Stephanie Kelton’s new book, The Deficit Myth, is finally making the rounds of reviews by some economists and commentators. As is expected, there are some what-about-isms. In the case of Josh Mason's review in the American Prospect, the question is: what about banks?
Now, The Deficit Myth isn’t meant to be "The Book" on Modern Monetary Theory (MMT). MMT as a body of work is a vast literature for which Kelton is attempting to condense a few very basic core arguments for a general non-academic audience. The confusion around public finance is hard enough to disentangle without bringing banks into the picture—which still required 300 plus pages. However, how bank money fits into MMT is one question, among others made in particular by Mason, worth addressing.
Mason makes three main objections to Kelton’s arguments that I want to respond to.
The first I have already mentioned above. Banks. Mason argues the existence of banks creates a "problem" for MMT's central claim that the government is the monopoly issuer of the currency. "Banks are money issuers every bit as much as the government. Government has tools to influence how much money is created by private banks, but its control isn't absolute. And when its control is effective, that's a function of the regulations and institutions of the financial system; it has nothing to do with the government monopoly on currency...Little is said about the private financial system." He also says that "Kelton, to be clear, never says anything factually untrue, but she gives the strong impression that the government is the only source of money that we use for transactions, which is not true at all."
Second, Mason notes that while the federal debt is an important asset for the financial sector, it does not entirely correspond to the increase in private wealth. While you can make this claim tautologically, he argues, “it is false--asset values go up and down without any change in the government budget position.”
Third, he argues the link between aggregate demand and supply is a historically contingent phenomenon and implies it is subject to change. And he expresses skepticism about the capacity of the Congressional Budget Office (CBO) to calculate the effect of spending on inflation any better than, say, the Federal Reserve can.
Let’s tackle these arguments in order.
The first thing to note is there is a difference between the currency proper, and other forms of private "money." (Money is too broad a term to be useful, but it basically implies it exhibits money functions, means of payment/exchange and store of value). The federal government is the only issuer of the currency proper. Full stop. It is illegal to counterfeit to Federal Reserve notes (bills) or coins. For electronic dollars generated by the Fed, i.e. reserves, it's the same.
What banks, and other financial institutions, issue are various forms of financial instruments, contracts that differ in conditions of maturity (when the money has to be paid back), negotiability (transfer of ownership), and convertibility (to another asset). These instruments are debt contracts which promise to pay the government's currency.
Bank deposits are a special sort of debt contract. Their maturity is zero. They are also negotiable, you can change the name on a checking account to someone else, or add someone to it. And most importantly, they are convertible on-demand to hard currency (bills and coins) or in reserves (electronic dollars) for settlement with another bank through the Federal Reserve System. To be clear, you as a customer cannot request that the bank give you Fed reserves. Customers may only have hard currency. Fed reserves would only be used when settlement between banks is required or when you pay your taxes to the government through your deposit account.
Now, not all cases of settlement between deposits accounts have to be done through the Fed. For example, if two customers have deposits at the same bank, settlement occurs within the bank marking one account down and another up by the same amount. Some banks might also have deposit accounts with each other, and allow some limit of continuous overdraft credit, which at some point must be settled. This arrangement is called net clearing, or net settlement. Many larger banks are also members of the New York Clearing House which is a wholesale net clearing operation between banks, but one in which Fed reserves still play a role as any differences in credits and debits are turned over to the Federal Reserve Bank of New York for reserve settlement. Most transactions between banks, however, occur through Fed reserve settlement.
What about bank loans? Don't loans create money? Yes, when banks make a loan, they create a deposit, which we noted exhibits the core functions of "money." In theory, there is no limit to the quantity of deposits a bank can create. You may have seen mailer ads, for example, from local banks offering some amount of money for setting up a checking account with them. I recently received one from Citizens Bank for a generous $400. Where does that money come from? The bank can simply create it as a deposit. But there is a practical limit to how much they are willing to create because deposits come with this condition of convertibility on demand to government money, which they do not create.
This is where the Fed comes in. As banks expand deposit creation through loans, the Fed has to respond by creating adequate reserves so banks can service those deposits and ensure the payment system runs smoothly, so payments clear and checks don't bounce. This does not mean there needs to be a one-to-one relationship between the quantity of deposits and quantity of reserves, it simply means the banking system requires sufficient reserves circulating in the interbank lending market to ensure banks can maintain par value (i.e. parity) between bank money and government money. This institutional configuration is by design--a public-private partnership. The implication of this arrangement is that the Fed follows the lead of the private banking system to supply credit as needed to the public. Certainly, the private sector can get overzealous and create too much credit without adequate regulatory supervision.
So while it is true that bank liabilities function as "money," as a store of value and means of payments/exchange, it is important to note that confidence in the use of that money is contingent on its convertibility on-demand from bank liabilities (bank deposits) to government liabilities (bills, coins, or reserves). If at any point a bank cannot convert your deposits to cash because, for example, a bank run, the bank fails; if it cannot obtain reserves to settle up with other banks, it fails. The former scenario was common before there was Federal deposit insurance. The latter was the main issue during the Great Financial Crisis--interbank lending came to a near halt and the Fed had to intervene as the lender of last resort.
