What is a Treasury bond?

[melveyr]

I posted this article on my blog. The treasury bond plays an important role in the PP so I think it is nice to have a good grasp on its purpose in our economy.

What is a Treasury Bond?

Answering this question is trickier than it may seem. The ignorance is everywhere and even Nobel Prize winning economist Paul Krugman does not get it. I do not know of any politicians who get it either.

The misunderstanding stems from gold standard logic. Our transition from a gold standard to a fiat currency has left some economists behind thinking it is still the 1870s.

Under a strict gold standard, a government can only spend gold that has been mined and is in their vaults. If a government desires to spend more gold than it receives in gold tax revenue, than the difference must be financed by borrowing gold from the private sector or other governments. The government cannot spend gold that it does not possess, hence the financing.

This borrowing would occur through the issuance of government debt, and an investor would be wise to keep an eye on the solvency of the government before deciding what interest rate to demand.

A fiat monetary system, like the one we have in the United States, has radically different implications for the role of government “debt.”?

Under a fiat system, money does not exist until the government spends. The government literally spends money into existence; money comes from nowhere.

Imagine the first day of a new fiat government. You demand a tax from your citizens in your currency, but no one possesses this new currency. How can your citizens pay tax in a currency that doesn’t exist? Under a fiat system it is impossible for the government to run a surplus in its first year. The first fiscal year has to be a deficit. How can you ask your citizens for more currency than exists? Similarly, it would be impossible to borrow money that doesn’t yet exist.

In a fiat economy, taxation and borrowing does not finance government spending. It is reversed. Government spending allows the government to impose a tax and government spending allows the government to borrow its currency.

In a gold standard deficits are not sustainable. In a fiat economy surpluses are not sustainable. This is not an ideological debate; this is accounting.

Now that we understand the basics of a fiat economy, let’s imagine a scenario where the government runs deficits for the first 5 years. Each year they are spending more money into existence than they take out of existence through taxation. If their spending is not producing goods and services then inflation will clearly result. Inflation can make commerce more confusing, and so it is decided that something must be done. Taxes could be raised, but implementing tax policies can be slow and unpopular. If only there was a way to take money out of the system without force…

Enter the Treasury bond. The Treasury bond is simply a security designed to entice investors to take currency out of circulation. The maturity determines how long the principal is taken out of circulation and the interest payments keep investors happy. No coercion or taxation necessary!

Everyone wins.

The word bond brings up connotations of “financing spending”? but the idea of a sovereign government with the power to create money financing itself through debt issuance is illogical from inception. If I could rename Treasury bonds I would call them “monetary manipulation contracts.”? That is their only functional role in a fiat economy.

That is operationally how a Treasury bond functions in a fiat economy. Government deficits can continue indefinitely, but government surpluses cannot. Treasury bonds and taxes do not finance spending, but help regulate inflation.

It’s a weird system, but it’s the one we have.

I just hope the Treasury keeps issuing 30 year Treasuries. My portfolio loves the combination of high volatility and low correlation to other asset classes.

[moda0306]

Regarding whether this should be the system we have, I still have qualms.  Part of me still buys the Austrian argument that money doesn't need to be manipulated, and that an economy can still grow reasonably with a gold standard... most of me doubts that, though.

I would ask, though, in a world where these things are being constantly manipulated, isn't it going to cause malinvestment, and isn't that handing the government way too much power to manipulate the economy?

Maybe these are more moral arguments than functional ones, but if the malinvestment is bad enough, it could make it difficult to lower unemployment later down the road without a lot more manipulation.

[Tortoise]

Under a fiat system, money does not exist until the government spends. The government literally spends money into existence; money comes from nowhere.

Imagine the first day of a new fiat government. You demand a tax from your citizens in your currency, but no one possesses this new currency. How can your citizens pay tax in a currency that doesn’t exist? Under a fiat system it is impossible for the government to run a surplus in its first year. The first fiscal year has to be a deficit. How can you ask your citizens for more currency than exists? Similarly, it would be impossible to borrow money that doesn’t yet exist.

I'd like to understand this a bit better, because it hasn't really "clicked" with me yet. So let's take this abstract concept and breathe life into it with a concrete example: The actual transition of the U.S. from gold to fiat currency in the early 1900s.

