Monetary Myths

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A message to monetary reformers: I get it.  I understand your motivation.  I was one of you until relatively recently.  I still advocate some monetary reforms, but my study of money has led to me to the conclusion that most of the reforms you’ve been advocating would be ineffective at best and catastrophic at worst.  It’s not all your fault, because mainstream economic theory gets money wrong too, and many monetary reformers who are otherwise critical of mainstream economics tend to take its theoretical underpinnings for granted.  I’ve decided to clear up many of the common misconceptions about money that exist both in the economic mainstream and among the monetary reform crowd.  I will also explain how the problems in banking and the monetary system can really be addressed.

Fractional Reserve Banking

In any economics textbook, you will find an explanation of the “money multiplier,” which explains how the fractional reserve system allows an initial deposit to grow several times over.  The reserve ratio can be any number from 0 to 100, but they always choose a reserve ratio of 10 percent for the sake of simplicity.  The theory goes like this:  Suppose you deposit $100 in the bank.  At a 10% reserve ratio, the bank can then lend out $90 of that $100.  But the 90 dollars doesn’t come out of the hundred, but instead is added to it, so that a total of $190 now exists.  They can then lend another $81 out of the $90, creating a total of $271, and so on.  This theory should allow economists to predict the total amount of money in the economy based on the Fed’s monetary policy.  Well, on April 12, 1992, the Fed set the reserve ratio at exactly the magic 10 percent that economics textbooks love so much, so we had a clear chance to test the assumptions of the money multiplier.  Did the Fed hit its target when it set this ratio?  No, it did not.  The money multiplier theory, even using its most simplified example, failed to predict the money supply.  That’s because the money supply has far more to do with fiscal policy rather than monetary policy.

 The problem is that this view of money puts the cart before the horse.  It assumes that loans come from deposits, when in reality, deposits come from loans.  Banks don’t check their reserves before making a loan.  Instead, when they find a credit-worthy borrower, they issue the loan and then borrow the reserves out of the money that has been created.  Reserves, then, play hardly any role in how much credit banks can create.  The mainstream theory assumes bank money is exogenous – that its quantity is determined on the supply side by monetary policy – when in fact it is endogenous, with the quantity of loans being driven primarily by the demand for loans.  Those who seek to attack the power of banks by constricting the ability of banks to issue credit may be doing more to harm to borrowers than anyone else.

 What’s more, the idea that banks “create money out of nothing” is a misunderstanding of the difference between money and credit.  Suppose a car dealership sold you a car on a payment plan.  You pay a certain amount each month until the car is paid off in full.  Let’s suppose you also have to pay interest, so that the total amount you pay is more than if you bought the car outright on the spot.  Would we say that the car dealer had “created money out of nothing”?  No.  We would say that they extended the payment over time.  Now, what is the difference between this scenario and one in which a bank issues you a car loan for the same amount of money, with the same monthly payments and the same interest?  The only thing that makes it seem like the bank is “creating money out of nothing” is that they aren’t directly selling you the product, but are instead selling you the liquidity with which to buy the product.  As with the car dealer, it is simply a matter of time discounting.

What's more, bank money never actually enters the real economy.  I know that sounds strange, but pay attention here.  When banks issue a loan, they do it through double-entry book-keeping.  The loan shows up as an asset for the bank and a liability for the borrower.  The loan also creates a deposit, which is an asset for the depositor and a liability for the bank.  All assets and liabilities add up to zero.  This is why in Modern Monetary Theory, bank money is called "horizontal money."  It is simply a matter of banks leveraging their positions.  By contrast, when the government issues a check, that creates an asset without a corresponding liability.  It becomes a reserve.  Thus, government money is referred to as "vertical money."  As we've already seen, reserve ratios do not affect the amount of credit creation banks engage in.  What they are necessary for, rather, is meeting the liabilities banks have in the form of deposits.  Thus, any time you cash a check or make a withdrawal, you are using government money, not bank money.  Any credit creation banks engage in exists entirely within the banking system, and doesn't add a dime to the real economy.

