The term ‘modern’ in Modern Monetary Theory (MMT) has a double meaning. On one level, ‘modern money’ is a literary reference to Keynes’ A Treatise on Money in which he suggests that the money of modern states has been chartal for at least four thousand years (see, for example, footnote 13 on page 10 of this paper by Randall Wray). On another level, the ‘modern’ in Modern Monetary Theory can be used to denote the period since the breakdown of Bretton Woods in 1971 (see, for instance, this post by Bill Mitchell that distinguishes the gold standard and Bretton Woods eras with the more recent resumption in many countries of sovereign fiat currencies). It is this second sense of the term ‘modern’ that is relevant in the present context.
A post-1971 ‘modern monetary system’ typically has three key features. Two of these features are always present. The third is optional but normally should be in place for the full benefits of modern money to be enjoyed:
1. The currency is a public monopoly. Government issues the currency and is the only entity allowed to do so.
2. The currency is not convertible into a commodity at a fixed rate. It is a fiat currency. The government does not promise to convert its currency into a precious metal or some other commodity at a set price.
3. The exchange rate is allowed to float. The government does not promise to maintain a fixed exchange rate with any foreign currency. Instead, the exchange rate is ‘flexible’ or ‘floating’. As already mentioned, this feature is usually operative, but not always.
Taking these three features together, we can say that modern money normally involves a ‘flexible-exchange-rate nonconvertible currency’, or ‘flex-rate currency’ for short.
Modern money is a public monopoly
In saying that government is the sole issuer of its money, both ‘government’ and ‘money’ are being referred to in specific ways.
Government, in the present context, refers to the ‘consolidated government sector’, which includes the fiscal and monetary authorities. In the US, for instance, the federal government includes the President and Congress at the top of the hierarchy. Congress authorizes taxing and spending measures. Below this level are the Treasury and Federal Reserve (central banking system). These serve, respectively, as the fiscal and monetary agents of Congress.
When the government spends or lends, it issues new money. The money issued is of two particular kinds, ‘physical currency’ and ‘reserves’. Physical currency comprises notes and coins. Reserves are special funds used for the final settlement of transactions. They are held by banks in accounts that they have at the central bank. Government is the sole issuer of physical currency and reserves.
Physical currency and reserves, taken together, are often referred to as high-powered money, outside money or ‘government money’. The purpose of these terms is to distinguish physical currency and reserves from other monies. A particularly important distinction is drawn between government money and ‘private bank money’.
Broader definitions of money include private bank deposits, and still broader definitions include deposits held at non-bank financial institutions. Private banks create deposits whenever they extend loans. This means that they are very much involved in money creation, in this broader sense. In fact, the vast majority of broad money creation takes the form of private bank money.
In extending loans, banks are not constrained by the balances in their reserve accounts, though they will factor the cost of acquiring reserves into their loan assessments. Banks can always obtain reserves if and when needed from other banks or from the central bank.
Even so, banks do ultimately rely on government to obtain physical currency and reserves because, as currency monopolist, government is the only source of these funds. Banks need access to physical currency and reserves because private bank deposits are banks’ promises to provide physical currency (either immediately or at some future date) to account holders as well as to have reserves sufficient to facilitate final settlement of transactions conducted from these accounts.
When a private bank requires more physical currency, the central bank debits its reserve account and delivers the physical currency. In such a situation, the bank might find itself short of reserves. If so, it will frequently be able to borrow them from another bank. But when the banking system as a whole is short of reserves, some banks will have to obtain additional reserves from the central bank. They can do this by selling previously purchased government bonds to the central bank or by borrowing from the central bank at a penalty rate. Typically this is executed as an overdraft on the bank’s reserve account.
In this way, the central bank stands ready to supply reserves to the banking system, but at a price and on terms (including acceptable collateral) of the central bank’s choosing.
