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Modern Monetary Theory describes our Money System at its current state

Where does money come from? Why is it usually scarce, but in crises suddenly available, almost indefinitely? From where do some governments in the era of the coronavirus disease take hundreds of billions of euros, pounds or dollars from? And why are some governments in the Eurozone unable to do this? Governments, central banks and banks: who actually creates the money, and who lends it to whom? Will our children really have to pay back these national debts at some point?

This article strives to outline the basic mechanisms underpinning our monetary system, information we need in order to answer the aforementioned questions. It does so by using the lens of Modern Monetary Theory (also known as Modern Money Theory or in short, “MMT”). At the moment, MMT is being heavily discussed for two reasons: it highlights the state monopoly on money, and it provides an alternative perspective on sovereign debt. Often the discussions and critique concentrate on normative questions about what fiscal and monetary policy should or should not do. This article instead starts from scratch, explaining our monetary system as it is, employing the descriptive elements of MMT. They offer a solid foundation as MMT is the only monetary theory that empirically studies the practice of banks, central banks and finance ministries and follows the money on its way through the balance sheets. In fact, the latest central bank publications of the European Central Bank, the Bundesbank and the Bank of England confirm the fundamental conclusions of MMT, while at the same time explicitly contradicting basic assumptions of previous mainstream monetary theory.

The descriptive part of MMT will help us to understand the different methods by which money is created, the hierarchy of government and banks, and the inseparable relationship between money and debt. To start with, the fundamental rules of our monetary system will now be briefly presented. In the long version of this article, you will find answers to questions that may arise upon reading, including information on the supranational currency of the euro, which is a more complex case, but is still a state money system to which the rules below apply.

Modern Money – The 5 Key Principles 

1.Our money is not guaranteed and limited by any other value, such as gold or silver. Our 50 Euro notes do not say: “The central bank promises you 1 ounce of gold for this note, exchangeable at any bank branch”. We only can use the 50 euros to buy whatever is offered at the price of 50 euros. Additionally, we can pay our taxes with it because the state that issues the money will accept it for all payments.  This kind of government money is called ‘fiat money’. Since it is not tied to a scarce other material, theoretically it can be produced indefinitely.

2. The state has the monopoly on its own currency and determines its monetary value. The state gives itself the monopoly over money creation as a sovereign right. Only the state has the right to produce the state currency. This also means that the state first has to create its currency in order to spend it. Only then can its people have the money to trade between each other, as well as the money to pay taxes. Therefore, first the state has to spend, and then it can tax; not the other way around. In the current COVID-19 crisis we can see in real time that the state does not need to tax first to be able to spend. It can create the money that it needs for its political purpose. Parliaments and governments can decide on the necessary spending thanks to the state’s monopoly on money creation. (See long version for technical questions on bond issuing, the relationship between the government, central bank, and banking system, and the politically imposed limitations in the Eurozone – all of which do not change the listed key principles that stem from the state’s money monopoly and accounting.) But if the state can create money, then why does it need to tax its citizens? Taxation is necessary to avoid inflation, as there would be too much money and therefore demand in the economy if the state would create every year’s budget without taxing money back. There are years when the state taxes all the money it has spent, producing a so-called ‘balanced budget’. The state can also make a ‘surplus’, taxing more money from the people than it spends into the economy. But often – especially in times of economic crisis – the state decides to tax less and to leave a part of the spending in the accounts of the populace. On the balance sheet this part is registered as ‘deficit spending’ and over the years it accumulates to create what is called ‘the national debt’. In a traditional understanding of money, the state debt is seen as a problem.

However, in the MMT analyses, the state debt is not a normal debt, like a person’s household debt, but instead represents the money created by the state that is registered as debt. It is the money that the state has spent and not taxed back – and which therefore still lies in the bank accounts of citizens, generating their savings. As long as that state deficits don’t create inflation there is no problem with national debt.

