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more armchair economics

I ran across a series of blog posts about "Modern Monetary Theory", and I'm trying to make sense of them.  The authors reach a lot of conclusions that I like politically, which suggests I'd better be more than usually skeptical to avoid confirmation bias.  One idea in particular intrigued me, and I thought I would try to analyze it on my own before reading more of what they have to say about it.

As I understand it, one of their fundamental principles is that over the past 80 years the U.S. and most other developed nations have moved from the gold and/or silver standard to the "tax standard": the value of the U.S. dollar, no longer backed by a fixed amount of gold per dollar, is ultimately backed by its ability to pay U.S. taxes (which, the libertarians will point out, is backed by the U.S. government's ability to punish people for not paying taxes).  In a way, this is nothing new: for hundreds of years of gold-and-silver coinage, a coin's worth was not only the value of the metal in it but also the promise that the King would accept it in payment of taxes.  We've just eliminated the precious-metal component entirely.

There are enough people and businesses that expect to owe U.S. taxes that there's always a demand for dollars... which means in turn that they're also valuable to anybody who does business with people and businesses that expect to pay U.S. taxes, and so on and so on.  The neat thing about this (from a government's point of view) is that a national government doesn't have much control over the supply of gold (which could be thrown off by piracy, natural disaster, the discovery of new mines, etc.), but has very good control over the amount of taxes people owe it.  Being on the tax standard is like being on the gold standard, if you (and only you) had the power to magically increase or decrease the amount of gold in the world.  If there's a need for more money in circulation, just raise taxes and somehow issue an equal number of dollars (whether paper or electronic); to put less money in circulation, do the reverse.

How does a government "issue" dollars?  This can happen in a variety of ways: the government buying goods and services from the private sector, the government paying wages to its employees, the government paying interest on bonds, the government handing out food stamps or welfare checks, etc.  Let's call all of this "government spending", for simplicity.

Which raises the question: what goes wrong if taxes and spending don't rise and fall in tandem?  If you tax more than you spend (i.e. you run a government surplus), then there aren't enough dollars in circulation to pay off all the tax liabilities, and whoever is caught without dollars when the music stops gets punished for tax evasion.  The desire to avoid this could set off a bidding war for dollars: people would pay more and more goods and services for them, a phenomenon known as "deflation".

On the other hand, suppose you tax less than you spend (a government deficit, analogous to issuing certificates for more ounces of gold than you have in the vaults).  What goes wrong in the gold-standard case?  Well, if everybody tries to redeem their certificates for gold at the same time, the government is unable to keep its promises, and people lose faith in it.  In the tax-standard case, if everybody urgently wanted to trade their dollars all at once for the desirable condition of having their taxes paid off, the government would be forced to say "I'm sorry, you can't pay your taxes; you don't owe any."  So what?  In fact, most people much prefer having dollars in their pockets and bank accounts over having their taxes paid off, so the likelihood of everybody simultaneously insisting on exchanging all their dollars for taxes-paid-itude is zero.  The threat that this might happen in the future might make people less willing to do business in dollars, but in the real world it's not a realistic threat.

Not surprisingly, governments generally favor the latter error over the former: the actual number of dollars in circulation (not just currency, but bank accounts and any other liquid asset denominated in dollars) usually far exceeds the total tax liability of any given year, so it would take many years of government surpluses before the economy started running out of dollars and experiencing the resulting deflation.

What else can happen to dollars?  Well, dollars with a physical manifestation (e.g. paper currency) can be lost or destroyed, and one has to expect a certain background level of such leakage; governments must run enough deficit to cover this leakage, or they risk the running-out-of-dollars scenario.  Another thing that can happen is that people acquire dollars and then mysteriously refuse to use them, whether to pay taxes or to buy stuff from other people; this is called "saving".  This also acts like leakage, except that it's reversible: at some point in the future, people who have chosen to save money can change their minds and spend it.  To the extent that people want to build up savings, the government must run enough deficit in a given year to cover the total savings (i.e. the total change in people's liquid net worth) in the economy in that year, or again we risk running out of dollars and going into a deflationary spiral.  On the other hand, if lots of people and businesses are spending down their savings, the government can afford to run a surplus, but isn't obligated to do so (after all, it's just government-issued funny money anyway).

Let's take some real-world examples.

  • It's 1928, 1999, or 2006: the economy is booming, households and businesses alike are optimistic about the future and taking on debt for various reasons (including investing in expansion and gambling on the stock market).  According to the previous paragraph, the government can run a surplus; in 1928 and 1999 it does, while in 2006 it runs a slightly smaller deficit than the year before.

  • It's 1930, 2008, or (less dramatically) 2001, people and businesses have seen a lot of their investments fail so their net worth is much less than they thought it was, so they stop spending for any but the essentials.  Big corporations, in particular, build up huge bank balances that they don't invest in expansion (who needs to expand when there are no customers?). In addition, since the 1929 and 2008 crashes were largely about chicanery in the finance industry, businesses and banks have much less faith in one another's financial stability, so they're very reluctant to lend money.  Everybody in the private economy is simultaneously trying to deleverage, reduce risk exposure, and increase liquid net worth.  It is of course mathematically impossible for everybody to do this at the same time unless money is being created from nowhere, so there's a shortage of dollars and a year or two of deflation; government obligingly creates more dollars by running a big deficit.

  • It's 1936 or 2010, the economy is no longer in recession, but far from healthy.  Inflation is still extremely low, flirting with deflation, but rather than continuing to create dollars, governments at all levels and in most developed countries decide (either voluntarily or under duress) that they too should deleverage, reduce risk exposure, and increase net worth: they all try to cut their deficits at once.  In 2010, the countries that do this most dramatically (Greece, Spain, Italy, Portugal, Ireland, the UK) see deflation and double- or triple-dip recessions; the U.S. does it less dramatically, and doesn't quite go back into recession or deflation, but continues sputtering along, experiencing the slowest job recovery since the 1930's.

  • In 2010, the Federal Reserve system continues trying to create dollars while the U.S. Federal, State, and local governments are all rowing the other direction.  But the only way the Federal Reserve can create dollars is by putting them into banks, not giving them to consumers; the banks continue not lending them out, either because they still don't trust anybody, or because nobody else wants to take on debt.  So all of these created dollars do approximately no good whatsoever.