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The Basics of MMT by Prof Bill Mitchell

This is a piece by Bill Mitchell of  Research Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW Australia.  It gives a quick (relatively) easy to understand outline of the basic mechanics of Modern Monetary Theory or MMT.  Take note,  MMT is a acronym that you will likely here a lot about in the coming months so you  should read carefully and impress your friends.

Back to basics

The following will be obvious for many of you but for the non-economists it might be a useful organising framework for understanding what is going on at the moment.

Sometimes we get lost in detail and forget the simple macroeconomic relationships that sit below the nuances. I also like to get lost in detail too – to work out tricky little aspects of the financial system, etc but it is always a sobering experience to go right back to the beginning. I have been forcing myself to think “basic” lately as I progress the macroeconomics textbook that my mate Randy Wray and I are writing at present.

So what drives output? What determines national income? What largely determines employment growth? What causes mass unemployment? These are much more important questions than having esoteric discussions about the pricing of some 3rd degree derivative that some engineer has contrived to fleece the clients of some hedge fund she/he is working for and redirect real output into the hands of the rich.

I am not saying that detailed discussions about financial markets, banking and whatever are not important but we tend to lose sight of what drives the big aggregates. The British government has clearly lost sight of what delivers wealth and prosperity in the UK.

Let us start at a most basic level. In this blog – Deficit spending 101 – Part 1 I discuss the two-person economy. It doesn’t get much simpler than that. You might nominate yourself to be the government and your partner to be the non-government private sector to make it personal.

The government issues the currency in this two-person economy and the non-government offers labour (productive resources) in return for payments. Some product is created. We open a spreadsheet that records all transactions.

The government announces a tax of 100 dollars. The non-government person asks: “Where will I get the 100 dollars from to pay this tax?” The government says: “I will spend $100 on private sector activity which will provide the currency necessary to pay the taxes”. The relevant spreadsheet entries are made recording these transactions.

The column – budget balance in period 1 records a zero. The government runs a balanced budget (for example, spends 100 dollars and taxes 100 dollars). The private sector receives 100 and pays it back in taxes so has a zero balance at the end of the period. The private accumulation of fiat currency (savings) is thus zero in that period and the private budget is also balanced – they spend all they get and do not save.

Sit down with your partner at the table and type some numbers into the spreadsheet to see the entries appear and disappear electronically as the economy evolves – as the government injects spending and drains it via taxation. Watch what happens to the private saving column and compare it with the entry in the government budget each period.

Note clearly that the printer attached to the computer is silent – there is no “money” being printed.

What happens if the government spends 120 and taxes remain at 100? Answer: then private saving is 20 dollars and this can be accumulated as financial assets – initially in the form of numbers in the spreadsheet under private currency holdings. The government might call these holdings “private bank deposits” if it liked.

Where did the 20 dollars in savings come from? The additional net spending by the government to elicit further activity in the non-government sector provided the funds. The budget deficit for period 2 is 20 and this corresponds to the private saving in that period. A simple, ineluctable and pervasive result.

The government person might then say to the non-government person that they are prepared to encourage further saving and will issue an interest-bearing bond. So a column in the spreadsheet is created to record any “bond sales” which just amount to reducing a number in the “private bank deposits” column and putting that number into the bond sales column.

The government is not obliged to issue this bond. The net spending will still appear as before in the spreadsheet. The deficit does not need to be “financed” by borrowing. There is no operational imperative for the government to issue this debt as things stand. It is clear that the government is “borrowing” back what it has already spent.

Should the non-government person not wish to buy the bond (and earn the interest) they would just leave their savings in the “private bank deposit” column and presumably be happy about that. Nothing significant would arise from this decision. Yes, we could conduct elaborate analyses of bond prices, yields, secondary markets, etc but the essential insight is provided in this example. Nothing significant would happen to the level of activity in this economy if the bond was not issued.

The government deficit of 20 is exactly the private savings of 20 which may be stored in bonds or deposits. We could add any number of financial assets without contradicting the basic finding – over time, the accumulated private savings would equal the cumulative budget deficits.

Now what would happen if the government person decided to run a surplus (say spend 80 and tax 100)? Answer: in the next period the private sector person would owe the government a net tax payment of 20 dollars.

Where would they get that shortfall from? They would need to sell something back to the government to get the needed funds or run down their bank deposits. The result is the government generally buys back some bonds it had previously sold.

Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus. The government surplus has two negative effects for the private sector:

* The stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and
* Private disposable income also falls in line with the net taxation impost. Some may retort that government bond purchases provide the private wealth-holder with cash. That is true but the liquidation of wealth is driven by the shortage of cash in the private sector arising from tax demands exceeding income. The cash from the bond sales pays the government’s net tax bill. The result is exactly the same when expanding this example by allowing for private income generation and a banking sector.

From the example above, and further recognising that currency plus reserves (the monetary base) plus outstanding government securities constitutes net financial assets of the non-government sector, the fact that the non-government sector is dependent on the government to provide funds for both its desired net savings and payment of taxes to the government becomes a matter of accounting.

You will not find this basic understanding of the relationship between the government and non-government sector outlined in any of the mainstream macroeconomics books. Students do not learn the basic nature of the relationship – that from a national accounting perspective – a government surplus (deficit) has to be equal ($-for-$) with the non-government deficit (surplus).

If the non-government sector is to save overall then the government has to run deficits. There is no escaping that result. It is not my opinion or my prediction. It is the most basic macroeconomic fact that there is. If you don’t like it – get over it!

The British Government clearly doesn’t understand this basic fact. If it does, then its actions in cutting net public spending amounts to a malevolent deed and satisfies the conventional definition of a terrorist act.

(link to full article)

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