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The State Theory of Money: Your shortcut to understanding Modern Monetary Theory (Part 2)

By Iain Dooley

What the Fiat?!

What you have created is a currency with a fixed exchange rate to a commodity.

Imagine if the computer broke one day and you sent it to get repaired. If the kids came to redeem their ticks on that day they might become disillusioned with the tick system because they could not play computer games.

In order to to keep them happy you could offer them extra ticks to be used when the computer is returned.

The rate at which the ticks accrue to children in the absence of the computer would be the “interest rate”.

This is the reason why a government with a fixed exchange rate currency cannot control its own interest rate (and why a government that allows its currency to float such as Australia can).

Now imagine your kids wander into a duplicating machine and all of a sudden there are more of them. Great! You can get more chores done right?

Only to the extent that there is enough computer time for them to redeem their ticks. If you had 1,000 children you would get to the point where the constraint would be computer time and you couldn’t get more work done, even though you had plenty of kids willing and able to work.

Fixed exchange rates have the same basic constraints whether they are a currency peg (where, for example we agree to convert AUD to USD at a fixed rate) or fixed to a commodity (such as a gold standard).

They work fine under certain conditions but ultimately they limit your domestic fiscal policy space to the extent where you might end up with unemployed kids; that is kids who were willing and able to do more work and earn more ticks but whom you could not pay because of the constraint of the underlying commodity.

The same would be true if, instead of ticks you issued pieces of silver stamped with your face. You would be limited in how much you could spend by how much silver you had access to.

As an interesting side note, imagine that the house next door ran the same scheme but they offered to create 2 coins with the same amount of silver you use to create one coin. Your kids might melt your coins for the silver content and have them re-minted by the folks next door, starving your mint of silver and limiting your spending capacity. This is basically what happened all the time in Europe in the middle ages and why commodity money is such a bad idea (further reading in the resources listed at the bottom of this page).

Basically fixing the exchange rate of your currency or making it out of some commodity constrains the currency and you’re going to have a Bad Time™.

So how do we make a currency that has value without tying it to some commodity?

People complain a lot about “fiat” currency and how it has no value because it’s made of paper and it’s based entirely on a confidence scam: as soon as the confidence drops the value of the currency drops and we’re in an inescapable downward spiral.

That’s how mercenaries thought of money when being paid to fight a war in the olden days. They wanted currency they could melt and take to a competing mint of the sovereign who won the war.

But they would always go and get the gold or silver minted into coin so they could spend it.

That is, the coin had a value that exceeded its commodity content because it was accepted in payment of taxes and therefore readily accepted by people under that sovereign rule as a medium of exchange.

In an already monetised economy, the value of the currency is defined by what is available for sale in that currency.

But how does a currency gain value initially?

The way that Christine Desan describes this (see video in resources section below) is that humans have always operated in groups, and that the leaders of those groups accept contributions from the members of the group in the interests of the group. When such a contribution is made ahead of time, a receipt is issued to the contributor as evidence (for example if I worked twice as hard this year than I normally do, I would get a ticket that said I worked an extra year’s worth of contributions).

This receipt can then be traded with other group members and becomes currency.

So outside of our family example it is the willingness of people to contribute to the good of the group and acceptance of sovereign rule (ultimately in the form of taxes) that drives value for the currency.

In other words saying that a currency will lose all value is tantamount to saying that the issuing sovereign will completely collapse and that nothing will be offered for sale in that currency.

This is also called hyper inflation and this is why you will typically see MMT proponents say that “no Australia cannot become Zimbabwe” (at least not in the near future … ) because hyper inflation or near total annihilation of the value of a currency also entails near total annihilation of the sovereign; that is to say for the US dollar to become worthless the US government would have had to collapse.

If that happens, then sure maybe you want to be like a mercenary from the middle ages and hold gold in the hopes that you can trade it for some other currency that has value.

But despite what manic street preachers and conspiracy theorists will have you believe, total collapse of the Australian and US federal governments to the extent that Zimbabwe or Venezuela or the Weimar republic in Germany collapsed is not really something we need to worry about right now.

It is not a collapse in the currency that causes a collapse of the government, but the other way around.

Private banking

Around this point in the article, I’m sure some of those still reading will be yelling at the screen “BUT BANKS CREATE 97% OF THE MONEY I SAW THAT IN ZEITGEIST AND YOU’RE JUST ANOTHER ROTHSCHILD!!1”.

Firstly let me just say that I agree with you that we have far too much private credit creation at the hands of banks and that financial deregulation has been a disaster for our society and our economy.

We need to rein in banks, and make finance boring again.

However banks don’t really create “money” in the same way that government spending creates “money”.

The “money” that banks create is kind of like Disney Dollars.

This topic could be a whole article of its own so I’ll just say that when banks issue loans they are creating deposits that are valid only within that bank.

