CMMT - Cate's Modern Monetary Theory

CMMT is a very simple model that helps expose the real impact of spending, taxes, and bonds on things like the money supply, inflation, and hyperinflation. With a few simplifications it is easier to understand at a high level what is going on. One big simplification is that the central bank and government are lumped together, as if in one big black box.

Here is the model:

1. The central bank is part of the government
2. All government spending is from newly made money (electronic or paper)
3. All money from taxes is destroyed (electronic or paper)
4. All money collected from government bond sales is destroyed
5. All government bonds are paid off with newly made money

If the government is spending more than it is getting from taxes, and it is not selling bonds, then the money supply will go up.

In this model the government can make as much money as it wants, so the only reason for taxes and bond sales is to control inflation. Since money from taxes is destroyed, taxes reduce the money supply. Bond sales temporarily reduce the money supply. As far as the effect on the money supply, a bond sale is equal to a tax and then later a stimulus check.

In this model it is easy to explain hyperinflation. If the total value of the bonds is multiples of the money supply, and government spending is twice taxes, then it will be forced to make lots of money if people stop buying bonds. The money supply will increase because spending is twice taxes, so creation is twice destruction, and because money is created to pay off bonds. If people get worried that in the future the value of money will be less then they don't want to hold bonds. However, the faster people get out of bonds the faster the government makes new money to pay off bonds, so once this process starts it feeds on itself and gets out of control. If over a year or two people get out of bonds then the money supply will increase very rapidly and you get hyperinflation.

Another way to think about it is that bond sales temporarily control inflation, but if too many bonds are paid off at the same time it can result in hyperinflation.

This CMMT model is just a slight correction to MMT or Modern Monetary Theory. While they have #1,#2,#3 above they are not consistent in how they treat bonds and do not have #4,#5. They say all government spending is from new money but then also have the government spending money from bonds. They say all spending is from new money but also say new money is not spent to pay off bonds. These errors make standard MMT far more complicated and not match reality. In particular, hyperinflation really happens but in MMT there is no reason for it. They have to say that the cause of the hyperinflation of money is outside their theory of money. This is just silly. With this little fix hyperinflation is easily explained. So CMMT is a big improvement over MMT. CMMT also stands for Corrected Modern Monetary Theory. :-)

An existing country, like the USA, could do everything it does exactly the same as it currently does and just with changes in accounting it could be like this model. Recycling tax money to be part of the money spent, instead of printing all new money, should be viewed as just a slight cost saving measure and not fundamentally changing things.

In the current system the US central bank pays its profits back to the government. So interest paid on government bonds held by the central bank mostly comes back to the government. So accounting for these as if they did not exist would not be far off. We can think of the government as just printing and spending money, instead of borrowing from the central bank, and not be far off. In reality governments never seem to reduce their total debt. We can imagine a black box around the central bank and government and ignore any accounting that goes on inside this box (social security trust fund, money owed by the government to the central bank, etc) as it does not change things in the real world.

This model is just a different way of thinking about what is really going on. The government can print money, so it really could burn all money collected from taxes and bond sales. We can match the current system by just saying that money inside the central bank and government is not part of the money supply. In fact, the definitions for M1, M2, and M3 do not include bank reserves or excess reserves, so this is already matching reality. Government spending adds to the money supply and bond sales and taxes reduce the money supply. With this definition we can save a lot of money burning and printing.

Note that in this model there is no difference between a bank keeping money at the central bank as excess reserves and buying a bond from the government, since the government and central bank are lumped together. In both cases the money is removed from the money supply and earns interest for the bank. In this model increasing excess reserves is not increasing the money supply. This model fits with the low inflation seen over the last few years even as base money in the form of excess reserves has shot up.

In real life, when things get desperate enough that hyperinflation is a real risk, the independence of the central bank always vanishes. If the government is spending twice what it gets in taxes and needs the central bank to buy government bonds and fund the deficit it always gets it to do so. So ignoring the official separation of central bank and government is reasonable when looking at hyperinflation.

