Explaining what is wrong with Magic Money Theory [MMT]

This was from Beachcomber in the comments:

Hi Steve, I just read a fascinating essay by Peter Smith at Quadrant: Money printing in the age of Covid

In the essay it states:

In the age of COVID-19, bonds sold to finance deficit spending are being largely or wholly bought up by respective central banks. This is manifest in banks’ holdings of deposits with their central bank and of treasury notes or bills.

In comments the question is asked as to from where the “central bank” garners the money to buy the bonds.

To which Peter Smith answers:

It creates it out of thin air cos it can.

The central bank simply issues a cheque or like instrument, drawn on the central bank, which allows the holder of the bond (assume it is a non-bank – the process is short-circuited if the holder is a bank) to lodge the cheque in its bank account. The bank correspondingly lodges the cheque with the central bank and sees its deposts with the central bank increase accordingly. The central bank now has an asset – the bond – and a corresponding liability – the bank’s deposit. It can go on doing this till the cows come home. Or, practically speaking, until inflation rears its ugly head.

Is this true? Can this continue forever? With shrinking incomes and the associated shortage of money supply, inflation seems unlikely. Peter Smith makes a distinction from Modern Monetary Theory without explaining how it is different. Can the creation of money from nothing by the Government continue forever? If so, then Andrews can reign forever!

First, if there is an authority on the banking system in Australia outside and beyond the reach of government, it is Peter Smith. He was, when I first met him, the economist for the Australian Bankers’ Association, then became the Chief Economist for the State Bank of Victoria and finally was the first Chief Executive for the Australian Payments Clearance Association. No one gets this stuff better than he does.

But let me buy into this because this is part of my expertise as well. And to follow this with any understanding you have to divide the economy into two halves. On one side is production, the actual goods and services produced, which also includes the production of inputs into the production process, such as iron ore and natural gas.

And on the other side there is the monetary side of the economy which is completely distinct. This comprises:

  • money as a medium of exchange, say a $100 note, but represents the value of goods and services so that we can sell what we produce to buy what others produce
  • money which we set aside as a store of value, such as bank accounts or superannuation savings, and
  • money which we use as a unit of account so that businesses can calculate how much things cost to produce so that they can determine what to charge so that they can calculate whether they are making a profit.

And it should be emphasised that only profit-making businesses create more value than they use up in production. Loss-making enterprises – which include virtually every activity run by governments – slow the economy, using up more value than they create. Loss-making enterprises cause the economy to contract. Only if there are other enterprises making profits – almost always private sector enterprises – can the economy expand. Without understanding that, you cannot understand the first thing about how an economy works.

Creating more money does NOT create productive resources. Giving more money to governments, or allowing them to print more money out of thin air, lets governments spend on non-productive activities which they inevitably do. Spending more on non-productive activities means less is spent on productive activities.

And adding to the problems, when the government expands the volume of money by just printing the stuff up, they undermine each of the uses money has: as a medium of exchange, as a store of value and as a unit of account. The economy can no longer be run as productively as it might have been and often even leads to a fall in real income across the entire community.

Virtually no politician I have ever met has understood this. Virtually no political leader I see in the news today understands this. All of the others are Keynesians now, who believe the mere spending of money creates jobs, growth and higher real earnings. On this they could not be more wrong.

We will be paying for this ignorance for a very long time to come.

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42 Responses to Explaining what is wrong with Magic Money Theory [MMT]

  1. mareeS

    You may like to add John Stone and the late former Finance Minister, Labor Senator Peter Walsh to the list of the few in public life who have understood this.

  2. Most people will think MMT works if the right political candidate proposed it to them.

    Sad but true.

  3. John A

    Could we add John Hyde (“Dry”) to the little list?

  4. Tim Neilson

    I don’t disagree at all.

    But there is one other aspect. Providing basic healthcare or other necessities of life to those who can’t afford them isn’t always altogether a “waste”. It may be a waste if e.g. excessive “welfare” enables people to be net recipients when they ought to be pulling their own weight. But some things e.g. military service pensions may be justified even though they’re not “productive”. It’s just that we need to see any such taxpayer funded expenditure for what it is, something that has to be paid for out of production, rather than deluding ourselves that we can borrow our way out of debt or tax ourselves into prosperity.

  5. Peter Greagg

    Fun fact about John Stone (former Commonwealth Treasury Secretary) is that his first degree was a First Class Honours in Mathematical Physics. It was after he won his Rhodes Scholarship that he studied economics.

