MMT & Private Debt Dialogue PART II

[Part I here]

A. So, last time you discussed how understanding how money really works leads to insights that can help make the real economy perform better, and increase the real material well-being of a country. And all this talk about problems with a “national debt” is just non-sense. It seems only to serve the rich who would like to impose “austerity” on the rest of us. You focused on the national debt and how the household analogy is false, but still haven’t explained the crash of 2008. You said it was and still is about private debt.

B. Yes.

A. How?

B. Well, we talked about how all the so called “national debt” is mirrored exactly by the net financial assets of the private sector. So what is usually called the national debt should really be thought of as a good number that reflects the amount of assets the private sector holds. Government spending is what allows that accumulation in the private sector.

A.  Yes

B.  However, not all money is created through government bonds.

A. What do you mean?

B. The vast majority of money is created by banks out of thin air. When banks make loans, someone walks away with money, an asset, a plus in their account. Yet the bank also records that loan as an asset, a plus in their account. This increases the effective money supply (more or less what is known as M2 in the US), which in turn increases effective demand in the economy. This effect is large, with the vast majority of money actually being private bank-credit money, not money based on US bonds. [Note this has nothing to do with reserve requirements, which under the modern banking system are an anachronism, but with the ability of banks to make loans and get reserves later, which the central bank has to accommodate (bc it targets interest rates) and record the loans as pluses.]

This seems fine when the economy is doing well. But it means the effective money supply is largely based on private debt. The debt ratchets up until a point where the non-financial private sector is deeply indebted to the finance private sector and cannot easily take on new debt. Eventually, with some slight downturn in the economy, there is a loss of creditworthy borrowers, so the system collapses and with it a great portion of the effective money supply.  Thus exactly when the economy needs a boost in demand, it instead suffers a sharp contraction. And the banks are the ones holding either the money or the ownership of assets that are defaulted on. The non-finance private sector loses greatly to the benefit of the finance private sector.

A. So what can be done about this?

B. Well, mainstream economists do not even recognize the factors that matter in this scenario. So they literally have nothing useful to say about fixing the economy in this situation. With their bad theory they are like monkeys with razor blades in an operating room – worse than useless.  Just one example:  they don’t understand the process where private bank-credit money is created only due to the demand for loans by the private sector. So they thought that essentially giving money to the banks, “quantitative easing”, would stimulate the economy. But with no creditworthy borrowers, that money just sits there. To really understand what is at the heart of this finance-based depression, you have to look to economists who understand the interactions of finance factors & the economy in the first place.

Among them there is one view that if both 1) the MMT policies we discussed in Part 1 were followed and 2) better banking practices followed, the economy would not fall into the trap just mentioned. Aggregate demand would be provided through intelligent fiscal policy, not widespread private debt. And the banking sector would be regulated in a way so as not to allow bad assets to back loans and to limit the many financial shenanigans the wealthy created to game the system. So the system would be more stable. Warren Mosler presents perhaps the best clear statement of the needed bank reforms, and regardless of any other changes discussed here, they should be implemented ASAP to stop much of the current harmful or downright corrupt practices in the current system.

A. Would this work?

B. Maybe. The worry is that the effective money supply is still created largely through private bank lending. This provides a huge incentive for the banks, which under this system are likely to be rich and influential, to always, little by little, manipulate regulations in their favor. This is known as “regulatory capture” and in turn leads to an unstable buildup of private debt and the finance sector gaining at the expense of everyone else. Remember, the banks gain no matter what under the current system – either they earn directly from their loans and dubious investment vehicles in the good times, or in a downturn, they earn from claiming the assets that the private sector used as collateral and by being propped up by the government because they are “too big to fail”. Privatized (finance sector) gains and socialized losses. The headlines in recent years that the 1% has done well by the crash of 2008 are sadly true.

A. Is there an alternative?

B. Possibly. It is possible to simply not allow banks to create private bank-credit money. Rather than banks being able to credit borrowers’ accounts with money out of thin air, they would have to lend already existing money, either that they already own, or that they have pooled from investors seeking interest on money they actually hold. A loan would not show as a plus on their balance sheets, but as a minus on someone’s balance sheet – real money that they or their investors have transferred to a borrower. And they would not be allowed to sell their loans, but would have to keep them on their own books. This incidentally would give them a large incentive to raise their scrutiny of borrowers, and thus increase the quality of loans in the first place.

A. Why is this important?

B. This would mean that banks would no longer in effect create new money. They would only be intermediaries, uniting willing investors actually transferring their existing money to borrowers, nothing more. Crucially, this means that the money supply would not collapse in an economic downturn, what is known as a “cascading liquidity crisis”. Lenders might lose money if borrowers did not pay them back, but the total amount of money in existence would remain the same, and so would effective demand. Also, banks would not be earning money through creating money out of thin air. The system would thus both be much simpler and tremendously more transparent, and additionally the banks would be less powerful to change rules in their favor. A crash like 2008 would simply not be possible under this system.

A. So are there any drawbacks to this system?

B. Well, some think that under this system the less wealthy would actually suffer.

A. Why?

B. Because under the current system, even the less wealthy, at least when the economy is good, are sometimes able to get loans and financing for projects. Under the new system, the less wealthy would depend on existing holders of money to finance them, argued by some to mean putting economic power even further into the hands of “the haves”.  And some seem to think that having a private system that can create money in response to private demand is good, a dynamic system that responds to the needs of the economy naturally.

A. What do you think?

B. We must balance the true, full cost of the proven inbuilt instability of the current system with the possible good and bad of an alternative system. The true costs of instability in the current bank-credit money system are seldom weighed as a whole, nor presented in a way the general public can understand. What is the true and total cost to the public of the crises of 1907, 1929, 2008, the many smaller crises such as S & L, the Japanese asset price bubble, LCTM, banking crises in Finland, Sweden, Asia, Russia, Mexico, Argentina, Ecuador, Uruguay, and throughout Europe, the and housing bubbles, the bailouts of AIG, Northern Rock etc.? The true cost of the current system to the non-finance private sector are probably much much greater than is commonly thought, if proper accounting standards were used to measure it.

