On Modern Money

By Marshall Auerback

Ed recently wrote a MMT for Austrians-themed post in response to a guest post by my friend Stephanie Kelton called "More thoughts on out of control deficit spending". While the title is more in line with his Austrian economics roots, I assume he meant the title somewhat tongue in check for he rightly began the post:

"Like it or not, we live in a fiat money world. No major currency now traded on foreign-exchange markets is linked to gold or other precious metals"…

in the U.S. there has been a lot of discussion about ‘starving the beast’ by shutting down the government until spending is brought to heel. [In the context of a fiat money system], this is an entirely political debate based on choices about the size of government and resource allocation in the economy. It has nothing to do with affordability.

This is the reality of our modern monetary system. Yet, most people use an idealised, textbook version of fractional banking which states as follows:

  • A person deposits say $100 in a bank.
  • To make money, the bank then loans the remaining $90 to a customer.
  • They spend the money and the recipient of the funds deposits it with their bank.
  • That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
  • And so on until the loans become so small that they dissolve to zero

As Bill Mitchell has noted many times:

None of this is remotely accurate in terms of depicting how the banks make loans. It is an important device for the mainstream because it implies that banks take deposits to get funds which they can then on-lend. But prudential regulations require they keep a little in reserve. So we get this credit creation process ballooning out due to the fractional reserve requirements.

The money multiplier myth also leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government”. This leads to claims that if the government runs a budget deficit then it has to issue bonds to avoid causing hyperinflation. Nothing could be further from the truth.

Another economist who is very good on highlighting this reality is University of Ottawa professor Marc Lavoie. In his 1984 article (‘The endogenous flow of credit and the Post Keynesian theory of money’, Journal of Economic Issues, 18, 771-797) he wrote(page 774):

When entrepreneurs determine the effective demand, they must plan the level of production, prices, distributed dividends, and the average wage rate. Any production in a modern or in an “entrepreneur” economy is of a monetary nature and must involve some monetary outlays. When production is at a stationary level, it can be assumed that firms have at their disposal sufficient cash to finance their outlays. This working capital, in the aggregate, constitutes credits that have never been repaid. When firms want to increase their outlays, however, they clearly have to obtain extended credit lines or else additional loans from the banks. These flows of credit then reappear as deposits on the liability side of the balance sheets of banks when firms use these loans to remunerate their factors of production.

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans.

The central bank can determine the price of “money” by setting the interest rate on bank reserves

Marshall Auerback


Marshall Auerback, has 29 years experience in the investment management business, serving as a global portfolio strategist for Madison Street Partners, LLC, a Denver based hedge fund. He also has also worked as an economic consultant to PIMCO, the world’s largest bond fund management group. He is a Fellow at the Economists for Peace and Security, a Research Associate at the Levy Institute, and a non-executive director of Pinetree Capital in Toronto, Ontario, Canada.