Misunderstanding Modern Monetary Theory

Paul Krugman wrote a post today regarding MMT called "I Would Do Anything For Stimulus, But I Won’t Do That (Wonkish)." The gist of Krugman’s post was to refute Modern Monetary Theory’s view on money and deficits. Krugman writes:

Right now, the real policy debate is whether we need fiscal austerity even with the economy deeply depressed. Obviously, I’m very much opposed — my view is that running deficits now is entirely appropriate.

But here’s the thing: there’s a school of thought which says that deficits are never a problem, as long as a country can issue its own currency. The most prominent advocate of this view is probably Jamie Galbraith, but he’s not alone.

Now, Jamie and I are, I think, in complete agreement about what we should be doing now. So we’re talking theory, not practice. But I can’t go along with his view that

So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system.

Krugman goes on to use a model with strongly monetarist/neoclassical embedded assumptions to make his points. Jamie Galbraith responded in the comments and I am posting his comments here.  But, first, a few words.

I agree that deficits matter. But I take a more Austrian/austerian view in general – so of course I would say that. 

However, as I understand MMT, Krugman’s post mischaracterizes both MMT and Galbraith’s statement. There are two separate issues here that should be disaggregated and treated in isolation. The first issue is about money and government’s source of funding. A separate but related issue is deficits.

On the funding side of things, it sounds like Krugman is trapped in a gold standard view of money as he assumes the government must issue bonds to fund itself. He forgets that we live in a fiat world and that taxes don’t fund government spending, requiring government to issue bonds for a shortfall. Remember, a fiat currency is one that is created by government. Government can satisfy any commitment in that currency if it so chooses. It could theoretically credit accounts electronically to fulfil its commitment, laws permitting – no bonds necessary.

From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to.  When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

If the U.S. stopped issuing treasuries, would it go broke? (also see On debt monetization)

This is where the austerian in me says "government could simply pay for things with money it prints electronically out of thin air." You may not like this fact but that’s operationally how fiat currency works. I would argue that this eventually leads to currency revulsion (Krugman talks about using lumps of coal as money) and inflation.

[W]hile there is no operational constraint on government because of the electronic printing presses, there is an effective constraint in the form of debt and currency revulsion and price instability (large measures of deflation or inflation).  On countries like Greece or Portugal in the Eurozone, the operational constraint is a lot more real than it is on the U.K. because of currency union. The same is true for countries with a currency peg or large foreign currency debts like Latvia, Hungary or Dubai.

On the sovereign debt crisis and the debt servicing cost mentality

So the problem for deficits is not national solvency but inflation and currency depreciation. That makes me worried about deficits. If that makes me an inflation hawk and anti-deficit, then so be it.  Nevertheless, MMT does say the same thing about deficits, namely that they can lead to inflation. But MMT also says that inflation is not a problem when you have an enormous output gap from 17% underemployment. MMT proponents recommend deficit spending to close that gap. But you can’t spend at will under MMT; eventually the output gap closes and inflation becomes a big problem.

Notice that Galbraith never specifically mentions deficits in his statement. I don’t think he’s talking about deficits at all. His statement goes more to how government funds itself i.e with fiat money that it creates. He also speaks to his view that U.S. banks are forced to accept the government’s money because they want to do business in the only legal tender currency unit of taxation. While Galbraith may be more sanguine about the prospect of currency revulsion in the medium-term than I am, he never mentions deficits.

So Krugman clearly misunderstands MMT because it sounds to me like he’s saying the same thing. Someone correct me if I’m wrong.

Here’s what Galbraith said in the comments in response:

James Galbraith
Townshend VT
July 17th, 2010
4:01 pm

Paul’s argument is that *infinite* inflation is a theoretical possibility. Well, yes. It happened in Germany in 1923.

There is no reason to cut Social Security benefits or Medicare now, with effect in the future, in order to avoid the theoretical possibility that some combination of policies might at some time in the future give us the economic conditions of post World War I Germany.

Those conditions were desperately resource-constrained.

In the actual world we live in, government does not have to "persuade the private sector to release real resources." In the actual world, the private sector has already released those resources by the tens of millions of people.

All the government has to do, in the actual world, is mobilize those resources, which it does by issuing checks, preferably to pay people to do useful things.

There is no reason why this should be considered "costly." Done correctly, in economic terms it amounts simply to the reduction of the waste that is associated with unemployment.

Nor is it necessary, when the government issues a check, that it issue a bond to "borrow" the money behind that check. The check creates money in the first place. (Yes, it does this from thin air, by changing numbers in bank accounts.)

Operationally, this is a free reserve in the banking system. The reason the government issues a bond later, is that the banks like to have a higher rate of interest than they can earn on reserves, and the government likes to oblige them.

This is why Treasury auctions don’t fail: the government has already created the demand for the bonds, by issuing checks to the banking system.

If the government spent but declined to "borrow," what would happen? Nothing much. Banks would hold their reserves as cash rather than bonds, and their earnings would be a bit lower. It is *not* true, as a rule, that people (or banks) move readily to substitute lumps of coal for dollars, unless the price level is already moving up and out of control.

It is very difficult to get other people to accept coal in place of dollars!

