Modern Monetary Theory for Dummies

by theflowerpot4 min read27th Apr 20215 comments

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World Modeling
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Modern Monetary Theory, called MMT, is a modern theory of how fiat money works and some implications of this. I don't know the intricate details of this theory but there are some broad conclusions you can draw about someone who talks positively about it.

I'll try to very briefly summarize the understanding I have got from how MMT people view the world. Fiat money is different from real-world commodities in a significant way because it is possible to print any amount of it. The American government can never default on their debts if their debts are in the form of dollars because the US government is able to print literally any amount of dollars. A significant and fundamental reason why fiat money is then valuable (even if the supply could become infinite) is that you need it to pay taxes in the US. The government does not accept tax payments by ANY other means. This means that if you are a US citizen when the tax day comes you will be forced to "buy" dollars from other people in order to avoid going to jail, this creates a demand for the dollar irrespective of the supply. Moreover, the tax amount is also decided by the government, which means that they can create whatever level of demand they want or the dollar by US taxpayers.

So how does fiat work? Firstly, every single dollar in the world has been printed by the American government (FED) and the act of printing and the act of government spending are exactly the same. The only way to spend is to print and the only way to print is to spend. However, since all spending prints money, the government tries to also destroy money. It does this via taxation, you can look at it like every dollar taxed is burned. Generally, however, the government spends more than it taxes, which is called running a deficit, which means that they print more money than they destroy. This creates something called inflation.

You can look at inflation as a tax on liquidity which is just a fancy word for cash. If the government prints the same amount of money that is in circulation at the time then everyone's dollars effectively lose half of their value. So imagine that you had a hundred dollars when the government printed this money you would effectively have lost 50 dollars.

This might sound a bit crazy, if they have total control over the supply and over the demand and they can make the demand sky-high while keeping the supply sky-high don't they have a free wealth creator? No, the wealth is capped by what is produced by US taxpayers. However, what you are seeing is an economic device that could theoretically be used to enslave people. You create enough of a demand for dollars by increasing taxes and you print enough money that people's liquidity is worth almost nothing then you've put the want-to-be tax-payers into an impossible situation. Obviously, they'd probably leave way before you do this.

It may or may not be obvious how this loss of buying power occurs, the technical explanation is that you originally had 100 dollars that we're able to buy some amount of commodities for example you could buy 100 milk packets at 1 dollar each. Then the government printed another 100 dollars but the amount of milk in the world stayed the same. Suddenly the supply of dollars has gone up and as such the "price" of a dollar goes from 1 milk packet to half of a milk packet. The reason the price drops when supply increases are because there is more availability of dollars. The milk salesman suddenly doesn't have to go to you in order for him to buy his dollars, he can also go to the government and sell his milk, and as such, I have to increase how much I'm willing to pay for the milk in order to compete with the government. Twice as much supply roughly translates to half the price.

So when the government inflates you can see it as a tax on liquidity, if you hold a lot of dollars at the time of inflation then you will be heavily taxed, if you instead hold a lot of commodities at the time of inflation you will be unaffected. Obviously, the group that is best off is the government since they got all of the money that was taxed from the liquidity holders. Another effect of inflation is that it reduces debt. Which kind of shows the interesting relationship between debt and liquidity where they are each other's inverses. Having cash is the opposite of owing cash, and you expect that if inflation reduces the value of cash then inflation should also reduce the value of debt in the sense that the person owing money has less value to repay back. An easy illustration of this is that the milkman owes 100 dollars to the bank, inflation happens which makes him able to sell milk for twice the price, and as such he is able to pay off the debt with half as much milk that he needed before the inflation. So his debt effectively halved in its value.

Another interesting aspect of inflation is that it really is only relevant as a process (transition), not as a state. If you have a society where a packet of milk is worth 1 dollar then you can never say what the "inflation" of this society is. Rather you could only say that if that society changed from milk being worth 1 dollar to 2 dollars then you experienced 100% inflation. However, after this price shift, you would no longer be able to say what the "inflation" of society is. So inflation is the change in the relative prices between fiat currency and commodities.

