Where does the Magic Money Tree Grow?

This week GIMMS extends a very warm welcome to Phil Armstrong, our guest MMT Lens author. GIMMS published his paper “Modern Monetary Theory and a Heterodox Alternative Paradigm” earlier this week in our new blog MMT Long Read. Currently studying for a PhD at Southampton Solent University, Phil is a ‘broad church’ Post-Keynesian whose research focus is pluralism with particular reference to Modern Monetary Theory.

Back in 1983, Margaret Thatcher set in motion a line of thinking that suggested that governments needed people’s tax or to borrow before they could spend. Thirty-five years later that false household budget narrative is still being repeated by politicians, journalists and think tanks alike.

In this factual, thought-provoking piece Phil debunks the mainstream theory of money and guides readers to challenge their deeply held beliefs about where money comes from and how it works.

The term ‘magic money tree’ is much beloved of the critics of modern monetary theory (MMT). Their story of the magic money tree begins with money’s traditional creation myth; money springs from barter and represents a cost-saving alternative to barter [1]. In the story, money is a private-sector invention, and only later do governments get in on the act. According to their fable, private sector business generates money from ‘productive’ activity. The state siphons off some of this ‘proper’ money in the form of taxation in order to fund public services.

This is an often wasteful and invariably inefficient process. The government can, of course, borrow money from the private sector, but this brings its own dangers; borrowing must be repaid and it places a burden on future taxpayers. Of course, the higher borrowing will raise interest rates, adding to the supposed intergenerational burden. This was famously noted by Margaret Thatcher.

“The state has no source of money, other than the money people earn themselves. If the state wishes to spend more it can only do so by borrowing your savings, or by taxing you more. And it’s no good thinking that someone else will pay. That someone else is you.”

“There is no such thing as public money. There is only taxpayers’ money.”

Margaret Thatcher, speech to Conservative Party Conference, October 1983.

A third option for funding exists but this is to be avoided at all costs; printing money. Any money printed by the government hasn’t arisen from productive private sector activity and must be inflationary; excessive money printing inevitably leads to hyperinflation. The magic money tree grows in the government’s garden but picking its fruit must be eschewed; such a harvest leads only to inflation and eventual economic collapse.

MMT advocates reject this myth and replace it with a new and far more convincing narrative based not on fables but history, anthropology and a deep-rooted knowledge of how the monetary system actually works. First, MMT rejects the orthodox money creation myth. It denies the notion that a unit of account can spring from the action of private individuals and instead argues that the state first introduces the unit of account and decides upon the medium which it will accept in settlement of tax liabilities [2]. Once the state has sufficient power it can use its control over the monetary system to provision itself. It first places some of its citizens in debt and requires them to pay a tax levied in the unit of account it has determined and payable by the means it is prepared to accept in settlement.

The state can now purchase the goods and services it requires, redistributing resources to itself from the private sector. Taxes serve first to create sellers of goods and services desiring the state’s currency in exchange. Private individuals need to acquire state money to pay their debts to the state. Second, the state is able to use its net spending to manage aggregate demand. It must net spend sufficiently to allow the non-government sector to meet its tax liability and satisfy net savings demand at the full employment level of income – otherwise, it will allow deflationary forces to exert downward pressure on income. Excessive net spending will generate inflationary pressures [3]. However, the key insight provided by MMT is that government must spend (or lend) before it can tax (or borrow). Taxes do not fund spending in a functional sense.

This logic is clear in a system where the state predominantly spends in coins. Clearly, a private sector taxpayer cannot mint her own coins without state permission. The state would need to spend them before she could acquire them. In the modern financial system, the government spends by data entry and the working of the financial system can cloud the issue; however, the logic still applies. When the government spends, it credits a bank account at the same time, adding reserves to the account-holder’s bank’s reserve account at the central bank.

It may appear that a private individual can pay their tax bill using bank money, however, on further reflection, this view can be seen as an illusion. If a private sector individual or institution pays taxes by means of a cheque its bank deposit falls by the amount of the payment but the settlement of the tax liability occurs when the taxpayer’s bank’s reserve account at the central bank is debited by the same amount. It is the transfer of bank reserves from the taxpayer’s bank’s reserve account to the Treasury account that settles the tax bill. To quote Mosler, ‘You can’t have a reserve drain before a reserve add.’

Before the private sector can pay its taxes the state must have spent or lent the money. Of course, the central bank might provide the reserves to the taxpayer’s bank by repo or buying bonds, but those transactions are merely the reversals of the central bank’s earlier draining of reserves by bond sales. The provided reserves originated from state spending. Thus it is apparent that state spending (or lending) precedes taxation; the only other way would involve counterfeiting of state money by the private sector!

We can now see where this fictitious magic money tree really grows; it grows in the non-government sector garden and must be used by private-sector agents who somehow want to pay their taxes before the government has spent the required state money into existence! Of course, MMT advocates know a magic money tree can’t provide state money; only the myth-believing critics believe such a thing exists.

In conclusion, we might amend Thatcher’s quote and make it an accurate reflection of reality, not an ideologically-based fable of a magic money tree growing in a free-market garden.

“The non-government sector has no source of state money except the state itself, it can only create bank money which can be used in private sector transactions but not to pay taxes. If the state wishes to spend more it can only do so without limit by data entry. Taxing or borrowing simply reduce the purchasing power of the non-government sector and serve to give value to state money and provide a means to manage demand.”

“There is no such thing as taxpayers’ money. There is only public money.”

Phil Armstrong, December 2018.

[1] See Menger (1892)  The Origin of Money for a typical example of the story

[2] G.F. Knapp (1924) The State Theory of Money

[3] See Warren Mosler (2012) Soft Currency Economics II

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Upcoming event:

1-2 February 2019 – GIMMS will be attending the 1st International European Modern Monetary Theory conference in Berlin. We will be speaking about our project and plans for promoting MMT and the Job Guarantee in the UK. Full details of the conference are available here. Registration for the conference is here.