Throughout the 2017 general election campaign and for a long time prior, many Conservative MPs, journalists and commentators said of Labour that their pledges relied on a ‘magic money tree’. ‘Where will you get the money from?’, they asked, ‘how will you pay for public subsidy X or social care system Y?’. It’s a common attack line and it makes intuitive sense. After all, if you as an individual were to spend £1bn on something, you would first need to raise £1bn.
In the aftermath of the election, and following the news that the Conservtives will be allocating another £1bn to Northern Ireland in order to secure a deal with the DUP, many Labour MPs, journalists and commentators have been asking the same questions. ‘How will you pay for it?’. Further comments include how many nurses, teachers, or incubators £1bn could buy. The idea is that the money has now been removed from the pot and is no longer available to pay for such things.
The problem is that both sides are wrong. The state does not need to raise money before it can spend. Removing £1bn from the state finances does not mean that there is £1bn less for anything else. The money tree allusion may sound clever at first, but the point of metaphorically saying something does not grow on trees is that it cannot be created from nothing. Money can be created from nothing; money is created from nothing; all the money in the world was created from nothing. In a sense, there is indeed a magic money tree, and – helpfully – the theory behind it shares its acronym: Modern Money Theory – MMT…the magic money tree.
An understanding of MMT is relatively simple to grasp, however, there are some fundamentals of economic theory which must be established first. These can also seem counterintuitive at first, but bear with me.
What is money?
Consider the pound in your pocket. Where did it come from? I am not referring to the object itself or the metal content or anything physical. I mean the intangible value of ‘£1’ – where did the value denoted by that pound coin come from? Perhaps you got the money in return for your labour from your employer, or from a customer in return for your goods, or from a bank in return for a promise of repayment with interest. In every case, the value of ‘£1’ denotes nothing more than a promise of future delivery of £1 worth of goods which may be transferred from person to person.
Things can be made simpler with the example of a hypothetical village (first imagined by Adam Smith) in which I sell shoes and you sell chickens. I need chickens, but you do not need shoes. In Smith’s imagination, this failure of ‘double coincidence of wants’ (me wanting something you have at the exact same time as you wanting something I have) would lead to both of us seeking a third object which we both want in order to facilitate a trade – gold for example. What Smith failed to realise was that there is another, simpler, way of doing things. I could simply hand over a piece of paper stating that ‘I promise to pay the bearer on demand, the sum of one pair of shoes’. I take my chicken and go on my way.
At some point in the future, you may realise that you do not need shoes, but you do need a new door. The joiner doesn’t need chickens, so what are you to do? You could make a new ‘credit note’ of your own, or you could simply pass on the note promising to pay a pair of shoes and promise the joiner that I am good for it. This dynamic could continue indefinitely, or until someone decides to redeem the note for a pair of shoes. This is all money is. A promise of payment at some point in the future, backed by the good name of the individual or organisation who issued the note.
There is one feature of the hypothetical village economy that I would like to highlight here. Notice that for every ‘asset’ there is a corresponding ‘liability’. In mathematical terms, we can say that all credits and debts in an economy ‘sum to zero’. This being the case, it is also true that the ‘net wealth’ (one could also use the term ‘GDP’) of our village will always be £0 unless it is able to accumulate claims on other villages. This is called ‘outside wealth’ – wealth in the form of an asset not offset by a corresponding liability within the sector in question. Bear this in mind.
Let’s add another layer to our village. At the moment, we have a private sector (you, me, the joiner and the rest of the village all trading together), we also have a foreign sector (the other villages to whom we may export goods or from whom we may import). What if the village council wants to fund a project; a new building perhaps? How will they pay for it? One answer is to say that they collect taxes from the villagers, however, if our economy sums to zero, there is no wealth to tax. Indeed, if our village imports more than it exports, there is negative wealth in the village, since the ‘foreign sector’ (other villages) have claims on us – we have promised to repay them for goods which they have delivered. Another option is for the council to issue its own promissory notes denoting – not goods to be delivered in the future – but some other imaginary unit of value (the pound, say) which may then be exchanged between the villagers for goods.
This is money. This is a small scale example which demonstrates how all economies work. In the modern world, the village is a nation, the other villages are other nations and the council is the state, but the principles still hold. This is the answer to where the pound in your pocket came from. It was created from nothing as a promise to pay in the future. It is a token denoting someone else’s liability, someone else’s debt to you. Furthermore, each sector – public, private and foreign – have a net wealth of zero unless they accumulate claims on one of the other sectors.
Introduction to Modern Money Theory
This description of money forms the basis of Modern Money Theory. The theory can be stated more succinctly thus:
MMT holds that:
- All money is debt.
- All money is ‘created’.
- One’s asset is another’s liability.
- The sum of all financial assets and liabilities within a given sector is zero.
- For a sector to accumulate wealth it must accumulate claims on an outside sector.
- Increasing the surplus of one sector entails increasing the deficit of another.
- Taxes do not (indeed, could not) fund public spending, since collecting taxes from the private sector to fund public sector spending would entail withdrawing a positive sum from a zero sum system.
- The state need not borrow from any other entity, as it can issue its own promises (money).
- If the public sector were to be in surplus (’eliminating the deficit’ in politician parlance), it would gradually chip away at the private sector surplus before gradually increasing private sector debt.
- An issuer of money can never become insolvent – no state using a sovereign currency can ever be unable to pay its bills, it can always just create more money.