In heterodox economics, what I have just described above is called endogenous money theory, which flips the conventional wisdom that the Fed creates reserves, reserves create deposits, which banks then loan out to customers. Rather, bank loans create deposits, and the Fed responds by creating reserves. So endogenous money creation doesn’t break the link between deposits and reserves, it merely reverses the direction of causation from the conventional wisdom.
Endogenous money theory is also a credit theory of money, which postulates that all money is an IOU, a debt, which anyone can create. “The trouble is getting it accepted” as the economist Hyman Minsky once said. But some proponents of this view lean too heavily on the "anyone can create money" insight, and forget or breeze through the rather hard part of "getting it accepted." In our modern financial system, most privately created financial instruments promise to pay government money or its practical equivalent which are bank deposits. This equivalence is accepted predominantly because of their convertibility to government money. And the government has set an expectation it will act as a backstop to this arrangement.
So while banks can leverage government money in all sorts of ways that increase the "money" supply, the fact remains that banks are a user of government money just like any other non-government agent of the economy. The legal bank charter granted by the government which grants them special access to the Fed only reinforces this fact.
Despite Mason’s argument, the existence of bank money has not been overlooked, nor does it undermine MMT’s claim about the sole currency issuer status of the government. Such statements, rather, suggest a certain level of ignorance of the endogenous money literature, let alone MMT.
L. Randall Wray, for example, a founding MMT economist, and the first to author a book on the subject back in 1998, Understanding Modern Money: The Key to Full Employment and Price Stability, also happens to be one of the foremost scholars on endogenous money theory. He has written dozens of articles on the subject, and a book. I myself learned of endogenous money from Wray's 2012 primer on MMT, Modern Money Theory: A Primer On Macroeconomics For Sovereign Monetary Systems. So for as long as I have been studying MMT, I have also been studying endogenous money. If there is an inconsistency to be found, it isn’t there.
Some critics have argued that certain MMT conclusions rely on logical tautologies. To be clear, any statement that is deducible from a set of statements in some system of deduction within propositional logic, say a system of equations representing an economy, is in fact a tautology, i.e. true by construction of their logical form. Therefore, all conclusions derived from models in economics are tautologies. The question we should ask is whether the conclusions that result from those tautologies correspond to the real world. And if not, what is wrong with our initial premises from which those conclusions follow. Simply stating some conclusion is a tautology is not a valid argument against MMT or any theoretical model of the economy for that matter. You need to explain why the tautology in question is wrong.
The claim Kelton is asserting, that the public sector deficit is equal to the private sector surplus, is derived from national accounting identities, which are the basis for how we construct our measure of GDP, which we aggregate from the summation of consumption, investment, government expenditure, and net exports.
(1) GDP = C + I + G + (X - M)
Equation (1) should be uncontroversial. This is how the Bureau of Economic Analysis calculates GDP. However, we can transform the equation to Gross National Product by brining in the net foreign income flows (FNI) which result from dividend and income flows of resident nationals abroad minus the flows to non-residents.
(2) GNP = C + I + G + (X - M) + FNI
The trade balance (X - M) plus FNI gives us the current account balance (CAB).
(3) GNP = C + I + G + CAB
We also generally define private sector savings as follows.
(4) S = GNP - C - T Where T is taxes to the government.
If we can agree on these definitions, then we should have no problem with the conclusion that follows when we derive the sectoral balances identity. Equation (5) follows from rearranging equation (4) such that GNP = S + C + T, moving C and T to the left hand side of the equation, and substituting it into equation (3).
(5) S + C + T = C + I + G + CAB
We can then rearrange the terms to the right side to get the sectoral balances equation in equation (4).
(6) (S - I) + (T - G) + (-CAB) = 0
Fairly straight forward is not? In case it's not obvious though, (S - I) corresponds to the private sector balance (the different between expenditures and income), while (T - G) to the government sector balance. +CAB itself indicates the position of the domestic economy with respect to the rest of the world. Taking the negative of the current account (-CAB) tells the position of the rest of the world as a sector unto itself. Thus -CAB corresponds to the foreign sector balance. Assuming (CAB) = 0, for example, we could conclude from equation (6) that S > I (private sector surplus) is only achievable when T < G (public sector deficit) to maintain equality to zero. We can also confirm this using real-world data.
The figure below plots the net lending/borrowing for the private sector (household, firms, etc.) and the government sector, with the foreign sector represented by the negative of the US current account position. The data is constructed from the National Income and Product Accounts (NIPAs) compiled by the Bureau of Economic Analysis (BEA). We can interpret bars above zero as being in surplus, while bars below zero means the sector is in deficit. This is why we take the negative of the current account position, to reflect that the foreign sector has a trade surplus when we (the US) are in deficit. Notice the bars mirror each other; indicating if the values of each sector's balance were added together, they would equal zero, just like our identity in equation (6).