  6. Steve Kates

    I have amended the article slightly to take out any names of people who I think do get the point. In a world where all economists are taught Keynesian theory alone, such people are much rarer than you think.

  7. Beachcomber

    Thanks Steve. I wasn’t expecting such a clear and complete answer!

    It’s insane! It does seem that virtually no-one in the entire Establishment understands that the Government creating money out of thin air, without producing anything in the economy, will inevitably drag us towards the oppressive misery of the Soviet Union, Venezuela etc.

  8. Gorgiasl

    Modern Monetary Theory is a misnomer, at best it is another monetary theory

  9. This reminds me of the ridiculous fairy tale that so many people fall for even after explaining why it’s a fairy tale.

    A man on tour stops by a motel in a small town looking for a room. The motelier tells him it’s $100 for the night. The man asks to see the room first. He gets a key to one after leaving a $100 note on the counter.
    As soon as the tourist leaves the reception, the motelier grabs the $100 and runs across the road to his butcher, gives the butcher the $100 and says “thanks mate, my debt to you is settled.”

    As soon as the butcher gets the $100, he runs next door where a prostitute lives, gives the $100 to the pro and says “thanks love, I don’t owe you anything anymore.”
    The pro grabs the bill, runs across the road to the motel and gives the $100 to the motelier and says “thanks for the use of the rooms, my debt to you is paid.”
    A moment later the tourist comes back to the reception, says he isn’t happy with the room, takes his $100 back and leaves for the next town.

    People believe the town’s economy increased by $300 because $300 worth of debts were paid off.
    When asked the questions “why would you have needed any money at all, wouldn’t a piece of paper with IOU written on it have done the exact same job?” and “why couldn’t you write endless numbers of IOU’s with any amounts you like to increase the economy exponentially?” the response is “you can.”

    They don’t seem to understand that money is just a representation of value created.
    Somebody somewhere has to first grow it or raise it or catch it or dig it up or cut it down to start the value creation chain.

  10. sfw

    “In the age of COVID-19, bonds sold to finance deficit spending are being largely or wholly bought up by respective central banks. This is manifest in banks’ holdings of deposits with their central bank and of treasury notes or bills.”

    What are these bonds? Who sells them? What do they consist of? These are genuine questions, can anyone tell me? Could I produce such a bond and sell it to the gov?

  11. I’ve started to collect old currency.

    I have a 1937 crown, some shillings, sixpence, pennies and florins. Some how I got a 1937 Swiss half franc handed to me as change last year. Hmmmm…

    I also have some of the early decimal currency

    We should not have gone off the gold standard.

    You can prevericate until the cows cone home, but this QE and MMT nonsense just isn’t possible.

    Private free banking allows the issuance of currency, but it is constrained by loan book considerations. Private banks don’t want to create asset-liability imbalances on their own books

    There is no way they would fund QE unless they were forced to do so.

  12. John Bayley

    Private free banking allows the issuance of currency, but it is constrained by loan book considerations.

    ^^^
    That.
    Add to that a free market in money, rather than ‘legal tender laws’, which just perpetuate our serfdom, and you have a self-correcting situation with optimal allocation of resources.
    Anyone with an IQ of 100 or so can understand that.
    The reason it is not being practised is not due to lack of understanding, but instead with political power.

  13. John Bayley

    Providing basic healthcare or other necessities of life to those who can’t afford them isn’t always altogether a “waste”.

    It only becomes ‘waste’ if you let the government manage it.
    For a current example, have a closer look at the NDIS, the spending there and the outcomes.

    The above used to be, and could again be provided by private charity, which would have plenty of sponsors/donors if we had a flat income tax rate of no more than 10%.

    Additionally, without the government interfering in labour markets via awards, minimum wages etc, most of the ‘unemployable’ would have jobs and some dignity, too, and with them a chance of moving off the bottom of the income ranks.

  14. iamok

    Admittedly I did an MBA back when it had some use and value, but more importantly I have run businesses for many years. This government led recovery bullshit is just that, and it is such a simple and obvious concept that I am amazed so many people do not understand it.

    Free markets will generally find the most efficient and effective way to create and do the things that society needs and wants. Governments only skew markets and favour their friends who are too often those who would not survive in an open bidding scenario. And that only happens after the govts have spent millions on committees and reports that tell them again what is blindingly obvious to the normal punter.

    And then we have three levels of government when it is debatable if we need more than one frankly.

    So much huff and puff, so much waste, so much corruption.

  15. duncanm

    Steve,

    thanks for the explanation – but you didn’t address the question regarding Peter Smith’s distinction.

