Modern Monetary Theory Explained. Part I: A toy MMT world

If you get this in email you may want to read it on the web. I originally posted it here; or you can read it here on the Beyond Labels site.

Modern Monetary Theory (MMT) is a theory of money. Specifically, it is a theory of fiat money. There are other kinds of money: commodity money or representative money, credit or debt money. Each has its own rules and behavior. Fiat money is different than the others. It is based on declaring: “This here thing is money and you can pay your taxes with this money, and ONLY with this money. You can use it for other things if you want, but you if you get a tax bill, THIS is what you need in order to pay it. Period..”
Bam! Fiat money is created.

 

To understand MMT you have to understand that MMT talks about fiat money and only fiat money. You have to understand the difference between fiat money and other kinds of money. If you don’t you’ll be hopelessly confused and MMT will make no sense and you’ll think I’m an idiot for wasting my time writing posts about it. (You may end up concluding that I’m an idiot anyway, but at I hope not for that reason.)

World economies run on a combination of fiat money and other kinds of money. They’re all mixed up together. That makes it difficult to see that these different kinds of money behave differently. I’m going to start with a little fiat money toy world, so you can see how fiat money works. Then I’ll put things back together again, and scale up to the sovereign nation leve.

But not in in this post. This is the toy-world-how-it-works post.


Fiat money is not a new thing. Wikipedia dates it to the 11th century. The term “fiat money” is newer: it dates to the late 1800’s. Chartalism, a theory from which MMT is derived is even newer. It dates to the early 1900. MMT, as a developed theory, is yet newer. It dates to the late 1900’s.

And this post is the newest thing of all.

1.

To see how fiat money works in isolation, I’m going to make up a toy example — a thought experiment. If people were interested, we could actually test the theory in the real world. This has actually been done and the experiment has been running for more than ten years, and the results are reported to match the theory.

By MMT’s definition, fiat money exists when an entity, with the ability to tax and to collect taxes declares: “This is money, and you can only pay your taxes with this, and with nothing else.” It’s that simple. Not backed by gold, or silver. Not backed by credit. Not a future claim on tax revenue. Not good for anything, initially, but to pay taxes. Nothing but what I said. Seems simple. But it will evolve into something pretty significant.

 

When we think about taxing and collecting taxes, and issuing money, we think government. But fiat money can be created by any group. As long as the group can levy taxes and collect them and decides to issue a special something and say “This is the only thing that can be used to pay our taxes” they’ve done it. Whatever it looks like, special something is fiat money.

A social group or club could create fiat money. If its members agreed that they would pay dues — which is, in the end, a tax on membership; AND if the group issued something that could be redeemed against that dues obligation; AND if the group said “nothing else can satisfy your obligation” they would have created fiat money. Many groups do have dues, but they don’t issue their own money for paying dues. Instead they say that the tax — sorry, dues —  can be paid in the the national currency.

If it’s not their own money, then it’s not fiat money.

Let’s consider an example. Suppose we had a group called (I am just making up this name) “Beyond Labels,” and suppose the members agreed that paying a tax — sorry, dues — might be acceptable, if only to work out a thought experiment. To have a fiat currency, this imaginary Beyond Labels group would not permit the dues to be paid with US dollars or any other conventional currency, but only with its own currency. I’ll call the official unit of currency of the imaginary Beyond Labels group the blab$. It’s pronounced blab.

Why on earth would the members of Beyond Labels tax themselves? By creating a fiat currency, and managing it intelligently they could produce a social good. If the members want to bring about that social good, they could start by taxing themselves.

To which you might say: What?

I say: Watch.

1.

So far nothing to watch. There are no blab$, so no one can pay their taxes and the taxes have not been set. (I’ll stick with ‘taxes’ most of the time. You can translate to ‘dues’ if you hate taxes.). And no one knows what a blab$ is worth. May be it’s worth infinity dollars because that’s how much money you’d have to pay to get a blab$. And even then it wouldn’t be enough. Maybe it’s worth zero, because right now there are zero taxes, so zero demand for blab$


Let’s next select a group of people and authorize them to create the blab$ for Beyond Labels and regulate their supply. Let’s put them in charge collecting dues; they are the tax collectors. Let’s give the the authority to set and revise the tax rate. (Dues, remember?) Let’s make up a name for the people in who are authorized to do this.  Let’s call them “The Government of Beyond Labels,” or The Government, for short.

In other organizations they might be called by nicer names — like “Board of Directors” just as in other organizations membership taxes are called by the nicer name “dues.” But dues and taxes are just different names for the same thing. And these guys are a government, and that’s what I’ll call them.

And while we’re at it, let’s remind ourselves that the members of this imaginary Beyond Labels organizations are kind of like the “citizens” of a nation. To be a citizen you must subscribe to the written and unwritten standards of the group (Basically, be polite. Engage in reasoned discussion) and — in this version of reality, you must pay your taxes. If not, you’ll be banished — if you don’t choose to emigrate on your own.

The Government sets the tax rate at 5 blab$ per month. It’s an entirely arbitrary figure because nothing else in the model is set. If you don’t like 5, and prefer ten, fine. Just double all my other blab$ numbers and we’re good.


Because Beyond Labels is the kind of imaginary group that I have imagined it to be, the Government is responsive to the will of its citizen-members, and not corrupt. We can assume that anything that the Government does in what follows is done by the consent of the governed. There are lots of ways to make this happen. Which way it happens doesn’t change much. So let’s just assume it so, and ignore how it comes about. Later we can add unresponsiveness and, and corruption dials, because — reality.


Or if you really want, you can add the dials now, and turn them to zero. Same thing.

Now the Government needs to create some blab$. Whether done by printing pieces of paper or by keeping track in a spreadsheet is mostly besides the point. If done by pieces of paper, blab$ might be counterfeited, thus degrading the currency, so we need to prevent that. If done through a spreadsheet we’d need to secure the spreadsheet to keep someone from hacking into it and changing the numbers, so we’d need to prevent that. So let’s assume that the means of accounting for blab$ has integrity, and is not subject to these or any other kind of attacks.


You see where I’m going here?


2.

Blab$, the currency, has been created as a concept. But actual blab$ don’t exist until blab$ are put into circulation. Until then blab$ have no sensible monetary value. Maybe it’s zero, maybe it’s infinity.


That’s cool . Once they are put in circulation, a miracle will happen. A blab$ economy will come into being, just as MMT says it will. And blab$ will have a better defined value, just as MMT says.

But first we need to circulate some blab$

Let’s put blab$ by having the Government gives some blab$ to the Blue Hill Public Library, an imaginary library in the imaginary town where I imagine that the imaginary Beyond Labels group meets. BHPL says: “OK, we’ll go along with the joke. We’ll take the contribution, but what do we do with it.” The answer is: “You can use it to get some people to do stuff for you, because the Beyond Labels people now need blab$ to pay their dues.”

How many blab$ should the Government issue? Does the Law of Supply and Demand come in here? If so, how.


Well, there’s a demand for blab$ because people (some at least) want to be Beyond Labels members. And the only way they can be members is by paying their taxes. So blab$ money has some value, based on the value of being a member. We just don’t know what it is, yet. A blab$ denominated market, which we are about to create will give us some of the answers.

We can start by calculating the demand. Suppose there are 10 people who typically attend Beyond Labels meetings. If everyone decided to remain a member, the monthly tax bill will be 50 blab$ per month. So let’s start by matching the supply to the demand, and setting the “number of blab$” knob to 50 blab$ per month. That’s enough for each member to pay their dues at the end of the month. Then the Government gives that many blab$ to the library. The library puts up a notice “We have some books that need sorting. We’re willing to pay 1 blab$ per N books sorted.” N, the number of books per blab$ is another knob in our thought experiment. Let’s start it out at 1.

3.

We now have a demand — which we can estimate. We have a supply, which we have set. And we have a price in “books per blab$” which might translate to labor effort, which might translate to dollars per hour. Or not.