This simple model makes it easier to think about some economic issues and it is reasonable to think about existing countries in these terms.

Comments

[clintballinger]

Yes, Peter Martin is correct, his stuff is always good. Vincent, you might find this of interest to see why Peter is correct, what I was referring to above but the link didn't link clintballinger.wordpress.com/... (outline of the economy from the vertical and horizontal pov)

[clintballinger]

Hello Vincent, interesting discussion. I will have to go over the details again to see the details of your framework v MMT (and Peter Martin's comments). I thought you might find this interesting, however, in the meantime. I do think you may have bonds "wrong" - see what I mean when I get to them. Cheers, Clint
1000 CASTAWAYS: Fundamentals of Economics

[Vincent Cate]

That banks can borrow deposits from the central bank at near zero interest does make for a brave new world of banking with different limits than in the past. And yes it lets banks not worry about getting deposits.

[PeterMartin2001]

You've still not got it. Banks just issue liabilities. They don't even need to borrow from the central bank to issue those liabilities. The banks swap and cancel out each others liabilities via the contra scheme.

Effectively they create their own currencies which are pegged on a 1:1 basis with the real currency. The strength of the banks' financial assets guarantees that peg not any percentage requirement like the 90% or whatever you have mentioned. Most countries don't have any reserve requirements. The USA is somewhat unusual in that.

Of course if anyone asks a bank for cash they will get it. Or if they have to pay a tax bill the bank will settle that payment in real dollars. But the banks don't need huge amounts of central bank money to do all that. They can get by on very little.

[Vincent Cate]

Banks can only loan out 90% of their deposits, by law. Now they can borrow deposits from the central bank, so if the central bank loans them unlimited amounts then they can make unlimited amounts. But really private banks can make at most a factor of 10 on their own. In hyperinflation you are getting factors of 1000x, 1,000,000x etc. Clearly the central bank is the key for hyperinflation.

[Asbytec]

Banks do not loan their assets (Fed deposits) outside the banking system, only to each other, anymore than a goldsmith would lend the gold deposits he's holding safe for the depositor. A bank will simply create a liability for you to spend (or withdraw as cash, if you choose) in the same way a goldsmith would issue a gold certificate, instead. They both issue their liabilities, not lend their assets.

[Vincent Cate]

I joined the MMT group and had an interesting discussion for a couple of hours, then was asked to leave and left. For the record, I think I was winning. :-)

[PeterMartin2001]

Winning? Yes that's what everyone says!

I'm sorry you were kicked off but as I was saying your understanding of how banks create loans is quite different from MMT theory.

This isn't from an MMT source but its pretty much the same as we'd explain it too. ie Banks create money when they lend. They don't lend out reserves. They don't lend out deposits.

http://bit.ly/1xjWJLe

[Vincent Cate]

As I said, the definition of M1 includes demand deposits and cash. So if someone makes a demand deposit and the bank loans out that cash to someone else then M1 has gone up. We can say the bank made the money supply go up when it made the loan.

If private (not central) banks could really make unlimited money then there should be some hyperinflation caused by a private bank and there is none.

[Asbytec]

"If private (not central) banks could really make unlimited money then there should be some hyperinflation caused by a private bank and there is none."

The money supply is, indeed, potentially unlimited. If a bank takes a deposit, as you describe above and folks always use in examples, were did the initial deposit money come from? Inflation has to do with the money supply relative to the goods and services it buys, hyperinflation is a different animal.

[PeterMartin2001]

"While they have #1,#2,#3 above they are not consistent in how they treat bonds and do not have #4,#5. They say all government spending is from new money but then also have the government spending money from bonds. They say all spending is from new money but also say new money is not spent to pay off bonds."

I'm not sure that's right. MMT views money essentially as an IOU of the issuer so when the issuer gets back its IOU it is effectively destroyed. That applies equally to the sales of bonds as the receipt of taxation revenue.

By the same token all spending occurs when new IOUs are written out. That too applies to the purchase of bonds.