This can all seem counter intuitive, and there are some questions which readers may have regarding (mainly) the ‘implications’ section above. I will try to address some of the most common questions here:
If taxes do not fund spending, why do we tax at all?
Lets return to the hypothetical village. Public spending was addressed very briefly, but you may have noticed one problem. When I issued my note promising to pay shoes for your chicken, there were tangible goods backing that note – the shoes. When the council issued its notes, they were backed by nothing at all, the recipient of these notes could not redeem them for anything useful with the council. The village council may have some ‘real assets’ (more economist jargon meaning ‘goods not owed to anyone else’) which it could give if someone wanted to redeem notes, but if everyone decided to do this at once, the whole thing would collapse. Indeed, there are examples from history of this very thing happening.
Some people imagine that modern states back their promissory notes (money) with precious metals – that they could walk into the Bank of England with £100 and redeem it for £100 worth of gold if they so wished. This was partly (although not entirely) true until the Bretton Woods conference of 1944, at which point currencies became redeemable for US dollars which were in turn (partly) redeemable for gold. This system also disappeared in 1971 and since then, currencies have been backed by nothing. It is worth stating simply: currency is redeemable for nothing.
So if our village council issues notes which can’t be redeemed for anything, why would people accept them? You only accepted my promise to pay shoes because you knew (or thought) that I would be good for the shoes, and that you would be able to redeem it for shoes in the future. The joiner only accepted it as payment from you because he would be able to redeem it for shoes, and so on. Well, states can do something which you or I cannot; they can force you, on pain of imprisonment, or even death in some cases, to pay back some of these promissory notes.
If our village council were to decree that everyone was to pay back one of its notes per month, then everyone – the cobbler, chicken farmer and joiner – would have a definite reason to want to get their hands on some. They would have to procure at least 1 of these notes per month or risk prosecution. This is why we tax. It ‘drives’ money. It ensures that people will sell for government promises even if they are not backed by anything, because the seller will have to meet their tax obligation. This is why ASDA will accept pounds but not your personal promise to pay, because they cannot meet their tax liability with your promise, but they can with a state promise.
Doesn’t printing money cause inflation?
This question has a much simpler answer: it depends what you spend it on.
To unpack that rather simplistic answer, lets consider what causes inflation:
Inflation is caused when too much money is chasing too few goods. If everyone in the village has £100 and a loaf of bread costs £1, all might be well, but suppose everyone in the village was given a windfall by the state and now has £100,000,000. The baker might well conclude that he could easily raise his price to £1,000,000. This is inflation.
However, this example demonstrates money being injected into an economy without taking account of anything else. Perhaps the money was spent on roads rather than arbitrarily giving it to everyone – the baker could move his bread more cheaply, the road workers would be able to buy more bread and the civil engineering company would be able to win more contracts. In this case, there would be more money chasing more goods, offsetting the inflation.
Injecting money into the economy by spending only causes inflation if it is simply injected without doing something productive. If the money is used to add ‘real value’ (things, tangible goods) to the economy, then the extra money is not chasing the same amount of goods, but vastly more.
Why can’t poor countries just print money and become rich by spending it on production?
This is a more complex question. For now, it is sufficient to say that poor countries have less ‘real wealth’ available within them, have been burdened by historical problems such as war and colonialism, and often have economies which rely on foreign currency such as the dollar more than on their own sovereign currency.
MMT in practice
So how does all this relate to the arguments about money going to Northern Ireland, or incubators, or teachers? Take the £1bn given to Northern Ireland in the aftermath of the election. Given what we have said about MMT, the state did not spend £1bn in tax money on this deal. It created £1bn worth of promises to pay and gave them to Northern Ireland to do with as they will. If the state wanted £1bn worth of nurses it could have done, and still could do, the same, tax revenue is neither here nor there. If Labour wanted to spend an extra £5bn on healthcare, it could do so, provided it was in government.
Furthermore, there is no requirement that any state spending pledge be ‘costed’. Offsetting a spending commitment by increasing taxation or withdrawing funding from another area is unnecessary under MMT.
It is important to note that this is not a partisan suggestion. MMT works for a conservative agenda as well as for a socialist one. Centrists, progressives, liberals, fascists, communists or feudalists can use this theory to fund their own particular spending aims. The purpose of this piece has merely been to point out that the question ‘how will you pay for it?’ is meaningless and pointless, whichever direction it comes from. A more pertinent question is ‘how will this spending be beneficial?’ or – especially important – ‘given that there is no real reason why you couldn’t, why did you choose not to spend money on the following…?’
L. Randall Wray – Modern Money Theory: A Primer (alternatively, the whole book can be read in blog form here: http://neweconomicperspectives.org/modern-monetary-theory-primer.html )
Tymoigne, E. and Wray, L (2013) ‘Modern Money Theory 101 – A Reply to Critics’, IDEAS working paper no. 788, St. Louis, St. Louis Federal Reserve Bank
The original criticism:
Palley, T. I. (2012) ‘Money, Fiscal Policy and Interest Rates: A Critique of Modern Money Theory’, Review of Political Economy, vol. 27, no. 1, pp. 1 – 23
Palley’s further response:
Palley, T. I (2015) ‘The Critics of Modern Money Theory (MMT) are Right’, Review of Political Economy, vol. 27, no. 1, pp. 45 – 61
A lecture from Wray:
And a more accessible one from Stephanie Kelton: