July 24, 2017

How money emerges out of nothing ― the functional account

Comment on Peter Cooper on ‘Short & Simple 10’


“Money is historically an emergent market phenomenon establishing a commodity money, but nearly all contemporary money systems are based on fiat money.”#1

“In MMT, ‘vertical’ money enters circulation through government spending. Taxation and its legal tender power to discharge debt establish the fiat money as currency, giving it value by creating demand for it in the form of a private tax obligation that must be met.”#2

Economists are storytellers, not scientists, and because of this, they explain economic phenomena historically. This is a bit dilettantish, just like physicists trying to derive the phenomena and laws of thermodynamics by recounting the history of major events from the Great Fire of Rome in AD 64 to the Great Fire of London in AD 1666. The methodological fact is that the historical approach does NOT work in science. It explains NOTHING.

Therefore, money has to be derived FUNCTIONALLY within an analytical framework that is defined in detail by
(i) Macrofoundations.#3
(ii) National Accounting, which determines the relationship between the nominal flows (wage income, consumption expenditures) and balances = differences of flows (saving/dissaving, loss/profit).#4
(iii) The relationship between the flows and balances of National Accounting and the changes in the stock of money/credit at the central bank.

Thus stock-flow consistency is secured. The pivot between stocks and flows is the positive or negative nominal balances.

In order to reduce the monetary phenomena to the essentials, it is supposed that all financial transactions are carried out (at first without costs) by the central bank. The stock of money then takes the form of current deposits or current overdrafts. From this follows: quantity of money = debit side of the central bank’s balance sheet = current deposits.

In the initial period the conditions of market-clearing and budget-balancing hold. The central bank provides the transaction medium and creates money out of nothing. Loosely speaking, it finances the business sector’s payroll, whatever it is. The economy NEVER runs out of money.

By sequencing the initially given period length of one year into months, the idealized transaction pattern that is displayed on Wikimedia AXEC86 #5 results.

It is assumed that the monthly income Yw/12 is paid out at mid-month. In the first half of the month, the daily spending of Yw/360 increases the current overdrafts of the households. At mid-month, the households change to the positive side and have current deposits of Yw/24 at their disposal. This amount reduces continuously towards the end of the month. This pattern is exactly repeated over the rest of the year. At the end of each sub-period, and therefore also at the end of the year, both the stock of money and the quantity of money are ZERO. Money is present and absent depending on the time frame of observation.

In period 2 the wage rate and the price are doubled. Since no cash balances are carried forward from one period to the next,  no real balance effect happens provided the doubling takes place exactly at the beginning of period 2.

The transaction pattern looks the SAME if employment L is doubled and productivity R, wage rate W, and price P remain unchanged. So, only the REAL variables employment L and output O double, but the transaction pattern is identical with a doubling of the NOMINAL variables wage rate W and price P. This tells one immediately that the commonplace Quantity Theory is false.

From the perspective of the central bank, it is a matter of indifference whether the household or the business sector owns current deposits. The pattern of transaction #5 translates into the AVERAGE amount of current deposits. This average stock of transaction money depends on income according to the transaction equation M=κYw.

The variable M is a straightforward period average that results from the AUTONOMOUS transactions between the business and the household sector in the elementary production-consumption economy. The central bank enables the average stock of transaction money to expand or contract with the development of wage income. Analytically (not historically), money emerges from autonomous market transactions. In order for money to come into the world, a central bank is needed that issues transaction money in parallel with expanding/contracting wage income.#6 There is NO commodity like gold and no deficit spending government needed.

Both the Quantity Theory of Money and the Chartalist Theory of Money are figments of the historical imagination.

Egmont Kakarot-Handtke

#1 Wikipedia Money
#2 Wikipedia MMT
#3 Macrofoundations are given by (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X. The nominal variables Yw and C reappear in National Accounting.
#4 See Wikimedia National accounts (a) balanced budget, (b) saving, (c) dissaving
#5 Wikimedia AXEC86 Idealized transaction pattern
#6 For more details see Essentials of Constructive Heterodoxy: Money, Credit, Interest and Reconstructing the Quantity Theory (I).

