The post that follows is one of my ongoing series on thinking about what modern monetary theory (MMT) says and what I think it should say. Because it assumes a reasonable level of understanding of double entry and the working of central bank reserve accounts I summarise it here, first.
As is commonly understood, MMT suggests that a government spends before it taxes. Unfortunately, as is now clear from the discussions that I have had with MMT exponents, that is not what MMT actually says in what I might call its 'creation narrative', which explains how it supposedly forces government-created money into use in an economy. In that narrative, tax comes first.
As I explain, however, spending does come first in practice. The problem is not with the conclusion MMT had to offer. The problem was with the explanation MMT uses.
However, what I think is a correct explanation (which I offer here, although I will be doing further work on it) does make clear that another MMT claim is unsustainable. In a modern economy, the claim that a taxpayer can only pay tax using government-created money is unsustainable, largely because government-created money does not exist in the private sector economy from which tax is usually paid.
The suggestion of this blog is, therefore, threefold:
- The MMT 'money creation' narrative is unreliable and certainly does not sustain the claims that MMT proponents make based upon it.
- MMT needs to reframe its thinking on the division between state and commercial bank money, taking into account the reality of the structuring and use of central bank reserves.
- MMT needs to offer an alternative explanation of why spending must, at least usually, precede tax in a fiat currency economy.
The narratives within modern monetary theory (MMT) that I have been discussing over the last week or so have revealed a real problem for those proposing MMT in the way that its founders suggest
This is apparent from the cycle of tax and spend, as they relate it. The fiscal cycle is, in their opinion, as follows:
- A government imposes a tax by law for which the currency to make payment is not available.
- That government then require that people transact with it so that those people might acquire the currency that they need to make legal settlement of their tax liabilities.
- The government, in settlement of the contractual obligations arising from the sale transactions into which people have now entered with it makes payment into the economy to settle the liabilities that it now owes.
- The currency to settle the tax liability due now exists, meaning that it can be paid.
The problem for those who propose that MMT works in this way is that MMT is, if it is anything, an economic theory based upon the principles of double-entry bookkeeping. I suspect that Hyman Minsky and Wynne Godley would have agreed if they could have done so. Much of Stephanie Kelton's writing implies that is the case. But, in the narrative that I note above, tax very obviously comes first, and well before spending. It cannot be argued, as some in MMT debates do, that only cash flow matters. It is assets and liabilities, and income and expenditure, both expressed as debits and credits, that drive taxation. And in that case, the core MMT argument that government spending precedes taxation fails in this most basic narrative that MMT uses to explain the fiscal cycle. Tax comes first in it.
That is disappointing because the reality is that spending really does precede taxation in the fiat currency world that MMT describes. The actual ordering of events within the fiscal cycle is as follows, in my opinion:
- A government with a legal mandate to spend instructs its central bank to advance to it the funds required to make that expenditure.
- The government, then instructed central bank to make payment to whomsoever it wishes, passing that newly created money into the real economy, via the central bank reserve accounts maintained by a jurisdiction's commercial banks with its central bank.
- In response to the receipt of the instruction to make payment from the government the central bank transfer money that they have created for the government to the central bank reserve account of a commercial bank together with an instruction that they should forward a payment to whomsoever the government desires. The commercial bank in question will then create commercial bank money to make that onward payment. They cannot, and do not, pass on the central bank-created money that they have received. That is because all currency transactions through a bank are bilateral. By definition, that means that they only exist between the parties to them. No other party is ever involved. The mutual promises to pay are not, in effect, transferable. What they can, however, be is sequential. In other words, the creation of central bank money does sequentially result in the creation of commercial bank money, which is what the beneficiary of the payment from the government actually receives. The commercial bank balances its books on the transaction by matching the increased asset it holds in its central bank reserve account with the liability it now has owing to the recipient of the commercial bank money it forwarded on the government's instruction.