Paul’s logical error here is that of assuming-the-consequent. He assumes the inflation which causes dumping of money. But if there is no dumping of money, the inflation will not generally occur.

Yes, again, it’s technically possible that the banks and others would start dumping dollars and buying up oil, wheat, rubber, and so forth (and leasing storage facilities for the stuff) thereby driving up the price level.

I wrote — correctly and deliberately — that bankruptcy, insolvency and high real interest rates were not risks. Inflation *is* a risk.

By this, to be clear, I mean an ordinary garden-variety increase in the inflation rate is a risk — not the *infinite-inflation* scenario.

Inflation, though unattractive, is not remotely comparable to bankruptcy or insolvency, unless you get to Paul’s *infinite* inflation scenario. So what about that?

In his model, it is driven by his monetarist (quantity-theory) simplification, that the increase in money flows directly into prices. But this is just a modeling error. In the real world, especially in broadly deflationary conditions, people — and banks — simply hang on to cash. There is a Paul Krugman who understands this, from close study over many years of the Japanese stagnation.

However, and again, in the present state of the world economy, and for the foreseeable future — and except for the energy sector — surely a small rise in the inflation rate is a trivial risk.

My position is that the government should focus on real problems: unemployment, care for the aging, energy, climate change, and the disaster in the Gulf of Mexico.

The so-called long-term deficit is not a real problem. And the capital markets demonstrate every day that they agree with this judgment, by buying long-term Treasury bonds for historically-low interest rates.


I may amend this post with links to prior posts at some future point today.

1 Comment
  1. Anonymous says

    PK clearly understands the concepts discussed by MMT theorists. He is only trying to be subtle in wiggling out of the position held by him so far.

    As far as I can see, I do not see anything wrong in JG’s statements. He does not say deficit is never a problem, as Pk claims.

  2. marketseer says

    A couple of problems with all of this. One of the primary ones is the way the system is created. Credit writedowns – I am going to forward you after posting this Dr. Hoisington’s latest quarterly letter where he is essentially arguing that much of QE does not create money.

    QE has no characteristics of money. It has the potential to be money but it isn’t money in its current state when a transaction is done with a commercial bank. The mechanism by which QE is executed is through a debt instrument. Debt, once it past a threshold, is inherently deflationary. In fact debt is synonymous with deflation. Debt allows consumption to be brought forward. Deflation follows. So the marginal change in debt is very important. So QE is occurring through a mechanism (debt) by which deflation is created. This also explains the fiscal stimulus and why it can work in the short term but also exacerbates the problem over the long term if the disease is misdiagnosed. (that being to much debt) Stimulus currently in the United States is done through debt creation. It brings forward consumption for a boost and than adds to the deflationary problem once it is done because the debt remains long after the consumption is consumed.

    So back to QE. One, there is a distinct limit to how much the Fed can do. The Fed is a private bank. They are a bank. That means they have a balance sheet and are limited in leverage just like everyone else is. This limit may be higher than for others but it is still a limit. You say, well the Fed can create its own currency. True but that actually means very little. In the 1800s there were alot of banks creating there own currency. It didn’t keep them from failing and there were limits to their balance sheet. Creating currency really isn’t creating equity and so doesn’t help the leverage issue.

    So than once again are they creating any money with QE? Is it inflationary as everyone believes it is? I am starting to think more and more it is not. Once again debt is deflationary and the medium for the QE function to occur is debt. So QE doesn’t reduce debt. There is no debt forgiveness. Leverage ratios do not decrease. So once again QE is a liquidity function not a monetary one. In many ways that is what Hoisington is essentially saying and if you sit down and try to create journal entries of a Fed quantitative action all it really does is help liquidity. It doesn’t help solvency which true money creation does.

    One more aspect to all of this and I don’t have all the pieces put together yet but legally, it is very difficult to create inflation once the debt tipping point has been passed. The Treasury cannot print currency. The Fed can. This wasn’t the case before 1913. The Treasury gave up its right to print currency (they can produce coins) The Fed has no real legal way to distribute currency except through the banking system. That means that something like the Wiemar Republic in our current system is almost technically impossible. Laws can be changed, but as it is now it can’t happen. The only way for true inflation to occur is for M0 / M1 to skyrocket in relation to M3 and the only way for that to really happen is to hand each individual in America thousands of dollars. That is impossible legally. Whoa whoa whoa. We have done that. The stimulus checks. No. The other side of the journal entry is debt. The US government borrowed money to do that. So you had a burst of activity but if the problem is debt, and debt is deflationary, you just created more problem and hence more deflationary forces over the longer term. Well that debt can just be purchased by the Fed. Yes, but their balance sheet limits that.

    There seems to be some constraints to monetary action in the legal set up of our current system that most investors / economist don’t realize. I think QE does create some money but the multiplier is less than 1. Once again I think this is Hoisington’s basic argument though I do believe he is forgetting about the credit risk side of the equation on his bullishness on government debt.