Also, there are other very real costs from the inherent instability and uncertainty of the current system. These costs arise from the uncountable suboptimal (due to high uncertainty regarding inflation, interest rates, and possible recessions and depressions) decisions on investment, insurance, and allocation of resources made by big business, government, and private households alike. The alternative system would be much more stable on every front, and there would be real gains in efficiency from this increased stability.

A. So that is the main downside some see to an alternative system where banks cannot create private credit money?

B. Yes, it seems the main concern by some seems to be that the little guys won’t easily be able to get loans and the system will not provide enough financing in general for the private sector.

But there seem to be good ways to finance worthy needs without banks creating money. There are lots of investors willing to risk their existing money to earn interest on loans. Additionally, there are many tried-and-true alternative finance options, such as tontine-type mutual funds, pari-mutuel mutual funds, and other banking arrangements that would provide plenty of access to funding for the private sector without allowing banks to create private bank-credit money.

Overall, the huge gain in stability would help everyone, from big business down to individual households.

A. So why isn’t the change tried?

B. The banks would fight it tooth and nail for a start.

Also, although directly using government bonds has worked well in the past, there has never been a pure system of this type – the banks always managed to force governments to allow them to create private bank-credit money.
Notable successful examples include US greenbacks, and the 700 years that the English/UK government used tally sticks. As we know, this period of British economic history was overall highly successful. But tally sticks and greenbacks were only part of their respective systems. The modern proposal for systemic change would essentially make the entire system run purely on what are in effect tally sticks or greenbacks.

A. So people would be afraid to try a system that has never been tried in full it seems.

B. Yes.

But there has never been a system like the current mostly bank credit-money one that has NOT suffered crashes like 2008. It may make sense to finally try something new.

At any rate, the take-home message is that the crash of 2008 was about private bank-credit money and private debt. Any full understanding of the real economy must take into account the long history of bank-credit money recessions and depressions and of ratcheting private debt causing real trouble in the real economy, and the close empirical correlations between changes in private debt, private credit money, effective demand, financial regulatory capture, and recessions/occasional massive depressions.

In Part 1 we discussed how MMT insights show ways to raise the productivity of the real economy to its natural limit, and thus the material well-being of a country. The theoretical debates concerning MMT have largely been worked out, and it is just a matter of time before the logic of it is accepted by the mainstream.

However, the debate on the full scope of the impact of the private credit-money system on the real economy has only begun to be worked on again in earnest.

Maybe implementing better fiscal policy and more logical banking regulations, as many MMTers propose, is enough to stop crashes like 2008 from occurring, and the ongoing regulatory capture of the finance system by the very rich.

But it may make sense to also change the finance system to a system where circulating Treasury notes alone forms the money supply, and banks can only serve as intermediaries of this money, and not create private bank-credit money through escalating private sector debt that alters effective demand, causes socialized losses and privatized gains (only for the finance sector), and ultimately leads to massive busts for the non-finance private sector.

A. Yes, that may make sense.

[PART I of this dialogue]

Help on MMT related dialogue

[This is a VERY rough draft of a dialogue/narrated animation aimed at regular folks highlighting important misconceptions about the economy. I have to travel for a bit and rather than going back and researching every term and point made, I am throwing it on the web for help. (I imagine the folks at will have some pointed comments here or there).

Please be nice. Some MMTers will disagree on certain points, and I am happy to have those debates elsewhere. What I am mainly looking for now is to get the terms right (on bond and treasury operations etc), any gaps in the flow of the discussion, and a clear exposition of the points I am trying to make even if some points are different from any particular MMTers view.

 PART 2 will deal with some further issues regarding private credit money and the crash of 2008, and address some of the points MMTers may disagree with.] 


A.  [An Average American, although this discussion applies to any sovereign country that, asserting its sovereignty, has a free-floating non-convertible fiat currency. Note that Eurozone nations such as Greece have voluntarily ceded this sovereign ability].

A. “There do not seem to be clear explanations for the 2008 crash, and thus no fixes to the economy since then. All I hear on TV is that we are in trouble because of the national debt. I’ve heard MMT has a different take. What is different and why is it important?”

B. Well, the media focuses largely on the so called “national debt” and presents it as somehow the problem. Yet the crash of 2007/8 was largely due to problems with private debt. So to start with, they are dealing with the wrong kind of debt. This is partly because they wrongly portray the nation as like a household – a household in deep debt is clearly in trouble (as the crash of 2008 showed). But a nation with what they call a “national debt” is not in trouble at all. This is the household analogy, and it is false.

A. Why?

B. Because a Sovereign government is not like a household.

A. Why not?

B. Because it creates its own money. It can always create more to buy what it wants and pay any debts denominated in its currency. The debt held by foreign governments is not a problem. It is held in Dollars. [transaction thing with the fed here, as Mosler describes it]

A. Is it really so simple?

B. It looks complicated, but actually sovereign governments fund themselves by printing bonds. To simplify for a moment, just think of those bonds as money, which at times they directly have been, such as with Greenbacks. There is no need to have bonds run through the Federal Reserve to “make” money. We can come back to this, but for the moment, just think of Treasury Bonds as money.

A. Ok. So let’s imagine US money just as bonds printed by the government. Now what?

B. Well, first, that foreign debt. If China wants to “cash in” on their bonds, as the News channels try to worry us about, the US just credits their account with that many dollars. Done. They can then continue to sit on it, or buy things wherever dollars are accepted, including, of course, in the US. They own about 1.3 Trillion dollars in bonds. If they want to go on a trillion dollar international shopping spree, good for them. It would be harmless, even good for many who would prefer to have those dollars rather than their current assets.[Note Ralph Musgrave's useful comment here]. Trust me, in the global economy, a trillion dollars is doing no one any harm. The same holds with the other big holders of US bonds (Japan, Brazil, Europe, Russia). If they want to go on a shopping spree, like the Japanese were feared for doing in the 1980s, fine. When the Japanese bought Rockefeller center, they didn’t cart it back to Japan. They just managed it like any other owner would.

A. OK, so there is no problem “paying” even the largest international holders of US debt. And if they did cash in, they would just be changing bonds to dollars and spending into the international or national economy. How does this all work IN the United States though?

B. The government also prints money into existence through bonds. It can fund anything we think is good for the public. Health care, roads, bridges, the military, the coast guard, NASA, pure research.

A. Weimar! Zimbabwe! Crowding out!

B. Are you ok? Sounds like you are having an attack of some kind.

A. Those are the terrible things that will happen if the government prints all the money it wants. Gold Standard! Hyperinflation! National Debt!

B. There you go again!

A. But it will! We will have hyperinflation! We should have sound money, the gold standard! And the government will “crowd out” the private sector!

B. Slow down there. Let’s look at these things one by one.

B. First let’s look at the so called “national debt”. Now, as we saw, the government prints bond money out of thin air. So it is not “owed” in the conventional sense of the word to anyone. Now here is a curious fact – all that “debt” you always hear about is mirrored exactly by the private sector – you, me, Joe Sixpack, small and large companies, as private “net financial assets”. That money printed out of thin air is what allows all of us in the private sector to accumulate assets and save money without the economy stopping. It could better be called the numerator for “net private assets”. Sounds a lot better, doesn’t it?

A. So if the government did not have this “national debt” or “national private assets” we could not all accumulate wealth at the same time?

B. Exactly. This can be shown historically. EVERY SINGLE DEPRESSION in US history was marked by a falling “national debt”. A low national debt has always meant greater, not less poverty for the private sector. The private sector needs and wants a huge so called national “debt”.

A. I can’t wrap my head around this. So – when the government creates more of this national debt, better called national private savings, then everyone in the private sector is able to accumulate more assets and money? That sort of makes sense.

B. You got it. The smaller the so called “national debt”, the less assets and money the private sector – you and me – can hold. We want and need the “national debt” – it is a good thing. Which is why it should be thought of as net national private assets.

A. Ok, that seems logical. But wait – don’t we run the risk of becoming Weimar or Zimbabwe? If the government prints more and more money, its money will become devalued and eventually worthless.

B. Good question. First of all, situations like Weimar Germany and modern Zimbabwe were cases of massively failed states in special situations. Their whole society was destroyed, and Weimar was not even truly sovereign monetarily. The failure of their money was because of the collapse of the capacity of their government to govern. Think about it – I would happily accept Swiss Francs or Norwegian Krone for payment, because they have strong effective governments that I trust will back their money, and well organized productive societies that I trust will be able to back up their Krone and Swiss Francs with real economic productivity. I would not make the same bet with Somalian money, or Liberian money. Not because it is paper money, but because their governments are not effective, and their economies are not productive and well organized.

A. But still, it is simple supply and demand. If you keep on printing money, even US dollars, then there will be inflation.

B. Well, first I wanted to deal with hyperinflation. Hyperinflation just does not happen in non war-torn countries or countries not dominated by corruption or ruled by crazy people. But yes, you should of course be worried about normal inflation.

A. So…?

B. Normal inflation is controlled by reducing spending and/or taking enough dollars back out of circulation to keep things in equilibrium. This is done in modern economies by fiscal policy and taxation.

A. But taxes are levied so we can pay for government, not to control inflation!

B. No. Remember – the government can issue all the Treasury money it wants to spend on anything it wants. If it is the effective government of a productive society its money will be accepted. It taxes not to pay for things, but to drain any money that might lead to inflation back out of the economy. It can easily do this at just the right rate to keep inflation at any level it wants. Including zero.

A. This is crazy! This is not what the textbooks say!

B. It is simply the way the system works in practice. The textbooks are wrong.

A. Ok, let’s assume for a minute you are right. The government can create and spend any money it wants as long as it balances it in a way to avoid inflation. Why don’t we spend less and have less taxes?

B. We can. That is a political choice. How many good roads and bridges, good research programs like NASA and medical research, good public healthcare and how strong a military do you want?

A. So we can have zero inflation and choose to have whatever level and quality of public goods we want?

B. Yes. With one more qualifier – it has to be within the bounds of the real economy.

A. What do you mean by “real economy”?

B. Well, every country has an upper limit on how much they can actually produce at any given time based on the overall quality of organization and technology. That is a real limit, not an abstract numerical limit. The US probably came close to that limit in the Second World War. The thing to notice, though, is that that limit was vastly, incredibly greater than what anyone would have guessed in the 1930s during the Great Depression.

A. So we need a war?

B. No. Not at all. We could mobilize in much the same way, but instead of modifying Detroit auto lines to make tanks, we could mobilize to fix our infrastructure, provide universal Medicare, fund NASA and pure research more, pay teachers more, and make sure our military and coast guard maintain their quality. Oh, and take much much better care of our veterans, disabled, and elderly. For example.

A. And all this new spending wouldn’t be inflationary?

B. Not in our present state. We are like the US was in the 1930s. The US is performing far below its true productive capacity. We could get much closer to the real capabilities of the economy, which incidentally would lead to something close to full employment as well. No nation is truly performing at its optimal real productivity when there are loads of idle but willing workers.

A. So why don’t we do this?

B. Mainly because people, including most prominent economists and virtually all politicians, believe that a government is like a household. They don’t understand that the way money works in a sovereign nation is not at all like a household. And they believe that the so called “national debt” is a problem. They don’t understand that that number actually reflects the net private assets of the people, and that it is a good thing.

A. But wait – this is mathematically impossible. What about all those interest payments on our debt? I know about compound interest – it will quickly become unsustainable.

B. Remember, we don’t have to sell bonds to make money – the bonds themselves can be money. And we don’t have to pay interest on bonds. We choose to.

A. What?! Loans always carry an interest burden. Impossible!.

B. This is the household analogy again. Bonds released by a sovereign government are special. People want them because they pay taxes in them. They can be circulated just as Treasury notes, with no interest at all. And thus our national “debt” need not pay any interest at all.

A. But then all those bond buyers in the private sector and abroad won’t buy dollars, so how will we get money?

B. First, they will hold enough to buy dollar denominated goods. But regardless – so what? The US does not need anyone to buy bonds to make dollars. Remember, a sovereign nation makes bonds out of thin air, and people want them so they can pay taxes, which then makes them acceptable to everyone else in an economy. People were just as desirous of a Treasury Note, a greenback, as for any other dollar. That is because dollars, like Krone and Swiss Francs, come from a clearly politically stable, effective government of a productive society. If Norway and Switzerland went to interest free Treasury notes tomorrow, I would gladly still accept a payment in Krone or Swiss Francs. The Norwegian and Swiss governments, like the US, are clearly able to maintain highly productive societies and effective governments, and as long as they do so, their money will be valued both in those countries and abroad.

A. OK, so this seems like a way for nations to become or stay wealthy, by maximizing the real economy, thus raising the material well-being of the country. Sounds like a good idea.

B. It is.



A note on this blog

This is not really a blog – it is more of a collection of some views & early stage working papers on some topics that I view as important, generally economics recently for reasons outlined here. So it is not a priority to regularly post. I have been busy lately elsewhere but still hope to further develop the ideas here, and thought it better to have them online in case they are of interest to anyone, and also to get feedback.



Question for Mosler/Mitchell/MMT: Bank Reform, Assets or Liabilities?

Warren Mosler, in his excellent recommendations for bank reform (similar to Bill Mitchell’s proposals
and others )focuses on the asset side of banks, and writes:

“The hard lesson of banking history is that the liability side of banking is not the place for
market discipline.”

Mosler doesn’t discuss this history or reasoning any further though. Can anyone elaborate on this banking history? And how it shows that disciplining the liability side of banking is not a good idea?

Jane Jacobs (years before Godley) on Currency Unions, Small Countries & Sovereignty

Jane Jacobs 1984 Cities and the Wealth of Nations

JACOBS, 1984

IN A PREVIOUS POST (here) I mentioned both the nefarious effects of modernism on architecture and the myopia of neoclassical economics. Good urbanism and Jane Jacobs are almost synonymous, and Jane Jacobs also both criticized neoclassical economics and wrote about precisely the problems countries like Greece and Cyprus would have in a currency union; I thought of her as I wrote but decided not to lengthen that post with a mention of her. Jacobs deserves some credit, however, that I think she is not getting at the moment.

JANE JACOBS IS WIDELY recognized for her brilliant The Death and Life of Great American Cities, as one of the most important, and with the greatest foresight, writers on urbanism. With the ongoing Eurozone crisis, most recently with Cyprus, there has been recognition of early warnings against a currency union without fiscal union, especially by Wynne Godley who, like MMTers after him, clearly understood the problem a nation without a sovereign currency would face, especially if thrust into a larger currency union (much deserved praise for the prescience of Godley can be found here here and here; the last is titled “The Greatest Prediction of the Last 20 Years”.)

I want to highlight the fact that Jacobs wrote in some detail on this problem well before Godley, in her 1984 Cities and the Wealth of Nations. She stated clearly that a currency union would lead to inevitable decline in peripheral regions who could not issue their own currency. It is an unusually lucid and early warning about the Euro. (I don’t have access to a copy a the moment here in China, and don’t remember if the specifically mentions the then EEC plans for a common currency – if anyone has a copy at hand and would like to put relevant passages or discussion in the comment section it would be appreciated)

Relatedly, I think Jacobs wrote the clearest, most sensible work (The Question of Separatism) on why small states and regions should have sovereignty in the first place, not just for the very important reason of having a sovereign currency. By the time she wrote she had been in Canada for some time, and the book partly revolves around discussion of Quebec, but mentions many other places and situations as well (I love the little maple leaf with the fleur-de-lis in it on the cover). I think it is perhaps the most compelling argument for sovereignty – of any state or region in the world – ever written.(FWIW, I am a quarter non-Québécois Canadian. I have some familiarity with separatist movements. Most directly perhaps, I lived in the greater Basque region (that is purposefully ambiguous) with two sometimes clashing cultures both dear to me. It gets your attention when a bomb explodes across the street from you, trust me.  I also lived in the UK and Israel, where of course regional/territorial independence is a major issue).

Jane Jacobs A Question of Separatism


As long a I am discussing Jacobs, I might as well mention Systems of Survival and The Nature of Economies. The former is a brilliant and original analysis that complements the social capital literature in an highly unique way. Once her point on the “two ways of taking” is understood, it lifts the veil on many important aspects of social and institutional structure, behavior, and ethics.

The Nature of Economies is written in a dialogue form that some found off-putting. It pissed Robert Solow off* which for me is alone good enough to make it a worthwhile read (Solow embodies all of the breathtaking ignorance and pettiness of neoclassical economists nicely in his review of the book; maybe I will make a post of it if I get time)

Oh, and The Economy of Cities is underrated as well (although Solow praises it, surprisingly), serving as an excellent segue from TDLGAC to Cities and the Wealth of Nations.