- To control the growth in commercial bank created money within the economy, which, as this explanation shows, is the inevitable consequence of its decision to spend, a government must tax. The tax imposed need not be on the person who was in receipt of the payment from the government. What is required is that the fiscal impact of an excessive supply of money be limited. Tax achieves that goal. But that tax need only be imposed after the spending has taken place. That liability can and should be the consequence of that spending, not its precursor. If it is instead the case that the tax is imposed before the spending takes place, then the government shrinks the size of the economy and reduces the capacity to pay. If it imposes the tax after its spend has taken place, this is not the case. As a result, tax takes place after spending, and not before it unless, that is, it is the deliberate intention of the government to withdraw excessive money supply from the economy, which could, for example, be the case in reaction to the creation of excessive commercial bank money. It is not a rational response to do so in reaction to the creation of government money. That is because to demand payment of tax from the economy before the government spends would inevitably and necessarily require that in time the commercial banks would have to effectively overdraw their central bank reserve accounts maintained with the central bank because there would have been insufficient deposits in them to fund the payments that they would be required to make on behalf of the customers to the government in settlement of tax liabilities. This is not an observed phenomenon in recent times, at least.
As a consequence, this is what I suggest is actually happening in the economy, day in day out.
In contrast, it is likely that no series of transactions of the type described by the founders of MMT has ever taken place. If they have, I suggest it was exceptional, and exceptions do not prove rules.
There is another commonly made claim by the founders of MMT, which the logic noted above proves to be impossible. MMT proponents usually say that tax can only be paid using government created money, by which they mean those funds created by the government to make payment into the economy. However, as the sequence of events noted above makes clear, the money created by the government to make a payment in settlement of its liabilities is described as base money, but this never moves beyond the central bank reserve accounts maintained by the commercial banks with the central bank of the jurisdiction. It does not, in other words, enter the private sector economy in which only commercial bank creative money is in existence.
The actual settlement of funds to the recipient of the payment from the government is always made using commercial bank create of money, with that commercial bank creating those funds on the instruction of the government, with assets backing for that payment being supplied by the base money placed by the government into the central bank reserve account of the commercial bank in question at the central bank.
When tax is paid, this process is reversed. The taxpayer will always, and necessarily, make payment of tax using commercial bank-created money because there is no government-created base money available to them in the private sector economy in which the taxpayer will operate (bank notes excluded, and these are not legal tender for this purpose in most jurisdictions, including the UK). The payment of taxes does, therefore, necessarily require the existence of both government-created base money in central bank reserve accounts and commercial bank-created money in the private sector economy from which tax payments are made. There is, however, no direct interaction between the two, and as such the claim that taxation is always paid using government-created money is only true to the extent that commercial banks complete the transaction to pay tax, which their customer has instructed them to undertake, via the central bank reserve accounts: all transactions prior to that final transfer will take place using commercial money.
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‘And in that case, the core MMT argument that government spending proceeds taxation fails in this most basic narrative that MMT uses to explain the fiscal cycle.’
Should ‘proceed’ be ‘preceed’?
‘MMT proponents usually say that tax can only be paid using government create of money, by which they mean those funds created by the government to make payment into the economy.’ Needs to be ‘created’, not ‘create’, no ‘of’?
‘They cannot, and do not, pass on the central bank creative money that they have received.’ Again ‘creative’ needs to be ‘created’?
‘The commercial bank in. question will then create commercial bank money to make that onward payment.’ Weird full stop after ‘in’.
All I can say though that I love the way you debunk myths. It seems pretty compelling – well, I think its stands up to scrutiny, let me say that in this reductionist, don’t question anything world that world we live in.
Thanks
I dictated most of that and clearly did not spot all the mistakes
Now edited
Please answer me this Richard for clarification.
The govt spends £1bn on state pension. Initially Commercial banks have assets = CBRA of £1bn and liabilities = customer deposits £1bn. This is spent and goes round the economy CBRA staying at £1bn. Can commercial banks lend indefinitely (assuming people want to borrow) because once this is spent an individual bank may end up with a negative on their CBRA?
I see no relationship between the CBRA and the lending after the first stage so do not know to what your question refers
Please indulge me. If all the pensioners banked with Barclays and they spent it with customers who all banked at LLoyds then the £1bn CBRA would now all be Lloyds. Could Barclays make loans (assuming no other transactions) as their CBRA is now zero? What is knawing away at me is the thought that if they did make a loan and their customer spent it with a Lloyds customer how would Barclays pay LLoyds given their CBRA is now zero?
