By J. D. Alt, author of The Architect Who Couldn’t Sing, available at Amazon.com or iBooks. Originally published at www.realprogressivesusa.com
I’m expanding an earlier essay into a short, book-length piece I hope will be useful in the unfolding public debate about MMT. The piece will utilize the “operation” of a “diagram-machine” to illustrate how our modern money system actually works. My hope is that it will be accessible and easily understood by people who have a genuine interest in MMT, but little time or patience to delve into its operations and implications. I’m posting the narrative here at NEP for comments and suggestions. Efforts to keep things simple and focused on basics might lead to some errors, or important omission—which I’d like to avoid. The diagram-machine, itself, I’m still working on—but I think the narrative, for now, can be followed (and evaluated) without it.
POST #1
This book has a purpose
Modern Monetary Theory (MMT) has burst into public awareness with a surprising message most people find hard to comprehend or believe:
The U.S. government can afford to spend a lot more dollars to achieve public benefits and collective purposes than our current political-economic narrative tells us is possible.
The result has been a back and forth of claims and counter-claims. Mainstream media and political-economic leaders tell us MMT is “hogwash” and a formula for economic disaster. America, they say, will become like Venezuela!
Modern Monetary advocates tell us that a sovereign nation which issues its own currency can never fail to pay any bill that is denominated in that currency. Consequently, America can afford to undertake much larger expenditures for the public benefit than is currently imagined or calculated.
Naysayers respond: this prescription is just “printing money”—it will destroy trust in America’s credit and lead to the hyper-inflation and political corruption of a banana republic.
Much depends on the outcome of this economic debate: Are we—or aren’t we—able to provide universal health-care for all Americans? Are we—or aren’t we—able to provide universal pre-school day-care and early childhood educations? Are we able to provide our high-school graduates with debt-free secondary educations or technical training? Are we able to provide a job-guarantee—with a living wage—for every citizen who is unemployed by private commerce? Can we invent and build, fast enough, the new energy systems, infrastructure, and ecological interventions necessary to mitigate and adapt to the coming climate change? And to accomplish these goals, is it true that America must become a “socialist” state with dramatically higher taxes and ever-expanding, intrusive bureaucracies?
How can we answer these questions? How can we know who is telling us the truth? How can we know if America does, or does not, have “enough money” to effectively address, in a decisive way, the big, unfolding challenges of our times?
Unfortunately, most Americans have little interest or time for delving into and understanding the underlying topic of monetary economics. Instead we must rely on talking-heads, poorly explained economic jargon, and intuitive memes that often hide reality rather than explain it. This book is an effort to change that.
It’s important to note at the outset that MMT does not propose a “new” monetary system, but simply that we truly understand the monetary system we are using every day. My goal, in the following pages, is to illustrate how that system actually operates—and to do so in a way that can be quickly grasped and understood by anyone—using their own power of observation—who is willing to dedicate thirty minutes of focused attention to the task.
To facilitate this “short-cut” to the heart of something (the American monetary system!) that’s so dry, convoluted, and tedious most people don’t even want to think about it, we’ll build what I call a “diagram-machine”—a dynamic diagram we can “operate” and tinker with to observe and understand its workings. It will be a highly simplified version of the real economic “machine” that is operating behind the scenes in our daily lives.
Running this simple diagram-machine through a few basic operations, I hope, will reveal the basic mechanisms of the real machine—and, in doing so, will make clear what MMT wants us to truly see and understand. And if MMT can be generally understood and accepted by the American public, the unfolding and crucial debate over the future of American society can go forward in a more rational and constructive manner. So, let’s begin!
Operations Overview
It will be useful to start with an overview of the diagram-machine’s purpose and how, in general, it achieves that purpose.
The most important parts of our machine are the Combustion Chambers, and the “fuel” that circulates through these chambers that enables it to operate. The “fuel” our machine uses is money. When money (fuel) flows into either of the two Combustion Chambers, something happens: goods and services are produced and consumed.
These goods and services—and the consumption of them—are the sole purpose of our machine-diagram.
In other words, the purpose of the diagram-machine is to produce what the American people—individually and collectively—need to live their lives (and pursue their happiness) in relative safety and comfort: food, water, clothing, houses and apartments, electricity and fuels, cars, buses and highways, law enforcement and courtrooms, education, medical care and medicines, Givenchy luggage and chocolate eclairs, etc. All these things are produced and paid for in the Combustion Chambers via the exchange of money—and then are “consumed” by the American people in the pursuit of their happiness.
