A guest post by Dirk Ehnts, originally published in German here
On Monday, January 29, 1996, Warren B. Mosler, Director of Economic Analysis at III Finance, wrote a message on a message board in which he asks academics for references and help regarding his model. The model was spelled out in his text “Soft Currency Economics” (SCE), which Warren Mosler worked on in the early 1990s. The following collaboration of Warren Mosler with academics like Randall Wray, Bill Mitchell and many others led to the (further) development of an empirical theory of money now know as Modern Money Theory. In this article, I quote some juicy passages from SCE to highlight the early foundations of MMT.
Warren starts his text by stating that current policy would be a disaster:
When a member of Congress reviews a list of legislative proposals, he currently determines affordability based on how much revenue the federal government wishes to raise, either through taxes or spending cuts. Money is considered an economic resource. Budget deficits and the federal debt have been the focal point of fiscal policy, not real economic costs and benefits. The view of federal spending as reckless, disastrous and irresponsible, simply because it increases the deficit, prevails.
He outlines why he wrote this text:
The purpose of this work is to clearly demonstrate, through pure force of logic, that much of the public debate on many of today’s economic issues is invalid, often going so far as to confuse costs with benefits. This is not an effort to change the financial system. It is an effort to provide insight into the fiat monetary system, a very effective system that is currently in place.
Then, Warren Mosler focuses on these seven points, which I will comment on briefly:
- Monetary policy sets the price of money, which only indirectly determines the quantity. It will be shown that the overnight interest rate is the primary tool of monetary policy. The Federal Reserve sets the overnight interest rate, the price of money, by adding and draining reserves. Government spending, taxation, and borrowing can also add and drain reserves from the banking system and, therefore, are part of that process.
This makes clear from the very first sentence that Warren’s ideas (which went into MMT) are not based on monetarist ideas. The central bank controls the price of money (interest rates at different maturities), not directly the quantity, as the monetarists claimed. The other big innovation contained in this paragraph is the view that fiscal operations (government spending, taxation, and borrowing) are monetary operations because the “can also add and drain reserves from the banking system”. Remember that almost all macroeconomics textbooks divide economic policy into fiscal and monetary policy. The line between the two is artificial, Warren says. This perfectly fits reality where central banks are not only the bank (or clearing house) of the banks, but also the bank of the federal government. The Fed describes itself as “Fiscal Agents and Depositories of the United States”.
- The money multiplier concept is backwards. Changes in the money supply cause changes in bank reserves and the monetary base, not vice versa.
Again, Warren puts SCE in opposition to monetarism. Whereas monetarism says that central banks lend reserves to banks which these then lend on to the private sector, SCE says that changes in the money supply (including deposits created by bank loans to households and firms) cause changes in bank reserves and the monetary base.
- Debt monetization cannot and does not take place.
This is very important: there is no such thing as “debt monetization”. The reason is the following. If the central bank sets an interest rate target, its purchases of Treasury securities are not discretionary any more. If the interbank rate goes down, the central bank has to sell Treasury securities in order to mop up “excess” liquidity and thus stabilize the interbank market interest rate. If the interbank market rate goes up, the Fed does buy Treasury securities, but only to maintain its interest rate target. As Warren explains later in the text: “The Fed is unable to monetize the federal debt by purchasing government securities at will because to do so would cause the funds rate to fall to zero.” Today, with the Fed Funds Current Target Rate set at 0.00-0.25 the Fed can buy all the Treasury securities it wants because the funds rate is supposed to be at zero or above. That has nothing to do with “debt monetization” and everything with bringing the interest rate down.
- The imperative behind federal borrowing is to drain excess reserves from the banking system, to support the overnight interest rate. It is not to fund untaxed spending. Untaxed government spending (deficit spending), as a matter of course, creates an equal amount of excess reserves in the banking system. Government borrowing is a reserve drain, which functions to support the fed funds rate mandated by the Federal Reserve Board of Governors.
So, government does not borrow to “finance” itself. It sells Treasury securities to “drain excess reserves from the banking system.” Borrowing does not “fund untaxed spending”. These are essential insights of MMT. Even today, many academics and commentators seem to believe that there are different ways a government can “finance” itself. That is not true. Government does not and cannot finance its spending.
- The federal debt is actually an interest rate maintenance account (IRMA).
By the way: Treasury notes only exist electronically, according to Treasury Direct. It is all just digital numbers in accounts at the Fed, owned by the Treasury. On January 21, 2021, the Fed holds $4,732,690 million worth of US Treasury securities. If it would be forced to sell them into the market, bond prices would collapse and yields shoot upwards. If it would buy up all federal debt (all Treasury securities), the interest rate would be zero permanently.
- Fiscal policy determines the amount of new money directly created by the federal government. Briefly, deficit spending is the direct creation of new money. When the federal government spends and then borrows, a deposit in the form of a treasury security is created. The national debt is essentially equal to all of the new money directly created by fiscal policy.
The last sentence is worth repeating: “The national debt is essentially equal to all of the new money directly created by fiscal policy.” When government spends more than it taxes, it creates new (additional) money. That’s all there is to it. The implication is that if you want to reduce the national debt, you have to destroy money by fiscal policy. This only happens when tax revenues are higher than government spending. Since this reduces private wealth, it will collapse aggregate demand eventually. The Clinton surpluses and the collapse of the dot-com boom are a case in point.
- The amount and nature of federal spending, as well as the structure of the tax code and interest rate maintenance (borrowing), have major economic ramifications. Options over spending, taxation, and borrowing, however, are not limited by the process itself but by the desirability of the economic outcomes. The decision of how much money to borrow and how much to tax can be based on the economic effect of varying the mix, and need not focus solely on the mix itself (such as balancing the budget).
Warren discards the idea that the mix of tax revenues and borrowing (issuing Treasury securities) should be driven by “balance the budget”. Instead, the “desirability of the economic outcomes” should be the guide to fiscal policy. This is Warren’s version of Lerner’s Functional Finance.
Summing up, the ideas contained in Warren Mosler’s SCE at the beginning of the 1990s already contained a lot of ideas that by now are accepted by large numbers of academics, policy-makers, bankers, journalists and the wider public. Expanding these ideas into MMT added more flesh and led to the formation of a proper macroeconomic school. At 25 years of age, MMT is now at the verge of becoming mainstream macroeconomic theory. This is well worth celebrating!