A 22nd Century Thought Experiment, Or, A World Without Modern Monetary Theory

January 7, 2011

Over at the Mercenary Seeking Alpha page, the debate on Modern Monetary Theory (MMT) continues to chug along.

Like the Energizer Bunny, it just keeps going and going — 175 comments and counting. You can see them here.

I’ve tried to extricate myself multiple times, but keep getting pulled back in.

Below is an off the cuff thought experiment, dreamed up after hearing that “governments must run deficits” for the umpteenth time.

Tell me if you can see the flaw (or if you agree)…

Here is a thought experiment.

Imagine it is the 22nd century, and all forms of government have been completely privatized. What was previously the country known as the United States is now territory 22A, run by GoverCorp.

GoverCorp is a publicly traded private enterprise. It conducts all the necessary functions of the old federal government we are used to, and negotiates four year contracts with the citizens of territory 22A including the right to physical and legal enforcement.

Govercorp does not issue or administer the currency, however. Instead there is a central clearinghouse run by another corporation, ClearingCorp, which handles transactions as a form of “credits” of major corporations like Wal-Mart, General Electric, and P&G (or their 22nd century equivalents).

The economy functions as it does today in a monetary sense, except everyone’s currency is backed by the “full faith and credit” of powerful Fortune 50 corporations. The various credits issued are completely fungible, based on a seamless system of exchange facilitated by ClearingCorp.
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Meanwhile ClearingCorp, like GoverCorp, is also publicly traded and investor owned. ClearingCorp earns its profits by taking a tiny transactional cut — the equivalent of 1/100th of a cent — on every transaction conducted.

Now here are the questions:

  • Why couldn’t this scenario theoretically work?
  • In this scenario, why would it matter whether GoverCorp (the privatized version of government) issued debt (i.e. ran a deficit) or not?
  • Furthermore in this scenario, why couldn’t the necessary “deficits” to expand or contract the money supply as dictated by the economy’s needs be handled by the private corporations issuing the credits (or banks issuing loans, i.e. creating new money as debt, against the same)?

Point being, from at least a theoretical standpoint we can reason to the following:

  • No matter what, we still need a real economy. In the above example, productive wealth is embedded in the currency-issuing corporations (that presumably offer goods and services that people want and need).
  • Governments do not “have” to issue deficits. Heck, governments don’t “have” to have a damn thing to do with the money supply at all. Theoretically they can stand aside from it and collect taxes in the manner that a public utility collects payments via negotiated bargain if need be. Apart from moral questions relating to freedom, fairness and social change, it is possible for government duties to be a purely administrative function.

Given the above, what the heck happened to Modern Monetary Theory, i.e. inviolable assumptions that governments “must” run deficits… that those deficits “must” grow with the economy and so on. Where did it go?


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9 Responses to A 22nd Century Thought Experiment, Or, A World Without Modern Monetary Theory

  1. Jack Sparrow on January 7, 2011 at 12:35 am

    p.s. More food for thought from yours truly, reposted from the SA discussion thread, in response to this link: http://rodgermmitchell.wordpress.com/2009/09/07/i

    "Opinion: That said, I believe there is a point (some theorize it’s the point of full employment) at which large deficits could cause inflation. History indicates: a) We are nowhere near that point and b) Such inflation could be prevented and cured by raising interest rates."

    Goodbye fact, hello speculation — serious speculation. The point at which "large deficits could cause inflation" is very hard to define, and rooted, among other things, in slippery factors like geopolitics, psychology and reflexivity.

    As for being "nowhere near that point," this belies the binary nature of crisis, which history also shows all too clearly. To the unobservant, everything looks fine… until suddenly it doesn't.