Whenever a transaction leaves the bank that originally created the deposit, it has to happen in government money (either notes and coins in the case of a cash withdrawal or exchange settlement funds in the case of electronic transactions).

When an electronic transaction takes place, banks don’t have to settle up with each other right away, they only settle up at the end of the day so they only need enough government money to cover the difference in flows between institutions.

We’re getting too far from the point of the article but I just wanted to include this note on private banking here to ensure that no-one comes into the comments and tells me how this whole article is null and void because of private banking and how could I be so stupid.

Tomorrow: Logical conclusions

 

22 comments

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  1. Don A Kelly

    Those that can remember when decimal currency was introduced in Australia the 50 cent coin disappeared very quickly because the silver content in the coin was worth 63 cents, not 50 cents. This was quickly rectified.

  2. Iain Dooley

    Don A Kelly:

    A perfect example of why the existence of coins from 2,000 years ago is a sure signal that they had a value that exceeded their commodity content!! Thanks for sharing that I’d never heard about it.

  3. Heterodox (@mmt_rod)

    Harquebus
    You say “MMT is just a plan to administer another wonder drug to a parasitic economy that is struggling to survive on a host that it is killing.
    MMT is not a plan it just describes how the the macro economy operates.
    MMT has only one policy, that is a job guarantee is this the wonder drug you are talking about?

  4. Harquebus

    Heterodox (@mmt_rod)
    Yes. Others have state that. My challenge has been and has still not met for someone who claims to understand MMT to provide a description of the economy in its current state. Perhaps you can provide us with one.
    Ultimately, it is just another fiat currency whose track record is atrocious and is my point.
    MMT can never provide job guarantee. It is cheap and abundant energy that is required for getting anywhere close to full employment and both of these attributes are heading in the wrong direction.
    The current parasitic fiat economy is doomed just like all those before it. It can not be saved and no one is willing to put it out of its misery. It will continue to suck the life out of our planet and ensure that unemployment trends will only going to go up.

  5. John Kelly

    Harquebus, you are far too pessimistic. Fiat currencies have not failed. In some cases, the management of them has failed, ie the government has “collapsed”. But the currency cannot fail because it is already worthless. Confidence levels can rise and fall too, but the currency remains constant, within the constraints of the resources that engage it.

  6. nurses1968

    Harquebus
    I think you are way ahead on points in this MMT thing as you seem to be explaining what it is not,while the proponents seem to have varing ideas of exactly what it is or does and have one hell of a time trying to explain it. This “debate” has been going on on the AIMN for ages and the are still failing to sell MMT to the wider readership or explain it so that even those who want to believe would understand. I can see why it is just a “theory”. There has been “Understanding MMT”, “Your shortcut to understanding Modern Monetary Theory”,etc I think I’ll wait for the mini series

  7. Iain Dooley

    Nurses1068:

    All Harquebus is doing is refuting new evidence and logic with existing false arguments without actually reading or understanding anything.

    He’s a denier. No different from any other form of denial.

    If that puts him ahead on points I assume you are a Malcolm Roberts or Trump fan because that is basically the level of debate he’s engaged in.

    What did you think of this and the previous article explaining the state theory of money? Which bits don’t you find “real” and which bits do you struggle to understand?

    The other day Trish Corry made the complaint that MMT proponents copy and paste the “same wall of text” which no one does so I’m assuming that is a compliment on the consistency with which the concepts are explained, but in this series of articles I tried starting from the very beginning which describes what money is an how it works in a historical and logical context first because I’ve found that when I discuss this with people those that concur with the state theory of money have a much easier time with the logical conclusions of MMT.

  8. Jennifer Meyer-Smith

    If highly qualified, reputable Economists like Prof Bill Mitchell and Steven Hail advocate Modern Monetary Theory (should be Modern Monetary Practice MMP), that’s good enough for me to allow myself to try to learn how money should be allowed to rise, flow and operate for our socio-economic benefit through our systems.

    I suggest the naysayers spend their time in working out how this monetary system can be adapted into what we need for Full Employment, a better standard of Living, free Education throughout a student’s life, free Health, protected Environment and ecosystems and affordable Housing for everybody.

  9. Iain Dooley

    Jennifer Meyer-Smith:

    I feel the same way although I went on a journey until I found MMT … I went through a fair bit of economic chaos online and the various zeitgeisty-type goldbug stuff … funnily enough I thought to myself “all this stuff is so focused on the US, I want something that explains the management of the Australian economy” then the next week I was at a garage sale and saw this book:

    https://books.google.com.au/books/about/The_Management_of_the_Australian_Economy.html?id=3AMjAAAAMAAJ&redir_esc=y

    It’s a book that predates neoliberalism (just) and has a lot of stuff in it that really made sense. It still has the money multiplier and a few other things in it but it is what you would call “post-keynesian” and it put me in the right frame of mind to instantly recognise that MMT was the “real deal” as soon as I found it.