  3. marketseer says

    Well I thought I was going to email it. Didn’t realize there wasn’t an email address in the contact section. Anyone interested can read it here: https://www.hoisingtonmgt.com/pdf/HIM2010Q2NP.pdf

    This is not a topic I fully understand but something I have been trying to figure out the last month or two. Is inflation really possible or is the structure of our system such, that contrary to popular belief, the way the system is structured ensures that inflation is really impossible if the real problem is a debt problem. I had always assumed it was but I am starting to lean otherwise. I know that is way in left field and I am not totally sure I buy it yet either but several voices are starting to come to similar conclusions.

    1. dansecrest says

      marketseer,I’m afraid I don’t follow all your reasoning and that of Dr. Hoisington. Certainly inflation is possible. Often, inflation is the result of exapnding debt. Deflation is the aftermath. I would be interested in learning more about banks which issued their own currency in the 1800s. One obvious difference from the U.S. government in the year 2010 is that the U.S. government requires that taxes be paid in U.S. dollars, thereby ensuring a demand for dollars for that purpose. I’m pretty sure Hoisington doesn’t understand MMT.

      To the extent that quantitative easing just exchanges U.S. Treasury bonds for cash, it won’t make much difference with regard to inflation/deflation, in my opinion. It’s not as if U.S. citizens who hold Treasuries are limiting their spending because they can’t readily convert these to cash. Fiscal policy, on the other hand, can make more money available to the private sector and boost prices. Imagine what will happen if there is a payroll tax holiday here in the U.S. Tens of millions of indebted households will be payable to cope with their debts and spend more.

      1. marketseer says

        Dansecrest – I was right there with you six months ago. I was a firm deflationist but when push came to shove I believed inflation was at the whim of man. I just believed very few understand how hard it would be to create inflation and so deflation would occur followed by hyperinflation due to an increase in money supply. Over the last several months, as I have studied the underlying system, I am not sure inflation as a result of an increase in money supply is at the whim of man anymore (at least without changing the law).

        Lets define what causes inflation. 3 primary reasons. 1) Massive increase in money supply. 2) A loss in trust in an underlying fiat currency. (i.e. Europe if all trust is lost in the EU) 3) Constrained resources such as raw materials, labor etc. I am primarily talking about the first one.

        Your exactly right. “Inflation is the result of expanding debt.” Inflation brings consumption forward. All things equal consumption is inflationary and the debt left over is deflationary. Debt brings consumption and hence inflation forward. As debt increases at an increasing rate, it helps foster inflation. That is somewhat simplistic but at its very core, that is what consumption and debt are. So what happens when debt meets its limits? When you can’t expand debt anymore? That is where I think we are. There is no free lunch. Debt has its limits.

        Okay – so you just create money. Our structure isn’t like the Weimer Republic. The treasury (i.e. the government) in those two countries created currency. Here only the Fed creates currency. The problem is, the only way for the Fed to create currency is through the banking system. The Fed can’t mail a thousand dollars to you and me. So lets take a QE function where the Fed buys 1,000 of US bonds from Citigroup.

        Fed journal entries
        Debit US Bonds 1,000
        Credit Cash (which it created) – 1,000

        Citigroup Journal Entries
        Debit Cash 1,000
        Credit Bonds 1,000

        What do you notice about Citigroup balance sheet during that transaction? There wasn’t any journal entries to the owners equity part of the balance sheet. So if Citigroup was insolvent, it is still insolvent. Just more liquid. Imagine the Fed bought every asset Citigroup had. If the problem was insolvency, Citigroup would be completely cash on the asset side and still have negative equity. All it did was change the liquidity part of the equation. To the extent Citigroup is insolvent and doesn’t lend out any of this new cash, no money was actually created. That is what Friedman and Schwartz meant when they defined what money was and that reserves in the montary base is not money (what Hoisington explains).

        It doesn’t really matter how much “cash” everyone has as long as the system is insolvent. So you have to get cash to the hands of those who need it above the asset value that is given up and above the debt value needed to be serviced by that asset. Back to the Citigroup example. Lets pretend Citigroup has 1 million in assets and 1.2 million in liabilities and -.2 million in equity. It doesn’t do any good if they are given 1 million in cash for the 1 million in assets. They still can’t lend. If that is a person, they still cant consume.

        So lets take the fiscal policy you mentioned. The only way that occurs is if the U.S. takes on more debt (already running a deficit). So you could have a little inflationary burst of activity since this is bringing consumption forward but the end result is more debt in the system. Again we have a debt problem. So that debt leaves a deflationary wake. One of 3 things has to happen. 1) Taxes has to go up later to pay off this debt 2) Government spending has to eventually cut spending to pay off this debt 3) Interest rates skyrocket as the market finally says to much (credit risk shoots up) The Treasury can’t prints its own money. No, only the Fed can do that. The US government gave up that right in 1913. The Fed can print money and buy this debt but once again, the only way “money” was created was because of the creation of debt. Through a debt medium. This debt creation is deflationary after the inflationary burst. The Fed right now can’t create money without debt being part of the equation.

        This has been a position shift for me. To the extent that anyone sees holes in this, please shoot at it.

        I still believe the end result will be hyperinflation, I just think it may be because of lost in trust in the currency itself instead of money created.