So I don't believe your CMMT is any different from standard MMT.

But if you have a reference to indicate otherwise I'd be interested in looking into that.

[PeterMartin2001]

I did make a post to the Facebook MMT group about your five points and there seems to be no disagreement on my interpretation?

http://on.fb.me/1oJ81nc

(4th October 2014)

So I'd say the disagreement would only be in your theory of hyperinflation. MMT views both bonds and cash as government IOUs so there is not a lot of difference in principle. One bears interest the other doesn't. That interest is very low at present so in the limit when it does equal zero there is no difference at all.

So, once that is understood, it can be seen that the fuss about Quantitative Easing which is the exchange of one type of IOU for another is much ado about nothing.

That is, if the price is fair. There may still be a scandal if QE is used as a cover to pay over the odds for toxic bundles of debt, but that's another story.

[Vincent Cate]

That Facebook group is a closed group so I can not see what you wrote there or any replies others made.

Yes, in MMT monetization of debt is "just an asset swap" of no importance because they define the bonds to be part of the money supply. But in reality when the central bank is forced to monetize a huge debt they always seem to get hyperinflation. In MMT this is just a coincidence and not because of the monetization. While CMMT better explains the experimental data.

[Asbytec]

Vince, I think you're close but still misunderstand some concepts.

Yes, taxation destroys money. When the government taxes (and it's a bit more complicated than this, but...) it simply debits a bank's reserves and our demand deposit by the same amount. It's just a simple check clearing process. Debiting a bank's reserve assets also means debiting their reserve holdings at the Fed. Those reserves are then credited to the Treasury's general checking account which is also a Fed liability. These reserves are what the government spends back into the economy later.

Our deposit is simply debited and our money as a bank liability goes no where. Thus our taxed demand deposit money does not fund the government. It is simply debited out of existence. It's destroyed. At the same time, the reserves held at the Fed are credited to the Treasury which is not part of the base money supply. The government could pay off some debt crediting those reserves back into the banking system by crediting the bank's reserve assets thus crediting the bond holders account. The bond disappears and the former bond holder now has liquid cash credited to his account.

The process of crediting and debiting bank reserve (bank asset) accounts, as Fed liability side transactions, similarly debits and credits our demand deposits (bank liabilities.) Our money appears and disappears accordingly.

The process for a bond purchase is similar, except that the money really does not disappear. It is credited to a government bond, it's a savings account and not a fiscal funding tool. Our money is always a liability of something or someone. In the case of borrowing, the asset is a bond and the liability side of that bond is our money. It does not disappear, it just becomes less liquid and cannot be spent immediately. So, if we still hold our money in a safe government bond as a liability side entry to that asset, then who's money did the government spend? It spent reserves held at the Fed, it spent it's own money - money it created as a central bank liability when it bought the bond. And it affected the actual money supply we spend by debiting and crediting reserves in the banking system.

Taxation destroys money, borrowing saves it in a less liquid form and pays interest for deferring our spending. Yes, these transactions are monetary in nature. When the government spends, it spends by crediting and debiting the commercial banking system with Fed reserve liabilities/bank assets of it's own creation backed (mostly) by it's own debt and by the government buying private sector debt.

Lest one thinks they can cheat the system by holding FRNs directly, think about what happens when you hand carry cash to the IRS to pay your taxes. To withdraw money, you've already debited your account and bank vault cash by the same amount. Those FRNs still exist as a Fed liability. When you hand them over to the IRS, they cannot deposit Fed liabilities to the Fed's asset side on behalf of the Treasury. All that happens is the cash is accounted for and the Fed transfers some freed up reserve liabilities to the Treasury just as it would have done if you had written a check. Paying our taxation in cash claiming the government is spending our money, we simply debit the bank's vault cash and our own deposit manually. The IRS nor the government has any more use for those paper IOUs we held as our own as they simply cannot be spent by the government, anyway.

