MMT 5: Monetary Operations

July 7, 2018

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This is the fifth in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

What is money?

In modern economies, money is not a thing, but “a unit of account in which we keep track of debits and credits.” The sovereign state specifies the accounting unit, in our case the dollar, when it issues a currency. It has value not because it is backed by anything tangible, but mainly because the state accepts it as payment for people’s tax liabilities. That forces people to keep records in dollars for any transactions with tax implications. Once people are using the currency to track their transactions, it transcends anything physical. Money includes the paper dollars in your wallet, but it also includes all the accounting entries that record exchanges and show that someone has a dollar-denominated claim on someone else.

The dollar no longer has any fixed value. Since 1971, when the U.S. went off the gold standard, the value of the dollar has fluctuated according to its supply and demand in global financial markets.

According to Modern Monetary Theory, the creation of money is driven primarily by the demand for loans. When Meili extended credit to Thelma to buy stuff at her yard sale (see the previous post), the loan became a financial asset for Meili and a liability for Thelma, whether recorded in an I.O.U., a ledger, or in their respective memories. That kind of personal loan is at the bottom layer of the “pyramid of liabilities” that constitutes the monetary system. At a higher level, when a bank makes a business loan, it creates the money by crediting the business’s checking account. It also records the account balance as a liability for the bank, since it represents the bank’s obligation to accept checks drawn on the account. The loan itself is an asset for the bank, but a liability for the business, since the business is obligated to repay it.

Bank reserves

But doesn’t the bank have to have the money sitting in its vault before it can loan it out? No it doesn’t. It only has to have a small fraction of it in cash reserves, and most of those are held not in its vault but in an account with the central bank, in our case the Federal Reserve. The local bank doesn’t need much cash on hand on any given day, since it has deposits and loan payments coming in as well as withdrawals going out.

Modern Monetary Theory does not accept the notion that the reserves put a limit on the bank’s ability to lend, so that loan activity is limited by the existing supply of money. Banks respond to an increased demand for loans by finding the additional money they need to keep in reserve, whether by selling assets or borrowing from other banks or from the Federal Reserve. They make a profit by borrowing money at an “interbank” rate of interest and then charging their customers a somewhat higher rate.

The Federal Reserve stands at the top of the “pyramid of liabilities.” It is the “monopoly supplier of reserves.” Its operations accommodate the demand for money to lend, but only within limits because of the Fed’s responsibility to control inflation.

Inflation and interest rates

The Federal Reserve tries to control inflation by setting a target for the interest rate on interbank loans. Since the banks mark up this rate to make a profit when they lend to customers, this rate also affects interest rates for mortgages, business loans, and so forth. The Fed’s aim is to set rates high enough to discourage borrowing and spending when prices are rising too fast, and low enough to encourage borrowing and spending when inflation is low and the economy is growing too slowly. The Fed keeps a constant watch on actual interbank borrowing to see if the rates on interbank loans are deviating from the target. That happens because of fluctuations in the reserves held by the banks.

When banks are short of reserves, the shortage may drive the interbank rate up. (Banks are willing to pay more to borrow, or they can charge more to lend.) The Federal Reserve can alleviate the shortage by injecting cash into the system with purchases of bonds or other assets from banks. When an excess of reserves drives the interbank rate below the Fed’s target, it can drain reserves from the system by selling bonds or other assets to banks.

Treasury spending and lending

When the U.S. Treasury spends money authorized by the federal budget, it also creates money for the economy, for example by crediting the account of a building contractor. When it taxes, it removes money from the economy. When it spends more than it taxes, the excess money increases disposable income and boosts aggregate demand.

Deficit spending can be a source of inflation, however, by pushing up the market demand for goods and services without adding to the supply, especially if the economy is already running near capacity. The government spending went to produce a public good, such as a new highway, but it didn’t add to the supply of consumer goods that people can buy. By issuing Treasury bonds, the Treasury drains excess cash from the system and replaces it with I.O.U.s. People who buy the bonds are saving rather than spending.

Notice that I did not say that the government had to issue bonds in order to borrow the money before it could spend it, like a consumer using a credit card. In principle, the sovereign state has the power to create money when it spends without draining that money back out again through taxation or bond sales. Selling bonds is mainly a prudent measure to ward off inflation. For that reason, Modern Monetary Theory considers it a part of monetary policy more than fiscal policy, which is concerned more with taxing and spending.