With the above in mind, it is clear that only the government is in a position to guarantee the viability of the banking system as a whole. Private banks, as currency users, can become insolvent, just as private businesses and households can suffer bankruptcy. A currency-issuing government, in contrast, can never run out of money. The only constraints on its capacity to issue its own money are those it places on itself. And since it is the government, it can always alter these self-imposed rules if necessary to safeguard the monetary system or conduct appropriate monetary and fiscal policy. The constraints on a currency-issuing government should always be construed in terms of real factors rather than financial ones. Such a government’s policy effectiveness is limited by the availability of real resources and political considerations, not by its finances.
Modern money is not convertible into a commodity at a fixed rate
The reason a currency-issuing government faces no revenue constraint, only resource and political constraints, is that it makes no promise to convert its currency into anything else at a fixed rate. For example, an American who visits the Federal Reserve and hands over 20 US dollars will not get an amount of gold or foreign currency in exchange, but simply 20 US dollars.
It is possible, of course, to buy 20 dollars worth of gold, or 20 dollars worth of Japanese yen, but the amount of gold or yen received in exchange for the 20 dollars will fluctuate with conditions of production and market prices.
Since the government faces no revenue constraint in its own currency, it rarely makes sense for it to borrow in a foreign currency. Doing so would require it to obtain the foreign currency to service its debt, causing exposure to exchange-rate risk. If the foreign currency happened to appreciate relative to the domestic currency, the government could find it necessary to raise interest rates or impose austerity to prevent unfavorable exchange-rate movements. The government’s policy space would be reduced.
There is little reason to get into such difficulties. The government can always buy whatever is for sale in its own currency. The only legitimate justification for borrowing foreign currency would be if certain essential items were not for sale in the government’s currency nor obtainable in any other way. This is not an issue for governments of wealthy nations. Even in low-income countries, governments should be extremely reticent to borrow foreign currency. It would be better, where possible, to negotiate trade in real terms (an amount of real resource X for an amount of real resource Y). To the extent low-income countries do resort to borrowing in foreign currencies, it is often due to pressure from the World Bank and International Monetary Fund. Such pressure is exerted to benefit international creditors at the expense of domestic populations.
The exchange rate regime
Ideally, issuers of modern money should allow exchange rates to float. This gives the most policy space. There is then much less need to accumulate or maintain foreign exchange reserves simply to protect or manage the value of the exchange rate. In contrast, running a fixed exchange rate, or deciding to ‘peg’ a currency’s value to movements in another currency, potentially limits policy options because of the need to accumulate or maintain reserves in the other currency. Basically, within a modern monetary system, there is a continuum in which a flexible exchange rate gives maximal policy space and a fixed exchange rate minimizes policy space. The option to peg lies somewhere in between.
Fixed or pegged exchange rates are most problematic for nations running trade deficits, and the majority of nations do run trade deficits. By importing more than they export, these nations experience a depletion of foreign exchange reserves, because foreign currency is needed to pay for the imports. With a flex rate, this might cause a depreciation in the domestic currency but leave fiscal and monetary policy largely unconstrained. In contrast, with a fixed or pegged rate, the monetary authority might find it necessary to raise interest rates in an effort to attract foreign currency into the country. Such an interest-rate policy might clash with domestic policy needs. Similarly, the fiscal authorities might find it necessary to cut spending or increase taxes in an effort to slow economic activity and curb import spending. Unfortunately, another effect of such a policy is to reduce domestic demand, production and employment.
Although it is clearly better for governments of trade-deficit economies to opt for a flex-rate regime, the risks of a fixed or pegged exchange rate should not be overstated. It is always possible for the government to alter its target exchange rate if desired. Although this may be frowned upon, or incite political opposition, the decision by a currency issuer to fix or peg is always a self-imposed constraint and, as such, can be overturned at a later date. For this reason, currency-issuing governments who fix or peg do not relinquish their monetary sovereignty, unlike the European governments who have agreed to adopt the euro. This is why currency-issuing governments operating under a fixed or pegged exchange rate can still be counted among the issuers of modern money.
In practice, it is the governments of trade-surplus countries that are most likely to fix or peg exchange rates. These countries are accumulating foreign exchange reserves, which makes the choice largely unproblematic.