        If you imagine an inverted triangle where M0 is the bottom tip all the way up to M4 (the big broad base) the only way to have inflation from a monetary phenomenon is for the triangle to be expanding. Right now M3 is plummeting. The triangle is shrinking. M1 has to explode to offset this and create a less pointed triangle. If you look at the M1 – M2 numbers of the Weimer Republic from the 1920s that is what was happening. But as I understand it right now, there is no funcational way with the way our system is created to create massive amounts of M1. As a result meaningless reserves build up.

        1. dansecrest says

          marketseer —

          Fiscal policy does not require that the government take on more debt. The government does issue bonds to offer interest on cash reserves, but it doesn’t need to do this. At any rate, the government can buy those bonds back at any time without raising taxes. Is this going to lead to hyperinflation? No. The government has done this Q.E. recently in the U.S. and Japan and still no inflation, much less hyperinflation.

          So the problem you are having is in thinking that the government needs to issue debt or raise taxes to pay for deficit spending. This is a fundamental misunderstanding of how fiat currency works, and any conclusion based on this assumption will be faulty.

          This has also been a position shift for me. To the extent that anyone sees holes in this, please fire away…

    2. JB McMunn, MD says

      In order to inflate you need people to spend money. Otherwise you’re just pushing on a string. The banks won’t lend and people don’t want to borrow. There’s been a lot of talk about why corporations are sitting on cash. One of these obviously is too much slack in capacity. However, the rest is lack of confidence. The government is fooling around in a major way with things they don’t understand. They are using solutions designed not for the public good but for the benefit of those who purchased said solutions. Furthermore, nobody really knows what the solutions will really entail because rules haven’t been written yet.

      There’s a quote by James Madison I keep coming back to these days: “What prudent merchant will hazard his fortunes in any new branch of commerce when he knows not that his plans may be rendered unlawful before they can be executed?”

      And we haven’t even started on cap and trade.

      1. Marshall Auerback says

        No, you don’t inflate “other people’s money” under a fiat currency regime. The government, as the sole monopoly provider of currency, does the spending when the private sector isn’t able or willing to do so. That’s just a complete misrepresentation of what is going on here.

        1. marketseer says

          Don’t disagree with you in theory but that isn’t the way the system in the United States is set up. The Treasury cannot legally print money, only the Fed can, and so the U.S. government doesn’t have any sort of monopoly over it unless the laws are changed. The US government has to borrow to spend. At best that is short term inflationary. Where in history has QE caused inflation? If you look at the massive inflatinary episodes of history, Dionsysius of Syracuse, the Roman emperors Nero and Galleinus, Constantine IX Monomachus of the Byzantine Empire, Sultan Mahmud II of the Ottoman Empire, Weimer Republic etc. etc., in every instance the central government had the right to print money. As a result, when money was printed there was no debt involved anywhere in the journal entry. It was just debasement. Not the case here. Every QE transcation involves debt in the journal entry. This makes inflation almost impossible if the problem is to much debt because money creation through the banking system involves debt.

          1. Marshall Auerback says

            The Fed is a creature of Congress so you’re making a distinction without a difference. And you can’t simply conflate a bunch of examples, such as Weimar, devoid of historical context. That’s the old Rogoff/Reinhart trick.

        2. marketseer says

          Wouldnt let me reply to your comment below. Maybe to many replies to replies. I agree Fed is a creature of Congress. I also made the distinction (in the comments above) that laws have to be changed which implies that they could be changed. As it is now, what your propose is not possible. Not that it is impossible to make it possible.

          I am not trying to creates examples devoid of historical context. I am just asking where QE created inflation in the historical context? History is the key to the future. I know money creation without an offsetting journal entry involving debt creates inflation. No where in history can I find where you have to involve debt (QE) that it creates inflation. So printing remains an effect, not a cause and if you have a debt problem it is impossible to have the cure through a debt medium. Tha is like having HIV and claiming the solution is through exposure to HIV.

          1. Marshall Auerback says

            QE is nothing more than the central bank buying one asset, and swapping it with another. It does NOTHING to add to overall aggregate demand, and therefore is not inflationary. The case of Japan is a perfect illustration of this. QE is probably the most overhyped policy out there, because the Fed doesn’t dare admit that it has nothing of consequence left in its tool kit.

        3. marketseer says

          Agree completely. So what are we discussing? QE is a liquidity function. It really isn’t printing money unless there isn’t a debt problem. Right now, there really isn’t a way for the government to print money and so the possibility of inflation (outside of a massive drop in trust in the currency), in the short term, appears like an extreme low probability.

          1. Marshall Auerback says


        4. JB McMunn says

          “No, you don’t inflate “other people’s money” under a fiat currency regime.”

          Maybe you’re responding to something else I wrote but I didn’t say this in the statement you replied to. I said in order to inflate, people have to spend money. We just saw that. Huge injection of money, not inflation.


  4. dansecrest says

    Krugman’s post was worthless — a clear example of equations obscuring common sense. He didn’t even begin to address Galbraith’s real issues, in my opinion. Let’s hope Professor Krugman follows up in a more coherent fashion…

    1. Marshall Auerback says

      Krugman has clearly decided just to stay on this side of what is supposedly academically respectable, and resorted to base caricature to distort Jamie Galbraith’s arguments.

