Single and split tally sticks in the Swiss Alpine Museum – similar items may have been used in debt based economic systems thought to pre-date the use of coinage.
Credit theories of money, also called debt theories of money, are monetary economic theories concerning the relationship between credit and money. Proponents of these theories, such as Alfred Mitchell-Innes, sometimes emphasize that money and credit/debt are the same thing, seen from different points of view.
Proponents assert that the essential nature of money is credit (debt),
at least in eras where money is not backed by a commodity such as gold.
Two common strands of thought within these theories are the idea that
money originated as a unit of account for debt, and the position that money creation
involves the simultaneous creation of debt. Some proponents of credit
theories of money argue that money is best understood as debt even in
systems often understood as using commodity money. Others hold that money equates to credit only in a system based on fiat money, where they argue that all forms of money including cash can be considered as forms of credit money.
The first formal credit theory of money arose in the 19th century. Anthropologist David Graeber
has argued that for most of human history, money has been widely
understood to represent debt, though he concedes that even prior to the
modern era, there have been several periods where rival theories like metallism have held sway.
Scholarship
Four
Interrelations in theory of "credit mechanics": Fundamental differences
are relations in payment flows after given loans by commercial banks to
nonbank sector.
According to Joseph Schumpeter, the first known advocate of a credit theory of money was Plato. Schumpeter describes metallism as the other of "two fundamental theories of money", saying the first known advocate of metallism was Aristotle. The earliest modern thinker to formulate a credit theory of money was Henry Dunning Macleod (1821–1902), with his work in the 19th century, most especially with his The Theory of Credit (1889).
Macleod's work was expanded on by Alfred Mitchell-Innes in his papers What is Money? (1913) and The Credit Theory of Money (1914),
where he argued against the then conventional view of money arising as a
means to improve the practice of barter. In this alternative view, commerce and taxation created obligations between parties which were forms of credit and debt. Devices such as tally sticks were used to record these obligations and these then became negotiable instruments which could function as money. As Innes puts it in his 1914 article:
The Credit Theory is this: that a
sale and purchase is the exchange of a commodity for credit. From this
main theory springs the sub-theory that the value of credit or money
does not depend on the value of any metal or metals, but on the right
which the creditor acquires to "payment," that is to say, to
satisfaction for the credit, and on the obligation of the debtor to
"pay" his debt and conversely on the right of the debtor to release
himself from his debt by the tender of an equivalent debt owed by the
creditor, and the obligation of the creditor to accept this tender in
satisfaction of his credit.
Innes goes on to note that a major problem in getting the public to
understand the extent to which monetary systems are debt based is the
challenge in persuading them that "things are not the way they seem".
Since the late 20th century, Innes' credit theory of money has been integrated into Modern Monetary Theory. The theory also combines elements of chartalism, noting that high-powered money is functionally an IOU from the state,
and therefore, "all 'state money' is also 'credit money'". The state
ensures there is demand for its IOUs by accepting them as payment for
taxes, fees, fines, tithes, and tribute.
In his 2011 book Debt: The First 5000 Years, the anthropologist David Graeber
asserted that the best available evidence suggests the original
monetary systems were debt based, and that most subsequent systems have
been too. Exceptions where the relationship between money and debt was
less clear occurred during periods where money has been backed by bullion, as happens with a gold standard.
Graeber echoes earlier theorists such as Innes by saying that during
these eras population perception was that money derived its value from
the precious metals of which the coins were made,
but that even in these periods money is more accurately understood as
debt. Graeber states that the three main functions of money are to act
as: a medium of exchange; a unit of account; and a store of value. Graeber writes that since Adam Smith's time, economists have tended to emphasise money as a medium of exchange. For Graeber, when money first appeared its primary purpose was to act as a unit of account, to denominate debt. He writes that coins were originally created as tokens which represented a unit of account rather than being an amount of precious metal which could be bartered.
Economics commentator Philip Coggan holds that the world's current monetary system became debt-based after the Nixon shock, in which President Nixon suspended the link between money and gold in 1971. He writes that "Modern money is debt and debt is money". Since the 1971 Nixon Shock, debt creation and the creation of money increasingly took place at once. This simultaneous creation of money and debt occurs as a feature of fractional-reserve banking.
After a commercial bank approves a loan, it is able to create the
corresponding amount of money, which is then acquired by the borrower
along with a similar amount of debt.
Coggan goes on to say that debtors often prefer debt-based monetary systems such as fiat money
over commodity-based systems like the gold standard, because the former
tend to allow much higher volumes of money to circulate in the economy,
and tend to be more expansive. This makes their debts easier to repay.
Coggan refers to William Jennings Bryan's 19th century Cross of Gold speech
as one of the first great attempts to weaken the link between gold and
money; he says the former US presidential candidate was trying to expand
the monetary base
in the interests of indebted farmers, who at the time were often being
forced into bankruptcy. However Coggan also says that the excessive
debt which can be built up under a debt-based monetary system can end up
hurting all sections of society, including debtors.
In a 2012 paper, economic theorist Perry Mehrling notes that what is commonly regarded as money can often be viewed as debt. He posits a hierarchy of assets with gold at the top, then currency, then deposits and then securities. The lower down the hierarchy, the easier it is to view the asset as reflecting someone else's debt.
A later 2012 paper from Claudio Borio of the BIS made the contrary case that it is loans that give rise to deposits, rather than the other way round.
In a book published in June 2013, Felix Martin argued that credit based
theories of money are correct, citing earlier work by Macleod:
"currency ... represents transferable debt, and nothing else". Martin
writes that it's difficult for people to grasp the nature of money,
because money is such a central part of society, and alludes to the
Chinese proverb that "If you want to know what water is like, don't ask
the fish."
In 2014, Werner found:
…that
it has been empirically dem- onstrated that each individual bank
creates credit and money out of nothing, when it extends what is called a
‘bank loan’. The bank does not loan any existing money, but instead
creates new money. The money supply is created as ‘fairy dust’ produced
by the banks out of thin air.
