Beyond MMT: How Banks Create Money and What That Means for Government Spending

Modern Monetary Theory or “MMT” has come of age. Everywhere you look it seems there are explainers for the once controversial theory that makes the case that the government can’t run out of money. The government borrows money by selling debt to big investors in the form of interest bearing bonds. When demand for these bonds starts to wane, the Reserve Bank starts buying them up with money it creates out of nowhere. When the dance is over, the treasury ends up owing money to the Reserve Bank.

This debt, owed as it is by one part of the government to another, is meaningless and consequence free. The head of the Reserve Bank isn’t going to show up at Kirribilli House and break the PMs legs. They aren’t going to send a tow truck driver around to an army barracks to start repossessing tanks, or call the sheriff to evict our elected officials from parliament so they can sell the building. Not only can the government spend any number of dollars it choses, it can do so without raising taxes. As long as there is untapped capacity (unemployed workers, unused buildings and machinery) this spending will stimulate the economy. Even as the debt grows in nominal terms (the number of dollars) it will shrink relative to GDP. But that doesn’t matter anyhow, except psychologically (it only matters if people think it does).

Obviously the government shouldn’t just print and spend infinity billion dollars. The danger of spending too much is not “going broke”, but inflation.

Conversely by printing too little they risk causing deflation. In Australia we just had the most deflationary quarter on record, so run the damn presses, already.

This is all true. But it’s only part of the story. The government is what MMT focuses on, but others in the broader category of “post keynesian” economics, like Australian heterodox economist Steve Keen, point out that the Reserve Bank isn’t the only place that creates money. Private banks do, too. This is actually where the bulk of the money circulating in the real economy comes from, and that creates problems.

When a private bank loans money out it creates money with keystrokes too, creating two values attached to your name. One is a credit — money you can spend, the other is a debt -money you owe, which they charge interest on. If the money you borrowed stays in a savings account, they might pay interest on that too, but at a lower rate than they charge on what you owe.

When you repay a loan, both values fall. The number of dollars you have access to falls, and the number of dollars you owe falls. By the time you pay back the whole loan, the original sum has been created, then destroyed. All that’s left over is the interest which the bank keeps as “profit” — if that’s even the right term. If, overall, more money is being paid back than being borrowed, the total amount of money in the economy shrinks, all other things held equal, this makes money more scarce, and more valuable — pushing prices, and therefore earnings and employment, down.

This is called “debt deflation”. And deficit spending by the government (of the kind we have seen in Australia and elsewhere recently) is the only way to avoid it — even without an external shock like the pandemic.

If the government ran balanced budgets, the banks would be the only way for new money to enter the economy. Since everyone needs to pay back the amount they borrow plus interest the creation of debt needs to constantly accelerate: New loans have to come into the economy fast enough to cover the debt from the old loans. The overall level of debt has to be constantly growing, and growing ever faster. When debt shrinks, the economy contracts, as indicated by this graph from Steve Keen, showing change in debt and the unemployment rate.

So it’s not just that the government can spend more into existence than it taxes, but that to promote the economic well being of its people, it must. Governments actually generally do this, running deficits to prevent collapse when the economy starts to wobble.

But the lack of clarity on this in public discourse prevents them from doing so as aggressively as they should. Debts and deficits are always described as necessary evils. They’re right about the necessary part, but not about the evil.

Consider the explosion of prosperity and technological progress that came out of the second world war. This wasn’t despite the governments involved running huge deficits, it was because of this. There is no reason that we can’t mobilise the economy to a similar degree towards goals other than the destruction of an external enemy; raising living standards and transitioning to sustainable technologies, for example.

Consider also the collapse and depression which preceded that war — a deflationary spiral, the likes of which we risk repeating if we refuse to move beyond a stubbornly stupid and simplistic view of money, debt, and government.



I sell mirrors in the city of the blind.

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