      1. Traderscrucible says

        My guess is that he already regrets posting it. It is a strategic error of the greatest magnitude. He has admitted that he thinks hyper-inflation is a real threat. Now his enemies can point to this as proof that “even Nobel-prize winning lefty economist says” blah, blah, blah, Even he sometimes forgets we are not dealing with people who care about nuance.

        And then, lets face it, MMT is easy to caricature. It sounds batty to someone that has never heard the arguments before. When I read Mosler and Galbraith and Mitchell, they sound crazy to me- and I think MMT is correct.

        This idea isn’t easy to wrap your mind around until you go through the math. Nobody really knows about money, and finding out that it is created by deficit spending isn’t just difficult to understand, it goes against everything we’ve been taught about money for the last 100 years.

        then when you add in stuff like:

        “Nor is it necessary, when the government issues a check, that it issue a bond to “borrow” the money behind that check. The check creates money in the first place. (Yes, it does this from thin air, by changing numbers in bank accounts.)”

        That first sentence is a doozy. I might have said it like this:

        “it is not necessary for the government to issue bonds. It can just spend money. All it needs to do is change the numbers in a bank account upwards. As long as people accept a increase of the money in their bank account as desirable, then the government does not need to borrow. In todays economy, most people would be happy for the government to increase the amount of money in their account. ”

        Yes, this is an argument between economists so you need the fancy words to help them understand. But that doesn’t mean you need to bury the point of the sentence after two clauses.

        1. Marshall Auerback says

          Fully agree with you, which is why we always have to be careful to spell out the theory clearly and slowly and hope that we can get it past the caricature stage. Not easy, but given the paucoty of good alternative views, we might as well try our best to be ready with a sensible alternative when all else fails.

  5. Gbgasser says

    Ed or anyone,

    Please tell me how “currency revulsion” would supposedly work?

    As I understand the picture you are painting here, there may come a time when the currency gets too devalued and people will get rid of it en masse.

    For this to happen, wouldnt those with the worthless currency, need to convince those with coal to take the currency and give up the coal?? Why would they do it, if in fact its worthless? Is it possible that the coal sellers wouldnt know the value of the currency and they would just be pigeons for the taking?

    The more I ponder the scenario the more preposterous a currency dumping seems, unless there is a just a world wide revulsion of all currencies and pure commodity hoarding, which would signal much much more than “the US running a large deficit” kind of problem.

    So, short of the scenario in the previous paragraph, doesnt the “genius” of floating exchange rate fiat currencies lie in the fact that if there were even a significant but not cataclysmic run to some commodity, the dumped currency would magically rise in value again, since they are all RELATIVE VALUES. This reality is one of the things that prevents “collectivist schemes” from working.

    Help clear me up if I’m wrong

    1. Marshall Auerback says

      It’s not usual, but currency revulsion could arise in a situation whereby the state loses all political legitimacy and the corresponding ability to enforce payment of taxes. In such a situation, the fiat currency loses all value because government is no longer able to summon forth labour, goods and services in exchange for payment in said local fiat currency. The loss of taxation power, and the corresponding currency revulsion came during the American Civil War in the Confederacy.

      1. Gbgasser says

        Thanks Marshall

        What you describe sounds like a political revolt and I’m interested in what happens prior to that point. We dont go from today where everyone accepts the currency to tomorrow where NO ONE accepts the currency. There must be a transition period where various things are happening that trigger the capitulation. Sure people are pissed now, for good reason and those that can are buying gold or whatever, but I still submit that if you went to a guy who bought $100,000 of gold today and offered him 200,000 next week he’d sell it back! What he really wants is more dollars, he’s looking for a better investment, he’s not rejecting dollars per se. There is a big difference I think between looking for a better investment and abandoning currency. I submit there is ZERO evidence that people are doing anything other than trying to maximize their DOLLAR return.

        Help clear my thinking if I’m making a distinction without a difference.

        1. JB McMunn, MD says

          If you offer $200K for $100K worth of gold, and he still likes gold, he’ll just flip the dollars you gave him back into his original $100K of gold plus another $100K worth of gold and send you a very nice Christmas card.

        2. Marshall Auerback says

          I think it’s a different issue. I am merely trying to point out the conditions in which hyperinflation could take place and suggested that the state’s inability to levy taxes (which after all is what imparts value to the currency) would be something would could conceivably create those conditions. But that is a fairly extreme scenario.

  6. JB McMunn, MD says

    Guys, I hope you’ll cut me a little slack with my comments. I have never taken a single economics course and maybe I like the Austrian school because I can’t do math. But I am a businessman and I think in businessman terms and how businessmen behave.

    Let’s go back to Edward’s imaginary island where he and I trade using shells. But this time Edward has a magic shell-making machine that can make shells at very little cost. He’s never used it but I know it’s there. I have acted as though he would never dare use it and thus far he hasn’t so I trust him. He has been running a deficit with me and I have extended him credit. I now have a palm leaf where he wrote that he owed me the 100 shells that he borrowed plus 2 more shells for my services and risk in extending the loan.