You rather oddly assume a sinle transaction world
I don’t
And you also assume that the CBRA could not be overdrawn
Why not?
With BoE permission it could be
It does not happen now but a lender of last resort may do this if they wished
It is complicated by capital and liquidity requirements but essentially, if the pensioners spend then Barclays borrows in the interbank market or raises deposits elsewhere by improving terms it offers.
In practice, banks are constrained by capital and LCR rules when lending. Everyday payments flows are not important and typically net out.
Precisely
Assuming a single payment economy is not a useful methodology
Thanks Clive. I used the simple example for ease (similar to Freda and Tom in Richard’s brilliant double entry explanation of money creation last June). Makes sense the two closed loops, I’ll go and work on the double entry of the commercial bank loop to prove it to myself!
@ Richard,
The first step in your alternative explanation of the spend and taxation cycle is:
“A government with a legal mandate to spend instructs its central bank to advance to it the funds required to make that expenditure.”
This appears to be true now because the cycle has been going for so long that, for all practical purposes, it has ceased to matter which is the first step. It is like asking which is the first stroke of a 4 stroke internal combustion engine which has been running for a while. It doesn’t matter; but, when we first start it up, then perhaps it does.
So what happens when we first start up the tax and spending cycle? We all agree that the government’s demand for taxes creates a demand for the currency and thereby gives it a value. So how can the central bank create “funds” if the currency hasn’t yet acquired a value?
Unless you can answer this, your explanation falls at the first hurdle!
The government took a desired commodity, call it gold
It used it to procure what it wanted, say soldiers
They spent the tokens paid to them
The government then imposed a tax to get those tokens back – for reuse in those times
There you are, problem solved without any of the nonsense you claim and without a single colonial hut being involved
It really is not hard
As a result your explanation fails
Mine works, not least because it is plausible
Now, shall we stop wasting time on this?
@ Richard,
If you think it’s a waste of time why have a discussion on the “spend and tax cycle in MMT” in the first place?
We all agree that governments used gold at one time but they also used tally sticks to create debts and collect taxes. However, even if we accept the somewhat more conventional narrative about gold you are suggesting we still have to answer the question of where governments got their gold to start with. If they didn’t have any, but there were others who did, they would have had to impose a tax payable in gold, or something else that could be exchanged for gold, to get it.
Just as feudal lords would have imposed a tax payable in corn or human labour or whatever it was they wanted to acquire.
In principle, this is no different from the MMT view of taxation with which you do seem to have a big problem.
My point is that discussing deepest history long gone via colonial huts is a complete waste of time
I am interested in influencing the real world
An MMT carrion narrative that rightly alienates people and is irrelevant because MMT only has current meaning is a total political distraction
And it can be entirely done without
NeilW is not claiming that MMT only has current meaning – he’s in fact explaining why the history of currencies is important, and the follow on of fiat currencies which are trusted because of tax and a trust in government not to overblow the printing of it.
Have you blocked him?
And I am saying that MMT has no relevance until we reach the era of managing money as if it is a fiat currency, with the perception being the issue.
That is why it is ‘modern’
Pretending what we have now is what happened in Babylon (or wherever) is I suggest simply not relevant, especially if it confuses issues
There are times for angels and pinheads
There is a time to discuss the world as it is
You, Neil and others can decide if you wish to discuss the world as it is, or what I think to be false narratives about ancient money history that no longer have any baering on reality
My choice is relevant to current policy making
Yours distracts from it
Now tell me why yours is more useful in the real world, because I don’t get it
And nor do you, or you would not refer to money printing
And of course, I have not blocked Neil. But you may be close
Thanks Richard. I’m an interested layman, and although I’ll have to read it a couple more times, it seems to reconcile a problem I’ve had. That is MMT theory and Prof. Richard Werner’s explanations of how commercial banks create and increase the money supply.
Cheers.
Thanks
So does this mean that Richard Werner is correct to assert that 97%of money in the economy is created by commercial banks (the other 3% being state created notes and coins)?