Taxes and Deficits

There is a common belief that just as you or I need to get our money by working for it, government must get money by collecting taxes.  This assumption pervades our everyday language about taxes and spending.  We see highway signs that say “Your tax dollars at work,” or complain about government “Wasting taxpayer dollars.”  This assumption is true with regard to state and local government, as they don’t have the power to issue money, but it turns out to be very different for the government that issues the money.  When you’re the one issuing the money, you don’t need that money in order to spend it.  In fact, you must spend it first before it can be given back to you.

 So what are taxes for, then?  Well, the right kind of tax, such as a land value tax, can do a lot of great things, but when it comes to spending, taxes play the role of controlling aggregate demand and giving money its value.  When the government taxes someone, they get to say what currency gets used to pay that tax.  Thus, the taxpayer will have a demand for that particular currency, and will be willing to produce goods and services in exchange for that currency.  Even someone who is not taxed will seek out that currency in order to buy the services of someone who is.  Many people, for various reasons, will want to save extra money in excess of their expenses.  When they do so, they are withdrawing money out of circulation.  So in order to make sure that there is enough money for people to pay taxes, the government must run a deficit which meets the net desired savings rate.  Any deficit smaller than this will draw upon previous years’ savings until deflation occurs.  A deficit above the net desired savings rate will cause inflation.  Since the net desired savings rate cannot be known in advance, governments have to tinker with the deficit until they get price stability.  A better alternative is to have tax the full unimproved value of land, which is self-adjusting to inflation and deflation.

 But what about borrowing?  Don’t all deficits have to be financed by government debt, thus mortgaging our children’s futures?  Well, sort of.  It is true that under current law, government has to “fund” its deficit spending through the sale of Treasury bonds, which is misleadingly referred to as “borrowing.”  But as with taxes, spending comes before borrowing.  Furthermore, these Treasury bonds are little more than savings accounts at the Fed, much like a savings account you might have at your local bank.  The bonds can be paid off by simply crediting the account.  The idea that the Treasury bonds could ever go bad would be like a football game in which it is announced that the stadium cannot award points for a field goal because they ran out of points.  The issuer of money neither has money nor do they not have money.  They are instead the scorekeeper that decides how the money gets allocated and the rules of exchange.

 Now, this still doesn't excuse the fact that the current law mandates the issue of Treasury bonds whenever government wishes to spend.  Such a law is based on a confused concept of money, and should be repealed.  Treasury bonds can still serve a purpose, in that they provide a source of savings for the public, in a form that effectively functions as an investment in one’s own government.  The Social Security Trust Fund is comprised of such bonds, and there is no reason that the government should be inhibited in issuing more of them to ensure that all citizens have a secure retirement.  There is also no reason why it should be “funded” by a regressive payroll tax, which, as should be clear by now, doesn't really fund anything.

The function that Treasury bonds currently play in our monetary system is in allowing the Fed to hit its interest rate targets.  When the government runs a deficit, it creates extra money in the economy which becomes savings for depositors and reserves for the banks.  Banks don’t like having excess reserves, which don’t generate any interest, and instead prefer to buy interest-bearing bonds from the government.  So the Fed sets the overnight interest rate and banks spend their excess reserves on buying up Treasury bonds at that rate.  Yet the whole reasoning behind the Fed’s interest rate targeting is based on an exogenous view of money, the flaws of which I’ve already addressed, and the quantity theory of money, which I will debunk in the next section.  Therefore, there is no reason for targeting such interest rates, and the overnight interest rate should be kept at its natural level: zero.

Inflation

A view which many people take as self-evident is the quantity theory of money, proposed by Irving Fisher.  People who’ve never heard of Irving Fisher or even studied much economics tend to implicitly assume it to be obvious.  The quantity theory of money states that prices are determined by the supply of money relative to the supply of goods, so that inflation is a result of “too much money chasing too few goods.”  Essentially, it applies a simple supply-and-demand analysis to money.