[Asbytec]

On debiting and crediting bank reserves in the act of tax collection, in some cases bond buying, and spending, the amount of reserves change across the banking system affecting the funds rate. There is a reserve effect of government fiscal policy. The Fed manages accounts through out the banking system to defend it's funds rate as base money is debited and credited from and back into the banking system.

If the government spends twice as much as its revenue, we may or may not have inflation. It all depends on how much money is circulating in the economy relative to the goods and services available for sale. The dollar is no longer pegged to gold, it is pegged to production. If the government spends exceeding output capacity, it puts upward pressure on prices causing inflation because of the monetary phenomenon. But, this is high inflation, not hyperinflation.

Hyperinflation, according to MMT, is a different animal. Everyone likes to cite Zimbabwe as the money printing evil. Turns out, land reform in Zimbabwe caused production to plummet as less productive workers inherited land from very productive, former owners or capital. This caused an economic downturn and investors pressured Zimbabwe to refund their loans to the government denominated in foreign currencies. The central bank had to print to buy foreign currency to remit foreign denominated debt. This printing sent the exchange rate plummeting and increased the domestic money supply. Thus massive printing well above the inability to produce goods and services created heavy demand on a weak supply with a debased currency that rapidly became toilet paper.

For Zimbabwe, it was the combination of a decimated economy and repaying foreign denominated debt that drove hyperinflation, not simply spending too much. The US has plenty of capacity, for now, and no foreign denominated debt.

If China wants it's money back (dollars) is can simply sell it's bonds to someone else holding dollars then spend it's dollars as it sees fit. It makes no difference to anyone. China could dump all of it's dollars in dollar denominated assets overseas or domestically. If China dumped it's dollars back into the US buying everything for sale, it would be a wonderful time for the government to tax some of it's excess money out of existence.

The thing about US debt is someone's liability is another's asset. Every dollar of US liabilities are someone's net financial asset...either cash or a bond. US debt should continually expand as our nation becomes financially wealthier and business and investors earn dollars through global trade courtesy of the US consumer who is creating most of the money supply (which pays savings and wages) through commercial bank lending, anyway. Just as a commercial bank liability is our money, the government's liabilities are someone's "money," too.

The difference is, our debt money creation must be repaid eventually netting to zero (individually) while government liabilities can persist indefinitely since the government is the monopoly issuer of the currency, anyway. It can always make good on it's dollar denominated debt. The trick is to manage the dollar and to keep it somewhat healthy - without debasing it at some high nominal rate. Outside of some developing nation's currencies, the dollar has fared very well.

[Vincent Cate]

An MMT site linked to this post and has more comments than here:
http://bit.ly/Y19mP6

One interesting comment is the idea that for every bond seller there is a bond buyer, so people can't get out. However, most bonds are short term these days so you can just hold them for a few months and get cash. Also, when the central banks are all pegging interest rates near zero you can sell a bond and they will buy it. So private parties can get out while the central bank ends up owning more. So really private parties can get out.

The other interesting comment is "we can just increase taxes to control inflation". The flaw with this one is in the numbers. If you look at a place like Japan it has effectively spent twice what it gets in taxes for many years (say equivalent of 10 years at 2x taxes). If the central bank is pegging interest rates and half the people get out, it is equal to 5 years worth of taxes. It is not possible to adjust the taxes this year enough to fight that large a problem.

[Matt Carpenter]

Thank you for laying out and simple but powerful way to look at monetary theory. Many people ignore the fact that the fed remits interest payments to the treasury, effectively allowing the govt to borrow at 0% on a sizable portion of its debt. We now hear that some, perhaps all, of the fed's holdings of treasuries will be held to maturity - which appears, to me at least, to be a euphemism for outright debt monetization. And so my question is: how big does the gap between money created and money destroyed have to be before we run into trouble in the form of a true inflation problem, or at least a serious currency devaluation with respect to stable currencies (eg Swiss) or precious metals?

[Vincent Cate]

That is the real question. It seems if the government is spending twice what they get in taxes then they have gone too far. But most countries don't really get this far before they get into trouble. The less trusted the government the sooner they get into trouble.