    Then he owes me 150 shells. Then 200 shells. Plus “interest” of 4 shells. Then he decides what the heck, I’ll turn on the machine and make 102 shells and pay the guy back half of what I owe.

    He just robbed me. He made not only made my own shells less valuable but also devalued those palm leaf notes.

    Now I’m royally pissed. I could just raise my prices to adjust for the inflation and suffer my losses gracefully. I might refuse to extend him credit ever again. I might continue to lend but ask for 5 shells per 100 borrowed. I might totally lose faith in the shell system completely and demand payment in something more useful, like fish or coconuts. Or perhaps I’ll switch to a shark tooth currency – something he can’t make at the throw of a switch.

    So what it comes down to – and Edward alluded to this in his article – is how people react to the government printing its way out of debt (not borrowing from the Fed but printing with checks presented to banks or others, or maybe just going the Lincoln route and directly printing).

    I don’t think anyone can predict the reaction but it’s bound to be ugly. We got away with screwing everybody in 1971 when we abandoned the gold standard. Back then we were the big dog and people had a choice of going along with the farce or going up against a vastly dominant economy. They flinched and we’ve been pretending ever since that dollars have value.

    We have been playing a game of musical chairs (without any chairs) for 4 decades: the world has given us the fruits of its labor and we have been giving them . . . palm leaves, which we now devalue with our magic machine. Music stops, no place to sit for anyone, anywhere.

    Does anyone (besides Mr. Galbraith) think the reaction to this massive ripoff would be mild?

    1. Marshall Auerback says

      You are using an incorrect analogy. If Edward has the shell creation mechanism, it is because he is the government, not a fellow private businessman. Government has the monopoly on currency creation. If you or I try to use this shell machine, it’s a jailable offence called counterfeiting. Why don’t we allow this? Precisely because it would degrade the value of the currency. In any case, if you look at the data on tax revenue growth over the previous two cycles you will observe that in the upswing federal revenue grows at an annual rate above 15%–typically two to three times faster than GDP and government spending. This is why the deficit is reduced. Your scenario in which govt just keeps “pumping” money into the economy even as we reach full employment of resources is not plausible. In any case, the original case against the Modern Money Theory approach adopted by Galbraith had to do with insolvency, not inflation. Insolvency is a matter of inability to meet NOMINAL commitments as they come due, which is not what you are describing here.. When govt spends by crediting bank accounts, there is no situation in which it cannot make its promised payments. You have tried to shift this to a case of full employment of all resources, when govt cannot move more resources to the public sector. But again that is not plausible–so long as there are any resources for sale for dollars (or, to use your example, shells), the federal govt can compete with the private sector for them, and can win by bidding up the price. Note I am not advocating such policy. Indeed, this is why we use price controls, rationing, and patriotic saving when war takes us beyond full employment. Jamie knows that well, since his dad was in charge of that during our last Great War.
      But describing this operation is reality, not “robbery” as you claim.

    2. Gbgasser says

      JB MD

      I’m certainly no economist (in health care also) but have spent hours and hours the last two years exploring many of these economic issues and am quite sure I understand many of the issues being discussed. It looks like you do too, but I think you are missing something with your story, as Marshall pointed out.

      In your imaginary economy of two people if you are still able to get all you need with the same percentage of your income flow are you not as wealthy as before?. I assume you are getting something from Edward, its only the two of you. If you are producing all you need yourself…… then whats the problem!!!

      I think your story demonstrates the weakness of much of the Austrian analysis, it looks at micro transactions, assumes all would behave the same in that situation and simply implies that macro is all those micros perfectly added together. The fallacy of composition shows much of their analysis wanting.

      You brought up the Lincoln route. I think it worked out pretty good for the Union. Much better than the confederate dollar………why?

      1. JB McMunn, MD says

        Interesting question. Like you, I have been spending hours and hours studying the economy and its history for the past 2 years. My daughter is an econ major currently doing an internship at the Fed and we have some very heated discussions. But I digress.

        As I understand it greenbacks were – at least initially – redeemable for coins. Later on in the war there was coin hoarding (both the citizens and the government) which made things a little shaky but the currency survived. The South, OTOH only had “hope and change” behind its currency – if they won, the money would be worth something. The North also took a page from the England’s Revolutionary War playbook and flooded the South with counterfeit Confederate bills.

        That’s about as much as I know about it. I do know, however, that the concept of a government issuing its own money debt-free was regarded with horror by the central bankers in Europe.

        1. Gbgasser says

          I dont know about the counterfeit bills,how prevalent they were, but I think the Norths productive capacity is why their printing worked. They actually mobilzed some resources with their efforts. They convinced some people to get off their duffs and do something or got those who were already doing something to do MORE. The South was a productive wreck, almost a pure agrarian economy that needed to pay others for war supplies.

          What I think this might illuminate is that when you have production to bring online “printing money” will be effective. When you dont you get inflation.

          There was a PBS Civil War special that talked about how the North “deprivatized” their rail systems and worked to coordinate the rail for the
          common good. The Souths rail lines stayed in private hands and were thus not of much use to the confederacy. I think these different response to hardship showed why one currency flourished and another floundered.