    Or are you being too subtle for this dense bird – and you think he’s talking shit?

  16. Entropy

    And then we have three levels of government when it is debatable if we need more than one frankly.

    Centralisation would create more consistency across this great nation. Thing is that includes the consistently bad with the consistently good, and you don’t know which you will mostly get.

    I prefer competitive federalism. The better ideas get adopted by others, and at worst you can always move.

  17. Adelagado

    The pushers of Miracle Money Theory are playing the long game. Its not about getting us through the pandemic. Its about eliminating all those dirty industries like coal. Hell, if you can just print money, who needs export income? Greens love this idea.

  18. 2dogs

    One aspect that I don’t get is this – why, since the GFC, have banks been so willing to allow their exchange settlement balances to rise?

    Why are they not keener to invest this off into other assets? Where a better return is to be had?

    Ultimately, it is such action by the banks which ends up causing inflation. But we aren’t getting that inflation because the banks are just sitting on these huge, bloated exchange settlement balances. Why?

  19. Colonel Crispin Berka

    but you didn’t address the question regarding Peter Smith’s distinction.

    Yeah, I didn’t get that either. Can there be any difference between issuing a debt that you never call in and plain old money printing?

  20. RobK

    Thanks Steve,
    You make a lot of sense to me.
    Sometime ago I read a book called “Currency Wars” by James Rickards. He describes, by way of background, that the gold standard was useful primarily because the rate of production loosely aligned with the rate of expansion of the economy (much of the time in earlier years). Along this line of thinking, is it possible that not only has the world economy out grown gold production, but is it possible that the quantum leap in data handling and robotics etc is adding value and expanding the economy at a much accelerated rate so it is able to absorb a lot of QE, like never before. The difficulty is judging when is too much. I expect that point may have been passed already and I suspect there should be alternative methods to QE. Can you comment on that.
    P.S. I did purchase your book Free Market Economics, but have not yet had time to consume it.

  21. bollux

    When someone tries to tell me that that dollar I saved up as part of what I earned over a 45 year working life, is only the same value as the one being cranked out from a sophisticated printer in a government office somewhere based on nothing but a bankers imagination, I instinctively know something is not right. Having converted most of my worth into bullion, I have thus far not suffered but I suspect that that will soon be under attack. They had better come well armed.

  22. Perfidious Albino

    They love the idea because they think it means never ‘running out of other people’s money’ again.

    They also think it means we no longer rely a productive private economy to generate taxable income – which means they can really put their jackboots on our necks.
    – Don’t like coal, iron ore, uranium? No problem, stop mining and exporting it.
    – Don’t think private enterprise is sufficiently woke? No problem, impose more draconian workplace laws.
    – Think breeding animals for food is cruel? No problem, mandate meat substitutes for all
    – Think irrigated agriculture is bad? No problem, shut it down
    – Public health pearl clutcher? No problem, government will provide for all so long as you comply
    – Running our of high rise dog boxes to house foreign students? No problem, Just make sure the historically leafy residential suburbs carry their fair share of the burden of high density living and French provincial mansions

    Oh, and they’ll still tax us up the wazoo to keep us dependent and paying ‘our fair share’ for their benevolence.

  23. Tel

    Most people will think MMT works if the right political candidate proposed it to them.

    Which is an intuitive understanding that this is not about economic policy, it’s merely an alternative mechanism for government to grab real resources out of the economy. Demonstrating that what most people think is kind of correct at the gut level, once you ignore the fluff and look only at the outcomes. Politics is the grabby grab game, and MMT is one of many ploys within that game.

  24. 2dogs

    Subsidiarity would be the best.

    My understanding of subsidiarity in monetary policy is that the federal government undertakes the “unit of account” function, while individual states/banks perform the other money functions.

    That is the feds say what a dollar is worth, but individual banks issue dollars (while holding the federally mandated backing).

    It is notable that the ECB isn’t structured that way, even though subsidiarity is part of the EU constitution. The EU only ever pays lip service to that concept.

    So if subsidiarity is to be part of the constitution, how do we get a framework under which it is actually enforced?

  25. Pyrmonter

    1 – something in a similar vein: https://johnhcochrane.blogspot.com/2020/07/magical-monetary-theory-full-review.html

    2 – Steve K – it’s often said that monetary expansion can’t increase output. Do you consider monetary contraction can reduce it? Was the ‘Recession we had to have’ the result of non-monetary events?

  26. Beachcomber

    John Bayley #3517871, posted on July 19, 2020 at 8:20 am

    “Providing basic healthcare or other necessities of life to those who can’t afford them isn’t always altogether a “waste”.”