Several things might happen: first, each member might sort 5 books over the course of the month, and pay their dues. That results in a an economy that’s mostly pretty boring. But it does have a couple very interesting characteristic that are true of all fiat money economies: first, the Government spends (in this case it makes a donation) before it receives taxes. (If you made a dollar donation to the library, you’d be spending; so a blab$ donation is no different) Note that the Government could have spent any number of blab$ as long as it was enough to let everyone pay their taxes. Suppose 20 people wanted to be members? Then the Government would have to spend twice as many blab$. Suppose only 5? Nothing would need to change. People would earn the blab$ as they needed to.


Second, what happens to the blab$ after they are paid in dues/taxes? You could say “the tax receipts fund the next round of spending. Yes, you could say that. But MMT says something different. The first round of spending was made out of thin air. When the blab$ comes in, we could equally well destroy it. Burn them up. Issue completely new ones. Taxation in the MMT model has a different purpose. It is NOT, repeat NOT used to pay for Government spending because under MMT, the government just says: “This is money” “You need to use this for taxes” and then spends it.


3.

In the simple, boring world, each person earns the blab$ they need to pay their dues.


Instead, imagine someone —  maybe not even a member — shows up, sorts 50 books and takes all the blab$. Things start to get interesting. Generosity is always an option, but let’s add a generosity dial to our model and set it to zero, meaning “everyone is selfish.” This is where most economic models set it. Also, sadly, a lot of reality. Selfishness makes things more interesting than generosity. As Adam Smith correctly tells us, even with selfishness we can get social benefit from an economy.

Let’s call the guy who grabs all the blab$ Sid Selfish. If he corners the blab$ market — and if the money supply is limited, an important caveat — he could set the price of blab$ to any number that he wants. Suppose membership in the group is very popular — at least to the ten people who want to be members. Sid might set the price at $10.00 US per blab$ or even $100. Sid might, loan blab$, and charge interest, denominated in blab$ or in dollars.


Members need blab$ so what can they do?


If Sid Selfish sets the exchange rate or the interest rate for blab$ too high, the blab$ economy will tank. Why? Because if people can’t pay taxes, they can’t be members and only blab$ is good for paying taxes. If the membership drops, the value of being a member drops — because the value of membership has a network effect. (More on this important point to come) As the value of being a member drops, fewer members will be motivated to pay Sid’s prices. If nobody is willing to pay their taxes, then then blab$ have no value at all.


If Sid is too selfish then he will not only screw Beyond Labels (which he does not care about), but also himself (which he does care about.) He’ll be left with a bunch of useless blab$.

So Sid, being rationally selfish and intelligent gets as much as he from his blab$ stash by loaning and exchanging blab$ at a rate that is as high as possible, but low enough that members are willing to pay it, just barely. That is called “charging  what the market will bear.” And market oriented people say that’s fine. Sid sorted the books. He got the blab$ and he should be able to sell it for what he wants.


It’s wouldn’t be fine to me if I were a member of such a group, because the price that Sid is getting is not based on the work required to sort the books — which I agreed that he did and he deserves. I would happily pay that price, and call it fair. Instead, he’s using the structure of the blab$ market to extract the value that I place of being a member of the group. Sid did nothing to create that value. It was created by me and other members — or would have been, had such a group existed.


(Side note: In similar fashion I would argue that a substantial part of the value of being a US citizen or working and paying taxes in the US is created by our fellow citizens.)


So what Sid is doing is exploitive. I don’t like it, and in this imaginary world, neither does the Government of Beyond Labels. The effect of issuing blab$ to the library and letting the library decide what to do was to promote a social good. That social good is still being achieved (thank you Sid), but Sid is making most of his money not by providing the social good, but from taking advantage of the scarcity of blab$. If there were more blab$ to be had, I’d sort five books myself, and to hell with Sid.


4.