Advocacy
The
conception that money is essentially equivalent to credit or debt has
long been used by those advocating particular reforms of the monetary
system, and by commentators calling for various monetary policy responses to events such as the financial crisis of 2007–2008.
A view held in common by most recent advocates, from all shades of
political opinion, is that money can be equated with debt in the context
of the contemporary monetary system. The view that money is equivalent
to debt even in systems based on commodity money
tends to be held only by those to the left of the political spectrum.
Regardless of any commonality in their understanding of credit theories
of money, the actual reforms proposed by advocates of different
political orientations are sometimes diametrically opposed.
Advocacy for a return to a gold standard or similar commodity based system
Former US presidential candidate Ron Paul has spoken out against fiat money, partly on the grounds that it encourages the buildup of debt.
Advocates from an Austrian School, right-libertarian
perspective often hold that money is equivalent to debt in our current
monetary system, but that it need not be in one where money is linked
to a commodity, such as a gold standard.
They have frequently used this view point to support arguments that it
would be best to return to a gold standard, to other forms of commodity
money, or at least to a monetary system where money has positive value.
Similar views are also occasionally expressed by conservatives. As an example of the latter, former British minister of state The Earl of Caithness made a 1997 speech in the House of Lords where he stated that since the 1971 Nixon shock, the British money supply
had grown by 2145% and personal debt had risen by almost 3000%. He
argued that Britain ought to move from its current "debt-based monetary
system" to one based on equity:
It is also a good time to stand
back, to reassess whether our economy is soundly based. I would contest
that it is not ... as it is debt-based ... a system which by its very
actions causes the value of money to decrease is dishonest and has
within it its own seeds of destruction. We did not vote for it. It grew
upon us gradually but markedly since 1971 when the commodity-based
system was abandoned...We all want our businesses to succeed, but under
the existing system the irony is that the better our banks, building
societies and lending institutions do, the more debt is created ...
There is a different way: it is an equity-based system and one in which
those businesses can play a responsible role. The next government must
grasp the nettle, accept their responsibility for controlling the money
supply and change from our debt-based monetary system. My Lords, will
they? If they do not, our monetary system will break us and the sorry
legacy we are already leaving our children will be a disaster.
In the early to mid-1970s, a return to a gold-anchored system was
advocated by gold-rich creditor countries including France and Germany.
A return has repeatedly been advocated by libertarians, as they tend to see commodity money as far preferable to fiat money.
Since the 2008 crisis and the rapid rise in the price of gold that soon
followed it, a return to a gold standard has frequently been advocated
by goldbugs.
From centrist
and left-wing perspectives, credit theories of money have been used to
oppose the gold standard while it was still in effect, and to reject
arguments for its reinstatement. Innes's 1914 paper is an early example
of this.
Advocacy for expansionary monetary policy
From a moderate mainstream perspective, Martin Wolf
has argued that since most money in our contemporary system is already
being dual-created with debt by private banks, there is no reason to
oppose monetary creation by central banks in order to support monetary policy such as quantitative easing.
In Wolf's view, the argument against Q.E. on the grounds that it
creates debt is offset by potential benefits to economic growth and
employment, and because the increase in debt would be temporary and easy
to reverse.
Advocacy for debt cancellation
Arguments for debt forgiveness have long been made from people of all political orientations; as an example, in 2010 hedge fund manager Hugh Hendry, a strong believer in free markets, argued for a partial cancellation of Greece's debt as part of the solution to the Euro crisis.
But generally advocates of debt forgiveness simply point out that debts
are too high in relation to the debtors’ ability to repay; they don't
make reference to a debt-based theory of money. Exceptions include David Graeber
who has used credit theories of money to argue against recent trends to
strengthen the enforcement of debt collection, such as greater use of
custodial sentences against debtors in the US. He also argued against
the over-zealous application of the view that paying one's debts is
central to morality, and has proposed the enactment of a biblical style Jubilee where debts will be cancelled for all.
Historically, debt theories of money have overlapped with chartalism and were opposed to metallism. This largely remains the case today, especially in the forms commonly held by those to the left of the political spectrum. Conversely, in the forms held by late 20th-century and 21st-century advocates with a conservative libertarian perspective, debt theories of money are often compatible with the quantity theory of money and with metallism, at least when the latter is broadly understood.
MMT is opposed to the mainstream understanding of macroeconomic theory and has been criticized heavily by many mainstream economists. MMT is also strongly opposed by members of the Austrian school of economics, with Murray Rothbard
stating that MMT practices are equivalent to "counterfeiting" and that
government control of the money supply will inevitably lead to hyperinflation.
Principles
MMT's main tenets are that a government that issues its own fiat money:
Can pay for goods, services, and financial assets without a need
to first collect money in the form of taxes or debt issuance in advance
of such purchases
Cannot be forced to default on debt denominated in its own currency
Is limited in its money creation and purchases only by inflation, which accelerates once the real resources (labour, capital and natural resources) of the economy are utilized at full employment
Recommends strengthening automatic stabilisers to control demand-pull inflation, rather than relying upon discretionary tax changes
Issues bonds as a monetary policy device, rather than as a funding device
The first four MMT tenets do not conflict with mainstream economics
understanding of how money creation and inflation works. However, MMT
economists disagree with mainstream economics about the fifth tenet: the
impact of government deficits on interest rates.
Knapp wrote in 1905 that "money is a creature of law", rather than a commodity. Knapp contrasted his state theory of money with the Gold Standard view of "metallism",
where the value of a unit of currency depends on the quantity of
precious metal it contains or for which it may be exchanged. He said
that the state can create pure paper money and make it exchangeable by
recognizing it as legal tender, with the criterion for the money of a state being "that which is accepted at the public pay offices".