    It only becomes ‘waste’ if you let the government manage it.
    For a current example, have a closer look at the NDIS, the spending there and the outcomes.

    The above used to be, and could again be provided by private charity, which would have plenty of sponsors/donors if we had a flat income tax rate of no more than 10%.

    Additionally, without the government interfering in labour markets via awards, minimum wages etc, most of the ‘unemployable’ would have jobs and some dignity, too, and with them a chance of moving off the bottom of the income ranks.

    Ain’t that the truth!

  27. Oh come on

    MMT strikes me as being one of those hoaxes that only the intelligent and very intelligent fall for (that’s not to say *all* intelligent and very intelligent people fall for it).

    Less intelligent people may come to understand the rationale of MMT and not be able to refute the theory, but they reject it intuitively; they know that the state cannot run up debt and distribute largesse indefinitely with no consequence. They are unable to convince themselves that something can be made out of nothing, which is essentially what MMT purports to be able to do.

    It takes a degree of intelligence to rationalise that something can be made out of nothing. The more intelligent the believer, the more sophisticated the rationale will be. It’s still wrong.

  28. they know that the state cannot run up debt and distribute largesse indefinitely with no consequence

    A heroic assumption.

  29. Oh come on

    Not at all, dot. Ask the average man in the street if the state can run up debt and distribute largesse indefinitely with no consequence and he’ll answer ‘no’. Ask an MMT acolyte that same question and they’ll answer ‘yes’ or perhaps ‘with the right policy settings, yes’.

  30. I am not sure the man on the street is catching the Clapham omnibus anymore.

  31. Peter Smith

    I define MMT in my Quadrant essay. I may be not have been clear enough in distinguishing between MMT and what is now happening. Cut down, MMT is a theory that government spending can remedy unemployment. To that extent it is Keynesian. Both MMT advocates and Keynesians see inflation queering their pitch. Only MMT advocates have solution. This solution is an employment buffer scheme operated by government. When things are depressed the government employs more people. When things get inflationary as government spending increases, people are let go from government employment into the private sector to quieten inflation. Such an employment buffer scheme would be an administrative, unworkable, nightmare. Practically speaking, it is fanciful. The only thing I said, or meant to say more clearly, is that right now spending money has the hallmark of MMT in that the government has ‘deliberately’ created a pool of unemployed, by closing businesses down, allowing them to spend money willy-nilly without causing inflation. Nothing about the current circumstances provides any validation of MMT. Finally, whether ‘money printing’ of the magnitude we have seen and will see in the months ahead will eventually cause inflation remains to be seen. But it seems unlikely to do so in the immediate future.

  32. Pyrmonter

    @ Peter Smith

    Applying the apparatus of intermediate macro, your analysis needs to be extended slightly. ‘Government has ‘deliberately’ created a pool of unemployed …’ – well, it has, because some sectors of the service economy (hospitality, tourism, education) have been severely curtailed, but crucially – without any use of the price mechanism to re-allocate labour to other parts of the economy. In fact, government seems to persist with the metaphor the Doomlord and his co-authors have mocked of ‘freezing’ the economy, when we need the benefits of price-discovery now more than ever.

    One thing that frustrates me about MMT is that so many of its louder exponents are people – political scientists, engineers, a few journalists – who haven’t undergone the sort of basic introduction to macro that most Australian accountants used to get, and which pretty much every holder of a BEc degree – of whom there are thousands – had until last least 2000. They claim (and get away with claims) that these are novel insights. Which is odd, because I can distinctly remember them in texts as accessible as Samuelson, Nordhause, Richardson and Wallace; Jackson and McConnell; Lipsey, Langley and Mahoney and Baumol, Blinder, Gunther and Hicks.

  33. Economic history shows seignorage to be a very dangerous policy.

    Argentina, China and the US all had currency collapses in the past 240 years from what can be described as MMT. They tried to print their way out of debt and to pay for expenses.

    It is very dangerous, when the currency goes, so does the banking industry (the payments system).

    No ability to make payroll or get inventory credit is disastrous.