    As for such inflation being "prevented and cured by the raising of interest rates," this shows a lack of consideration or forethought in regards to the debt burden. When an economy is struggling under a heavy weight of debt, raising interest rates carte blanche is an economy killer. This is precisely where the Von Mises prophecy comes from:


    I'm beginning to better understand the psychology of MMTers now. They appear to be comfortable assuming away fat tail risk, or criticizing an appeal to fat tail risk as alarmist, without realizing that 1) you get from here to there incrementally, and 2) once you are there, the problems you face are self-reinforcing and not so easy to solve.

    p.s. The fact that government could pay all its bills "if GDP were $0" is, again, a technically true but pragmatically ludicrous point. My neighbor's pet poodle has a GDP of $0; yet it could pay an infinite stack of bills too, could it find anyone to accept poodle paper. The entire point of a closed loop system is its ability to leverage the real productive wealth of an underlying economy — the leveraging capability based on "full faith and credit" must rest on something real. Take that away and you have nothing but a stupid pet trick.

    …And by the way, the more I look at that link, the more I see extremely heavy-handed assumptions lurking within it.

    Like this one: "Federal taxes, as a money-raising tool, are unnecessary, harmful and futile."

    Again, from a pure technical standpoint, it can be argued that taxes are redundant. But as a policy tool, a means of shaping incentives, and otherwise recognizing the different ways capital flows through an economy (some of them excessive or harmful), it's a different story.

    In the absence of actual taxes, one would also have to consider who the invisible tax burden falls upon. If the government spends a trillion dollars for the war, who pays for it? In the absence of actual tax policies, an equally distributed tax (through monetary dilution) is arguably regressive, as lower income individuals would forfeit a higher % of their gross income than higher income individuals.

    Then too there is the bond problem. "Technically" we don't need bonds either. But what if you want to draw on the wealth of foreign investors in the short run, or otherwise give them a place to park their excess credits? What would those middle eastern oil exporters have bought if not our bonds?

    And, re, the assertion that "government debt must grow" alongside the economy. Again I ask — why "must" this be so?

    If we take as a given that money is debt, but further recognize that money can be created by the banks — and, indeed, via credit in the form of novel private transactions, like the secondary gray market in Facebook shares — then why "must" government run a deficit? The historical examples where government caused problems with its withdrawal were due to temporary liquidity strains. But in this modern age, why is the private sector not theoretically capable enough, and technologically enabled enough, to create liquidity as needed — creating its own debt as well if need be, via investor / creditor exchange — without government's help?

    Again, a theoretical point… and not a challenge of the basic logic that the debt side of the government balance sheet can logically grow with the economy, just as Microsoft can safely borrow more than flybynight.com… but a theoretical point that directly challenges another supposed point of MMT orthodoxy, as to why the government "must" run a deficit, even when the job of money creation is to some degree outsourced to the private sector in a sufficiently sophisticated financial system.

    Death by a thousand cuts my good man.

  2. Trader on January 7, 2011 at 6:44 am

    This may sound like a chicken and egg question, but where would the base money of the economy come from if the government didn't spend it into existence? You mention that : " Theoretically they can stand aside from it and collect taxes in the manner that a public utility collects payments via negotiated bargain if need be." If the government perpetually taxes more than it spends(creates money), won't the supply of money will go to 0? The major flaw I see with your thought experiment is that it creates a barter system. With each corporation having its own credits, the relative worth of those credits dictates the overall price level.

    • Jack Sparrow on January 7, 2011 at 8:27 am

      Good point, except why does it particularly matter where the circle begins?

      If each corporation issues tradable credits, backed by the full faith of its own productive resources, and banks are willing to accept these as deposits and lend against the same as collateral, and the credits are smoothly fungible in a well-managed system, does it really matter where things got started?

      As for relative worth, the clearing entity (in cooperation with the corporations themselves) could monitor supply and demand conditions in real time (along with prices) and conduct open monetary operations of a sort… and Clearingcorp could even be given a mandate to adjust banks' required reserve levels…

      Deeper point here being, it doesn't necessarily matter where the circle begins as long as faith in the system is present and basic management tools are present, both of which are tools of a sufficiently advanced productive real economy and not necessarily the sole provinces of government. The "magic" of the MMT-described closed loop system is secondary to a functioning real productive economy beneath. At the end of the day, it's ALL barter to a certain abstracted degree, as the purpose of a well designed monetary system is simply to facilitate liquid mediums of exchange.