Alfred Mitchell-Innes wrote in 1914 that money exists not as a medium of exchange but as a standard of deferred payment, with government money being debt the government may reclaim through taxation. Innes said:
Whenever a tax is imposed, each
taxpayer becomes responsible for the redemption of a small part of the
debt which the government has contracted by its issues of money, whether
coins, certificates, notes, drafts on the treasury, or by whatever name
this money is called. He has to acquire his portion of the debt from
some holder of a coin or certificate or other form of government money,
and present it to the Treasury in liquidation of his legal debt. He has
to redeem or cancel that portion of the debt ... The redemption of
government debt by taxation is the basic law of coinage and of any issue
of government 'money' in whatever form.
— Alfred Mitchell-Innes, "The Credit Theory of Money", The Banking Law Journal
Knapp and "chartalism" are referenced by John Maynard Keynes in the opening pages of his 1930 Treatise on Money and appear to have influenced Keynesian ideas on the role of the state in the economy.
By 1947, when Abba Lerner wrote his article "Money as a Creature
of the State", economists had largely abandoned the idea that the value
of money was closely linked to gold.
Lerner said that responsibility for avoiding inflation and depressions
lay with the state because of its ability to create or tax away money.
Hyman Minsky seemed to favor a chartalist approach to understanding money creation in his Stabilizing an Unstable Economy, while Basil Moore, in his book Horizontalists and Verticalists, lists the differences between bank money and state money.
In 1996, Wynne Godley wrote an article on his sectoral balances approach, which MMT draws from.
Rodger Malcolm Mitchell's book Free Money (1996) describes in layman's terms the essence of chartalism.
Pavlina R. Tcherneva has developed the first mathematical framework for MMT and has largely focused on developing the idea of the job guarantee.
Bill Mitchell, professor of economics and Director of the Centre of Full Employment and Equity (CoFEE)
at the University of Newcastle in Australia, coined the term 'modern monetary theory'. In their 2008 book Full Employment Abandoned, Mitchell and Joan Muysken
use the term to explain monetary systems in which national governments
have a monopoly on issuing fiat currency and where a floating exchange
rate frees monetary policy from the need to protect foreign exchange
reserves.
Some contemporary proponents, such as Wray, place MMT within post-Keynesian economics, while MMT has been proposed as an alternative or complementary theory to monetary circuit theory, both being forms of endogenous money,
i.e., money created within the economy, as by government deficit
spending or bank lending, rather than from outside, perhaps with gold.
In the complementary view, MMT explains the "vertical"
(government-to-private and vice versa) interactions, while circuit
theory is a model of the "horizontal" (private-to-private) interactions.
By 2013, MMT had attracted a popular following through academic blogs and other websites.
In 2019, MMT became a major topic of debate after U.S. Representative Alexandria Ocasio-Cortez said in January that the theory should be a larger part of the conversation.
In February 2019, Macroeconomics became the first academic textbook based on the theory, published by Bill Mitchell, Randall Wray, and Martin Watts.
MMT became increasingly used by chief economists and Wall Street
executives for economic forecasts and investment strategies. The theory
was also intensely debated by lawmakers in Japan, which was planning to
raise taxes after years of deficit spending.
In June 2020, Stephanie Kelton's MMT book The Deficit Myth became a New York Times bestseller.
In 2020 the Sri Lankan Central Bank, under the governor W. D.
Lakshman, cited MMT as a justification for adopting unconventional
monetary policy, which was continued by Ajith Nivard Cabraal. This has
been heavily criticized and widely cited as causing accelerating
inflation and exacerbating the Sri Lankan economic crisis.
MMT scholars Stephanie Kelton and Fadhel Kaboub maintain that the Sri
Lankan government's fiscal and monetary policy bore little resemblance
to the recommendations of MMT economists.
Theoretical approach
In sovereign financial systems, banks can create money, but these "horizontal" transactions do not increase net financial assets
because assets are offset by liabilities. According to MMT advocates,
"The balance sheet of the government does not include any domestic
monetary instrument on its asset side; it owns no money. All monetary
instruments issued by the government are on its liability side and are
created and destroyed with spending and taxing or bond offerings." In MMT, "vertical money" enters circulation through government spending. Taxation and its legal tender enable power to discharge debt and establish fiat money
as currency, giving it value by creating demand for it in the form of a
private tax obligation. In addition, fines, fees, and licenses create
demand for the currency. This currency can be issued by the domestic
government or by using a foreign, accepted currency.
An ongoing tax obligation, in concert with private confidence and
acceptance of the currency, underpins the value of the currency. Because
the government can issue its own currency at will, MMT maintains that
the level of taxation relative to government spending (the government's deficit spending or budget surplus) is in reality a policy tool that regulates inflation and unemployment,
and not a means of funding the government's activities by itself. The
approach of MMT typically reverses theories of governmental austerity. The policy implications of the two are likewise typically opposed.
Illustration of the saving identity with the three sectors, the computation of the surplus or deficit balances for each and the flows between them
MMT labels a transaction between a government entity (public sector) and a non-government entity (private sector) as a "vertical transaction". The government sector includes the treasury and central bank.
The non-government sector includes domestic and foreign private
individuals and firms (including the private banking system) and foreign
buyers and sellers of the currency.
Interaction between government and the banking sector
MMT
is based on an account of the "operational realities" of interactions
between the government and its central bank, and the commercial banking
sector, with proponents like Scott Fullwiler arguing that understanding
reserve accounting is critical to understanding monetary policy options.
A sovereign government typically has an operating account with
the country's central bank. From this account, the government can spend
and also receive taxes and other inflows.
Each commercial bank also has an account with the central bank, by
means of which it manages its reserves (that is, money for clearing and
settling interbank transactions).
When a government spends money, its central bank debits its
Treasury's operating account and credits the reserve accounts of the
commercial banks. The commercial bank of the final recipient will then
credit up this recipient's deposit account by issuing bank money. This
spending increases the total reserve deposits in the commercial bank
sector. Taxation works in reverse: taxpayers have their bank deposit
accounts debited, along with their bank's reserve account being debited
to pay the government; thus, deposits in the commercial banking sector
fall.