The money (fuel) for these exchanges in our diagram-machine is fed into the Combustion Chambers from two different sources. Spending source #1 is a bank account in the Private Banking system. (Our machine has two of these.) Spending source #2 is the U.S. Treasury Reserve account at the Central Bank of the Federal Reserve.
After an exchange takes place in the either of the Combustion Chambers—producing and allocating goods and services—the money (fuel) flows out of the Combustion Chamber and into another private bank account, ready to be used again. That’s the basic operation. And the net result of the operation is that needed or useful goods and services are produced and consumed by the American people.
In operating our diagram-machine, what we want specifically to observe is how (and when) the fuel that runs the machine is produced. One of the central mysteries of our current political-economic debate is whether there is “enough” money to accomplish our collective goals—or, as it’s often framed: “That’s a nice idea, but how can we pay for it?”
The first thing you’ll notice when we go to the next page—“Parts and Pieces”—is that our diagram-machine doesn’t have a gas-tank! What we want to observe and understand is how the machine, itself, produces the gas it needs to fuel the Combustion Chambers. It is this understanding that is the essence of what MMT wants us to “see.”
To help us observe this, the components of our diagram-machine have been given a “fuel flow-meter” showing three different tallies: (1) a beginning tally, (2) a change, and (3) an end tally. We’ll keep it simple, but it’s important to take the time to follow along and keep up with the tallies—to observe how the fuel is flowing in the machine.
Parts and Pieces
Our diagram-machine is a very simplified version of the real machine that runs our economy. Even though the real machine is an enormous, sprawling complexity, its logistics are driven by a few key parts, components, and operations which are, in themselves, relatively simple mechanics—though they might well surprise you! If we can see how these key parts and components operate, individually and in concert with each other, we will have a surprisingly robust understanding of the entire grandiose and bewildering operation—enough of an understanding, at least, to form a useful opinion of what the machine can, or cannot, be expected to accomplish.
As illustrated, our diagram-machine consists of four major components. The first two components produce and direct the fuel (“money”) that powers the machine:
- Central Bank of the Federal Reserve System
- The Private Bank System
The second two components are the “combustion chambers” in which the fuel is converted to work that accomplishes the goals of production and consumption for American Society:
- Private Combustion Chamber
- Public Combustion Chamber
Within the Central Bank we have the following subcomponents:
- The Federal Reserve account (FED)
- The Treasury Reserve account (TSY)
- Bank#1 Reserve account (B1Ra)
- Bank#2 Reserve account (B2Ra)
Within the Private Bank System, the subcomponents are:
- Private account at bank#1 (B1a)—this is a private bank account belonging to a person or a business.
- Private account at bank#2 (B2a)—ditto
- Promissory Note to Bank#1 (PN1)—this is a promissory note held by bank#1 in exchange for a loan.
- Promissory Note to Bank#2 (PN2)—ditto
Connecting these components and sub-components are flow channels through which fuel (money), or things related to money, flow.
That’s our diagram-machine. Simple as it is, virtually all the realities of America’s modern money system can be observed and understood by operating it. So, let’s see if we can start it up!
30 comments
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Here’s a challenge to scott fullwiler’s explanation of the operational realities of the monetary system. It would be interesting to see a reply by the more informed here – https://medium.com/@hpublius/does-mmt-describe-the-operational-realities-of-our-monetary-system-93f05657e106
Thanks for the link! The first point is obviously right in a sense that the current operational realities of the Fed and Treasury would have to change to accommodate the MMT approach to deficits. But I don’t think any MMT economist would claim otherwise.
Regarding the second point I couldn’t follow the logic so I leave it to someone else to respond.
The third one is that the banks can only freely create variable-interest loans and for fixed-rate loans they are constrained by the need to find willing savers in the capital markets. I suspect this constraint is not that hard as he makes it look. First, for shorter-term loans this duration mismatch is less of an issue if we are talking about a stable economy without wild interest rate things and the longer-term loans often have variable rates (most of the mortgages in the UK for example). A lot would also depend on the interest-rate policy of the MMT-governed central bank because the duration mismatch would primarily hurt lenders if the rates grow quickly.
@Alex
May 7, 2019 at 5:49 pm
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“…and for fixed-rate loans they are constrained by the need to find willing savers in the capital markets.”
No.