PS We have to give Paul Krugman some credit here too, who wrote in Monomoney Mania (1999) “So let’s recognize this current enthusiasm for currency unification as what it is: an intellectual fad, not a deep insight. I say let a hundred currencies bloom. Well, maybe 20 or 30.”


*Solow, Robert M. 2000 Economies of Truth The New Republic May 15. Review of The Nature of Economies by Jane Jacobs


Why lately I write more on sane economics (MMT, MCT) than good urbanism & the social sciences

I have mainly focused in recent months on MMT (Modern Monetary Theory) & MCT (Monetary Circuit Theory, also see here, esp. credit-money & stability), not the other things mentioned in this blog’s tagline.

The reason is fairly simple: It is where I see the most good can come about now.

In this blog I am most interested in addressing what I see as three main problems in the social sciences and their use for the real world:

(1) The highly destructive impact on society brought about by high-modernist architecture/planning on our cities (later aided & abetted by postmodernism; Kunstler is good on this point)

(2) The undermining of the social sciences by postmodernism (Sokal & Bricmont is still a classic on this) diverting attention from real problems. This has served to turn many away from the social sciences, which is particularly destructive in the political realm, when those responsible for funding looked at the results and content of (often postmodern dominated) social science, and understandably rejected it.

(3) Neoclassical “economics”. Economics is the most expensive discipline by far. That is, its undercurrents of thought influence the trillion dollar decisions, actions and policies of governments probably more than any other social science. Whole societies and generations end up essentially as lab rats for the theories of an earlier generation’s “academic scribblers” as Keynes so rightly stated. Incidentally – I see the refuge of neoclassical economics in meaningless equilibrium formulas as the same response as postmodern babble in other social sciences: giving up on understanding in the face of the incredible complexity of the social realm.

 Of these three, I think at the moment it is economics that is most important. Fortunately the tide has changed significantly with the first two. “New urbanism”, which is nothing more than a return to common sense and the normal urbanism of the last 11,000+ years, has pushed the absurd notions of high-modernism (and its subsequent nihilistic, postmodern apologists) more and more out of the picture. It will take generations to undo the damage done by the imbecilic building methods of modernism, but we are on the right path.

More or less the same can be said of postmodernism in academia, although mercifully with a much quicker time-frame for how quickly the puerile, self-serving prattle of the postmodernists and their ilk is being left to gather the dust it deserves: contentless, unreadable, and unread.

THE CASE WITH ECONOMICS is different for several reasons. The Great Financial Crisis (GFC) continues, so the time for change is as urgent as ever, and the political possibility greater. The bad economics of recent decades remains as entrenched as ever, dismayingly illustrated by the policies of most Western governments in response to the GFC.

Additionally, it is not as if the answers aren’t there. This is not an attack on something with nothing constructive to replace it with. There are true descriptions of the economy (e.g., MMT, MCT, Post-Keynesianism in general, The Other Canon), and with them, functional policies that empower the citizenry to optimize its well-being.

So it seems that of the three scourges on intelligent discussion of society mentioned, that somewhat or completely arose from academia – high-modernism in planning and building, postmodernism in the social sciences and humanities, and neoclassical economics – that it is most timely to attack the latter, and strive towards supplanting it with the sane, functional economics of MMT and other heterodox approaches.


Knapp State Theory of Money cover, 1905[Prologue to this post]

MODERN MONETARY THEORY (MMT) notes correctly that money is a creature of the state, and that important macroeconomic and policy conclusions follow from this understanding, e.g., sovereign states are not revenue constrained and spending is primarily limited by inflation. Taxes give value to state money and maintain its value (i.e., inflation can be controlled through taxes).

One (among many) key policy insight is that a job guarantee is possible. A job guarantee not only achieves what many think should for myriad social reasons be a primary goal of macroeconomics but also further creates a buffer stock (the most useful one of any imaginable given the social reasons just mentioned) that achieves an additional primary macroeconomic policy goal – stability.

However, there is no state that operates under a pure state system of money. Most of what serves as money in most banking systems in the world is privately created credit money.

We can compare the current most common banking system with a pure state system of money:




Money is a creature of law.

Money is a creature of law.

Money is valued because it can be used to extinguish debt to its issuer.

Money is valued because it can be used to extinguish debt to its issuer.

The issuer is the state.

The issuers are the state and private banks.

Taxes move resources into the public sector

Taxes move resources into the public sector.      Loan repayments move resources into the private (often finance) sector

This raises important questions. If the state is not a monopoly issuer of money, do other neo-chartalist/functional finance/MMT insights hold?

A sovereign currency issuer is still not revenue constrained. And it can still spend towards full employment and other public purposes.

One major worry, however, is whether, because the state does not have a monopoly on money creation, it can set prices in the ways MMT argues. Especially, trying to do so while not having a monopoly on money creation may be inflationary even with otherwise appropriate taxation.

So what are the possibilities? Let’s imagine a system where the state truly has a monopoly on money creation. The state creates money and a payment system. There can still be loans and borrowing, but borrowing will be from someone else giving up use of their money, just as if you loaned a friend a tenner from your pocket. The risks and rewards of this can be pooled for large capital projects.

Let’s ignore the sometimes heard first criticism of this: “deflation!”. Imagine moving to this system in a portfolio neutral way, so that essentially all M’s (M2 and beyond) are, through bookkeeping entries, changed to M1 in a one-off system change. (There are also worries that this “creation” of M1 would be inflationary by others; they seem not to understand what “portfolio neutral” means.)

The obvious advantage is that bank runs will be a thing of the past – assuming a few other obvious regulatory moves (on securities and such) and all bad loans will be losses to individual investors, never systemic (this incidentally puts the incentives for loan quality and underwriting in the right places, raising the quality of loans in the first place). If Joe doesn’t pay you back his tenner, you are the only loser and there is no amplification of this loss. Cascading liquidity crises simply are not possible under this system.