        2. JB McMunn, MD says

          As I understand it the counterfeiting was massive. In addition, the Union would send agents into the South to pay for things using counterfeit Confederate money and get their change in greenbacks. Since the Confederate currency was in rapid decline there was an underground economy in the South that used Northern greenbacks. By getting their change in greenbacks they multiplied the damage done with each transaction.

  7. JB McMunn, MD says

    My point is not to dissect the little microeconomy of the island but to point out the erosive effects printing money has on confidence.

    I agree that Edward, as the government, can’t be insolvent since he has the shell machine. And of course I agree that if any of us tried to print our own money (or lend $9 out when we only have $1 – another topic for another day) we’d go to jail. However, if there are 100 shells on the island and he whips up 50 more for himself out of thin air without producing any commensurate increase in wealth, the value of my shells is diluted. I am poorer now. In my book, he has transferred buying power from my account to his against my wishes and without permission.

    Whether you agree that it’s theft or not, my confidence in both shells and Edward is now as debased as the currency and I am going to act accordingly. As I said, I might not accept that form of currency if he’s going to play games with it, or I might charge a high premium on future loans, or I might not lend him any more at all under any circumstances. I would very likely start to use another form of wealth counter like shark’s teeth that he can’t manufacture and restart the system using the new wealth counters.

    I just don’t think the U.S. can wave a wand and create a bunch of currency to pay off debts and people will shrug their shoulders and say,”Oh it’s just a little inflation.” People are very “twitchy” right now. I think they would panic and start dumping dollars and anything related to them and shortly thereafter we’d have a new reserve currency run by the IMF. Maybe it will be shark’s teeth.

    1. dansecrest says

      “shortly thereafter we’d have a new reserve currency run by the IMF” [JB McMunn, MD]

      JB– The U.S. and Japan have engaged in what you describe, i.e. quantitative easing, and these are two of the strongest currencies in the world.

      Would you rather have a currency backed by an institution such as the IMF which does not have the power to raise taxes? If inflation becomes a problem, the U.S. government has the power to deal with it…

      1. JB McMunn says

        Maybe we are talking about two different things here. I was under the impression that the root principle was “A government can’t go bankrupt if it borrows money in currency that it can print”. Our government can’t print, it can only borrow. The Fed prints money. What I’m talking about is if the government did try to pay off its debt by printing its own money. I have been looking at this in terms of “Suppose the Treasury printed up money and used it to pay off all the debt?”

        Maybe the reason we’re having trouble throughout this thread is that I misunderstood the central thesis of the article entirely.

      2. JB McMunn, MD says

        It’s not a great honor to be a strong currency when you consider the competition. I forget who said it, but it was to the effect that all currency is toilet paper, but the dollar is 3-ply toilet paper.

        I am not advocating that the IMF issue currency. I’m saying that in the event of “currency revulsion” they will be held out as the savior, and the solution proffered will be SDRs instead of dollars. There are already well-known pockets of “dollar revulsion”, e.g. Russia, China, Brazil, etc. Like Rahm Emmanuel I doubt they’d let a good currency crisis go to waste.

  8. Namazu says

    Congress will not grant Krugman his $5T stimulus, nor will the Fed grant Galbraith true helicopter money (thus calling into question the banking system’s raison d’etre). Neither side of their (academic) dispute deals with the importance of global commodity pricing, and neither of them betrays a whiff of understanding of the bond market. On what I consider the elephant in the room–that most of our economic predicament is structural rather than cyclical–I suppose MMT wins on points, insofar as it doesn’t advocate further debt slavery or government boondoggles. It would be nice to see more of the tenured elite put away their calculus texts and grapple with these messy and critical issues.

    1. dansecrest says

      Ah, the bond market. As James Galbraith says,

      “Markets are not calling for Deficit Reduction; now or later…

      Most informed laymen believe that the Federal government must borrow in order to spend. They believe that the interest rate on Treasury securities is set in a market for government bonds. The markets impose discipline on the government. Thus their idea is that “fiscal responsibility” will produce low long-term interest rates and tolerable borrowing conditions for the federal government, while “irresponsibility” will be punished by higher, and eventually intolerable, debt service costs.

      Accepting this view for the moment, what does the present level of long-term interest rates tell us? As I write, thirty year Treasury bonds are yielding just over four percent — or just a little more than half their yield a decade back. On the argument just given, this must be an extraordinary success of virtuous policy.”

      So, bond rates are half what they were a decade ago when the U.S. was running a budget surplus. There is actually a sensible explanation for this, which stems from the fact that the government doesn’t really need to borrow in order to spend and thus doesn’t face “funding risks” in private markets. Read the full Galbraith paper here. It’s straightforward; i.e. not wonkish (c:

      1. Tom Hickey says

        Trouble is that most informed laymen are wrong in their understanding of operational reality under a nonconvertible floating rate currency issued by a monopoly provider that is monetarily sovereign, like the US government. This misunderstanding is based on the government-finance-is-like-household-finance analogy. But the government is currency issuer, hence not financially constrained, while households, firms, and states in the US are currency users, hence are revenue constrained. The latter can become insolvent, the former never can, although government can decide politically to devalue it currency or even default on its obligations. But that is a matter of choice rather than financial necessity.

