Money

Here is a familiar scenario where money plays a central role.

After several years of diligent saving, you have enough money for the down payment on your first home (or your first car). After finding the right one, you sign the purchase agreement and head to your bank to secure a mortgage (or car loan). Once you complete the paperwork, the bank conducts research to confirm that the house (or car) you are buying is valued at the amount you agreed to pay. Having happily passed that hurdle, along with those related to your income and creditworthiness, they grant you the mortgage (or car loan), and off you go. You now possess an asset in the house (or car) and a liability in the mortgage (or car loan). You will be making monthly payments to the bank. The bank has an asset in these monthly payments, and you, similarly, have a liability in the funds they loaned you. Ultimately, the bank can seize your home (or car) if you fail to repay them.

This commonplace event illustrates the uses of money.

• First, money serves as a medium of exchange for labor, goods, and services.
• Second, it serves as a store of value. Place it in your wallet or checking account for future use.
• Third, money serves as a measure of value, providing a standardized metric for comparing the worth of goods, services, and labor.
• Fourth, it serves as an accounting unit for assets and liabilities.

The question of how to define money is a leap of faith. Money has value because we all agree on its worth. Governments insist that we pay taxes and fees in this currency. Everyone within a given country agrees that their nation’s money is trustworthy. If you accept a dollar for a candy bar, you feel confident that you can use that dollar to buy something else. Money represents a claim on the products and services available in the marketplace. Similarly, our labor, when sold in the market, is how we acquire these claims. This is how individuals and families secure claims on goods and services. The same holds true for businesses and other private entities.

Sovereign Money

As we will see, money is quite different for sovereign governments. By sovereign, we refer to a government that issues its own currency, collects taxes, and borrows in that currency. The US, Canada, the UK, Australia, India, Japan, and China are examples of countries that are sovereign in this sense.

Given that humans have been using money, coins, and paper for at least 6,000 years, you might think we would have settled how they function in human economies long ago. This is not so.

The remainder of this discussion of money is largely grounded in Modern Monetary Theory (MMT)², also known as neo-Keynesian or post-Keynesian monetary theory. A precursor to MMT is Abba P. Lerner's functional finance model from the early 1950s.³  MMT has developed over the past 15 years, although it originates from much earlier theories regarding money.

Orthodox economics, as taught in your Econ 101 course, views money as a neutral and passive component of the economy. It serves merely as a medium of exchange and a reservoir for potential investment, acting as a neutral agent. As you will see, this is not so.

There are three central tenets in MMT. We will explore them now.

Money is issued by sovereign governments, so a sovereign government can never run out of its own money. For this discussion, a sovereign government issues its own currency, accepts tax payments exclusively in that currency, and borrows in that same currency. The US, Canada, England, Japan, China, India, and Australia are examples.⁴ In all of these sovereign countries, there is a comprehensive system of exchange utilizing this fiat currency. This system underpins and enables the economy to conduct transactions.

Federal Reserve Chairman Alan Greenspan⁵ confirmed the essentials of this argument in a speech in 1997:

“.... a government cannot become insolvent with respect to obligations in its own currency. A fiat money system⁶, like the ones we have today, can produce such claims without limit. To be sure, if a central bank produces too many, inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation. If it produces too few, the economy's expansion also will presumably be constrained by a shortage of the necessary lubricant for transactions. Authorities must struggle continuously to find the proper balance”.⁷

 Let’s examine the concept of a sovereign government to deepen our understanding. The government is not like an individual, family, or business. A sovereign government can utilize all of a country's resources within the bounds of its legitimacy and authority. This implies that it can access all of the nation's assets, including people, raw materials, and manufacturing and service capabilities, to achieve its objectives. This is the definition of a sovereign government. Sovereignty, though its meanings have varied throughout history, has a core meaning: the supreme authority within a territory. It represents a modern notion of political authority.”⁸

For instance, we can observe the boundaries of a sovereign government during a crisis.  During WWII, the US government mobilized the entire society to send over 10 million fighters into battle worldwide. Almost every factory produced armaments and materials to support this effort. Food and fuel rationing were enforced, and price controls prevented a surge in inflation. Food was rationed. Women were employed in various occupations they had never held before, and Rosie the Riveter reigned. The federal government facilitated this mobilization by spending money in the sectors where it sought production and forbade the production of competing products. For example, no private automobiles were manufactured during the war. In today's dollars, the war cost $3.646 trillion, funded by the federal government, with an additional $1.935 trillion sourced from current tax receipts.

In more recent times, the Federal government has issued trillions of dollars to fight a series of wars in the War on Terror, bail out the financial system (e.g., the Savings & Loan crisis of 1986-1995 and the Great Recession 2009-2015), and keep the economy afloat during the pandemic (2020-2022). As noted by Chairman Greenspan above, a sovereign government cannot mindlessly create money. It is constrained by the actual resources and capacities available to absorb the demand created by money, and in parallel, too little money inhibits the use of these same resources.