This is the old idea that “banks are intermediators between savers and borrowers” that is not valid under our monetary system. In fact, it is the investment of loan proceeds that creates savings.
The only constraint on bank lending of any kind is the pool of willing and qualified borrowers. Banks will make whatever loans they deem profitable and acquire any required reserves after the fact. Savings balances at the bank are irrelevant.
This is the mechanism by which the banks create about 95% of the money supply. The rest is created directly by the federal government.
Something new. I had to prove I wasn’t a robot with a Captcha before my comment was posted. Perhaps the trolls are getting more sophisticated.
Whatever the reason, as long as it supports the high level of intelligent engagement of the comment section, I’m all for it.
Also, it seems that editing is no longer possible.
(Edit) Apparently some comments are editable. Perhaps because this one went into moderation?
Again, I’m in favor of whatever steps are necessary to keep this site as great as it is.
Same here.
Sometimes I am able to edit, sometimes I go into moderation, sometimes I get Captchaed, and sometimes I just get posted straightaway unable to edit.
Yeah, but the argument in the linked article was that this is not the case for fixed interest loans.
The Val Popov article makes at least 2 mistakes or obfuscations:
1. Fixed-to-variable rate swaps are not a funding mechanism–variable rate payers do not “buy” swaps from the primary dealers. The swaps are just the exchange of net cash flows over time that represent interest on a notional amount of principal that does not actually change hands (“notional” means “imaginary” in this context). So the idea that primary dealers obtain funds from entering into rate swaps is wrong.
2. In the repo transaction used by the Fed to provide liquidity to primary dealers to buy new bonds from Treasury, Popov does not say where the reserves come from (they come from the Fed via keystroke, as described by MMT).
I believe this column by peterc at the heteconomist blog addresses the first point. Specifically:
As I understand it, the reserves the Fed adds to the primary dealers’ banks are new $ that previously did not exist.
Peterc’s column provides a step-by-step description of the whole process.
This is from the article linked to:
I don’t know about the over-draft part, but I do know about how the Fed gets around the prohibition against direct purchase of Treasury bonds.
The Fed has a Primary Dealer system (currently 13 private dealers, all of whom are significant players in the U.S. Treasury market).
Primary Dealers are required, per agreement with the Fed, to bid on every Treasury auction of new government securities. Each one of the thirteen current Primary Dealers must bid for at least one-thirteenth of the amount being auctioned.
One of the end customers of these Primary Dealers is….the Fed.
When the Fed purchases the newly issued Treasury securities from a Primary Dealer it is an “open market” purchase and legal under the current law.
So, the offer of U.S. Treasury securities to the public by the Treasury is for the convenience of the public and not out of necessity. If no one wanted a particular Treasury issue, the Primary Dealers would all purchase their pro-rata share and then sell them to the Fed.
You will also note that I said “newly issued” Treasury securities. The Fed can and does purchase Treasury securities which are being rolled over directly from the Treasury.
Another important point is to keep the distinction between private bank deposits and reserves issued by the Fed clearly in mind.
The amounts due to the Treasury in exchange for the purchase of a Treasury security sold at auction is the latter, not the former. The Treasury has an account at the Fed, as do member banks. Reserves which appear on the liability side of the Fed balance sheet are transferred to and from the Treasury General account.
Sometimes the Treasury will leave tax and other receipts on deposit at certain private banks for money management purposes, but the main source of spending from Treasury accounts is the Treasury General Account at the Fed, not private bank accounts.
Also from the article:
Where does the author think that the Fed came from? It is a creature of Congress and Congress has often changed the Federal Reserve act (including after the 2008 financial crisis). It is as much a part of the government as the Import/Export bank or the Securities and Exchange Commission.
“Central bank independence” is like “free trade” — they are slogans, not actually existing things
There are good reasons the mainstream are so against MMT.
Powerful vested interests like things the way they are.
This paper comes from 1943 when WW2 Government spending had made it clear that full employment was perfectly feasible.
http://delong.typepad.com/kalecki43.pdf
He understands why the private sector doesn’t like the idea. It is all about control and not the economy.
Everyone assumes our current knowledge has built up over time as we learn from past mistakes.
With economics and the monetary the system there was too much to lose from allowing knowledge to develop in the normal way.
Our knowledge of privately created money has been going backwards since 1856.
