplishes this via monetary policy. Its monetary agent, the central bank, acts on its behalf and is never permitted to add points to the scoreboard. It is only allowed to reallocate points. For example, the central bank can take some points away from those who hold points as bonds and add some points to those who hold their points as reserves. These are point swaps. There is no net addition to the number of points on the scoreboard, ever.
Relative price levels change and winners and losers emerge because of this policy. More and more people owe more points than they can possibly hope to pay back. Eventually when the price of money falls to zero, the game of padding the score artificially is up.
Unlike its agent, the central bank, the scorekeeper (government) can always add or subtract points (net financial assets) in the system if it so likes. This is called using fiscal policy. If you pay taxes, what you have is a net loss of points. Deficit spending, on the other hand is a net gain of points. That is to say, when the scorekeeper (government) taxes you, on net, it is draining points (net financial assets) off the scoreboard. Whenever the government spends, it is adding points to the private sector’s scoreboard (instantly creating a zero-day net financial asset).
During a recession, the scores – both on absolute and on a relative basis revert to their mean trend values. If the score has been padded a ton as it has in the past generation, you get debt deflation as more and more people become unable to pay off the points they owe. And this is the problem we now face. The government wants to keep adding to the score, but doing so always creates distributional problems because debts are contracted in nominal point (money) terms and because some people receive points (money) while others do not.
I will stop there. I think the scoreboard thing is an interesting way to look at it. It has its limitations but I hope running through the analogy was useful.
P.S. – Randall Wray argues the case for nominalism forcefully i.e. that all state money has been fiat money. For that view, see here.