No, he’s not
The economy is divided
There is 100% base money in one part without which the 97% of commercial money in the other could nit function
It is a symbiotic relationship
“The commercial bank in question will then create commercial bank money to make that onward payment.”
Is this really commercial bank money? I appreciate that the number in a deposit account is being marked up. But is that commercial bank money in the sense that Keynes meant it?
In 1930, Keynes appears to see the creation of commercial bank money as, for the most part, independent of central bank reserves:
“If we suppose a closed banking system, which has no relations with the outside world, in a country where all payments are made by cheque and no cash is used, and if we assume further that the banks do not find it necessary in such circumstance to hold any cash reserves but settle inter-bank indebtedness by the transfer of other assets, it is evident that there is no limit to the amount of bank money which banks can safely create provided that they move forward in step… Every movement forward by an individual bank weakens it, but every such movement by one of its neighbour banks strengthens it; so that if all move forward together, no one is weakened on balance. Thus the behaviour of each bank, though it cannot afford to move more than a step in advance of the others, will be governed by the average behaviour of the banks as a whole – to which average, however, it is able to contribute its quota small or large. Each bank chairman sitting in his parlour may regard himself as the passive instrument of outside forces over which he has no control; yet the ‘outside forces’ may be nothing but himself and his fellow-chairmen, and certainly not his depositors.
“A monetary system of this kind would possess an inherent instability; for any event which tended to influence the behaviour of the majority of the banks in the same direction whether backwards or forwards, would meet with no resistance and would be capable of setting up a violent movement of the whole system….”
J.M. Keynes, The Pure Theory of Money (1930) pp 23.
But Keynes knew that was fantasy
So do I
So I am not sure what claim you are making and why that changes my suggestion
What am I missing?
When a government spends, the reserves of commercial banks increase by the amount spent. The commercial bank will mark up the deposit accounts of its relevant customers by the same amount.
Commercial bank money has not been created.
Commercial bank money is created when customer deposits are marked up via loans. There is not necessarily any corresponding increase in reserves. There may be an increase in reserves if commercial banks are creating bank money at different rates.
Sorry, but you are quite simply wrong
I a, nit saying the events are not sequential: they are, but a commercial bank cannot transfer funds from reserve accounts into the real economy so they must make new commercial money as a result
Do the double entry
Commercial bank money is created when the commercial bank changes both the asset and liability sides of its balance sheet, via loan and deposit respectively, without any role for the central bank.
That was Keynes’s point (and why he introduced the condition that ‘no cash is used’).
When a government spends, the central bank is forcing the change in commercial banks’ balance sheets.
These are fundamentally different activities.
So, a bank makes a payment on behalf of a customer – who happens to be the government.
It pays the person to whom the sum is due. That is a credit on their balance sheet.
The customer making the payment has been debited.
Both sides of the balance sheet have altered.
What point are you trying to make?
IMO, Kelton and others are clear. She compares and contrast
S(TAB) with (TAB)S in a highly effective manner to show the order of spending, tax and borrowing. A very simple set of acronyms
On the tax issue, IMO and reading, the whole currency/tax issue is simply to explain one reason why we currencies or what is their purpose. There is not fight to be had here.
The big fight that needs coordination is to ingrain S(TAB) into our understanding and policy making.
My point is just that
What I am saying is a waste of time to have a creation narrative within MMT that is a real distraction because it is wrong
The thing that gets me is that money is entirely man made. So somebody somewhere must know exactly how it works. Once we find that person and beat the truth out of him, no more need for theories – modern or otherwise.
But she died some time back without telling all 🙂
When income tax is paid, logically and automatically, it should pay off some of the National Debt as this is its source.
But it occurred to me that the government does not have to do this. The Institute for Fiscal Studies (IFS) claims “Until recently, revenues were paid into a central pool before being redistributed via grants” (ref: A survey of the UK tax system, IFS, https://ifs.org.uk/publications/survey-uk-tax-system )
Isn’t this just money in the public sector that is temporarily held by the government until it “re-spends” it?
The IFS then goes on to tell us what the money is spent on. (ref: What does the government spend money on?, IFS, https://ifs.org.uk/taxlab/taxlab-key-questions/what-does-government-spend-money )
The IFS is clueless on such issues