Remember, this is a fiat money system, run by a wise Government that understand MMT. The Government creates money, and controls monetary policy. So our wise Government issues some more blab$. In more traditional monetary terms, it prints money.


It could issue 50 more blab$ to the Library — after all the other people want blab$ and there are plenty of books to sort.


Suppose Sid Selfish jumps in to make sure he’s the first one there to sort books so he can maintain his monopoly and extract high prices. Maybe he even bribes (choke!) the library staff to let him come in early whenever new blab$ are released. The Government does not care. They consider sorted books to be a social good, and issuing blab$ is cost free, so they issue more blab$.

They issue more. And more. And more. Until finally the members can sort books, earn blab$ and pay their taxes. Or until Sid drops his prices to levels based on work done, not value created by others and exploitation of the system.


The Government of Beyond Labels has other tools to accomplish its purposes. It could declare a tax holiday. It social good has been accomplished and it wants members. Or it could make “unemployment” payments to the members who are willing to work, but who can’t find a paying job.


This is a principle of MMT: you issue money until there’s full employment.


5.
Sid hates the idea that the Beyond Labels Government can just issue more money. He argues passionately against it.

“It’s not sustainable,” Sid says. “If the Beyond Labels Government keeps issuing blab$, it’s increasing its debt burden. Then the interest payments on the debt will exceed the — “


Wait! Who said anything about interest. This is fiat money, not debt money from bonds. It’s not tax money. The Government of Beyond Labels does not borrow anything to create fiat money. It just says: “You can pay your dues (taxes) with this money and only with this money,” and then creates the money. No debt and no interest payments. So there!

Sid says, “Too much money chasing too few goods! Inflation. Bad!!” But where’s the inflation?


In the case of the tax holiday, or unemployment or welfare Sid could say: “Giving money to people who did not earn it is morally wrong!” But in this case, we have people who are willing to work, but there’s no money to pay them (because Sid has it all).


“They can work!” Sid says. And to prove it, he offers them jobs sorting books at low wages. For example he could let people sort books at the rate of 10 books per blab$ or a hundred per blab$. Because he has the money and they don’t. But that’s the economic equivalent of charging a high price for blab$ — he’s trading on the value of Beyond Labels. He can do this only because there’s a scarcity of blab$.


And he wants to make sure blab$ are scarce.

6.

So far, this little toy captures some of the key features of MMT.


The value of fiat money money is based on taxation.


It is NOT a promise made against future tax revenue.

The government spends money into existence.

New money can be created to provide jobs to people who are willing to work.

New money can be created to apply unused labor to generate social goods

The government never runs out of fiat money.

The size of the so-called debt (the amount of fiat money generated and not yet redeemed) does not matter because there is no interest,

Fiat money can be created to create a social good (sorted books in the library)

The money supply can be regulated to keep people from exploiting the system.

7.
What’s wrong with this?


I don’t know. The more I read about, and think about MMT the more sense it seems to make. It you see flaws, let me know.


Why is it such a fringe idea?


I don’t know. But I have two theories.


Theory number one is the charitable one, and probably true, in part. People have not adopted it for the same reason that it takes a long time for new theories in science to be adopted.  As Max Planck said:


A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grow up that is familiar with it.


When I’ve talked to smart, motivated people about MMT I find that they misunderstand what I am saying because their heads are full of theories taken as fact. One common one, that I will address in another post, is the origin of money. The common understanding, taken from Adam Smith is that money arose to facilitate barter; or that it is a store of value. Since fiat currency doesn’t match the story or the definition, it can’t be money, and discussion ends, until I can get them to consider other possible understandings. This takes a lot of time.Theory number two is the uncharitable one. People have not adopted MMT because it true, or false, it goes against their interests Selfish Sids exist in the real world. Fiat money works against their interests and so it is bad — even if valuable for society at large. MMT is a theory about something bad, so tit is also bad.


The charitable version of the uncharitable reason: they are unaware that they are doing this.

The uncharitable version: they know, and they don’t want us to know.

Whatever the case, the truth will eventually emerge.

Leave a Reply