    I originally found out about MMT specifically when reading the comments on this David Graeber article reacting to the now infamous BoE paper:

    https://www.theguardian.com/commentisfree/2014/mar/18/truth-money-iou-bank-of-england-austerity

  10. Harquebus

    I have just spent some time revising this MMT thingy. It’s been a while since I have last done this and is why my comments have been general rather than specific.

    A: Fiat currencies are intrinsically worthless and always fail. There can not be any argument over this. So, what plan do our eggspurts come up with? Yep, more fiat.
    B: With MMT, fiat currencies are conjured into existence by governments rather than banks. Neither can be trusted.
    C: Needs and causes inflation. (see below)
    D: Proclaims that full employment can be maintained by currency creation. This is its main flaw.

    It is the rate of energy flowing the system that determines employment rates and the amount of surplus energy that determines the rate of GDP growth. Both are heading down. The physical limitations are not factored in economics, including MMT, will be its and our downfall.

    Those who advocate this MMT rubbish have no understanding of the physical laws that govern us.
    I suggest that all MMT advocates study a little physics and you will see just how illogically absurd all fiat currencies are.

    “By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The process engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose.” — John Maynard Keynes

    John Kelly
    All fiat currencies have failed and those currently in use will fail. You are claiming that the effects of fiat currencies are the causes of its unblemished track record of complete failure.

  11. Harquebus

    “Money is simply a medium of exchange and a store of value. A distinction can be made between money and currency, in that money has intrinsic value while currency is simply a medium of exchange that can be used to purchase something of value.”
    “Throughout history, many things have served as currency- shells, spices, coins, paper bills; even cigarettes are used as currency in today’s prisons. But as currencies have come and gone, only gold and silver have stood the test of time as real money.”
    https://libertyinsight.com/money/

  12. Harquebus

    I have warned a couple of times in this forum to keep one’s eye on Deutsche Bank.
    The end approaches.

    “Many people are still delusional, thinking that since nothing has crashed since 2008, crashes can’t happen. Those people are about to be taught a very expensive lesson in economic reality.”
    “a failure of Deutsche Bank would trigger a systemic banking contagion the likes of which the Western world has never seen.”
    http://www.naturalnews.com/055462_Deutche_Bank_debt_collapse_financial_catastrophe.html

  13. David Gordon Hill

    Harquebus , if fiat currency is worthless can you please deposit all your money into my bank account 😛

  14. Jennifer Meyer-Smith

    😛

  15. Harquebus

    David Gordon Hill
    My money (bullion) is in my safe and for the time being is staying there.
    My currency I trade for useful items such as hand and garden tools etc. Quality hand tools will be in demand.
    It is a good deal trading intrinsically worthless crap for soon to be unavailable quality items. Quality items do not include smart phones, TV’s, designer handbags or works of art etc.
    Do the same or you, like most, will hit the floor when the music stops.

    Jennifer
    Search criteria: bank bail in g20

  16. PK

    @Harquebus

    I suggest you contact Ellis Winningham on facebook… as someone who also work with the USA Federal Reserve I think that he would more than adequately dispute what you are saying…

    Gold is a commodity that has value, yes… but the taxes of Kings in the past gave it value as it was the “currency they decided on and used’, before that it was just a pretty soft metal that had very little real value… and it no longer forms part of the legal tender thus useless changed for fiat currency is of little use in the wider world.

  17. Jennifer Meyer-Smith

    H,

    you need to advise a set of moves that you and your ilk and other sympathisers could adopt to ensure they meander any political systems for the best results.

    I say this coz you are still taken seriously although some of your views are alarming.

  18. Harquebus

    Jennifer
    I don’t think any form of politics at this stage will produce results.
    My current thinking is to help as many I can survive the coming catastrophe, hope that I do, pick the up the pieces and rebuild something better.
    Limiting the damage is, at this stage, probably the best that we can do.

  19. Senexx

    From what I can tell of Kaye Lee’s arguments on the previous post where she is looking for how the economy actually operates and suggests MMT does not describe it as it is – I would say that is the confusion between legal constraints and economic constraints, the former is political, the latter is operational. No matter what laws are put in place the operational mechanics come out the same.

    The other concern I saw was resource use & environmental concerns. This is fairly standard issue people raise but assumes that all economic systems what economic growth at all costs.

    For Harquebus above – A. It depends on what the issuing authority or authorities do with it and if they understand their system
    B. Actually both banks and governments create money – MMT just adds the State (the govt) to the economic circuit.
    C. What’s wrong with a little inflation. The whole idea of currency in the unit of account is to facilitate exchange of resources.
    D. In no way does it say currency creation can get to Full Employment – that misses a lot of steps and nuances. In all economics you can set the price or the quantity. In the policy option provided it chooses the price level. You can always choose P or Q and let the other one float.

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