Such analysis seems plausible enough until you add the element of time.  The distinction between stocks and flows is lost in much economic analysis.  Michał Kalecki once defined economics as “the science of confusing stocks and flows,” specifically when addressing the quantity theory of money.  A stock is the quantity or value of a given commodity at any given point in time.  Flow is the rate at which that commodity goes into and out of the economy, through what are called inflows and outflows.  For bank money, inflow would be the creation of a loan and an outflow would be the repayment of that loan.  For government money, the inflow would be the spending of money and the outflow would be taxation.  To think of money purely in terms of its ratio to goods and services in the economy is to miss the fact that the supply of money is not constant.  What is important, rather, is velocity of money as it changes hands between inflows and outflows.

 Now, this doesn't mean that quantity plays no part.  But it plays a part only insofar as it influences velocity.  As I already pointed out, the size of the deficit matters when it comes to inflation or deflation.  If the deficit is larger than the net desired savings rate, people will be quick to spend any extra money they have, and this “hot potato” effect will increase prices.

 Often, when a major asset such as land gets bid up by speculators, this will raise the cost of living, which will show up in other prices.  Government also plays a role in bidding up prices, since when it spends new money on commodities it needs, it sends a signal to the producers of those commodities that demand is going up, thus prompting them to raise the price, leading government to pay the new, higher price the next year.  This is because the government purchases these items at a fixed quantity and a floating price – that is, whatever price the market sets.  What government can do to counter this tendency is to purchase a buffer stock – a commodity which they buy at a fixed price and a floating quantity.  In plain English, what this means is that the government chooses a commodity which it will offer to buy from anyone willing to sell it at a fixed price.  The amount people are willing to sell may vary from year to year, but the price stays the same even when bought and sold on the private market, and other commodities are then valued relative to the buffer stock.  The buffer stock should ideally be some major commodity central to the economy.  Modern Monetary Theorists advocate using unskilled labor as a buffer stock, replacing minimum wage with an “employer of last resort” program that hires anyone willing and able to work for a given wage which will set the floor level for what other jobs pay.  Since I believe Georgism offers a better full employment program, I would only advocate such a policy as a transitional measure toward a Georgist economy with high wages and full employment.  Land value taxation in and of itself would help control inflation, since land values would automatically adjust to net desired savings, as well as putting the breaks on any speculative rise in prices.  Once full employment in the private sector has been reached, a better buffer stock might be something related to energy.  Or we might humor the goldbugs by using gold or silver as a buffer stock, even though this would be an inversion of the kind of gold standard they tend to idealize.

Speaking of which…

Silver and Gold

There is a large group of people who claim that gold is “real money” or “sound money,” with the corresponding implication that paper money is worthless unless it’s “backed by” something of real value.  As I mentioned earlier, taxes are what gives money its value, regardless of whether it’s paper, gold, or beaver pelts.  When asked what makes gold sound money those goldbugs who aren’t simply falling victim to magical thinking and worshipping a shiny object will say that it is valuable because it is scarce.  They’ll point to the rising value of gold as evidence that it’s “real money.”  But a good investment does not a good currency make.  Money is money precisely by virtue of its not being wealth, but rather as standing in for real wealth.  Even goldbugs seem to have some implicit understanding of this, as most of them are fine with using paper money as long as it is “backed by” gold or silver.

 What most goldbugs are unaware of is that there has never been a monetary system which was purely commodity-based in the way they imagine.  Gold was originally used for coinage not because it was scarce(it was relatively abundant at the time), but rather because it was malleable and could be stamped easily.  Furthermore, the value of the coin was the amount stamped on it by the authorities – the amount they accepted it for in payment of taxes or tribute – and not the commodity value.  The commodity value of the coins only mattered when one went outside the jurisdiction of issuing government, as soldiers often did.  David Graeber suggests that this dual value of coins – the fiat value and the commodity value – may have influenced the idea of the dualistic division between body and soul which developed during the Axial Age, when coinage became common.

 When paper money came along, it was circulated as a certificate redeemable in a certain quantity of gold.  But this did not mean that the value of gold determined the amount of paper money.  Rather, there was simply a fixed exchange rate between a given denomination of currency and a given quantity of gold.  Though the gold standard is no longer followed, fixed exchange rates still exist in certain countries that peg their currency to another currency in and attempt to achieve price stability.  Fixed exchange rates do not have a very pleasant history, and countries that use it often have to go back to a floating exchange rate when there is an economic crisis.  A better version of the gold standard, as I already mentioned, is the use of gold as a buffer stock.