THERE ARE THEN TWO RELATED objections – first, that without continued private credit money creation, this new system would still be deflationary. The related objection is that the “dynamic” private credit money system is behind much innovation and growth, and this would be lost.

On the first – this is interesting as it highlights a major question on the purpose and effectiveness of government. If money is a creature of the state, and a sovereign government cannot be insolvent, then it cannot be that a pure state money system will be deflationary because there is not enough money. The state can create as much money as it needs to re-inflate an economy.

The worry, then, must be that somehow the state will not be able to get the money it can endlessly create into the right hands, while somehow the private credit money system does. This highlights the fact that the worries about abolishing private bank credit money creation cannot truly be about the quantity of money or credit but about how and by whom the money and credit needed to keep the economy from deflation is created and spent into the economy.

This gets to much of what is the core concern of a pure state money system by both advocates and detractors alike, although often they are not nearly as clear as they could be about it.

What serves the public purpose more- having only the state create and spend money and credit into the economy, or allowing the private sector to control part of this public utility?

We already saw that one concern is that private credit money may force a tradeoff between public spending and inflation. What are some other potential costs? What is the real value and real cost of funding borrowers’ needs by allowing credit money to be created privately?


- We already mentioned policy space – the current system of substantially privatizing a public utility seems to move many resources into the private finance sphere, arguably reducing the policy space for public purpose (job guarantee, education, health care, etc.).

- A major tenet of MMT/Functional Finance is that it is how we utilize real resources now that matters, not deficits, and that we cannot borrow from the future. Money creation through credit likewise does not magically transport future resources to the present, it can only redistribute existing resources. Ceteris paribus (on taxes, policies, and who is utilizing the money) there is X amount of money that can be spent into an economy without inflation. Credit money creation can only redistribute this X amount of money and the real resources it affords (or cause inflation), and it is not clear that the private system does this in an equitable, nor necessarily the most efficient, manner.

- Where private money creation is combined with maturity transformation, as in the shadow banking system, money market and many bond funds, there is a distorted yield curve on interest rates. Some, especially Austrians, view this as leading to market inefficiencies in the long run, in addition to being severely unstable. This system allows narrow private benefits at the expense of widespread socialized costs and chronic instability (Maurice Allais’s non-Austrian work on this seldom receives the attention it merits, especially in the English speaking world.)

- Instability – allowing credit money has time and again led to intense and highly damaging episodes of instability. Diamond & Dybvig formalized the multiple equilibrium nature of banks runs; there is no stable equilibrium of credit-money creating banks without a lender of last resort. The true costs of instability are seldom weighed as a whole, nor presented in a way the general public can understand. What is the true and total cost to the public of the crises of 1907, 1929, 2008, the many smaller crises such as S & L, the Japanese asset price bubble, LCTM, banking crises in Finland, Sweden, Asia, Russia, Mexico, Argentina, Ecuador, Uruguay, and throughout Europe, the and housing bubbles, the bailouts of AIG, Northern Rock etc.? Is it truly, with proper accounting, worth the growth that some defend the current private system as promoting? On balance, a stable economy without socialized losses may be more dynamic and productive and allocate the real resources of the economy more efficiently than the current system, if judged with proper accounting standards.

- This leads to another point: Reality. The government already funds the banking system, both with occasional trillion dollar bailouts and on a daily basis. “Private” systems have shown time and again to be backstopped by governments (e.g., the U.S.and U.K.bailouts). The US government has proven to de facto guarantee the entire U.S. financial system (and the UK government the British system and so on), and lenders know it, much to their advantage (and distortion of the real economy). As someone else has written* “When A guarantees B’s liabilities, B needs to be on A’s balance sheet. This is accounting 101, folks.”

- MMT very correctly insists that an economic theory, to be worth considering at all, must at a minimum match real bookkeeping. To meet basic standards of accounting we would have to “[c]onsolidate the entire financial system onto USG’s balance sheet. While we’re at it, merge the Fed, Treasury, Social Security and Medicare into one financial entity. Clean up the whole mess of interlocking quasi-corporations. The US government is one operation. It should have one balance sheet.”* Again,  this is Accounting 101.

 IF IT IS INDEED THOUGHT that the benefits of credit money creation are worth the instability and other costs this system incurs on society, this raises another question:

Can a government duplicate credit money creation while distributing the gains and losses more equitably (i.e., socialized gains as well as socialized losses, instead of the current system that is mostly private gain and socialized loss)?

As we noted, in the current system, in addition to the money that people and businesses already have, they often want more money for productive and socially useful purposes. We further noted that there are two ways to get this money:

1. through other people loaning money that they already have or

2. through private credit money creation.

The first is not problematic, while the second is.

Would it be possible for the state to maintain something like the current system operationally, just making the parts of it that already are backstopped by the state actually state? This raises questions: Could this system be kept apolitical? (this potential political downside has to be weighed against the already existing downside: our private system has already experienced extensive regulatory capture). Could it be kept as competitive as it is now? Would it be as unstable as now with a truly “risk-neutral non-liquidity-constrained economic agent” (that is, the government) behind it?

This system could be thought of in this way:  Individuals and businesses that desire more money for productive purposes than they can get from other money holders are granted the privilege of additional state money created just for them; alongside this special privilege they voluntarily accept an additional tax burden to maintain the value of the money system. Let’s add that (in bold) into the comparison we made above between a pure state theory of money and the current state/private hybrid system:




Money is a creature of law.

Money is a creature of law.

Money is valued because it can be used to extinguish debt to its issuer.

Money is valued because it can be used to extinguish debt to its issuer.

The issuer is the state.

The issuers are the state and private banks.