    • bankster on January 11, 2011 at 5:51 pm

      Trader — (Reposting from SA re. the need to pre-spend before borrowing):

      In the current operational reality, the Treasury cannot have a negative balance. Therefore, it has to borrow *before* it spends.

      As the Treasury borrow/spend process is continuous and the base money flows mutually cancel each other, the amount of cash the treasury bill/notes/bonds buyers should have on hand is insignificant and does not require prior spending of base money to keep it going.

      Should additional amount of base money be required to make the process smooth (keep the overnight rate at the target), the Feds happily oblige by manufacturing the needed amount of brand new FRNs through open market operations. That's pre-2007.

      Today, the situation is somewhat different due to excess of base money (about $2T), but it does not change the fact that borrowing/taxation should occur before government spending.

      The Feds interest rate games are called *monetary* policy as opposed to the Treasury *fiscal* policy. In no way does the Feds finance the Treasury directly although with QE1/2, the line between monetary-fiscal gets somewhat blurred.

      As someone mentioned before, rocket science it ain't.

  3. Charlie Price on January 7, 2011 at 8:20 am

    Hey MT. I just posted this comment at SA, but it doesn't appear to post aginst the article, so I thought I'd come visit and post it here.

    The reason your thought experiment doesn't work, goes back to how it all began.

    What happened to money when territory 22A was created? Either all dollars were suddenly worthless, or someone would accept them in exchange. But why would someone accept them in exchange? What could they do with them? If our current institutions no longer exist, then they are worthless, other than as collectibles.

    Consequently, we can assume that when territory 22A was created, all dollar wealth (cash, bank deposits, Treasuries etc.) was destroyed. Real assets would still retain some value, but realistically, everything would crash and the economy would be taken back to ground zero.

    Just before this happened, we would have seen hyper-inflation as people tried to get rid of imminently worthless dollars. Would Walmart and others still be standing after that to be able to offer credits? What would they take in exchange if they were?

    The only way to get round this is for someone, or some thing, to offer to take dollars in exchange for new currency. Walmart, GE etc won't take worthless dollars. The only entity that will do so would be a something that has the power to create new money ex nihilo.

    But what gives an entity the power to create new money ex nihilo? We can all run a printing press and churn out paper, problem is it would be worthless. No fully private entity has the power to create money ex nihilo.

    In short, what is required is an entity that has the power to make currency valuable by legally enforcing certain things, like payment of taxes in that currency. That sort of legal power only comes from a government. That entity then needs to put out more of that currency than it demands back in taxes (i.e. a deficit), because otherwise saving and investment would be impossible.

    What happens after that point is a different question. Does the government need to run subsequent deficits? That would require more than this comment to answer, but the basic answer is: it depends what sort of economy you want.

    I thought your last article pointed to some of the key weaknesses in MMT, but I don't think this thought experiment adds anything to your argument. However, I must say I admire your bravery in coming back for more punishment from the MMT crowd!

    • Jack Sparrow on January 7, 2011 at 8:57 am

      Hi Charlie,

      Thanks for the insights. I guess the punishment is relative — doesn't feel like I've taken any punishment at all, really, except maybe some unfriendly words… but then maybe yours truly is just used to good old fashioned rough and tumble debate and sees it as fun… thus far I see this whole venture as intellectually refreshing and more than worthwhile, as it has opened up some interesting avenues of thought and really helped get a bead on those guys.

      As for your objection — the handover wouldn't have to happen all at once. It could happen incrementally and by degrees.

      Imagine, if you will, a systematic privatization of federally provided services, amount by amount, bit by bit.

      Along with this process new credits, or "newbucks," could be introduced into the system, trade along dollars for a while, and then gradually expand in acceptance as the existing monetary base (oldbucks) shrank.

      The actual handover process doesn't have to be that logistically controversial, especially if spread out — think of existing processes in which countries have transitioned from one medium of exchange to another (adopting a regional currency, undergoing dollarization etc.).