Virtually all central banks set an interest rate target, and most now
establish administered rates to anchor the short-term overnight
interest rate at their target. These administered rates include interest
paid directly on reserve balances held by commercial banks, a discount
rate charged to banks for borrowing reserves directly from the central
bank, and an Overnight Reverse Repurchase (ON RRP) facility rate paid to
banks for temporarily forgoing reserves in exchange for Treasury
securities. The latter facility is a type of open market operation
to help ensure interest rates remain at a target level. According to
MMT, the issuing of government bonds is best understood as an operation
to offset government spending rather than a requirement to finance it.
In most countries, commercial banks' reserve accounts with the
central bank must have a positive balance at the end of every day; in
some countries, the amount is specifically set as a proportion of the
liabilities a bank has, i.e., its customer deposits. This is known as a reserve requirement.
At the end of every day, a commercial bank will have to examine the
status of their reserve accounts. Those that are in deficit have the
option of borrowing the required funds from the Central Bank, where they
may be charged a lending rate (sometimes known as a discount window or discount rate)
on the amount they borrow. On the other hand, the banks that have
excess reserves can simply leave them with the central bank and earn a support rate from the central bank. Some countries, such as Japan, have a support rate of zero.
Banks with more reserves than they need will be willing to lend to banks with a reserve shortage on the interbank lending market.
The surplus banks will want to earn a higher rate than the support rate
that the central bank pays on reserves; whereas the deficit banks will
want to pay a lower interest rate than the discount rate the central
bank charges for borrowing. Thus, they will lend to each other until
each bank has reached their reserve requirement. In a balanced system,
where there are just enough total reserves for all the banks to meet
requirements, the short-term interbank lending rate will be in between
the support rate and the discount rate.
Under an MMT framework where government spending injects new
reserves into the commercial banking system, and taxes withdraw them
from the banking system,
government activity would have an instant effect on interbank lending.
If on a particular day, the government spends more than it taxes,
reserves have been added to the banking system (see vertical transactions).
This action typically leads to a system-wide surplus of reserves, with
competition between banks seeking to lend their excess reserves, forcing
the short-term interest rate down to the support rate (or to zero if a
support rate is not in place). At this point, banks will simply keep
their reserve surplus with their central bank and earn the support rate.
The alternate case is where the government receives more taxes on
a particular day than it spends. Then there may be a system-wide
deficit of reserves. Consequently, surplus funds will be in demand on
the interbank market, and thus the short-term interest rate will rise
towards the discount rate. Thus, if the central bank wants to maintain a
target interest rate somewhere between the support rate and the
discount rate, it must manage the liquidity in the system to ensure that
the correct amount of reserves is on-hand in the banking system.
Central banks manage liquidity by buying and selling government
bonds on the open market. When excess reserves are in the banking
system, the central bank sells bonds, removing reserves from the banking
system, because private individuals pay for the bonds. When
insufficient reserves are in the system, the central bank buys
government bonds from the private sector, adding reserves to the banking
system.
The central bank buys bonds by simply creating money – it is not financed in any way.
It is a net injection of reserves into the banking system. If a central
bank is to maintain a target interest rate, then it must buy and sell
government bonds on the open market in order to maintain the correct
amount of reserves in the system.
MMT economists describe any transactions within the private sector as "horizontal" transactions, including the expansion of the broad money supply through the extension of credit by banks.
MMT economists regard the concept of the money multiplier, where a bank is completely constrained in lending through the deposits it holds and its capital requirement, as misleading.
Rather than being a practical limitation on lending, the cost of
borrowing funds from the interbank market (or the central bank)
represents a profitability consideration when the private bank lends in excess of its reserve or capital requirements (see interaction between government and the banking sector).
Effects on employment are used as evidence that a currency monopolist
is overly restricting the supply of the financial assets needed to pay
taxes and satisfy savings desires.
According to MMT, bank credit should be regarded as a "leverage" of the monetary base
and should not be regarded as increasing the net financial assets held
by an economy: only the government or central bank is able to issue
high-powered money with no corresponding liability.
Stephanie Kelton said that bank money is generally accepted in
settlement of debt and taxes because of state guarantees, but that
state-issued high-powered money sits atop a "hierarchy of money".
Foreign sector
Imports and exports
MMT proponents such as Warren Mosler say that trade deficits are sustainable and beneficial to the standard of living in the short term.
Imports are an economic benefit to the importing nation because they
provide the nation with real goods. Exports, however, are an economic
cost to the exporting nation because it is losing real goods that it
could have consumed. Currency transferred to foreign ownership, however, represents a future claim over goods of that nation.
Cheap imports may also cause the failure of local firms providing
similar goods at higher prices, and hence unemployment, but MMT
proponents label that consideration as a subjective value-based one,
rather than an economic-based one: It is up to a nation to decide
whether it values the benefit of cheaper imports more than it values
employment in a particular industry.
Similarly a nation overly dependent on imports may face a supply shock
if the exchange rate drops significantly, though central banks can and
do trade on foreign exchange markets to avoid shocks to the exchange
rate.
Foreign sector and government
MMT
says that as long as demand exists for the issuer's currency, whether
the bond holder is foreign or not, governments can never be insolvent
when the debt obligations are in their own currency; this is because the
government is not constrained in creating its own fiat currency
(although the bond holder may affect the exchange rate by converting to
local currency).
MMT does agree with mainstream economics that debt in a foreign
currency is a fiscal risk to governments, because the indebted
government cannot create foreign currency. In this case, the only way
the government can repay its foreign debt is to ensure that its currency
is continually in high demand by foreigners over the period that it
wishes to repay its debt; an exchange rate collapse would potentially
multiply the debt many times over asymptotically, making it impossible
to repay. In that case, the government can default, or attempt to shift
to an export-led strategy or raise interest rates to attract foreign
investment in the currency. Either one negatively affects the economy.
Economist Stephanie Kelton explained several points made by MMT in March 2019:
Under MMT, fiscal policy
(i.e., government taxing and spending decisions) is the primary means
of achieving full employment, establishing the budget deficit at the
level necessary to reach that goal. In mainstream economics, monetary policy
(i.e., Central Bank adjustment of interest rates and its balance sheet)
is the primary mechanism, assuming there is some interest rate low
enough to achieve full employment. Kelton said that "cutting interest
rates is ineffective in a slump" because businesses, expecting weak
profits and few customers, will not invest even at very low interest
rates.