Taxes move resources into the public sector

Taxes move resources into the public sector.       Loan repayments move resources into the private finance sector

Some businesses or individuals want to borrow money. There are two ways to do so. One is for others to loan their existing money. This may be too restrictive and keep growth at suboptimal levels. The other is for new money to be created. 


Some businesses or individuals want to borrow money. There are two ways to do so. One is for others to loan their existing money. This may be too restrictive and keep growth at suboptimal levels. The other is for new money to be created.

The government creates this new money. The individual or business pays an additional tax for this privilege.

 Private banks create this new money. The individual or business pays the bank interest for this privilege.

The “lender of last resort” is the lender of first resort. There are both private and social gains and corresponding private and social losses.


Privately created money is inherently unstable without a lender of last resort. The government is the lender of last resort. There are private gains and socialized losses

 As a monopolist over its currency, the state has the power to set prices, including both the interest rate and how the currency exchanges for other goods and services. As a monopolist, the state can fund a job guarantee and other public goods without causing inflation.  In a system with “redundant currencies” (Innes 1914) the state may not be able to achieve macro policy goals and prevent inflation simultaneously
 The system is inherently stable. Stability leads to optimal investment, insurance, and allocation decisions and optimal long-term growth and welfare. Redistribution of private and social gains and losses is minimized.  The system is inherently unstable and uncertain. Chronic instability and uncertainty leads to suboptimal investment, insurance, and allocation decisions and suboptimal long-term growth. The system continuously transfers unearned wealth into the private (often finance) sector, furthering suboptimal economic performance and incentivizing rent-seeking and regulatory capture.


Currently, many of the most important neo-chartalist/MMT functional finance insights are not applied in the US, UK, and other countries, and they are clearly desperately needed. However, even if they were applied, the private credit money system would still interfere, possibly greatly, and would still lead to the same type of instability it always and everywhere has. The ongoing “crash” of 2008 seems to be fundamentally and deeply related to issues of private credit money creation, not the equally important issues of state money that MMT has so usefully brought to light. A true state theory of money must address the fundamental instability and inequitable nature of what Innes (1914) called a situation of “redundant currencies”, a system of both state and private money creation, and to be fully consistent, integrate it into its framework completely. It is not enough to “agree with the MCT folks” (or vice versa). The two must be a seamless whole.


* This wording is by an arch-Austrian good with pithy wording; I am not “Austrian” but on this issue, at least, he has interesting observations.



Neo-chartalists rightly look to Georg Friedrich Knapp and Alfred Mitchell-Innes as brilliant forefathers of a state and credit theory of money. However, Knapp and Innes* of course wrote in a different time and had their hands full with explaining the fallacies of metallism and explaining why money is credit.

Now, however, the problems of metallism and the idea of money as credit, and in turn the functional finance implications, are well understood. Besides the contributions of Knapp and Innes to these areas, what did they think about private credit money creation? There is, given their focus on metallism and other issues of the time, relatively little on private money creation in their work. The past century, as mentioned, has seen the development of more or less a full understanding of the implications of the ideas of Knapp and Innes. However, there have been numerous relatively small crises in the past century (just since the 1980s: Savings & Loan in the US, the Japanese asset price bubble, LCTM, banking crises in Finland, Sweden, Asia, Russia, Argentina, Ecuador, Uruguay, and throughout Europe) and two massive economic crises (1929, 2008) that have had much or most of their basis in the private credit money creation realm of the economy. In other words, although a great deal of the suboptimal performance (sustained unemployment, lack of investment in infrastructure, education, and healthcare) has been due to a failure to understand and apply readily implementable state money & functional finance insights, there has also been another major source of economic suffering, resulting from the non-state-money side of the economy. The worldwide private credit money system has caused untold suffering and misery for millions. This side of the equation must be integrated into any functional finance insights that arose from Knapp, Innes, and others (the subject of my next post).

Although the answers to questions about state and private credit money stand or fall on their own merit, it is perhaps useful to note what Knapp and Innes thought about the private credit money side of the financial system.

Knapp does not focus on this area, perhaps in part why subsequent neo-chartalist developments did not either. The most interesting passage in Knapp on the subject may be the following:

  “It is a great favour to the banking world that the State permits the issue of [bank] notes. As is well known, other business men may not issue notes, or private till-warrants. Certainly the State also controls the business by law, for it rightly counts it of public utility. But it is nevertheless remarkable that the profits which are increased by this means, of a magnitude only explainable by the note issue, should flow exclusively to the owners of the capital. The State is giving to the holders of bank shares a means of increasing their profits which it absolutely denies to other businesses.” (Knapp 1924 [1905], 136-137)

It seems somewhat surprising that many (by no means all) of the others who built on Knapp’s work did not focus more on integrating this “remarkable” “great favour” of the state to “the owners of capital” and the social and systemic implications for a state theory of money (again, some have; I think not enough).


Innes, of course, wrote from within the Anglo-American financial milieu, and, it is important to remember, immediately after the creation of the Federal Reserve and under the gold standard.

In his two influential papers (1913, 1914) in The Banking Law Journal he develops the credit theory of money which Wray (Wray, working paper**) and others show is consistent with and reinforces Knapp’s state theory of money. Innes only turns his attention to private credit money at the end of the second paper (1914).

Innes, before considering private credit money, discusses a mechanism for inflation of state money under the gold standard. He then goes on to argue that the system where government money is leveraged by private credit money creation amplifies this inflation significantly, and that this is “by far the most important factor” in inflation. (Innes uses the common yet mistaken “fractional reserve” argument for how this leveraging occurs. Considering how common this mistake is, and that he was writing only 1 year after the creation of the Fed, this is understandable in his case).

In my opinion it is difficult to tell where Innes is laying the blame here (and he warns that he does not fully understand this area of money). He uses the term “redundant currencies” several times (all quotes from Innes are from Innes 1914, p. 166-167), which implies he thinks that this mixed system is somehow flawed. It seems, however, that in one case the “redundant currency” is private money, and in another use, it is state money.

