MODERN MONEY AND FUNCTIONAL FINANCE L. Randall Wray, UMKC and CFEPS [email_address] UNAM May 31, 2007
The state money approach is associated with Knapp, Keynes, and Lerner, while credit money is associated with Innes and Schumpeter, and more loosely with the Circuit and endogenous money approaches. The functional finance approach is associated with Lerner. Modern Money = endogenous money + state money + credit money + functional finance
Two approaches to Money <ul><li>Dominant view: Metalist. M-theory; Monetarist </li></ul><ul><li>M itself not important; but linked to variables that matter; “real analysis” </li></ul><ul><li>M originates and evolves due to private sector attempts to reduce costs of exchange. </li></ul><ul><li>Barter spontaneously chose some MOE (sea shells, cows, rocks, landmarks, wives) </li></ul>
Commodity Money <ul><li>Value of M detd by intrinsic value; eventually settle on gold goldsmith discovers deposit multiplier </li></ul><ul><li>discovered they could lower trans costs by allowing paper to circulate, but redeemed on demand. </li></ul>
M-theory continued <ul><li>Currency school: so long as M is backed by 100% gold, private mkts will regulate and generate equilibrium. Try to make a paper money system operate as if it were a commod M system. </li></ul><ul><li>If too much M is issued relative to the backing, it will just fall in value. </li></ul>
Govt came along and screwed things up by issuing a fiat M w/o backing. Causes inflation. Too much money chasing too few goods
M-theory: international <ul><li>Since M is not related to the state, no need for each state to have its own M. Better to separate—remove ability of state to issue M. </li></ul><ul><li>Optimal Currency Area: if M evolved to reduce trans costs, no reason for separate currency. Euro and ECB </li></ul><ul><li>This is a good thing, to divorce M from fiscal authority. </li></ul>
Heterodox Approaches <ul><li>Marx, Keynes, Veblen: M-C-M’; MTP; Theory of business enterprise </li></ul><ul><li>Institutionalists: M is all bound up with power: to do good and bad; perhaps the most important institution in CapEcon </li></ul><ul><li>Post Keynesians: M and uncertainty; M and contracts; holding M </li></ul><ul><li>Chartalists: State M, bound up with sovereignty </li></ul><ul><li>Functional Finance: State M and Govt spending </li></ul>
Alternative: Chartalism or cartalism. C-theory <ul><li>Use of currency and value of M are based on the power of the issuing authority, not on intrinsic value. </li></ul><ul><li>State played central role in evolution and use of M. </li></ul><ul><li>Separate currencies not a coincidence. Tied up with sovereign power, political independence, fiscal authority functional finance. </li></ul>
Why do economists begin monetary analysis with a potted history? To focus attention on the essential characteristics, or nature, of money. We will never “know” the origins of money. First, the origins are lost “in the mists of time”—almost certainly in pre-historic time.
Second, money consists of complex social practices that include power and class relationships, socially constructed meaning, and abstract representations of social value—so it is not easy to identify those social practices that are “money”.
Origins and Nature of Money <ul><li>When we attempt to discover the origins of money, we are identifying institutionalized behaviors that appear similar to those today that we wish to identify as “money”. </li></ul><ul><li>Trying to “uncover” the origins of money is impossible or at least misguided unless it is placed within the context of a theoretical framework. </li></ul>
The typical barter story is consistent with a neoclassical, asocial, approach in which money is “natural” but “neutered”: -Social power and economic classes are purged from the analysis; -the market is exalted; -role of government is downplayed; -money is a “neutral veil” that obscures social relations. Whether barter story is “correct” in some sense is really not the issue --it is useless for understanding the way money works today.
The heterodox alternative: -locates the origin of money in credit and debt relations -Must identify the social nature of the money unit of account and the social processes that generate creditors and debtors -The unit of account is emphasized as the numeraire in which credits and debts are measured -The store of value function could also be important, for one stores wealth in the form of others’ debts -The medium of exchange function and the market are de-emphasized; indeed, one could imagine credits and debits without markets and without a medium of exchange
State or Chartalist Approach: Traces creation of a money of account to the penal system; wergild or payment of “fines” by transgressors to victims. -word for debt in most languages is synonymous with sin or guilt, reflecting these early reparations. -Until one paid the wergild fine, one was “liable”, or “indebted” to the victim. -We still think of a traffic fine as an “obligation” to pay, and speak of the criminal’s debt to society.
The debt/credit relation was involuntarily imposed and socially created to “pacify” the victim (from which comes our verb “to pay”). Wergild fines were gradually converted into “obligations” that required payment of fines, fees, tribute, tithes, and finally taxes to an authority. Eventually the obligations were standardized in a unit of account—from whence comes the money of account.
