Tuesday, January 3, 2012

Reframing Money

You probably all know about the story of Copernicus.  In the 1500s he spread the idea that the Sun - and not the Earth - was at the center of our solar system.  Despite fierce resistance from the Church, the idea caught on and changed the way scientists think about our place in the Universe.  One part of the story you may not know is that there was such a thing as a pre-copernican astronomy.  It involved complex theories to explain the movement of planets that involved things like "epicycles" and "coils".  Believe it or not, they did a fairly decent job of predicting the movement of plaanets and forecasting eclipses.  However, as accurate as those models may have been, Copernicus's model was much simpler to understand and ended up being even more accurate.  When Copernicus changed the frame of reference from the Earth to the Sun, suddenly everything else fell into place and was much easier to understand.  To understand modern economics, we need a similar change of perspective from the old.

Most of us have a 19th century view of money.  That is, the view that money and dollars are nothing more than a unit of exchange that is representative of something concrete like gold or silver.  Granted, most people know that the gold standard has been over for over 40 years now.  However, when talking about money, we still carry the thinking and language of money as gold.  We think of dollars in terms of being physically limited, like gold.  Also like gold, we think of in terms of supply and demand - if there is more of it, it is automatically less valuable and vice verse.  We think of the government "saving" dollars like it saves gold in a vault.  We think of the government needing to hoard dollars today so that they can be used tomorrow.  This view of money comes with a (unsubstantiated) story of money that goes like this:  A long time ago humans used barter to exchange goods.  This was inconvenient so they decided to find a common unit of exchange.  Gold and Silver were settled on because they were rare and one piece of gold(or silver) was just as good as another.

An increasing number of economists are taking a different approach to understanding money and that is called Modern Monetary Theory or MMT that I've been writing about for almost a year.  Rather than thinking of money as purely a unit of exchange created spontaneously, MMT economists take a different approach. The approach was proposed, most famously, by Knapp.  He viewed Money as "a creature of the state".  MMT economists view is that money is how the government of a capitalist country brings resources to the government.  Here's how the story goes:
Say you are the head of your own country.  You want to build a new highway for your people.  To do so, you must convince people to work for you and sell you the concrete and tools you'll need to build your road.  You therefore decide to create a new currency and give it a name... say iCoin.  You offer your iCoins to people to work for you or to sell you construction equipment, but nobody accepts your offer because nobody wants an iCoin.  Therefore, as head of the government, you impose a tax on all your people of 10 iCoins that must be paid by next April 15th or be faced with jail time.  Suddenly, people need iCoins and are willing to work or sell the government equipment in exchange for iCoins that they will eventually give back to the government.  (A by product of this is that people start exchanging it with each other.)

The take away from the story is that taxes are what gives a currency value and the purpose of the currency is to make private resource public.  These concepts give us a new approach to understanding money in a modern economy.  Just like when Copernicus put the Sun at the center of the solar system, this new approach simplifies our understanding and reveals once obscure truths that now seem obvious.  I'll briefly go over a few of them, although each deserves their own blog post.

What gives Fiat money value.
As far as I'm concerned, there has never been a really good explanation of why fiat money(money with no gold backing) has value.  The traditional approaches have been less than satisfactory.  The one traditional explanation is that all fiat money grew out of gold or silver certificates and that even when the exchange was closed, people keep accepting the certificates out of habit.  The second traditional explanation - the one still taught at places like Harvard - is even less concrete.  It goes something like this "As a hair stylist, I accept dollars from my customers because I know that I can use them to buy a hamburger at my favorite restaurant which accepts my dollars because they can use it to pay their waiters who also accept dollars because they know they can use them to get a hair cut at my salon."  Both of the traditional explanation requires a leap of faith by currency users every time they accept dollars.  In the MMT approach, it is real simple why people accept dollars as a payment: "I need dollars to pay my taxes."

Extended Recessions
There are several possible causes for temporary, short-lived recessions that no economic understanding can always prevent.  However, the MMT approach provides a simple understanding of extended recessions like the one we're in now, or the ones in the early 80s and 90s.  A long term recession is caused by the government not providing enough dollars for everyone to meet their tax requirements and dollar savings desire.  Where-as the traditional approach requires understanding everything from sticky prices and wagesIS-LM charts, and Phillips curves.

Currency Value and Inflation
The traditional approach to understanding how a government can control the value of a currency is based on interest rates - The idea being that if you raise interest rates the currency becomes more valuable-, "quantity theory" if the amount of money in the system goes up then the value of the currency must (eventually) go down, and reserve levels(the amount of money banks must keep in their vaults).  The MMT approach views it differently.  MMT views that the only way a government can control the value of their currency is by the level of taxation and spending level(i.e. fiscal policy).

New Insights
In the previous 3 examples comparing the different approaches one can see that neither approach is definitively wrong or right.  Just like the ancient astronomers vs. Copernicus,  MMT just offers a different approach that makes things easier to understand.  MMT also makes a few things obvious that aren't obvious in more traditional approaches.
The first is the limits on federal spending.  Those trapped in the traditional approach believe that a government can only spend what money it gets (or will get) from taxes.  The MMT approach suggests that tax level isn't the limitation - the ability of the economy to create the resources the government wants to buy is the only limitation.  If the government deficit spends too much it'll hit resource limitations which manifests itself as inflation.  Therefore, inflation is the only limitation on government spending - not tax revenue or even borrowing.

Recessions and Inflation
Another thing MMT shows is an explanation of why governments can spend more during a recession without raising taxes.  In the traditional approach, a large budget deficit is thought to automatically cause inflation based on the "quantity theory of money".  Therefore, even during a recession when tax revenue drops and unemployment rises, it is recommended to cut spending so as not to cause inflation.

However, the MMT approach shows why that is wrong.  During a recession, people are out of work.  If the whole point of money is to bring resources to the government... then people being out-of-work means that the government has MORE room to spend because there are more resources available.  In fact, the government should not only spend more, but even tax less.  As long as the unemployed resources are available, the government has no reason to cut back during a recession.  That's why we can have 3 years of trillion dollar plus deficits and still have very low inflation.

Final Remarks
There are of course numerous other things that your understanding of is changed once money ise viewed as how the government of a capitalist country brings resources to the government.  There are too many to cover in a single post.  Not the least of which is the relationship (or lack there of) between inflation and unemployment, trade deficits, interest rates, and many more.  All these topics need their own posting to due them any justice.  I won't get into it now, but the point of this is to acknowledge that MMT completely reframes the role of money and that the reframing makes it easier to understand the real world mechanics of modern economies.

You don't have to accept MMTs reframing of money to understand all these concepts mentioned above, but just like with reframing the Earth moving around the Sun helps to understand astronomy, so does MMTs reframing of money.  Otherwise, to explain everything that we've seen just in the last 3 years we have to accept things like sticky prices, an ever-changing Phillips curve, and maybe even Ricardian equivalence.
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