      As for creating money ex nihilo etcetera, and "we can all run a printing press and churn out paper," I agree with those points wholly — EXCEPT that a sufficiently large and multi-resourced corporation would have the ability to issue paper that individuals would be willing to accept, based on a combination of psychology and available resources. Point being here that a large enough entity can represent a meaningful store of, and source of, productive wealth against which to facilitate faith and medium of exchange.

      As with Wal-Mart, for example — from the beginning, any paper that Wal-Mart issued would be redeemable for the full scope of goods and services (including groceries and gas) that Wal-Mart offers. This would certainly be a start.

      So again, playful yet serious point being, I do not see an absolute necessity for a government to be involved in this process, especially given that non-government mediums of exchange worked for better or worse (mostly worse, but mainly due to lack of technology and communication tools) in non-central bank periods of old…

  4. Jack Sparrow on January 7, 2011 at 4:06 pm

    Side note: Bunch of SA comments on this one too:

  5. Ingolf Eide on January 23, 2011 at 3:56 am

    I've come to this discussion way too late, Jack, but having long shared some of your frustrations with MMT, I couldn't resist passing on some thoughts.

    First, I'm not at all sure we need hypotheticals to dispense with MMT's more extreme assertions. After all, through much of history governments had little to do with either money or credit and when they did, they were often the supplicants. The shift from specie based private money (which arose organically and could, in extremis, do so again) to fiat money sovereign currencies was incremental and, at each stage, brought about by law.

    Even under this highly "artificial" structure, most money and credit is generated by the private sector. Only the monetary base on which this immense inverted pyramid rests is truly a creature of government (broadly defined to include the Fed).

    (I know you know all this — and in all likelihood what follows — but dealing with MMT's claims often forces us to constantly return to basics. So, apologies in advance for all the boring bits.)

    As things stand this monetary base grows when the Fed's balance sheet expands and shrinks when it contracts, which usually happens through the purchase and sale of government securities. To that extent, basic MMT theory is of course correct and they're also right that there are no constraints on a government's capacity to spend (i.e. create money) under such a system. No nominal ones, that is (their frequent failure to take proper account of the potentially yawning gap between the nominal and the real is to my mind perhaps their greatest weakness).

    It doesn't follow, though, that even fiat systems are reliant on governments running continuing deficits in order for base money to grow.

    – To begin with, the great bulk of accumulated US government deficits have been funded through the issuance of debt to the markets, not through monetisation by the Fed. Until all the recent drama, the Fed's entire balance sheet was about 15% of outstanding government debt (narrowly defined) and only around 2% of the total debt outstanding in the US; even now, with the Fed having roughly tripled its balance sheet, those figures are still only about 30% and 5% respectively. So, no shortage of existing raw material.

    – Secondly, there is in any case no particular reason why the Fed has to rely on Treasuries to expand the monetary base. As we've seen recently, mortgage-backed securities work perfectly well, and so too could corporate bonds, or for that matter damn near anything else.

    MMT enthusiasts clearly believe they've discovered something novel and profoundly important but I don't think MMT breaks much, if any, new ground. To the extent it's correct, it mostly seems a restatement of monetary basics, sometimes in a sufficiently novel fashion as to be irritatingly confusing. On the other hand, the many proposals from various proponents about the purposes this money creation capacity should be put to are highly contentious, as they always have been, and ought to be analysed on their merits, not as an offshoot of MMT. Because these two aspects are so often conflated, the resulting discussions seem to generate a whole lot more heat than light.

    MMT's one true (unintended) blessing may be to gradually give more people a better sense of just how slippery a concept fiat currency actually is.

    • Jack Sparrow on January 23, 2011 at 11:58 am

      Thanks Ingolf, and agree… I enjoyed diving into MMT for a brief period of time, but came to much the same ultimate conclusion, that there is very little "there" there. At the end of the day, the equations are tautologous and the mindset is neo-Keynesianism in drag.

      As the old criticism goes, "The thoughts of MMT are both good and original. Unfortunately what is good is not original, and what is original is not good."

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