        Moreover, the Fed has control over interest rate setting and it is able to set not only the FFR and the discount rate, as it regularly does, but also control the yield curve if it chooses to do so. The US could also choose not to issue debt at all. Bonds do not finance government. They drain excess reserves created by deficits, and the same monetary operation could be accomplished more directly by paying a support rate on excess reserves equal to the overnight rate that the Fed targets.

        The idea that the Treasury and Fed are controlled by the whims of the bond market is nonsense.

        1. JB McMunn says

          The idea that the Treasury and Fed are controlled by the whims of the bond market is nonsense.

          And vice-versa.

        2. Tom Hickey says

          “and vice versa”

          All the Fed has to do is announce its target rate and the interbank market falls in line immediately because it knows that the Fed has the operational ability to hit its target. The Fed can to the same operationally along the yield curve through “QE” by buying bonds of longer maturity.

          It is a myth that “the bond vigilantes” can move US interest rates by demanding higher or lower rates.

        3. JB McMunn, MD says


          There are conditions that affect the bond market that their limited tool box can’t control. Tell me how the Fed and the Treasury controlled the bond market when OPEC turned off the spigot. War, famine, pestilence are all beyond their control. They can nudge but they can’t control.

        4. Tom Hickey says

          I grant you, war and acts of God the government cannot control. But the US had no problem selling low yield bonds in WWII. Moreover, the government can always set the rates it desires, or just stop issuing bonds as a deficit offset, since as issuer of a fiat currency, the government does not use taxes to fund itself or debt issuance to finance itself.

          Government is capable of managing aggregate demand relative to real output capacity by increasing nongovernment net financial assets through deficits and decreasing NFA through taxation. This is not even MMT. It was proposed by Abba Lerner as principles of functional finance in the forties. MMT adopted it.

          Moreover, in a fiat system bond issuance is unnecessary and interest on the national debt constitutes a subsidy to bond holders. Debt issuance should just be eliminated and that subsidy directed to advancing public purpose.

  9. Max says

    The real long term issue with the budget can be stated simply: the government has made promises which can’t be kept under current tax law, and probably not even with large tax increases. (Note that one of the promises is that inflation will be lowish). This is a real problem, not a phony one.

  10. Max says

    On the subject of QE: the Fed can theoretically inflate without limit by paying too much for what it buys, by losing money. But the Fed would not do that intentionally, at least not on a large scale (only for a few good friends in a time of need…)

    1. marketseer says

      Agree – that is how you get inflation. If the system is insolvent, a QE function, if a fair price is paid, is not only not inflationary but I would argue even exacerbates the deflationary forces after the initial little liquidity surge has made its way through the system.

      Can anyone tell me what the credit is for the Fed when it prints money? So the accounting for the Fed when it prints money and than does a QE function.

      Fed’s Balance Sheet During Money Creation
      Cash 1,000
      ???? 1,000

      Buying 1,000 worth of bonds
      Bonds 1,000
      Cash 1,000

      Assets must equal liability + OE

      Is the credit where I have the questions mark – should you credit a liability or should you credit equity? A dollar bill is a note. Hence, that makes me think a liability should be credited. However, it never comes due and has an infitine life does it not? So that makes me think equity. Seems like an important piece of information in determining how much QE the Fed can do from a balance sheet perspective.

      It is a question of ignorance on my part. If anyone knows, please let me know.

  11. Stanley Mulaik says

    While the right to print money has been delegated to the FED (while using the government’s mint),
    Congress and the Secy of Treasury (power delegated to same by Congress) has power to coin
    money and a platinum coin in any denomination he chooses.  Fullweiler (sp?) has argued that the 
    Secy of Treasury can order some $10 Trillion coins be minted, and then deposited at a Treasury account at the Fed. The Treasury could then ask that the monetary value of the coin be replaced by cash (paper money or eqjuivalent). The Fed creates the money out of thin air as usual.
    Using that cash, the Treasury could then use the money in that account to pay off the debt to
    the Fed. It would be simply a transfer on the Fed’s books and nothing gets into the economy, so
    doing this is not inflationary.  And the Secy of Treasury is authorized to do this by the fact that
    it is a debt of the United States to the Fed, and the debt was made in financing spending of
    Congress.  So, the national debt to the Fed could be wiped out at any time by a few trillion dollar
    coins on deposit at the Fed.  There is no worry about the so-called debt to the Chinese or
    Arabs or Germans for bonds they have purchased from the Treasury at interest.  It doesn’t
    fund spending by Congress (contrary to common misconceptions). Any deficit spending just
    is done by borrowing money made out of thin air from the Fed.  The taxes can be thought of as
    being allowed to vanish into thin air, or fund some of the expenditures.  It matters not how you
    look at it.   So, with fiat money, it doesn’t matter if Treasury can or cannot print money;
    it can coin money in any denomination desired by the Secy of Treasury. And that means that
    the medium in which money is circulated (some just as numbers in computers) is irrelevant,
    as long as the Treasury and Congress has the power according to Article I Section 8 of the
    Constitution to coin money and determine the value thereof.

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