  34. Pyrmonter

    @ Dot

    Indeed. It amuses me that so many ‘libertarians’ cluster around the Lost Cause – the Rockwells, a regrettably large number of the Mises Institute followers and so forth – when the South engaged in conventional war finance: hyperinflation.

    https://www.richmondfed.org/-/media/richmondfedorg/publications/research/econ_focus/2005/fall/pdf/economic_history.pdf

  35. Did not know that, I was merely referring to the Continental Dollar.

  36. TPL001

    -Politics: Modern Monetary Theory creates money. It takes from the taxpayers’ future and deficit spends in the present.
    -Economics: the marginal value of each unit of exchange (i.e. the Australian dollar) diminishes, given the volume of production goods and consumption goods. That is called inflation.
    -Ethics: it is justified when the state does it; when you and I do it, it is counterfeiting! This notion highlights the reprehensible power of state monopoly in money creation.
    -Politics: MMT’s call for increased government spending via deficits is tantamount to increased spending by government on consumption goods (e.g. military, infrastructure, whether needed or not, and in typical Keynesian fashion, this expenditure is on their bridges to nowhere). This causes an increase in time preferences (i.e. there is now a higher premium on present consumption by the state, not by the citizenry). The funds are spent by government; they do not enter via the loanable funds market. MMT leads to higher time preferences and a shorter structure of production. Greater present consumption increases the demand for present consumption goods.
    -Economics: with savings, and a lower preference for present in favour of future consumption, individuals’ time preferences (for consumption in the present) are lower. Only an increase in savings provides for capital investment. This facilitates lower interest rates on the loan market, thus increasing the profitability of long-term production in higher-order capital goods’ industries; this contrasts with lower investment in (shorter-term or) lower-order production of goods and services, which are closer to consumer consumption. Is not this the same as the central bank lowering interest rates? No, because in their world, the manipulation of loan market rate of interest downwards disguises a very low savings rate, which might otherwise be reflected in a higher market rate of interest. It is subterfuge.
    -Economics: if time preferences remain lower, due to increased savings, investment and the economy expand. This produces a lengthening of the roundabout processes of production in the economy’s capitalist structure of production. It lengthens the structure of production, which in turn provides more producers’ (or capital) goods and consumers’ goods from the original volume of the factors of production (i.e. the capital stock). It produces a higher standard of living (and higher employment); this is the fruit of an advanced capitalist economy.
    -Economics: MMT is also a one-shot stimulus. It does not matter how many shots! It does not produce the sustained capital investment borne of debt and equity investment that arise from savings.
    -Politics: debt monetisation produces higher time preferences; it diverts the structure of production from what it would be without the (false) stimulus. The state burdens the economy with wasteful action and projects that would otherwise not occur in a free market. Capital consumption occurs, the economy stagnates and slows, economic retrogression ensues, or real GDP slows, and this permanently lowers living standards.
    -Economics: in simple terms, one cannot spend more than what one earns. But with one’s savings, one’s seed capital, the economy can afford to extend the contiguous stages in all industries, and produce a greater level of employment of all factors of production, a higher level of produced production goods and consumption goods and higher living standards.

    Steve’s argument, that value-adding profitable businesses grow an economy, makes a lot of sense.

  37. Mother Lode

    It has been my beef for quite some time that (most) economists and governments mistake the dynamics of the economy.

    The significance of the economy is the transfer of goods and services from one person (or business) to another, not the money that is transferred in the opposite direction. It is the value of the goods and services to the people that is the engine of it all. It can even happen in the absence of money (which case is called barter).

    They seem to think that wealth can be created by making money move about to create the impression of the transfer of wealth. It is like hiring a mime to act out walking down stairs instead of building stairs.

    And the printing of money is just adding zeroes to a price ticket, but with this one pernicious twist people seem not to realise – when the government prints more money then the money possessed by ordinary people is worth less. A bit of their spending power has been removed from them and taken by the government. But this is invisible. It does not appear on payslips or bank statements. It is never calculated or rendered into a specific amount to the person robbed.

    And the final indignity? The exercise is sold to the average Joe as being done for their benefit.

  38. Youngster

    This paragraph:

    “And it should be emphasised that only profit-making businesses create more value than they use up in production. Loss-making enterprises – which include virtually every activity run by governments – slow the economy, using up more value than they create. Loss-making enterprises cause the economy to contract. Only if there are other enterprises making profits – almost always private sector enterprises – can the economy expand. Without understanding that, you cannot understand the first thing about how an economy works.”

    explains as awful lot to a non-economist like me who understands that something isn’t right with the current approach, but can’t quite explain it.

  39. DrBeauGan

    No worries, people. We can all get hopelessly in debt, and leave it to our children to pay it off. Which they can do by borrowing more money for their children to pay off. And so on, until the last man in the world owes himself about $101000 or thereabouts.

  40. DrBeauGan

    That should have been 10^{1000} . The html died.

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