Government interest expenses are proportional to interest rates, so
raising rates is a form of stimulus (it increases the budget deficit and
injects money into the private sector, other things being equal);
cutting rates is a form of austerity.
Achieving full employment can be administered via a centrally-funded job guarantee, which acts as an automatic stabilizer. When private sector jobs are plentiful, the government spending on guaranteed jobs is lower, and vice versa.
Under MMT, expansionary fiscal policy, i.e., money creation to fund
purchases, can increase bank reserves, which can lower interest rates.
In mainstream economics, expansionary fiscal policy, i.e., debt issuance
and spending, can result in higher interest rates, crowding out
economic activity.
Economist John T. Harvey explained several of the premises of MMT and their policy implications in March 2019:
The private sector treats labor as a cost to be minimized, so it
cannot be expected to achieve full employment without government
creating jobs, too, such as through a job guarantee.
The public sector's deficit is the private sector's surplus and vice
versa, by accounting identity, which increased private sector debt
during the Clinton-era budget surpluses.
Creating money activates idle resources, mainly labor. Not doing so is immoral.
Demand can be insensitive to interest rate changes, so a key
mainstream assumption, that lower interest rates lead to higher demand,
is questionable.
There is a "free lunch" in creating money to fund government
expenditure to achieve full employment. Unemployment is a burden; full
employment is not.
Creating money alone does not cause inflation; spending it when the economy is at full employment can.
MMT says that "borrowing" is a misnomer when applied to a sovereign
government's fiscal operations, because the government is merely
accepting its own IOUs, and nobody can borrow back their own debt instruments.
Sovereign government goes into debt by issuing its own liabilities that
are financial wealth to the private sector. "Private debt is debt, but
government debt is financial wealth to the private sector."
In this theory, sovereign government is not financially
constrained in its ability to spend; the government can afford to buy
anything that is for sale in currency that it issues; there may,
however, be political constraints, like a debt ceiling
law. The only constraint is that excessive spending by any sector of
the economy, whether households, firms, or public, could cause
inflationary pressures.
MMT economists advocate a government-funded job guarantee scheme to eliminate involuntary unemployment. Proponents say that this activity can be consistent with price stability
because it targets unemployment directly rather than attempting to
increase private sector job creation indirectly through a much larger
economic stimulus, and maintains a "buffer stock" of labor that can
readily switch to the private sector when jobs become available. A job
guarantee program could also be considered an automatic stabilizer to the economy, expanding when private sector activity cools down and shrinking in size when private sector activity heats up.
MMT economists also say quantitative easing is unlikely to have the effects that its advocates hope for.[68]
Under MMT, QE – the purchasing of government debt by central banks – is
simply an asset swap, exchanging interest-bearing dollars for
non-interest-bearing dollars. The net result of this procedure is not to
inject new investment into the real economy, but instead to drive up
asset prices, shifting money from government bonds into other assets
such as equities, which enhances economic inequality. The Bank of England's analysis of QE confirms that it has disproportionately benefited the wealthiest.
MMT economists say that inflation can be better controlled (than by setting interest rates) with new or increased taxes to remove extra money from the economy. These tax increases would be on everyone, not just billionaires, since the majority of spending is by average Americans.
Comparison of MMT with mainstream Keynesian economics
MMT can be compared and contrasted with mainstream Keynesian economics in a variety of ways:
Topic
Mainstream Keynesian
MMT
Funding government spending
Advocates taxation and issuing bonds (debt) as preferred methods for funding government spending.
Emphasizes that government fund spending by crediting bank accounts.
Purpose of taxation
To pay down debt from central banks loaned to the government at
interest, which is spent into the economy and the taxpayer needs to
repay.
Primarily to drive up demand for currency. Secondary uses of
taxation include lowering inflation, reducing income inequality, and
discouraging bad behavior.
Achieving full employment
Main strategy uses monetary policy;
central bank has "dual mandate" of maximum employment and stable
prices, but these goals are not always compatible. For example, much
higher interest rates used to reduce inflation also caused high
unemployment in the early 1980s.
Main strategy uses fiscal policy; running a budget deficit large enough to achieve full employment through a job guarantee.
Inflation control
Driven by monetary policy; central bank sets interest rates consistent with a stable price level, sometimes setting a target inflation rate.
Driven by fiscal policy; government increases taxes on everyone to remove money from private sector. A job guarantee also provides a NAIBER, which acts as an inflation control mechanism.
Setting interest rates
Managed by central bank to achieve "dual mandate" of maximum employment and stable prices.
Emphasizes that an interest rate target is not a potent policy. The government may choose to maintain a zero interest-rate policy by not issuing public debt at all.
Budget deficit impact on interest rates
At full employment, higher budget deficit can crowd out investment.
Deficit spending can drive down interest rates, encouraging investment and thus "crowding in" economic activity.
In addition to the other stabilizers, a job guarantee would increase deficits in a downturn.
Criticism
A 2019 survey of leading economists by the University of Chicago Booth's Initiative on Global Markets
showed a unanimous rejection of assertions attributed by the survey to
MMT: "Countries that borrow in their own currency should not worry about
government deficits because they can always create money to finance
their debt" and "Countries that borrow in their own currency can finance
as much real government spending as they want by creating money". Directly responding to the survey, MMT economist William K. Black said "MMT scholars do not make or support either claim." Multiple MMT academics regard the attribution of these claims as a smear.
The post-Keynesian economist Thomas Palley has stated that MMT is largely a restatement of elementary Keynesian economics, but prone to "over-simplistic analysis" and understating the risks of its policy implications.