Money is not created at government printing facilities; that method is a trivial factor in the overall process of money creation. Instead, money is generated by keystrokes on a computer through the banking system. The majority of money is created through the processing of bank loans. This may seem fantastical, but it is the reality.¹⁰ Another theory is the money multiplier theory, which describes interactions between banks that generate money. We will stick with the theory presented here, supported by descriptions and documents from the central bankers themselves.[/note]  Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System (the U.S. central bank), described how the $160 billion bailout of AIG Insurance in 2009¹¹ was accomplished:

"The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. So, it's much more akin to printing money than it is to borrowing."¹²

The US Federal Reserve and the Bank of England both have instruction manuals explaining how this works.¹³  This loan creation process is the primary source of new money for the economy.

To return to our example of obtaining a loan for a house (or car), when the bank approves your loan, it simply inputs the amount into its computer system. This credits your account with the loan amount as a credit while simultaneously recording the loan as an asset on its balance sheet. The primary constraint on a bank's loan creation capacity is its assessment of the risk that borrowers will fail to repay the interest and principal, rather than the availability of savings deposits.

This undermines the common assumption, shared with orthodox economics, that banks act as intermediaries between savers and investors. This process involves banks gathering savings from individuals and then lending that money to entrepreneurs and existing businesses to finance new plants and machinery. This is incorrect. Banks generate the money they lend through the process previously described.¹⁴

As an aside, when the government creates money by spending more than it taxes, a political process determines how that money is utilized. In theory, this implies that a democratic process selects the priorities and the amount of resources (the total dollars) allocated to achieving the objectives. Is it healthy for society to have the majority of money generated through the banking system? These private enterprises operate for their own interests, producing a significant portion of all new money. This is likely not an optimal system.

The third MMT tenet states that understanding the workings of the economy is best achieved by analyzing the flows of money within it, utilizing accounting tools, with the balance sheet and income statement being the most prominent. A central notion in this perspective is that money serves as a measure of both assets and liabilities. When the government spends money beyond its taxation, the difference becomes a liability (debt) for the government, while the private sector gains a corresponding asset. For instance, when the government invests in goods and services to establish broadband internet access in rural America, it incurs a new liability, while the private sector accrues a new asset.

Exploring money flows as a tool to understand the economy will wait for another book.¹⁵

Before proceeding, let's explore several ways money is depicted in our media and politics.

• The government should manage its budget as households do. You earn money and then spend it. A balanced budget is ideal; going into debt creates the burden of repayment.
• Government debt is a burden that our grandchildren will have to repay.

The first claim is simply wrong. Government is not like a household; it issues money and cannot go bankrupt. The history of federal debt, dating back to the origins of the country, demonstrates an almost permanent state of deficits

When a household runs a budget surplus, it is saving. Money is being set aside for future purposes. The funds become an asset on the family's balance sheet. When a sovereign government, like the US Federal government, runs budget surpluses, it extracts money from the private economy. Consequently, there are fewer dollars in the hands of consumers and businesses to purchase products and services. Government surpluses are deflationary.

Professor Stephanie Kelton suggested that the history of federal budget surpluses indicates that surpluses (removing money from the private sector) can lead to economic calamities. See the chart below.¹⁶

The household notion of earning and then spending is mistakenly applied to the government in the phrase "government taxes to spend." The reality is that the government spends first and then taxes.

This shifts the conversation about the national debt. Our political discourse only addresses the amount of national debt and rarely mentions that an equivalent level of economic activity is generated on the other side of the equation. When the government spends money on goods and services using debt dollars, that money is used by someone to create those goods and services. Roads, bridges, schools, and education are all funded through debt and become public assets. As a result of this spending, people receive paychecks.

If the federal government can spend by creating more money, why bother with taxes? First, and perhaps primarily, taxes create a demand for money. This helps to establish and maintain its value. Second, part of the issue involves managing interest rates and the money supply. Third, as mentioned, taxes control the money supply to prevent price inflation. Fourth, taxes influence behavior; consider sin taxes on tobacco and alcohol, for example. Fifth, taxes redistribute income and encourage other behaviors, such as home ownership.

In fact, the US Federal government has been spending more than taxing for its entire history, with only a handful of brief periods in which taxes were higher than spending. You should recall this the next time you hear politicians bleating about how our debt will bankrupt the country and put our grandchildren in penury. How do they explain that we have been in debt from the very beginning of the Republic?

There are several limits on government issuance of money. First, there is the political question of what activities our political system deems appropriate for the government to initiate. The current ethos of small government and favoritism for market solutions severely constrains government actions. Numerous initiatives that would greatly benefit many people are simply off-limits because our politics, influenced by the money of the rich and corporations, assumes that the market will supply the necessary products and services. To name just a few: low- and moderate-income housing, daycare and early education for children, public transportation, and healthcare. Second, government spending must align with the economy's capacity to produce the requested products and services. Are there unused resources available to accommodate these new demands? If the economy, or a specific sector within it, is already fully utilizing all available labor, machinery, and raw materials, introducing additional claims will only lead to rising prices. Inflation will follow. It is worth noting that the US economy has not approached full capacity utilization throughout my entire life (77 years).

You might wonder why the government borrows money at all if it can simply spend money into existence. The answer lies in its need to manage interest rates and regulate the money supply circulating in the economy. This borrowing also offers a very secure, interest-paying haven for excess funds in both the finance sector and the real economy.