<ul><li>Eventually, authorities created price lists for items to be delivered in payment of taxes. </li></ul><ul><li>And finally the authority would “buy” items by issuing a money-thing that it would accept in payment of taxes. At this stage, money emerges as means of payment. </li></ul><ul><li>All this predates markets, indeed, sets up the necessary prerequisites for markets by </li></ul><ul><li>establishing prices; and </li></ul><ul><li>creating a need to “sell” to obtain “that which is necessary to pay taxes”. </li></ul><ul><li>So the heterodox story reverses the sequence: first taxes, then money, then prices, then markets and exchange. </li></ul>
Money is not a veil that hides the essential characteristics of the “market economy”. Rather, the money of account and those credit-debt relations are the key relations of the capitalist economy.
THE STATE THEORY OF MONEY Highlights the role played by “authorities” in the origins and evolution of money. The state imposes a liability in the form of a generalized, social, unit of account--a money--used for measuring the obligation. Once the authorities can levy such obligations, they can name what fulfills this obligation by denominating those things that can be delivered, in other words, by pricing them.
State M <ul><li>M was invented to reduce govt trans costs, not private trans costs. Before M, hard to tax anything except prod of goods & labor services. </li></ul><ul><li>But Tax in M form allows one to expand taxes to property, income, prod of services, land </li></ul><ul><li>And allows govt to buy things using M—rather than taxing exactly what it wanted </li></ul><ul><li>T creates D for the currency. Can be used to monetize a subsistence economy (Africa). Drive peasants into a monetary relation (Feudal Europe). </li></ul>
In (almost) all modern developed nations, the state accepts the currency issued by the treasury (in the US, coins), plus central bank notes (Federal Reserve notes in the US), plus bank reserves (liabilities of the central bank)—together, HPM. The state money approach might appear to be inconsistent with the credit money approach but it is not: Even state money is credit money. For the government, a dollar is a promise to ‘satisfy’, a promise to ‘redeem,’ just as all other money is.
Whether the government’s IOU is printed on paper or on a gold coin, it is indebted just the same.
What is the nature of the government’s IOU? Innes: this brings us to the “very nature of credit throughout the world”, which is “the right of the holder of the credit (the creditor) to hand back to the issuer of the debt (the debtor) the latter’s acknowledgment or obligation”. What is special about government? Its credit is “redeemable by the mechanism of taxation”: “[I]t is the tax which imparts to the obligation its ‘value’…. A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it”. (Innes 1914, p. 152) The value of the dollar is maintained by what one must do to obtain it to discharge tax liabilities.
Horizontal and Vertical State money is “leveraged” “horizontally” by the private sector
Lerner’s Functional Finance Approach This is all related to Lerner’s “money is a creature of the state” and “functional finance” approach. 1. The first principle of functional finance is that taxes should be raised only if the non-government sector has too much income; 2. The second principle is that bonds should be sold only if the non-government sector has too much money. Neither taxes nor bonds “finance” government spending. Taxes create a demand for the government’s money; bond sales are part of monetary policy that allows the CB to hit its interest rate target.
Comparison to Orthodox View of Budget Orthodoxy: G = dM + T + dB “ Monetary finance” is inflationary. “ Bond finance” leads to crowding out. Deficit finance and Ricardian Equivalents. All of these are incorrect for a Sovereign nation that issues the currency. The orthodox view of the Government Budget Constraint and the Crowding Out effect have to be dropped. All else equal, budget deficits push interest rates down as excess reserves cause the overnight rate to fall below target.
CONCLUSION: AN INTEGRATION OF THE CREDIT, STATE, AND ENDOGENOUS MONEY APPROACHES The state chooses the unit of account in which the various money things will be denominated. In all modern economies, it does this when it chooses the unit in which taxes will be denominated and names what is accepted in tax payments. Imposition of the tax liability is what makes these money things desirable in the first place. And those things will then become the (HPM) money-thing at the top of the “money pyramid” used for ultimate clearing.
CONCLUSIONS Ability to impose liabilities, name the unit of account, and issue the money used to pay taxes gives power to the authority to further the social good; allows society to organize social production. “Sovereignty” Much of the public production is undertaken by emitting state money through government purchase. Much private sector activity, in turn, takes the form of “monetary production”, or M-C-M’ as Marx put it, that is, to realize “more money”. This is mostly financed by credits and debits—that is, “private” money creation.
Because money is fundamental to these production processes, it cannot be neutral as it contributes to the creation and evolution of a “logic” to capitalism, largely “disembedding” the economy. At the same time, many of the social relations can be, and are, hidden behind a veil of money. This is most problematic with respect to misunderstanding about government budgets, where the monetary veil conceals the potential to use the monetary system in the public interest. Misunderstanding or mystification of the nature of money constrains government by the principles of “sound finance”.