Modern Monetary Theory (MMT): How Fiat Money Works

[Ed. Note: There are plenty of theories out there that seek to explain the intricacies of money and its role within the economy. The problem is, “money” today looks an awful lot different than it did several years ago. That’s why, for the last year or so, Chris Mayer has been extolling the virtues of the Modern Monetary Theory (MMT). We gave readers of our email edition an inside look at some of his thoughts on Monday (if you missed it, you can read them here.) Below, is his assessment of why MMT is the best explanation of how fiat money works. Read on…]

Warren Mosler tells a good story that shows how our economy works at its most basic level.

Imagine parents create coupons they use to pay their kids for doing chores around the house. They “tax” the kids 10 coupons per week. If the kids don’t have 10 coupons, the parents punish them. “This closely replicates taxation in the real economy, where we have to pay our taxes or face penalties,” Mosler writes.

So now our household has its own currency. This is much like the U.S. government, which issues dollars, a fiat currency. (Meaning Uncle Sam doesn’t have to give you something else for it. Say, like a certain weight in gold.) If you think through this simple analogy, all kinds of interesting insights emerge.

For example, do the parents have to get coupons from their kids before they can pay them to do any chores? Obviously not. In fact, the parents have to spend their coupons first by paying their children to do chores before they can collect the tax. “How else can the children get the coupons they owe to the parents?” Mosler writes.

“Likewise,” he continues, “in the real economy, the federal government, just like this household with its own coupons, doesn’t have to get the dollars it spends from taxing or borrowing or anywhere else to be able to spend them.”

The government creates dollars. It doesn’t even have to print them. The vast majority of spending is simply done by adding electronic dollars to bank accounts. Therefore, the U.S. government can’t go bankrupt. It pays all its bills in U.S. dollars, of which it is the sole issuer.

the state is… at best, bumbling and incompetent and wasteful. At worst, it is an evil force on society.

This sounds really obvious, but it is amazing how many people — even very smart people — forget this simple fact. They get hysterical about the fiscal deficit or the national debt. (This is not to say there aren’t bad consequences from issuing too many coupons, or from government spending in general.) The only way the U.S. government can default is if it chooses to do so.

Going back to Mosler’s example, let’s ask another question: How can the kids “save” coupons in excess of the weekly tax? Well, they can only do that if the parents spend more than they tax. There is no other way to hoard coupons. In the real economy, the same is true. The private sector can save dollars only if the government spends more than it taxes. Spending pours fiat money into an economy; tax payments drain it away.

Another question: Do the parents have fewer coupons if they spend more than they tax? No. The parents make the coupons. They don’t even need physical coupons. They can simply track them on a piece of paper or in a spreadsheet. Likewise, the U.S. government doesn’t have any fewer dollars after running deficits. It can’t run out. (There are real-world restraints on how much government spends.) To borrow from another Mosler analogy, the U.S. government can no more run out of dollars than a scorekeeper can run out of points.

You don’t have to like this. (I don’t.) It’s merely a description of how a fiat currency system works. That’s the world we live in. Too many people tackle economic questions ideologically. I can be as guilty of this as anyone. My own view of the state is that it is, at best, bumbling and incompetent and wasteful. At worst, it is an evil force on society. (My sympathies lie with those old American radicals, such as Lysander Spooner [1808–87]. If you don’t know who he is, look him up. He was a great American. I have his six-volume collected works here on my bookshelf.)

Nonetheless, after much reading and thought, I agree with Mosler: The state’s ability to enforce tax liabilities, fines and fees drives the demand for money. Or as Mosler says, “Taxes drive money.” This is a view of money called “chartalism” and it is one I subscribe to. It has been around a long time. And it forms one of the building blocks of a school of thought Mosler helped to found, called Modern Monetary Theory (MMT).

It’s hard to talk about MMT with people, because they are often quick to draw hasty cartoonish conclusions about what MMT is or represents. (I have to admit, I choked on MMT a bit at first, too.) Over the last several months, I’ve read a handful of books and perhaps a dozen academic papers on MMT. So I believe I can speak by the card.

On one level, MMT is simply a description of how a fiat currency system works. On another level, there are policy prescriptions that flow from this understanding. My only advice on the latter is this: Don’t let your politics deter you from making sense of MMT. (MMT itself is politically agnostic.)

I’d recommend both of Mosler’s books. Start with The 7 Deadly Innocent Frauds of Economic Policy. It’s a short book, just over 100 pages and written in plain English. Mosler has a gift for making complex things simpler. If you try to think through the issues in an honest way, you’ll come away with some “Ah-a!” moments.

Then you can move on to Soft Currency Economics. Believe me, these books will challenge your long-held views on money. (Always a good thing, in my mind. What’s the point of only reading things you know you’ll agree with? Challenge yourself… or ossify.) If you want more, pick up Randall Wray’s primer Modern Money Theory.

Mosler himself is an interesting character. Unlike most economists, he is no armchair theorist. Mosler made a lot of money in markets. And in markets, you get paid to be right, which is where all too many economists fail.

For an investor, macroeconomics has limited uses most of the time. Mosler’s career shows this can be otherwise.

Warren Mosler is, like me, a former banker. He began his career in banking in 1973, working to collect on bad loans. After a year of that, he became a lender. And I can tell you: This is great training for an investor. As Mosler recounts, he had ongoing discussions with his boss about the “logic of banking” and the “theory of lending.” As every lender learns, you want to make loans where the odds are heavily in your favor so that profits easily make up for small (but expected) losses. Investing is not much different.

Anyway, Mosler was a good banker with a head for the odds and the payoffs. Eventually, he would move on to manage the bank’s $10 million investment portfolio. He came up with a bunch of good, if unconventional, ideas. He made the bank a lot of money pursuing no-risk trades. Mosler had a knack for smoking out mispricing in the market for things like bonds and CDs.

He went on to join the Wall Street broker Bache & Co., followed by Bankers Trust and then the investment-banking firm of William Blair & Co. in Chicago. (In his books, he recounts his adventures at these places.) He made each firm a bunch of money with his “free lunch” trades, just as he did in his banking days.

In 1982, he co-founded his own fund, Illinois Income Investors (III). Over the next 15 years, III would rack up a remarkable record with only one losing month — and that was a 0.1% loss due to a timing issue that reversed the next month. Managed Account Reports ranked III No. 1 in the world through 1997, when Mosler left the firm.

One great story Mosler tells in both books is how he cleaned up on another free lunch in lira-denominated bonds in the early ’90s. This was before the euro and back when there was worry over a default by Italy’s government. Italy’s national debt was 110% of GDP and interest rates were high on its bonds.

But Mosler knew that it was the sole issuer of lira. Italy could not default unless it wanted to. Mosler actually met with senior officials in Rome to let them in on the “secret.” Long story short, Italy didn’t default. Mosler’s fund made over $100 million.

For an investor, macroeconomics has limited uses most of the time. Mosler’s career shows this can be otherwise. But then again, you have to study economics that actually describe the real world. And Mosler’s economics, or MMT, does that rather well.


Chris Mayer
for The Daily Reckoning

Ed. Note: Knowing the theory is one thing. Understanding how it can help you improve your investing skills is something else entirely. Lucky for you, Chris has spent countless hours researching just how to use this theory to make great investment decisions. And readers of The Daily Reckoning email edition are often in a unique position to benefit directly from his research. Don’t miss your chance to do the same. Click here to sign up for The Daily Reckoning email edition, for FREE, before you do anything else today.

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