Palley has disagreed with proponents of MMT who have asserted that
standard Keynesian analysis does not fully capture the accounting
identities and financial restraints on a government that can issue its
own money. He said that these insights are well captured by standard
Keynesian stock-flow consistent IS-LM models,
and have been well understood by Keynesian economists for decades. He
claimed MMT "assumes away the problem of fiscal–monetary conflict" –
that is, that the governmental body that creates the spending budget
(e.g. the legislature) may refuse to cooperate with the governmental body that controls the money supply (e.g., the central bank). He stated the policies proposed by MMT proponents would cause serious financial instability in an open economy with flexible exchange rates, while using fixed exchange rates
would restore hard financial constraints on the government and
"undermines MMT's main claim about sovereign money freeing governments
from standard market disciplines and financial constraints".
Furthermore, Palley has asserted that MMT lacks a plausible theory of inflation, particularly in the context of full employment in the employer of last resort policy first proposed by Hyman Minsky and advocated by Bill Mitchell
and other MMT theorists; of a lack of appreciation of the financial
instability that could be caused by permanently zero interest rates; and
of overstating the importance of government-created money. Palley
concludes that MMT provides no new insights about monetary theory, while
making unsubstantiated claims about macroeconomic policy, and that MMT
has only received attention recently due to it being a "policy polemic
for depressed times".
Marc Lavoie
has said that whilst the neochartalist argument is "essentially
correct", many of its counter-intuitive claims depend on a "confusing"
and "fictitious" consolidation of government and central banking
operations, which is what Palley calls "the problem of fiscal–monetary conflict".
New Keynesian economist and recipient of the Nobel Prize in Economics, Paul Krugman,
asserted MMT goes too far in its support for government budget
deficits, and ignores the inflationary implications of maintaining
budget deficits when the economy is growing. Krugman accused MMT devotees as engaging in "calvinball" – a game from the comic strip Calvin and Hobbes in which the players change the rules at whim. Austrian School economist Robert P. Murphy stated that MMT is "dead wrong" and that "the MMT worldview doesn't live up to its promises".
He said that MMT saying cutting government deficits erodes private
saving is true "only for the portion of private saving that is not
invested" and says that the national accounting identities used to
explain this aspect of MMT could equally be used to support arguments
that government deficits "crowd out" private sector investment.
The chartalist view of money itself, and the MMT emphasis on the importance of taxes in driving money, is also a source of criticism. In 2015, three MMT economists, Scott Fullwiler, Stephanie Kelton, and L. Randall Wray, addressed what they saw as the main criticisms being made.
Stock price graph illustrating the 2020 stock market crash, showing a sharp drop in stock price, followed by a recovery
A stock market crash is a sudden dramatic decline of stock prices across a major cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic selling and underlying economic factors. They often follow speculation and economic bubbles.
A stock market crash is a social phenomenon where external economic events combine with crowd psychology in a positive feedback
loop where selling by some market participants drives more market
participants to sell. Generally speaking, crashes usually occur under
the following conditions: a prolonged period of rising stock prices (a bull market) and excessive economic optimism, a market where price–earnings ratios exceed long-term averages, and extensive use of margin
debt and leverage by market participants. Other aspects such as wars,
large corporate hacks, changes in federal laws and regulations, and
natural disasters within economically productive areas may also
influence a significant decline in the stock market value of a wide
range of stocks. Stock prices for corporations competing against the
affected corporations may rise despite the crash.
There is no numerically specific definition of a stock market crash but the term commonly applies to declines of over 10% in a stock market index over a period of several days. Crashes are often distinguished from bear markets (periods of declining stock market prices that are measured in months or years) as crashes include panic selling
and abrupt, dramatic price declines. Crashes are often associated with
bear markets; however, they do not necessarily occur simultaneously. Black Monday (1987), for example, did not lead to a bear market. Likewise, the bursting of the Japanese asset price bubble occurred over several years without any notable crashes. Stock market crashes are not common.
Crashes are generally unexpected. As Niall Ferguson
stated, "Before the crash, our world seems almost stationary,
deceptively so, balanced, at a set point. So that when the crash finally
hits — as inevitably it will — everyone seems surprised. And our brains
keep telling us it’s not time for a crash."
Tulip Mania (1634–1637), in which some single tulip bulbs allegedly sold for more than 10 times the annual income of a skilled artisan, is often considered to be the first recorded economic bubble.
In 1907 and in 1908, stock prices fell by nearly 50% due to a variety of factors, led by the manipulation of copper stocks by the Knickerbocker Trust Company. Shares of United Copper rose gradually up to October, and thereafter crashed, leading to panic.
Several investment trusts and banks that had invested their money in
the stock market fell and started to close down. Further bank runs were
prevented due to the intervention of J. P. Morgan. The panic continued to 1908 and led to the formation of the Federal Reserve in 1913.
Crowd gathering on Wall Street the day after the 1929 crash
The economy grew for most of the Roaring Twenties. It was a technological golden age, as innovations such as the radio, automobile, aviation, telephone, and the electric power transmission grid were deployed and adopted. Companies that had pioneered these advances, including Radio Corporation of America (RCA) and General Motors, saw their stocks soar. Financial corporations also did well, as Wall Street bankers floatedmutual fund companies (then known as investment trusts) like the Goldman Sachs Trading Corporation. Investors were infatuated with the returns available in the stock market, especially by the use of leverage through margin debt
(i.e., borrowing money from your stockbroker to finance part of your
purchase of stocks, using the bought securities as collateral).
On August 24, 1921, the Dow Jones Industrial Average
(DJIA) was at 63.9. By September 3, 1929, it had risen more than
sixfold to 381.2. It did not regain this level for another 25 years. By
the summer of 1929, it was clear that the economy was contracting, and
the stock market went through a series of unsettling price declines.
These declines fed investor anxiety, and events came to a head on
October 24, 28, and 29 (known respectively as Black Thursday, Black Monday, and Black Tuesday).
On Black Monday, the DJIA fell 38.33 points to 260, a drop of 12.8%. The deluge of selling overwhelmed the ticker tape system that normally gave investors the current prices of their shares. Telephone lines
and telegraphs were clogged and were unable to cope. This information
vacuum only led to more fear and panic. The technology of the New Era,
previously much celebrated by investors, now served to deepen their
suffering.