The Debt Virus

Many monetary reformers believe they can explain both the business cycle as well as capitalism’s drive for unlimited growth in terms of an “impossible contract” of interest.  The story goes something like this:  Banks create the principal for the loans they issue, but not the interest, which has to come from somewhere else.  That “somewhere else” means other loans.  This means that new loans are required to pay the interest on old loans, meaning that debts pile up on top of one another, until the debts can no longer be serviced, and a crash ensues.

 There are a couple problems with this.  The first is that it ignores the distinction between stocks and flows.  Even if new loans are needed to pay off existing loans, this does not require that the total stock of debt keep piling up.  When lending is made efficiently toward more short-term projects with high capital turnover, there can be a steady flow of credit which allows for consistent and sustainable payment of debts.  What causes debts to pile up is the extension of credit toward the bidding up of speculative assets like land, and the corresponding overextension of credit into long-term fixed capital with a relatively lower turnover rate.  These things are part and parcel of what is known in economics as a “bubble.”

 Another simpler problem with the “debt virus” theory is that it’s only looking at one side of the ledger.  For every person paying interest, some shareholder in the bank is receiving interest.  They can then use that money to buy goods and services from people who are paying interest.  As with the principal, it all balances out to zero.

 This is not to say that interest is of no consequence.  Like rent, interest is a monopoly privilege.  It is based on the artificial scarcity of capital, which in turn is rooted in the monopoly of land.  As land is held out of productive use, or is underused, it pushes production onto marginal land, which restricts the formation of capital.  What’s more, because land is used as collateral for loans, those who have the most valuable land also get easier credit, and thus capital flows disproportionately toward them.  If land rents were captured, more capital would be produced, and it would be distributed more evenly, which would eliminate its artificial scarcity and bring real interest down to zero, resulting in what John Maynard Keynes referred to as the “euthanasia of the rentier.”

Proposals

I will now venture to make some recommendations as to what reforms should be done to improve the monetary system.  One proposal of monetary reformers which does merit some consideration is to either nationalize the Fed or abolish it and put its functions under the control of the Treasury.  Some like Ellen Brown have gone further and proposed the idea of state banks, which would allow for states to have greater control over their budgets.  Ideally, I would suggest an even more radical proposal than this and suggest that local municipalities be given the power to issue money(still denominated in US dollars, of course), so long as they collect the rents from their expenditures.  It doesn’t matter how distributed this monetary authority is, so long as the rent is recaptured, and I see no reason why the level at which these rents are collected should not also be the level at which money is issued.  Since this would require a Constitutional amendment, however, perhaps for now it’s best to focus on reclaiming the authority now ceded to the Fed.

 Attempts to curtail fractional reserve lending are hopelessly misguided, and considering that government spending generates excess reserves anyway, there is no reason to have any reserve requirements at all.  People are right to be suspicious of the power of banks, but that power is ultimately rooted in the land.  With the public capture of all land rents, and the elimination of the Fed’s interest rate targeting, interest would fall to zero, and banking would shift to a non-profit enterprise, presumably dominated by credit unions and the like.  Under such a system, lending would become not so much a matter of turning a profit, but rather a form of mutual aid in which communities lend out credit amongst themselves to assist local farms, businesses, entrepreneurs, and other individuals and enterprises in need.

 Money is indeed an important part of the economy, and ought not to be overlooked.  However, those who focus on monetary reform tend to get it backwards when looking at money as the source of problems in the real economy.  Rather, the problems in the monetary system derive largely from problems in the real economy, particularly land.  The problems of money are relatively minor compared to the land problem, and solving the latter problem would cure most of the former.  The power of the banks lies not in the “money power,” but in the land power.  The only real money problem, aside from simply misunderstanding the nature of money, is the sovereignty of governments.  Give local governments money sovereignty and capture land rents.  The rest is commentary.