07 May 2019
“A vulgarised version of Keynes’ theory, at one time prevalent in the West, is that governments can always make up for a deficiency of demand by spending money, in excess of revenue, on something or other, that is, by running a budget deficit” - Joan Robinson
Modern Monetary Theory (MMT) is enjoying its time in the sun with the publication of Stephanie Kelton’s book, The Deficit Myth. The message is positive: we can have job guarantees, a Green New Deal and more. The only caveat? We will get inflation if the government tries to spend too much.
"Sometimes things claiming to have a certain measurement don’t quite measure up. Exactly how long are Subway’s “footlong” sandwiches?”
But how valid is this claim? It relies heavily on a particular feature of the monetary system, which holds as a fact, but not so much in principle.
Like Hume’s guillotine, we need to be careful not to base what we think “ought to be” simply on what “is”.
To shed some light on this, we need to understand the relationship between money and value.
The idea of a dollar represents not just a note or a coin but also a unit of measurement. As a unit of account, the dollar is just a measure - like metres or kilograms. Importantly, sometimes things claiming to have a certain measurement don’t quite measure up. Exactly how long are Subway’s “foot long” sandwiches?
This disconnect between claim and reality leads us to the concept of discounting - something banks and discount houses have been doing for hundreds of years.
So what is discounting? Think of book vouchers: you can buy unwanted book vouchers online and strangely they are mostly offered at a discount. A $10 voucher could be bought for only $8, for example, even though the bookshop itself would still let you purchase a book for $10.
Here we can see the difference between the voucher’s discounted (or market) value at $8 and its nominal value at $10. This discount could be due to a variety of reasons but an obvious one is doubts about whether the bookshop will be around to honour the claim. The discounting reflects the creditworthiness of the voucher’s issuer.
Discounting based on creditworthiness is one part of what banks do - they apply market values to financial assets which are often less than their nominal values.
Inflation or debasement
Think about what might happen if government tried to spend way more than it ever plans to receive in taxes. Modern Monetary Theorists warn of the dangers of this spending pushing the economy beyond its inflation barrier. Is this the only thing that could happen though?
Put simply, inflation is the fall in the market value of money. But money itself takes many forms - government money, central bank money, commercial bank money, to name a few. Yet they all share the same characteristic - they are vouchers.
In normal times these vouchers are fungible - they maintain value equivalence. But what if this equivalence broke down? What if the economy at large started to doubt the value of the government’s vouchers? What if shops stopped accepting cash all together?
Now comes the really radical part - and to be absolutely clear this is not a prediction, suggestion or recommendation but purely a hypothetical illustration of what could happen.
What if you went to your bank to deposit $100 in notes and the bank only credited you with an $80 deposit? In other words, it applied a discount to state money. Surely this breaks a bank’s obligation to honour convertibility between state and bank money? But no, banks only need to maintain dollar-for-dollar conversion for withdrawals. No problem - later on, when you withdraw your $80 deposit the bank would be only too happy to give you $80 in notes!
Clearly, this is not an outcome the public would be prepared to accept for long. Either physical deposits of cash would cease or an ‘exchange rate’ between cash and bank deposits would develop. What would happen if you had $100 tax to pay? No problem, the bank could convert your $80 deposit into $100 of state money and send it off to the central bank as it does now.
What about legal tender laws, surely these will protect the value of state money? I’m not sure but it doesn’t seem to have stopped cafes and other retailers from restricting payments to contactless (or bank only) methods*.
How will we get on?
But where would banks get their deposits from? Actually - known and forgotten for as long as banks have been around - loans create deposits. The lending by the banking system determines the lending to the banking system.
Banks currently use central bank money to settle payments between themselves but this has not always been the case. Interbank credit or privately run clearing houses have all been used in the past and could be again.
Wages are paid in bank deposits, goods are purchased with bank deposits, large investment projects are funded by borrowing bank deposits. No changes in wage or price levels are needed to compensate for this radical change in the value of state money.
The economy could continue to operate quite happily using bank deposits. But it could be worse - the economy could even continue to suffer from the recession the government was attempting to fight with all its spending.
The value of state money might disconnect from the nominal unit of account - the dollar - while leaving the rest of the economic system unaffected. The government would need to restore the value of its money through higher taxation.
So when we are assured inflation is the only outcome to be feared when the government attempts to “spend first, tax later”, we are right to be to be sceptical.
The problem is placing too much weight on an equivalence - between state and bank money - which could break under pressure. The economy could carry on, without inflation, but with a vastly depreciated state currency and diminished fiscal power. All in keeping with “the way the banking system actually works”.
James Culham is Director, Institutional Portfolio Management at ANZ
* An update on the above: I have been assured by Rohan Grey on Twitter that 'legal receivability' enforces the correspondence of state money and the unit of account, and that my doomsday scenario above could not come about. Whew.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
07 May 2019
05 Jun 2020