The Federal Reserve does not buy Treasury bonds directly from the Treasury, but it can buy and sell them on the secondary market. Those buys and sells are an important way of adjusting bank reserves, as described above. Although the Federal Reserve has a degree of independence from the Treasury, in practice they work together to control inflation.

A tight monetary policy keeps interest rates high enough to discourage too much borrowing and spending. Experience has shown that it can be effective in controlling inflation. The downside is that it can slow economic growth and keep the economy running below capacity. The holy grail for economists would be a set of government policies that would promote both full employment and low inflation. Modern Monetary Theory tries to develop such a policy.

Continued

 


Postcapitalism (part 4)

May 18, 2016

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The last part of Paul Mason’s Postcapitalism discusses how the transition out of capitalism might unfold, with special attention to the role of the state in facilitating change.

To review, Mason expects information technology to liberate people from the capitalist market economy. We will be liberated as workers because fewer hours of paid work will be required to produce the necessities of life. We will be liberated as consumers because goods and services will be more abundant and less expensive. We will be able to devote more of our time to voluntary activity and sharing.

A rough road

If this sounds too rosy and idealistic, readers should take a close look at Chapter 2, “Long Waves, Short Memories,” and Chapter 9, “The Rational Case for Panic.” Mason does not expect a smooth, leisurely and pleasant transition beyond capitalism, but something more tumultuous. As the historical material in the book makes clear, the history of capitalism is not just a story of steady progress through technological innovation and rising productivity. It is a story of periodic crises as the profitability of existing industries wanes and capital has to find new opportunities elsewhere. The transition now underway is especially difficult because it calls into question the viability of capitalism itself. As production becomes more knowledge-based, the means of production become harder to own and maintain as sources of private profit. Since the 1970s, capitalists have been counteracting the tendency for profits to fall by holding wages down in the developed countries and exploiting the cheap labor of poorer countries, but at the cost of increasing inequality and social resistance.

To make matters worse, new environmental and demographic conditions are delivering “external shocks” to the economic system. The prime example is climate change, a problem that Mason does not believe the market can solve on its own. When the price of fossil fuels goes up, energy companies take that as a signal “that it’s a good idea to invest in new and more expensive ways of finding carbon.” When the price goes down, consumers conclude that they can drive more or buy less fuel-efficient vehicles. However the market fluctuates, the price does not factor in the externalities, the true costs of environmental impacts on the global economy.

Another shock is the “demographic timebomb,” the addition of another two billion people to the planet by mid-century, most of them in poorer countries. In the richer countries, falling birth rates and rising longevity are creating rapidly aging populations. With fewer working-age people to support more retirees, workers are under pressure to generate enough wealth to save for their own long retirement as well as contribute to the support of today’s retirees through payroll taxes. Demographic change puts additional stress on the economy in several ways: requiring the financial system to deliver high investment returns for retirement accounts, increasing the demands on public spending for the elderly, and increasing the flow of migrants from rapidly growing poor countries to slower growing but aging rich countries.

The world cannot afford a leisurely transformation to the postcapitalist economy Mason foresees. The world needs a rapid deployment of new technologies to produce as much as we can, but do it in a cleaner, greener way that mitigates environmental damage. The potential benefits are enormous, but the task of getting from here to there is daunting.

“Project Zero”

Because of the urgency of the situation, Mason believes that a spontaneous process of increasing information-based activity is not enough. The process needs to become a conscious project, based on the insight that “a new route beyond capitalism has opened up, based on promoting and nurturing non-market production and exchange, and driven by information technology.” He calls it “Project Zero” because “its aims are a zero-carbon energy system; the production of machines, products and services with zero marginal costs; and the reduction of necessary labour time as close as possible to zero.”

The state has a special role to play in Project Zero because only the state is “centralized, strategic and fast” enough to address the urgent problems. However, Mason rejects the old socialist idea of a centrally planned economy, arguing that a centralized bureaucracy cannot respond to new data fast enough to keep up with the pace of change in the information society. Recall the earlier point that the key agent of change will be the educated and networked individual, which implies a high degree of decentralization.