The following day, Black Tuesday, was a day of chaos. Forced to liquidate their stocks because of margin calls,
overextended investors flooded the exchange with sell orders. The Dow
fell 30.57 points to close at 230.07 on that day. The glamour stocks of
the age saw their values plummet. Across the two days, the DJIA fell
23%.
By the end of the weekend of November 11, 1929, the index stood
at 228, a cumulative drop of 40% from the September high. The markets
rallied in succeeding months, but it was a temporary recovery that led
unsuspecting investors into further losses. The DJIA lost 89% of its
value before finally bottoming out in July 1932. The crash was followed
by the Great Depression, the worst economic crisis of modern times, which plagued the stock market and Wall Street throughout the 1930s.
The mid-1980s were a time of strong economic optimism. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average
(DJIA) rose from 776 to 2722. The rise in market indices for the 19
largest markets in the world averaged 296% during this period. The
average number of shares traded on the New York Stock Exchange rose from 65 million shares to 181 million shares.
The crash on October 19, 1987, Black Monday,
was the climactic culmination of a market decline that had begun five
days before on October 14. The DJIA fell 3.81% on October 14, followed
by another 4.60% drop on Friday, October 16. On Black Monday, the DJIA
plummeted 508 points, losing 22.6% of its value in one day. The S&P 500 Index dropped 20.4%, falling from 282.7 to 225.06. The NASDAQ Composite lost only 11.3%, not because of restraint on the part of sellers, but because the NASDAQmarket system failed. Deluged with sell orders, many stocks on the NYSE faced trading halts and delays. Of the 2,257 NYSE-listed stocks, there were 195 trading delays and halts during the day. The NASDAQ market fared much worse. Because of its reliance on a "market making" system that allowed market makers
to withdraw from trading, liquidity in NASDAQ stocks dried up. Trading
in many stocks encountered a pathological condition where the bid price for a stock exceeded the ask price. These "locked" conditions severely curtailed trading. On October 19, trading in Microsoft shares on the NASDAQ lasted a total of 54 minutes.
The crash was the greatest single-day loss that Wall Street had
ever suffered in continuous trading up to that point. Between the start
of trading on October 14 to the close on October 19, the DJIA lost 760
points, a decline of over 31%.
In October 1987, all major world markets crashed or declined substantially. The FTSE 100 Index
lost 10.8% on that Monday and a further 12.2% the following day. The
least affected was Austria (a fall of 11.4%) while the most affected was
Hong Kong with a drop of 45.8%. Out of 23 major industrial countries,
19 had a decline greater than 20%.
Despite fears of a repeat of the Great Depression,
the market rallied immediately after the crash, posting a record
one-day gain of 102.27 the very next day and 186.64 points on Thursday,
October 22. It took only two years for the Dow to recover completely; by
September 1989, the market had regained all of the value it had lost in
the 1987 crash. The DJIA gained 0.6% during calendar year 1987.
No definitive conclusions have been reached on the reasons behind
the 1987 Crash. Stocks had been in a multi-year bull run and market price–earnings ratios in the U.S. were above the post-war average. The S&P 500 was trading at 23 times earnings, a postwar high and well above the average of 14.5 times earnings. Herd behavior and psychological feedback
loops play a critical part in all stock market crashes but analysts
have also tried to look for external triggering events. Aside from the
general worries of stock market overvaluation, blame for the collapse
has been apportioned to such factors as program trading, portfolio insurance and derivatives, and prior news of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a falling U.S. dollar, which seemed to imply future interest rate hikes).
One of the consequences of the 1987 Crash was the introduction of the circuit breaker or trading curb on the NYSE. Based upon the idea that a cooling-off period would help dissipate panic selling, these mandatory market shutdowns are triggered whenever a large pre-defined market decline occurs during the trading day.
The collapse of Lehman Brothers was a symbol of the Crash of 2008.OMX Iceland 15 closing prices during the five trading weeks from September 29, 2008, to October 31, 2008During the 2008 global financial crisis, the BSE Sensex experienced a sharp decline. It dropped from over 21,000 points in January 2008 to below 8,000 points in October 2008.
On September 15, 2008, the bankruptcy of Lehman Brothers and the collapse of Merrill Lynch along with a liquidity crisis of American International Group,
all primarily due to exposure to packaged subprime loans and credit
default swaps issued to insure these loans and their issuers, rapidly
devolved into a global crisis. This resulted in several bank failures
in Europe and sharp reductions in the value of stocks and commodities
worldwide. The failure of banks in Iceland resulted in a devaluation of
the Icelandic króna and threatened the government with bankruptcy. Iceland obtained an emergency loan from the International Monetary Fund in November.
In the United States, 15 banks failed in 2008, while several others
were rescued through government intervention or acquisitions by other
banks. On October 11, 2008, the head of the International Monetary Fund (IMF) warned that the world financial system was teetering on the "brink of systemic meltdown".
The economic crisis caused countries to close their markets temporarily.
On October 8, the Indonesian stock market halted trading, after a 10% drop in one day.
The Times of London reported that the meltdown was being called the Crash of 2008,
and older traders were comparing it with Black Monday in 1987. The fall
that week of 21% compared to a 28.3% fall 21 years earlier, but some
traders were saying it was worse. "At least then it was a short, sharp,
shock on one day. This has been relentless all week." Other media also referred to the events as the "Crash of 2008".
From October 6–10, 2008, the Dow Jones Industrial Average (DJIA)
closed lower in all five sessions. Volume levels were record-breaking.
The DJIA fell over 1,874 points, or 18%, in its worst weekly decline
ever on both a points and percentage basis. The S&P 500 fell more
than 20%. The week also set 3 top ten NYSE Group Volume Records with October 8 at #5, October 9 at #10, and October 10 at #1.
Having been suspended for three successive trading days (October
9, 10, and 13), the Icelandic stock market reopened on 14 October, with
the main index, the OMX Iceland 15,
closing at 678.4, which was about 77% lower than the 3,004.6 at the
close on October 8. This reflected that the value of the three big
banks, which had formed 73.2% of the value of the OMX Iceland 15, had
been set to zero.