Related 'Macro for dummies' and 'A crash course in macro accounting' and 'Where MMT got macro wrong' and 'A tale of three accountants' and 'Money and debt in six elementary steps' and 'Money and time' and 'The ultimate ― analytical ― origin of money' and 'Macro for dummies' and ' Money: from silly stories to the true theory' and 'Money is information'.

REPLY to Peter Cooper on Jul 25

One way to explain the actual state of the world is the historico-genetic (K. Mannheim) approach. And this is how the development from barter to fiat money is usually presented. This history is quite interesting, but history is not science. From the history of the practical use of levers among animals and humans, one will never arrive at the Law of the Lever as put down by Archimedes.

Take notice that economics is defined as a science, and science is well-defined by material and formal consistency. Your series Short & Simple is inconsistent storytelling.

First of all, the theory of money/debt cannot stand alone but must be embedded in what Keynes called the 'monetary theory of production', which in turn must be based on macrofoundations.

The fact is that your macrofoundations are ill-defined. More specifically, your profit theory is provably false. As a consequence, your theory of money is false, too, no matter how many plausible pieces of history it contains.

This is lethal: you cannot show how, in principle, the flows of a simple monetary economy (which are measurable) affect the stock of money (which is also measurable). This cannot be compensated by stories like ‘how government’s position of strength’ had been used ‘in getting its own IOU widely accepted’.

Take notice that MMT has been thoroughly refuted. Here are all proofs and arguments for your convenience collected

To continue your series Short & Simple is pointless.

REPLY to Peter Cooper

Money has taken various historical forms (token, coin, note, deposit, etc.) and the banking system in each country is the outcome of a murky historical process. Therefore, the first thing to do is to ABSTRACT from the historical detail and to define a clear-cut analytical frame of reference. This frame has been called by Keynes the 'monetary theory of production'.

(i) The pure production-consumption economy consists of the business and the household sector. The household sector provides the labor input to the business sector which consists initially of one firm. The product of the firm is sold to the household sector. Example: the wage income per period (e.g. year) is 100 [thousand/million/billion, euro/dollar/yen]. So, in a period of defined length, the households put in their work and the firm owes in total 100 monetary units to the household sector.

(ii) The firm issues IOUs and these are used in turn by the households to buy the output. For simplicity, the wage income of 100 monetary units is fully spent on consumption goods. Starting from zero at the beginning of each period IOUs are created by the firm and vanish completely until the end of the period. Clearly, IOUs are debt and they are used exclusively for the transactions between the business and the household sector.

(iii) IOUs work fine with one firm but not with many firms. If the business sector consists of many firms the need for a GENERAL IOU arises. This general IOU is produced by the central bank and is called money. The central bank gives the firm money in the form of current deposits and the firm owes overdrafts to the central bank. The firm pays the workers by transferring the deposits instead of IOUs. The workers spend their income and the deposits return to the business sector which reduces the overdrafts. At the end of the period, all deposits and overdrafts are again ZERO. So money is created out of nothing and vanishes into nothing until the end of each period. This process can continue in principle for all eternity no matter how big or small the economy is. There is NO such thing as a fixed quantity of money.

(iv) Only deposits are money but, clearly, deposits are always exactly equal to overdrafts. Hence, money is the central bank’s half of what is essentially a credit relationship. Both sides of the central bank’s balance sheet are equal at any point in time by logical necessity. So, there is no such thing as debt-free money. But note that deposit/overdraft money as TRANSACTION medium is entirely different from CREDIT for houses and cars or for financing real investment of the business sector or for financing public deficits. Not keeping these things properly apart is a recipe for messing up the theory of money.

The fact that money is debt does NOT mean that it should be spent into existence by government deficits. The proper way of creating money is to finance an expanding wage bill. To bring money into the world by financing government deficits is a program for increasing the profit of the business sector. So, either MMTers in their scientific incompetence do not understand how the economy works or MMT is a pseudo-scientific veil for a free-lunch program for the one-percenters.