Credit creation theory -> fractional reserve theory -> financial intermediation theory
“A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner
http://www.sciencedirect.com/science/article/pii/S1057521915001477
Financial stability is much easier than our central bankers make it look when you understand the monetary system.
Economics, the time line:
Classical economics – observations and deductions from the world of small state, unregulated capitalism around them
Neoclassical economics – Where did that come from?
Keynesian economics – observations, deductions and fixes for the problems of neoclassical economics
Neoclassical economics – Why is that back?
We thought small state, unregulated capitalism was something that it wasn’t as our ideas came from neoclassical economics, which has little connection with classical economics.
On bringing it back again, we had lost everything that had been learned in the 1930s, by which time it had already demonstrated its flaws.
1920s inequality came back with 1920s economics; it’s just the way it works.
The project of simplifying MMT for the lay-person is without a doubt, absolutely and totally *crucial* to advancing the Sanity-Progressive Agenda here in the US. So much material I find at NC, including your work especially, has been instrumental to my understanding of macro economics and MMT; my guess is that your book will be terrific and I’ll be first in line to purchase.
Doesn’t the US government already employ MMT? Isn’t that how we fund the miltary and tax cuts for corporations and the wealthy?
exactly correct. The swift rejection of Herman Cain to the Fed Board showed that those in power know this too.
The title is catching, but I can’t find the word ‘Zen’ mentioned again after that.
Nor other typical words associated with Zen, like, meditation, mind, non attachment, etc.
Looks like a take on the old Zen and the Art of Motorcycle Maintenance by Robert Pirsig.
I remember the dscussion of the Scientific Method from the book, that in the heart of it, it involves something not quiet rational – the mystery of how one comes up with a hypothesis, so that it can be tested.
Is it how that book is related to MMT – something mysterious involved in money creation?
Even though I know it’s not, this machine analogy just smelled fishy to me. I think an average American’s BS detector would be blinking like crazy if they read this. To me, all the average American needs to know about MMT is:
THIS IS HOW THE US CONJURED ALL THE MONEY FOR ITS ENDLESS WARS
That one point will disarm every anti-MMT talking point I’ve seen in the popular press. There’s no argument about whether it will or won’t work (it worked). There’s no argument about whether we’ll become Venezuela (we didn’t).
There’s no argument about whether we’ll become Venezuela (we didn’t).
Yet. Loss of petrodollar and reserve currency status could reverse that overnight. Additionally, many if not most of the people who need MMT explained to them in the first place are just fine with endless wars and view them as a necessity, whereas social programs – which were never there for them when they needed them most – are viewed almost universally as a sham. Yes, the political conditioning of the past 50 years or so has been more than effective, which speaks to the real problem that will be encountered in selling MMT to the gen pop. They don’t need more information, especially from the people they already trust the least. They need reprogramming and rehabilitation after all the trauma they’ve been through.
‘Petrodollar’ has nothing to do with reserve currency status. Reserve currency relies on running permanent trade deficits. I’m also not clear how a loss of said status is supposed to change much.
Money for nothin’, chicks for free
Get your money for nothin’ and your chicks for free…………….
Although you do describe the proper operation of money, I disagree with the usage of a combustion chamber as an analogy… it implies that money is a fuel that is consumed… some of the red state people, who may not know finance but who know how to diagnose and repair a car or pick up truck, will be put off when you continue to use the analogy but saying that the money ‘ fuel ‘ flows out of the combustion chamber and goes into someone else’s bank account. Using a town as the market, local citizens and some friendly outsiders (such as guvmint) and describe the bank properly, would still be understandable to most people.
I agree. Money is not “fuel”. It is at most “lubricant”, in the analogy.
Money is a social construct…not a thing
It’s probably best thought of as a measure of debt, but that’s not intuitive.
A 2017 post by Alt on Fiat Money, which I took to be a humorous metaphor for our current monetary system got one very acrid reaction – to my surprise. The only explanation that makes sense is that MMT is viewed to be heresy because it challenges life-long assumptions hammered in grad school.
If one has built their career on such assumptions, fear of losing face might indeed be what triggers such reactions.
I used to try to think up clever analogies to explain MMT, but I’ve given up on that approach.
I think it’s better to try and explain the idea on its own terms and give people credit for being smart enough to figure it out.
In line with that approach, I would start with two basic ideas:
1. Real resources matter.
2. Money is a form of debt.
From those two ideas you can build an explanation for both the public and private systems through the use of balance sheets and, as Randall Wray said recently on The Real News, you can explain how money has worked for the past few thousand years.