Innes makes clear, (in his notes and several other places) that he views private money creation as a natural state of affairs, although he also seems to see the modern mixing of the two systems as possibly problematic (“in old days…it was easy to draw a sharp distinction between government money and bank money”). He also, however, implies that it is merely the way the system is being used (“ignorance of the principles of sound money”) that may be the problem.

As mentioned, Innes cites “this redundant currency” in a way that it seems he is referring to private credit money in the first use. But in the second use of “redundant currency” he seems to be referring to HPM (state money) – a “redundant currency operates to inflate bank loans in two ways, firstly, by serving as a ‘basis’ of loans” (Innes is assuming a loanable funds system).

At any rate, I do not want to make a claim that Innes was against either state (in favor of some kind of free banking) or private money (in favor of some kind of narrow banking system that would soon be in vogue – e.g., by Soddy, The Chicago Plan, Fisher etc.).

But it is clear that Innes saw the state/private hybrid system, as it was in his time, as deeply problematic and the root of inflation.

“Just as the inflation of government money leads to inflation of bank money, so, no doubt, the inflation of bank money leads to excessive indebtedness of private dealers, as between each other. The stream of debt widens more and more as it flows.

That such a situation must bring about a general decline in the value of money, few will be found to deny. But if we are asked to explain exactly how a general excess of debts and credits produces this result, we must admit that we cannot explain. ” (Innes 1914, 166)

I do not want to misrepresent Innes, so I include the entire passage below, with what I see as some of the more relevant parts in bold. I do want to make clear that I am not making, nor do I think Innes actually meant to make, an anti-Fractional Reserve argument, but rather, had he understood that loans create deposits and reserves are not of much importance, Innes would simply have stated his concerns as being about the relation of private to state money.

“Again in old days the financial straits of the governments were well known to the bankers and merchants, who knew too that every issue of tokens would before long be followed by an arbitrary reduction of their value. Under these circumstances no banker in his senses would take them at their full nominal value, and it was easy to draw a sharp distinction between government money and bank money. To-day, however, we are not aware that there is anything wrong with our currency. On the contrary, we have full confidence in it, and believe our system to be the only sound and perfect one, and there is thus no ground for discriminating against government issues. We are not aware that government money is government debt, and so far from our legislators realizing that the issue of additional money is an increase of an already inflated floating debt, Congress, by the new Federal Reserve Act, proposes to issue a large quantity of fresh obligations, in the belief that so long as they are redeemable in gold coin, there is nothing to fear.

But by far the most important factor in the situation is the law which provides that banks shall keep 15 or 20 or 25 per cent, (as the case may be) of their liabilities in government currency. The effect of this law has been to spread the idea that the banks can properly go on lending to any amount, provided that they keep this legal reserve, and thus the more the currency is inflated, the greater become the obligations of the banks. The, importance of this consideration cannot be too earnestly impressed on the public attention. The law which was presumably intended as a limitation of the lending power of the banks has, through ignorance of the principles of sound money, actually become the main cause of over-lending, the prime factor in the rise of prices. Each new inflation of the government debt induces an excess of banking loans four or five times as great as the government debt created. Millions of dollars worth of this redundant currency are daily used in the payment of bank balances; indeed millions of it are used for no other purpose. They lie in the vaults of the New York Clearing House, and the right to them is transferred by certificates. These certificates “font la navette” as the French say. They go to and fro, backwards and forwards from bank to bank, weaving the air.

The payment of clearing house balances in this way could not occur unless the currency were redundant: It is not really payment at all, it is a purely fictitious operation, the substitution of a debt due by the government for a debt due by a bank. Payment involves complete cancellation of two debts and two credits, and this cancellation is the only legitimate way of paying clearing house debts.

The existence, therefore, of a redundant currency operates to inflate bank loans in two ways, firstly, by serving as a “basis” of loans and secondly by serving as a means of paying clearing house balances. Over ten million dollars have been paid in one day by one bank by a transfer of government money in payment of an adverse clearing house balance inNew York.

Just as the inflation of government money leads to inflation of bank money, so, no doubt, the inflation of bank money leads to excessive indebtedness of private dealers, as between each other. The stream of debt widens more and more as it flows.

That such a situation must bring about a general decline in the value of money, few will be found to deny. But if we are asked to explain exactly how a general excess of debts and credits produces this result, we must admit that we cannot explain. (Innes, 1914, 166-167)

Again, I am not sure on how precisely to interpret Innes’ argument or intentions here. He clearly felt something was wrong with the system but, as he says, he is not entirely sure what. Had Innes lived to see the demise of the gold standard and other developments in the financial sector, one can’t help but wonder what he might have thought about state money, private bank credit money, inflation, and financial instability.


* Although it seems his correct name was Aflred Mitchell-Innes, references to him as both Mitchell-Innes and Mitchell Innes can be found. Innes’ original Banking Law Journal articles did not use a hyphen, and in them, Innes allows himself to be addressed in a letter as “Mr. Innes”, so I will use the shorter of the two.

** L. Randall Wray.  “The Credit money, state money, and endogenous money approaches: A survey and attempted integration.”

Knapp, Georg Friedrich. (1924 [1905]. The State Theory of Money. Clifton: Augustus M. Kelley.

Mitchell-Innes, Alfred (1914), ‘The credit theory of money’,  Banking Law Journal, (Dec/Jan.), 151-68.



Beijing, New Year

Great trip to the Philippines, amazing place.

Because it is the Chinese New Year break, I am very busy, headed to Shanghai and then Beijing.

Sorry posting here is delayed.


I am off to the Philippines tomorrow for some sun and hopefully some kitesurfing. Starting here 

I will keep up with comments and approve any with links as i can

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