Martin Wolf: Lerner, Chartalism and Modern Monetary Theory

Martin Wolf: Lerner, Chartalism and Modern Monetary Theory

The Shifts and the Shocks: What we've learned - and have still to learn - from the financial crisis (2014)

http://www.amazon.com/gp/product/B00MEYU6GI/

A final school of thought, which is called ‘chartalism’ (from the idea that money is just a token, for which the Latin word is charta), argues that the conceptual failure of the contemporary monetary and fiscal orthodoxy is not that it gives too much room for central-bank or government discretion, but that it gives far too little: thus, it goes beyond Keynes and most Keynesians.49 The essential idea is that the purpose of monetary and fiscal policy is to ensure full employment. In an economy based on freely floating fiat (government-created or government-backed) money, the government suffers from no fiscal constraint: it can always create money that residents have to accept. The constraints are only macroeconomic, particularly excessive inflation.

Adam Smith made reference to the idea of state-created paper money, noting that the governments of the British colonies in North America ‘find it for their interest to supply the people with such a quantity of paper money as is fully sufficient and generally more than sufficient for transacting their domestic business’.50 But the theory emerged in full form in 1895, the heyday of the gold standard, with the publication of Georg Friedrich Knapp’s analysis of the role of the state in creating money.51 Taxation makes money valuable, he argued, since private citizens need it to pay those taxes. This, in turn, makes paper money acceptable in the economy at large. It is simply the most readily transferable of all possible credits, since the government is the most powerful and most permanent of all possible debtors and all money is just transferable credit: its value derives from the willingness of people to trust in it.

This idea influenced Keynes and was taken up in ‘functional finance’ proposed by the influential post-Keynesian, Abba Lerner (1903–1982).52 Since the government can issue currency at will, the level of taxation and the extent of borrowing are tools to influence the economy. They have nothing to do with any need to finance the government, since it can fund itself by creating money. Thus all forms of balanced-budget household economics applied to the government are nonsense unless it has ceased to be able to create money (as has happened inside the Eurozone). In Lerner’s words, ‘Government should adjust its rates of expenditure and taxation such that total spending is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money”, etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability.’53 So long as these policies do not generate excess demand, there is no reason to fear their inflationary effects. This does not mean no constraint on monetary policy exists, but those constraints come from inflation and the associated risks of sharp declines in the value of the currency against other currencies.

Today’s proponents of this set of ideas call it ‘modern monetary theory’.54 An essential point is that the private sector can be a net accumulator of financial assets if and only if the government runs a deficit or the economy as a whole runs a current-account surplus (that is, foreigners run a financial deficit). If the government runs a financial surplus in good times, as orthodox Keynesians propose, the private sector will, in the absence of a current-account surplus, run a financial deficit. The latter deficit will need to be financed by the creation of bank credit, which may ultimately prove destabilizing.

A crucial and unquestionably correct point in modern monetary theory is this: banks do not lend out their reserves at the central bank.55 Banks create loans on their own, as already explained above. They do not need reserves to do so and, indeed, in most periods, their holdings of reserves are negligible. Only the central bank (by open-market operations), government (by spending and taxation) or private individuals (by reducing or increasing their holdings of cash) can change the aggregate level of bank reserves. Nor is the amount of money that banks create related in any direct way to reserves in the contemporary monetary system, as central banks have discovered: reserves increased dramatically after the crisis, but lending did not. The amount of money that banks create is dependent only on how much they think they can profitably lend at the interest rates set by the central bank.

Because the risk perceptions of banks vary dramatically, depending on the economic climate (for which they themselves are, in aggregate, in large part responsible), their willingness to create loans will also vary dramatically, from feast – a time of credit boom – to famine – a time of credit bust. If a bank needs reserves to meet settlement or cash obligations, today’s central banks will freely supply them at the rate of interest it has determined. Thus, this rate of interest will then determine the rates at which banks lend. If the central bank engages in quantitative easing (that is, it creates money with which to buy assets from the public), it will increase aggregate banking reserves automatically. The central bank pays members of the public in return for the bonds it buys from them. Members of the public then deposit this money in their accounts at commercial banks, which then have increased liabilities to the public and a matching increase in deposits at the central bank. Those matching deposits are, of course, bank reserves.

Moreover, to repeat, banks themselves can do nothing to lower the aggregate levels of bank reserves, since the only use of reserves is to settle accounts with other banks. Other businesses and households do not hold accounts at the central bank. So one bank’s loss of reserves (deposits) at the central bank is always another bank’s gain. It does not affect the total quantity of reserves outstanding. Of course, the government and central bank can change the quantity of reserves by buying and selling assets in the market. Similarly, the public can change the quantity of reserves by asking for cash, instead of bank deposits. The banks, in turn, get the cash from the central bank, in return for their reserves or by borrowing from the central bank, which creates the reserves. In brief, one should envisage the relationship between banks and the central bank as being identical to the one between the public and the banks. The central bank is the banks’ bank.

Modern monetary theory poses another fundamental challenge to the official orthodoxy. It argues that in an economy based on fiat money, the job of the central bank and government, together, is only to stabilize the economy. Moreover, these entities can always create the needed demand by spending the money they create. Of course, there is a constraint: too much demand relative to supply will indeed generate inflation. But this will not happen just because of quantitative easing, unless its effect is to increase the overall supply of (broad) money faster than the public is willing to hold it. That has certainly not happened during this crisis, which is why the hyperinflation some feared has turned out to be an illusory danger. Deflation is a far greater risk.

The reason not to give the government the power to use its ability to create money as a tool of stabilization, in this direct way, is not that it is technically difficult. It is rather that many view it (with reason) as politically dangerous, because it puts too much discretionary power in the hands of politicians whose estimate of full-capacity output might be dangerously optimistic. The answer to that concern is institutional: give the power to decide how much money to create to the central bank, but ask the central bank to do this directly via the creation of outside money, not indirectly via the expansion of inside money. Interestingly, the MMT view of monetary policy and the Chicago Plan are essentially the same, the difference being mainly the institutional setting within which the state creates money, rather than private banks.