Although economists argue about chickens and eggs, the effective model is the same. Governments create money, spend it, collect the money back as tax and cancel it out.
“Balance the books” economists claim that if a Government does not collect and cancel all the money it creates, the amount of money in the system will increase until it becomes worthless.
There is a gaping hole in this argument.
It is only true if tax is the sole way that money leaves the system. If money is leaving the system in other ways, “balancing the books” will reduce the amount of money available until the economy can no longer function.
Just one example
I suggest that every time a bankruptcy occurs, money disappears out of the system. We saw this clearly in 2008, but it is happening every day on a small to medium scale (in the UK we have had our Carillion and Debenhams).
So that when a Government tries to “balance the books” it is gradually draining away the money that the economy needs in order to function.
Similarly, when a bank makes a loan, it charges interest, both to make a profit and to cover the risk of default. The profit is fine, but the default is once again money falling out of the system. The higher the risk of default, the higher the interest rate. Thus default is covered by loans that are successfully repaid. So that, effectively, money is draining from the section of the economy that needs it most.
Anyway, the simple question for any colour of economist is: How else does money disappear from the system?
If people really want to enable a progressive agenda, why should we keep the regressive structure in place the federal reserve act created; wherein the money we use is created by creating debt.
The entire edifice of MMT is built on a foundation that creating that debt, (and the financiers and primary dealers,and wall street enablers) are “good”.
HOW is THAT “progressive”?
What is really needed, and SHOULD be the goal, is to replace the federal reserve act with a better law, that allows the treasury to create the money, without DEBT.
This idea has been around for 80 years already. It was proposed in congress as a stand alone bill in 2011/2012 112th congress HR 2990. The NEED act.
This is the better way to move forward on all “PROGRESSIVE” agenda fronts.
Espousing MMT as a way to get where we need to go, is silly and dangerous. The fed is a group of private banking interests, catering to the private banking system, which makes most of our money through the loan making process… they are getting the “free lunch” everyone says doesn’t exist…. but it does here.
And after a hundred years of basically the same system in place, the gold standard may have gone, but these actors have NEVER been ones to do “good” for this country. In fact they are perennially at the root
many of our problems.
We ought to be eliminating the middle man to our money creation system, and let the treasury do it, and stop the endless debt the bankers want created. End fractional reserve banking. End banks being allowed to create money by issuing loans.
Then , Only AFTER we change the law, and we stop creating all this debt; we could truly pursue a “progressive” agenda.
Right now, we are feeding the beast…. we are making the financial behemoths fat and strong…. and all other things take a back seat to their whims. It means nothing progressive will happen. Even if it seems like it does, it won’t.
Why do people think MMT and wall street are going to save us now?
in all of the discussions i’ve read about mmt there is something important that seems to be missing. it is always assumed that the funds made available through mmt will be spent on good progressive stuff (gps) such as health care, a jobs guarantee, family leave etc. unfortunately, those gps do not seem to reflect our collective national values which lean more towards aircraft carriers, f-35’s and other stuff that goes bang (stgb). the experience of european countries that do have all the gps without mmt proves that mmt is not a necessary condition for gps. i strongly suspect that mmt is also not a sufficient condition for gps.
will someone please explain to me how it can be assured that, if mmt reasoning is adopted in the u.s., the additional funds will not be captured by the military/surveillance state and simply spent on more stgb?
MMT is simply a description of the way the system already works, and you are correct in that we are using it to use resources for the military/industrial machine. The issue is that the public has been misled into thinking that spending on the public welfare comes out of the federal tax base, and their attention is diverted away from figuring out how much we are spending on the military.
The leaders in MMT are trying to convey the point that we can and should use our resources to benefit our society, not destroy others. Groups like Real Progressives are working hard at trying to get this information out, so people understand that we can have nice things. But we have to understand the system, and fight for ourselves against the entrenched and corrupted interests.
Unfortunately we also have to try to get through to other progressive groups that don’t want to know what MMT is about, or somehow feel threatened by it. This is what Bill Mitchell has frequently talked about.
MMT itself is neutral. It has already been captured.by the military/surveillance state. MMT activists are fighting for the good stuff. You might think about joining them to help make it happen.
If you want a visual model for MMT, instead of reinventing the wheel, look at the System Dynamics graphic mediated modeling system called STELLA. This can be as simple or complex as you choose.