Lastly, it's interesting that banks and governments pretty much serve the opposite positions in balancing inflation. Banks produce debt which we already understand to be anti-liquidity. If you borrow 100 dollars from a bank at a rate of 1% interest then you will have to pay them back 101 dollars at the end of the loan period. Imagine that there are only 100 dollars in the world because only 100 dollars were ever printed. This then means it's impossible for you to pay your debt back. This would cause you to desperately try to first get all 100 dollars in circulation then try to get another dollar from somewhere, perhaps you pay 100 dollars of your debt to the bank and then they purchase a 1 dollar commodity off of you and you use that last dollar to pay the rest of your debt off. This is how and why it is possible that the world is in more debt than there is money (way more debt) because debt is created out of thin air when interest is applied. Additionally, we saw an interesting effect caused by the debt in our example which was that money suddenly came in short supply. We desperately needed all of the money in the world and a little bit more, which means the demand for dollars increased, and thus we would be willing to perhaps sell our packet of milk for less than a dollar. This is called deflation and is the opposite of inflation. Deflation is the effect of fiat getting more buying power through either the creation of debt or the increase in productivity.

Just being able to produce more things more effectively at a cheaper price causes deflation, there is even a hint in there for why that it's "at a cheaper price". As the milkman is able to increase efficiency at his farm by using machines the amount of milk he has gone up by a lot. As such supply rises and as such the prices go down. Since the price went down we see natural deflation. If there was a fixed amount of dollars in the world then the dollar would become more and more valuable as time went on. We would start dividing it up into cents again since we would be able to buy more and more milk for the 1 dollar.

So deflation is caused by banks (or anyone) creating debt as well as an increase in production while inflation is caused by government spending and a decrease in production.

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There is one logical gap in this summary: the assumption that the total goods produced remains fixed when the government spends money. This is obviously false, since the things the government buys (the military, medical care for seniors, etc.) would not have been produced (or not as much of it) had the money not been spent. There is a smuggled assumption that the people making stuff for government would have made the same amount of goods for other people, but that isn't proven.

Whenever discussing the effects of increasing the money supply, we tend to highlight the first order effects: if there's twice as much money, then prices are expected to double after a while.
This effect is already hard for the public to notice compared to straight-up taxation, but the effects during the transition are even more insidious (so called Cantillon effect): some people receive the fresh money first while prices haven't adjusted, and some people receive the fresh money last (after prices have already almost doubled). The folks who are the furthest away from the source suffer doubly: not only do they not receive any direct subsidies, they must deal with the increased prices before the demand curve for their own products shifts.

More generally on the topic of MMT, they seem to start from sound analysis (ie. money printing can fund things, as many economists had already pointed out) but incorrectly leap from accounting identity (which correlate multiple variables for a given period of time) to a theory of causation (changing one variable at one period of time affects another at the next periods).

There are some other problems...  Two critical reviews of Kelton's book on MMT:
- https://johnhcochrane.blogspot.com/2020/07/magical-monetary-theory-full-review.html
- https://mises.org/wire/review-stephanie-keltons-deficit-myth 

Those reviews are very helpful, but looking at "Derek" comments in the Cochrane blog, it is not at all clear whether these are critiques of MMT or critiques of Kelton ( or more specifically what Kelton believes that governments can do given that MMT is an accurate representation).

I am also very suspicious of how this would work within a democratic system. Many countries do not let governments set interest rates - that is the role of the independent central bank to control inflation. I would feel happier about governments printing money if the central bank was also dictating the level of taxation (the amount of money to be destroyed but not how that tax is distributed).

This misses the role of private banks in creating currency.  Every time they issue debt the amount of circulating currency goes up by an identical quantity.

Yup!  When large nominal price increases finally hit, we'll be able to blame the shorts!