On October 24, 2008, many of the world's stock exchanges
experienced the worst declines in their history, with drops of around
10% in most indices. In the U.S., the DJIA fell 3.6%, although not as much as other markets. The United States dollar and Japanese yen soared against other major currencies, particularly the British pound and Canadian dollar, as world investors sought safe havens. Later that day, the deputy governor of the Bank of England, Charlie Bean, suggested that "This is a once in a lifetime crisis, and possibly the largest financial crisis of its kind in human history."
By March 6, 2009, the DJIA had dropped 54% to 6,469 from its peak
of 14,164 on October 9, 2007, over a span of 17 months, before
beginning to recover.
Indices: S&P BSE 500
(January 2015 to November 2020). Blue highlight reflects COVID-19
period (taken to start from March 2020 as per first lockdown).Indices:
S&P BSE 500 (Period Jan – 2015 to May – 2020). Open, High, Low,
Close visible. Fall depicted in black. Rise depicted in white.
During the week of February 24–28, 2020, stock markets dropped as the COVID-19 pandemic
spread globally. The FTSE 100 dropped 13%, while the DJIA and S&P
500 Index dropped 11–12% in the biggest downward weekly drop since the financial crisis of 2007–2008.
On Monday, March 9, 2020, after the launch of the 2020 Russia–Saudi Arabia oil price war,
the FTSE and other major European stock market indices fell by nearly
8%. Asian markets fell sharply and the S&P 500 Index dropped 7.60%. The Italian FTSE MIB fell 2,323.98 points, or 11.17%.
On March 12, 2020, a day after US President Donald Trump announced a travel ban from Europe, stock prices again fell sharply. The DJIA declined 9.99% — the largest daily decline since Black Monday (1987) — despite the Federal Reserve announcing it would inject $1.5 trillion into money markets. The S&P 500 and the Nasdaq each dropped by approximately 9.5%. The major European stock market indexes all fell over 10%.
On March 16, 2020, after it became clear that a recession was inevitable, the DJIA dropped 12.93%, or 2,997 points, the largest point drop since Black Monday (1987), surpassing the drop in the prior week, the Nasdaq Composite dropped 12.32%, and the S&P 500 Index dropped 11.98%.
By the end of May 2020, the stock market indices briefly recovered to their levels at the end of February 2020.
In June 2020 the Nasdaq surpassed its pre-crash high followed by the S&P 500 in August and the Dow in November.
Mathematical theory
Random walk theory
The conventional assumption is that stock markets behave according to a random log-normal distribution. This implies that the expected volatility is the same all the time. Among others, mathematician Benoit Mandelbrot suggested as early as 1963 that the statistics prove this assumption incorrect.
Mandelbrot observed that large movements in prices (i.e. crashes) are
much more common than would be predicted from a log-normal distribution.
Mandelbrot and others suggested that the nature of market moves is
generally much better explained using non-linear analysis and concepts of chaos theory. This has been expressed in non-mathematical terms by George Soros in his discussions of what he calls reflexivity of markets and their non-linear movement. George Soros said in late October 1987, 'Mr. Robert Prechter's reversal proved to be the crack that started the avalanche'.
In 1963, Mandelbrot proposed that instead of following a strict random walk, stock price variations executed a Lévy flight.
A Lévy flight is a random walk that is occasionally disrupted by large
movements. In 1995, Rosario Mantegna and Gene Stanley analyzed a million
records of the S&P 500 Index, calculating the returns over a five-year period. Researchers continue to study this theory, particularly using computer simulation of crowd behavior, and the applicability of models to reproduce crash-like phenomena.
Result of investor imitation
In 2011, using statistical analysis tools of complex systems, research at the New England Complex Systems Institute found that the panics that lead to crashes come from a dramatic increase in imitation
among investors, which always occurred during the year before each
market crash. When investors closely follow each other's cues, it is
easier for panic to take hold and affect the market. This work is a
mathematical demonstration of a significant advance warning sign of
impending market crashes.
Trading curbs and trading halts
One mitigation strategy has been the introduction of trading curbs, also known as "circuit breakers", which are a trading halt
in the cash market and the corresponding trading halt in the derivative
markets triggered by the halt in the cash market, all of which are
affected based on substantial movements in a broad market indicator.
Since their inception after Black Monday (1987), trading curbs have been modified to prevent both speculative gains and dramatic losses within a small time frame.
United States
There are three thresholds, which represent different levels of decline in the S&P 500 Index: 7% (Level 1), 13% (Level 2), and 20% (Level 3).
If Threshold Level 1 (a 7% drop) is breached before 3:25pm,
trading halts for a minimum of 15 minutes. At or after 3:25 pm, trading
continues unless there is a Level 3 halt.
If Threshold Level 2 (a 13% drop) is breached before 1 pm, the
market closes for two hours. If such a decline occurs between 1 pm and 2
pm, there is a one-hour pause. The market would close for the day if
stocks sank to that level after 2 pm
If Threshold Level 3 (a 20% drop) is breached, the market would close for the day, regardless of the time.
France
For the CAC 40stock market index
in France, daily price limits are implemented in cash and derivative
markets. Securities traded on the markets are divided into three
categories according to the number and volume of daily transactions.
Price limits for each security vary by category. For instance, for the
most liquid category, when the price movement of a security from the
previous day's closing price exceeds 10%, trading is suspended for 15
minutes. If the price then goes up or down by more than 5%, transactions
are again suspended for 15 minutes. The 5% threshold may apply once
more before transactions are halted for the rest of the day. When such a
suspension occurs, transactions on options based on the underlying
security are also suspended. Further, when stocks representing more than
35% of the capitalization of the CAC40 Index are halted, the
calculation of the CAC40 Index is suspended and the index is replaced by
a trend indicator. When stocks representing less than 25% of the
capitalization of the CAC40 Index are halted, trading on the derivative
markets are suspended for half an hour or one hour, and additional
margin deposits are requested.
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