3. The state creates its currency with the help of the central bank, either on the initiative of the government for the benefit of the citizens, or on the initiative of the central bank for the financial system. The state institution that technically produces the currency is the central bank. In a fiat money system, it can theoretically create unlimited amounts of money. Technically, it cannot go bankrupt. There are two methods by which states create money. The first we have seen above: government and parliament decide via the democratic process on expenditures that then are sent to households and businesses. Here the central bank collaborates according to the relevant national or supranational law.However, the central bank can also use its own initiative to create currency. As the central bank has much less democratic legitimation, this money is designed only for the functioning of the banking sector and in exertion of the central bank’s monetary policy. This money will stay in the banking system and not spill over into private banking accounts. (See also point 4. and chart). In moments of economic crisis, we can observe how these two different types of state money creation tend to increase. The central bank itself creates large amounts of money to stabilize the banking system, and the government operates a deficit in favour of households and companies, thereby directly stimulating demand and the economy.

4. We live in a two-stage monetary system. It is not only the state, but also commercial banks that are permitted to create money. Although the state has a ‘currency monopoly’, it also allows private banks to create one kind of money. It is the deposit money in our checking and savings accounts that we use for transfers. This bank money is not the real currency, it is only second-order money. The deposit money is a promise to pay. The bank promises to us that they will cash out the deposit money at any time we want, or to transfer this promise on our behalf to a third party. We, ordinary members of society, trust this money because we can always receive state cash for it, and furthermore, because the state guarantees it through laws.The money that the banks create is called ‘bank money’ or ‘deposit money’ (or sometimes also cheque money, bank deposits or more technically, ‘giral money’). Only the private sector (which are households and companies) utilizes it for their money transfers. The state money on the other hand, is called ‘currency’, ‘central bank money’ or ‘reserves’. It comes in a very material form as cash, but also in a virtual form, as numbers in central bank accounts. The state, banks and central banks use only central bank money for their transfers between themselves. The non-cash central bank money can only be found in central bank accounts, and the bank money only in accounts of commercial banks.  Therefore, the two types of money do not mix, but circulate in separate monetary circuits. Only cash flows in both cycles and guarantees the exchangeability for us citizens (see chart).

5. Money is always produced in balance sheets and always in the form of a loan, i.e. it is registered with an equally high debt. Generating money is simple: it is entered into the balance sheet of a central bank or a commercial bank together with a corresponding debt. The medium of our money is the balance sheet, so it is virtual by its very nature, regardless of whether the balance sheet is administered in a bank book or in a computer. Nevertheless, this way of creating money has very real implications, as the party to whom the money is credited is simultaneously obliged to repay it in the future, bound by all of the corresponding legal consequences of non-repayment. The bank must now pay out the newly created money in cash or transfer it to the client.Technically, newly created money is accounted for as ‘the exchange of two receivables and two liabilities. If money is paid back to the money creator, i.e., the loan is paid off, all mutual liabilities and claims expire – and the money disappears again from the balance sheet. Money is thus created and expired in balance sheets, according to accounting regulations, within the framework of contracts, under the applicable laws. And it produces legal consequences itself. It can therefore be stated that our money is a creature of the legal system. Furthermore, our accounting system implies a fact that is often ignored but unavoidable: there must always be as much debt as money. For one party to have money, another party must have debts.

If you extrapolate these inevitable accounting rules onto the macro level, you can study the distribution of money and debt on a state or global level. For every country you can define three so-called ‘sectors’, with every economic agent belonging to one of them: 1. The private sector (households and companies), 2. The government, 3. The so-called ‘rest of the world’ (all agents in all foreign countries). Each of the three sectors as a whole can either have more assets or more liabilities in total, thus, be net savers or net debtors. If for example, the private sector in Germany wants to have net savings, the German government and/or foreign countries must have debt of the same amount. If in Germany the government does not want to take on new debt, but the private sector wants to have higher net savings, the rest of the world has to raise their debt level. If one party wants new savings, another party has to have more debt, on an individual as well as on a sectoral and global level. This is not theory, but accounting

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