MMT in Simple Parables

Modern Monetary Theorists have employed parables or simple teaching models to illustrate how sovereign currencies work. Usually the parables are used to drive home the most fundamental aspect of state or chartal money; namely, the manner in which a tax obligation underpins demand for the currency. It can be instructive to explore the parables in depth. For example, Bill Mitchell has provided a series of posts (here, here and here) adding layers of meaning to a ‘business card model’ initially due to Warren Mosler in which parents represent government and their kids represent non-government. A similar exploration is presented in Parable of a Monetary Economy. These treatments can get fairly elaborate in terms of the numerical calculations, even though the calculations themselves are elementary. This is fine for reading purposes, but when it comes to explaining the basics to a friend or colleague in a social situation it will sometimes be better to avoid numbers and tell a simple verbal story. For this purpose, another variant of Warren’s parable, which he sometimes uses as an opener in seminar presentations, seems especially suited to the purpose. It is possible to delve into the story as deeply as is likely to be necessary in most informal situations.

The parable begins as follows:

A seminar speaker named Warren gives a weekly talk in a crowded room. He announces that at the end of his talk he would like the crowd to help tidy the place. He offers to pay each helper one of his business cards. Actually, to save the bother of always needing to print business cards, he will record the payment in a spreadsheet on his laptop. Initially, no one is willing to take him up on the offer. Business cards or entries in a spreadsheet seem worthless. But Warren goes on to explain that before leaving the room, each person will be required to pay one of Warren’s business cards. His friend at the door has a gun in case anyone is thinking of making an escape. On hearing this, audience members agree to tidy up. They realize there is little choice if they want a business card.

The parable so far depicts the way in which a state money is established at inception. Warren symbolizes the consolidated government sector (including both the fiscal and monetary authorities) and his business cards represent the government’s fiat money. The audience symbolizes non-government. For now, the economy will be assumed closed, meaning there is no external sector, making ‘non-government’ and ‘domestic private sector’ synonymous.

Since fiat money has no intrinsic value, there initially seems little reason to accept it in exchange for the labor service of tidying the room. It is only when the government imposes a tax to be paid in its own currency that people desire to get hold of it. Provided the government effectively enforces the tax obligation, there will be demand for the currency.

The parable, even at this stage, illustrates several further key points.

  • It is impossible for non-government to get hold of the currency until government has actually issued it. The government must spend or lend before anyone can pay tax. In other words, government spending and lending logically precede tax payments. In fact, for non-government to free itself of all financial obligations to the state, the government must spend. A loan would simply turn a tax liability into a loan liability. Only government spending can enable non-government to extinguish its financial obligations to the state.
  • Government sets the terms on which it issues the currency. The private sector is in no position to dictate terms. The private sector needs the money to pay its taxes. In the parable, the government requires labor services in exchange for its fiat money.
  • The imposition of a tax obligation enables the government to transfer some resources (in this case labor services) to the public sector. In real terms, it is actually the government spending that effects this transfer of resources. By paying for labor services, the government entices some employment from the private to public sector. In this way, the government as agent of the people can conduct its socioeconomic program. (See the previous post for more on this point.)

So far, government net spending is zero. What the government spends it gets back in tax payments. But the parable continues:

Now that the audience members are acquainted with the system, some of them realize that they would like to save. They ask if they can earn business cards in excess of those needed to pay the tax. Some are worried that next time they attend a seminar they might need to leave early, before the clean up, to pick up the kids from school or meet a friend. Others spot a potential opportunity to make extra business cards in the future by lending at interest to audience members who find themselves short. Warren agrees that saving will be allowed. By doing extra tidying up on the present occasion, audience members can pay the tax and still save. To the extent audience members in aggregate save business cards, Warren will be spending more on wages than he receives in taxes. He understands this and is fine with it, since the cost of keeping records in his spreadsheet is negligible.

Here it is seen that once a demand has been established for the currency, members of non-government become willing to use the currency for other purposes, such as private saving. They are willing to do this because they know there is a general need within the community to obtain the currency.