Limits on private capital

So what can the state do to facilitate the transition to postcapitalism? First, it can curb private economic power in industries where it has become a danger to the public good. The energy industry would be one, as the discussion of the climate issue illustrates. The state should actively discourage fossil fuel production and encourage cleaner sources of energy. Mason also sees a much larger role of government in the financial industry. One proposal sure to provoke controversy is that the state take control of the central bank in order to implement a monetary policy that helps debtors more than creditors. That would be a looser monetary policy that keeps interest rates low but allows the inflation rate to be somewhat higher. Over time, that erodes the real value of debt, in contrast to a strict monetary policy that protects wealthy lenders by placing primary emphasis on fighting inflation. Since government itself is a large debtor, that would help governments recover from the fiscal crisis resulting from demands for both low taxes on capital and high spending on social programs to assist struggling wage-earners.

Mason would also reorganize the banking system to make it less profit-driven, by encouraging non-profit banks, credit unions, peer-to-peer lenders, and “a comprehensive state-owned provider of financial services.” He would regulate the remaining profit-oriented banking to curb wasteful speculation and encourage its proper role of efficiently allocating capital to productive activities.

In the economy as a whole, the state would act to insure that what profits remain would be a reward for entrepreneurship, and not just a “rent” based on ownership. Creators of new knowledge would get the rewards of intellectual property rights, but those rights would be short-lived to encourage the flow of knowledge and the continued incentive for further innovation.

Liberating workers

Another thing the state can do is strengthen the legal rights and protections of workers to give them more bargaining power in their relationship with capital. This will indirectly encourage the fuller application of new technologies that can produce economic abundance. “If we legally empowered the workforces of global corporations with strong employment rights, their owners would be forced to promote high-wage, high-growth, high-technology models, instead of the opposite.” Owners would try to make each worker as productive as possible if they could no longer profit from paying such low wages.

An obvious objection is that higher wages and productivity would have the downside of less employment. But for Mason, less employment in capitalist workplaces where owners profit by overworking and/or underpaying workers is ultimately a good thing. Ideally, workers would be better paid for the hours they worked, but also have the option of working fewer hours. They could then experience the decline of paid employment as a liberation, not an involuntary displacement.

The other side of the transformation of work is the increasing opportunities for work outside of traditional profit-centered firms, such as in non-profits and co-ops. Mason recommend that the state “reshape the tax system to reward the creation of non-profits and collaborative production.”

Liberating consumers

The replacement of millions of workers by automated systems is unlikely to be experienced as a good thing unless it has benefits for people as consumers, not just as workers. Here the state can facilitate the transition by providing a basic income to all households, to support those who are voluntarily or involuntarily outside the system of paid employment. That can improve the safety net for those who are displaced by new technologies. It also “gives people a chance to build positions in the non-market economy” by subsidizing participation in volunteer work, co-ops and adult learning opportunities. Market work would still be rewarding as long as minimum wages were higher than the basic income.

In the long run, the abundance of things made available by hi-tech production methods would bring the monetary cost of living down and reduce consumers’ dependency on earned income. People could rely more heavily on non-market forms of sharing, since they would have more time for unpaid but socially useful activity. As the income tax base became smaller, government’s ability to pay a basic income would decline, but so would people’s need for one.

Can democracy survive the transition?

Just about every one of Mason’s political suggestions goes against conservative thinking, which sees the free market as the creator of wealth and the limited state as its supporter. In the conservative view, the state should tax and regulate capital as little as possible, protect wealth against inflation with tight monetary policy, and keep people dependent on paid employment by providing only the most meager welfare benefits. Mason ends his book by warning that if the democratic state tries to facilitate a transition beyond capitalism, the economic elite may decide that preserving capitalism is more important than preserving the democratic state!

How long will it take before the culture of the Western elite swings toward emulating Putin and Xi Jinping? On some campuses, you can already hear it: “China shows capitalism works better without democracy” has become a standard talking point. The self-belief of the 1 per cent is in danger of ebbing away, to be replaced by a pure and undisguised oligarchy.”

We can already see the beginnings of an alliance between right-wing autocrats and blue-collar workers fearful of losing their jobs, especially in doomed occupations like coal mining or pipeline construction. If such alliances succeed in taking over the governments of developed countries such as the United States, then things could get pretty ugly in the next few decades.

In the last great transition of capitalism, in the early twentieth century, authoritarian politics had to be defeated before the democratic state could help create a broader-based prosperity. (Third-world peoples and racial minorities remained excluded however.) We should not be surprised if the same turns out to be true of the twenty-first century, as we struggle to create a more inclusive and sustainable prosperity.