Understanding Modern Monetary Theory (1) - A Different View of Government Spending

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Let me try to summarise J.D. Alt's book on Modern Monetary Theory (MMT).

The Conventional Image of Government Spending

The authors first lays out the received wisdom on government spending.

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There is a Private Sector (PS), which is vaguely conceived of as being a huge reservoir of money from which money flows via (a) tax payments and (b) lending out to the Federal Government (FG).

The FG is without resources of its own and therefore needs to drain by taxation or borrow money from the PS to obtain funds used to acquire what need it has of goods and services provided by the PS.

From this it is concluded that Government spending is absolutely constrained by the amount of money contained in the PS pool. By spending too much the Government may inordinately reduce or even empty the PS pool of money: the entrepreneurs in the PS will not have enough money to invest in projects and jobs, and the GNP (which equals the PS money pool) will shrink.

For this reason, the FG must see to it that its spending remains reasonably constrained.

Then there is another danger for the FG to guard against. Apart from being overtaxed, the PS can be drained further by borrowing from it in too large a measure. After all, the repayment of the principal and interest payments must be covered by taxes, which drain the PS. The more the FG borrows the larger the repayment bill to be honoured by future generations. Excessive borrowing today leads to excessive taxing and draining of the PS.

Thus, the funds available to the FG flow out into debt financing (principal and interest), entitlements and discretionary spending - and these channels of outflows compete with each other: the higher the borrowing costs the fewer dollars remain available to fund entitlements and discretionary spending. Eventually, wishing to extend its means, the FG may have to look for a foreign funding source, thus getting into debt and dependence vis-à-vis a foreign power like China.

What Is Wrong with the Conventional View of Government Spending

Actually, the conventional view is fundamentally flawed. Demanding a clear answer as to how the PS creates its own money on which the FG is supposed to be dependent, we do not get a satisfactory reply. That is not surprising, as the conventional view overlooks the fact that no one but FG has the right to create money by issuing currency.

So, before their can be any money in the PS it must get there from its source, the FG. The latter needs to spend its currency first before anyone else in the PS can have any money at all to return it to the FG or do anything else with it.

Now how does the FG get to spend - that is, why would anyone work hard to produce the things or offer the services the FG desires and sell these goods and services in return for the Government's currency?

The reason why is that they need the currency to pay taxes. Being the monopoly supplier of the currency, the FG is also the monopoly supplier of coercion - it is the only institution that can force the citizenry to pay a "tribute" to it, so the FG can be what it is and provide its services.

The FG "says," if you make this product or service available to me, in return for it I will give you something very useful: an IOU issued in the form of Government currency, which entitles you to extinguish the tax that you owe the Government. You give me your product, and I shall abstain from killing you or putting you in prison. Apart from that, the IOU I am offering you has other useful features - it makes the conduct of rational economic life possible.

To be continued in Understanding Modern Monetary Theory (2) - A Different View of Government Spending.

See also Steven Keen's article in which he explains that the loanable funds theory (banks funnelling money from PS to FG, or form some sectors of PS to other sectors of PS, with PS being the origin of money) on which mainstream economics is predicated condemns economists to misread the origons of the GFC and weds them to erroneous policy recommendations.