This second part of the parable also illustrates the following:

  • If non-government net saves, the government will be in deficit. There is no private investment yet, so net saving (saving minus investment or, equivalently, disposable income minus private expenditure) equals saving at this stage. Whereas the government is spending more than it receives in taxes, non-government is in surplus, spending less than its income.
  • The government’s deficit exactly matches the non-government’s surplus. They are always equal, by definition. Non-government can only run a surplus if, and to the extent that, the government runs a deficit. (For more on this point, see here.)
  • Running a fiscal deficit causes no difficulty for the government. It can issue as much fiat money as is deemed necessary at negligible cost. Just as Warren in the parable conducts most transactions with his audience through spreadsheet entries, government money is created and destroyed by marking up and marking down entries on a computer screen.

A few weeks have past when we pick up the parable again:

In running deficits, Warren has been marking up audience members’ accounts when he pays them wages and marking down the accounts when he receives tax payments. One day he announces that he has decided to require himself to issue debt to match his deficit. He says he will offer to accept business cards in exchange for certificates representing his debt. Whenever audience members purchase certificates, Warren will mark down their existing accounts, which earn no interest, and mark up new special savings accounts that can earn interest if Warren wishes.

This illustrates the nature of government debt. Its issuance essentially involves shifting funds from reserve accounts (akin to checking accounts) to securities accounts (akin to savings accounts). When the debt falls due, the government simply shifts the funds along with any interest (also paid by marking up entries in a spreadsheet) back out of securities accounts and into reserves. So, shifting funds from reserves to securities is called “going into debt”; shifting them back again plus interest is called “paying off the debt”.

It is clear that even if Warren agrees to pay interest on his “debt”, the audience members cannot demand a particular interest rate or pressure him into offering a higher interest rate than he thinks appropriate. The choice for audience members is between receiving zero interest on savings in business cards or receiving at least some positive interest on certificates. The term structure of the debt is also determined solely by Warren. He could make the time to maturity as short as he liked when enticing savers out of business cards and into certificates.

This brings out the following:

  • The interest rate on government debt and its term structure is at the government’s discretion. The choice for savers is between reserves that pay no (or little) interest and interest-bearing securities.
  • The exercise of issuing government debt is actually an unnecessary one. In real-world modern monetary systems its function is to keep the interest rate at the central bank’s target rate, but this could be done without debt issuance simply by paying the policy rate on reserves. This would remove the deception that the government is going into debt in any meaningful sense.

Extending the parable a touch further, it is possible explicitly to include domestic private-sector activity as well as to introduce an external sector:

After a while audience members realize that it is convenient to use Warren’s business cards for transactions among themselves. It becomes common to do favors in exchange for business cards. Audience members also learn that there is another weekly seminar series taking place in the room adjacent to their own with a similar system in place. A seminar presenter named Pavlina issues her own business cards also backed by a ‘tidy tax’. Soon trade between the two sets of audience members becomes part of normal activity.

The transactions between audience members in Warren’s seminar symbolize activity in the domestic private sector. Pavlina’s seminar group introduces the external sector, enabling international trade.

Just as non-government is willing to hold the government’s fiat money as a form of saving provided a tax obligation is effectively enforced, it will also be willing to accept the money in private-domestic and international transactions. At the same time, individuals and corporations will be willing to hold established foreign currencies for the same reason they are willing to hold their domestic currency: there are foreigners who must obtain it to pay their taxes.

When Warren’s deficit is of the appropriate size, audience members will have access to enough business cards for their own transactions (achieved by business cards moving from hand to hand around the room or between rooms) and for meeting their tax obligations and saving needs. If this is achieved, business cards will be in sufficient abundance to enable strong activity levels yet not so plentiful as to undermine Warren’s ability to attract helpers to tidy the room.

The parallel in the real-world economy is that full employment and price stability can be maintained if the deficit is just sufficient to eliminate the output gap. This occurs when the fiscal deficit matches the amount non-government would desire to net save at full-employment output. This point is treated in greater detail in ‘Parable of a Monetary Economy’ (linked to earlier).