So we have proven Kelton’s claim mathematically using conventional accounting identities, and we have verified it with data. Therefore, to properly debunk it, you have to go back to our initial definitions and explain what is missing.
Now we can also rearrange equation (6) in another way that makes it more explicit that private savings are a function of private sector borrowing and government expenditure.
(7) S = I + (G - T) + (CAB)
Equation (7) confirms private sector savings is a function of investment, which is financed these days mostly out of savings by firms but also bank credit and debt securities, as well as the government's deficit position, and the current account balance. This also captures both what Kelton is describing, government deficits equal private savings, but also Mason's point about money creation by banks to firms for investment which also creates private savings. However, net financial wealth for the private sector is still defined as (S - I), which means assets and liabilities net to zero in the aggregate for the sector as a whole--unless an external sector, either the government sector and or the foreign sector, is running a deficit.
Mason's comment regarding the fluctuations in value of private assets is a bit of a red herring and a good example of the fallacy of composition. All else constant, fluctuations in asset values occur through the buying and selling of those assets. If the price of a given asset increases, that is because there is now more demand for that asset than there were willing suppliers. The exchange of money for that asset just shifts around money values between traders. Mason is guilty of the fallacy of composition here because although an asset, or class of assets, maybe appreciating in value, it does not mean that net private sector wealth is also increasing in the aggregate. It just means that wealth has shifted from one group to another within the sector.
Mason's observation that the correlation between expenditure and inflation is historically contingent is an important one, but that contingency is not a mystery. It is because the US has strong political and monetary institutions. None of this is lost on MMTers who account for this in their framework using the concept of "monetary sovereignty."
A government with a high degree of monetary sovereignty generally has to meet five criteria. (1) The national government chooses the unit of account and issues currency denominated in that unit; (2) imposes a debt obligation in that unit, and (3) accepts its own currency in payment of that obligation; (4) only denominates debt instruments against itself in that unit; and (5) floats its exchange rate (if it's going to operate with an open capital account).
A country with less than reliable political and monetary institutions will be subject to economic volatility as confidence in those institutions wanes. No one, especially MMT scholars, is suggesting achieving these criteria is easy. I suspect countries bountiful in natural resources, particularly in food and energy, with a highly educated workforce, and robust political institutions, will have an easier time of it than others. Although the club of monetary sovereigns is relatively small, they have significant sway over the rest of the world economy. MMT provides a lens by which to study them and understand their advantages. There is no reason in principle why many countries could not have the level of monetary sovereignty Canada, Australia, or Japan have achieved.
This is also not to disregard the political economy of the international monetary system (IMS). Indeed, there are power dynamics between countries, particularly the global north and global south which make the task of achieving monetary sovereignty even more difficult, if not impossible in some cases without reform of the IMS. This is also not lost on MMT scholars, and one could argue that this aspect of MMT has not been theorized enough. But even lacking substantive reform to the IMS, there are steps developing and emerging market countries can take to attain a greater degree of monetary sovereignty, but it requires dispelling myths and doing away with the conventional framework of mainstream economics which paralyzes countries from the start.
Lastly, whether the Congressional Budget Office (CBO) would be the best institution to determine the impact of government spending on inflation in the economy is not really the point Kelton is making. Certainly, MMTers would not argue the CBO as presently constituted has this capacity. Nor does the Fed. The Fed’s own theory of inflation, which relies on the flawed non-accelerating interest rate of unemployment (NAIRU) paradigm, is in crisis. One Fed official admitted as much in 2017. The Financial Times reported Daniel Turillo, who had recently retired from the Fed's board of governors that year, said in a speech that economists display "a paradoxical faith in the usefulness of unobservable concepts such as the natural rate of unemployment or neutral real rate of interest, even as they expressed doubts about how robust those concepts were." Quoting him directly, Turillo was unequivocal about the problem facing policymakers at the Fed, "we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking."
What Kelton is arguing for is the establishment of new institutional capacity, one staffed with experts capable of appropriately assessing the nation's real supply constraints. The US used to have this institutional capacity--as Kelton has noted in prior interviews. During World War II, the National Resources Planning Board (1933 - 1943) was responsible for managing an inventory of the nation’s resources and inflation pressures during the war. Its “advisory [role in] national planning became a policy process bringing together social scientists, executive and legislative branches, and private and public institutions.” It was staffed with “experts, temporary consultants, and field branches [which] conducted studies of land use, multi-use water planning, natural resources, population, industrial structure, transportation, science, and technology that provided the first national inventories of significant American resources.” However, NRPB was relatively short-lived, and chronically underfunded.
But whether it’s a reconstituted NRPB, a reformed CBO, or even the Fed is not Kelton’s point. The point is this isn’t remotely how we assess public spending currently.
Mason obviously isn't the first to bring up some of these arguments. I'm only picking on him because he is a fellow heterodox economist, and I respect him. But it is frustrating that these same what-about-isms come up again and again without effort to address the already vast literature that has confronted these issues.
Aaron Medlin is a PhD student at the University of Massachusetts Amherst studying macroeconomics of private debt, monetary economics, international finance, and comparative economic systems.