When the Federal Reserve System was created in 1913, it did not have to create debt to bring the fiat currency (Federal Reserve notes) into existence and get them into the citizens' hands. The Fed simply induced the citizens to trade their gold for Federal Reserve notes for convenience, and then years later, when most of the gold had flowed into the Fed's vaults from the private banks, the government simply confiscated the gold in the vaults overnight by issuing a law ending the redeemability of the fiat notes in gold and prohibiting private ownership of gold.

In that historical example I just gave, how did the initial creation of the Federal Reserve notes automatically create debt? The notes started out as gold-backed notes, were traded for actual gold until most of the gold was in the Fed's vaults, and then were declared overnight to be fiat notes. That's not debt creation; that's just theft.

Enter the Treasury bond. The Treasury bond is simply a security designed to entice investors to take currency out of circulation. The maturity determines how long the principal is taken out of circulation and the interest payments keep investors happy. No coercion or taxation necessary!

I'm not sure I fully understand this. Treasury bonds don't remove the principal from circulation; they transfer the principal from the investor to the government. And when the bond reaches maturity, the principal is transferred from the government back to the investor. The principal therefore remains in the money system the entire time. And the interest is paid either with taxes or by the issue of yet more Treasury bonds. Lending, borrowing, and taxing are all simply forms of transferring existing money from one person to another--they do not create or destroy money.

An increase or decrease in the money supply enters the picture only when the investor purchasing or selling the bonds is the Fed. When the Fed buys bonds through its open-market operations, it is creating money since it buys them with new dollars it creates out of thin air. And when the Fed sells bonds through its open-market operations, it removes that money from circulation. There's nothing inherently special about Treasury bonds in regards to this process; the Fed can buy or sell any asset to create or destroy money, respectively.

One may read this and wonder, Why then does our government manipulates the money supply in this roundabout, Rube Goldberg-esque manner involving the Fed and its open market operations rather than simply having the Treasury print new money whenever it needs to spend it? It's simply because the roundabout Fed-centric mechanism makes the theft via monetary inflation harder for Joe Six-Pack to identify and understand.

If the Treasury were simply to print money at will, thereby causing inflation a short while later, eventually people would see the cause-and-effect relationship clearly and protest against it. But since the Fed is the entity expanding the money supply via the complicated web of fractional-reserve banking, it's harder for Joe Six-Pack to pin down exactly why prices are rising.

So the government pretends to "borrow" the massive amounts of money it's spending, when in fact it is effectively confiscating it since it knows the Fed will always be there to keep the Ponzi scheme going by purchasing new Treasury bonds to pay the principal and/or interest on the existing ones.

[darkcharro]

I posted this article on my blog. The treasury bond plays an important role in the PP so I think it is nice to have a good grasp on its purpose in our economy.

Hi,

I'm new on this board. I recently discovered the PP while reading about passive investing and find it interesting.
However, like several people here, I'm worried about putting 25% in bonds right now (no need to tell me about
not timing, economic cycles, etc, I already read that). I think the PP has never really been through a period like
the current one.

melveyr, do you have a reference for this article where one can read more? Thanks!

[melveyr]

darkcharro: I wrote this little article. The best way to learn more about a fiat currency is to research "modern monetary theory". The MMT wiki is a good place to start. http://mmtwiki.org/wiki/Main_Page

Tortoise: You are almost there. A government can engage in deficit spending without going into debt. They have the power to coin money. The idea of them borrowing money to spend is nonsensical. If you had a printing press, would you borrow money so that you could spend it? Of course not.

The creation of money and the creation of debt are two separate events and debt serves only as a way of controlling the money supply.

A government could operationally have a budget deficit each year without ever going into debt. They simply spend more money than they take in, no debt is necessary because they are not on a gold standard. The cost of this would be inflation which is born on the backs of everyone who holds dollars.

When the government spends money, they credit bank accounts. There is NO corresponding debit on their account. The dollars come from nowhere. When the government receives money, from taxes or bond sales etc., they debit bank accounts with NO corresponding credit on their account. When you pay your taxes, that money effectively vanishes. It goes nowhere. It ceases to exist.

Why?

Because it makes no difference to them. Let's say the government had "100" dollars in their account. Why would they need this money? What purpose does it serve them to hold onto their currency? They can create money whenever they want. Would you care if someone gave you 20 dollars if you had a printing press? It is worth nothing to you.

[darkcharro]

From what I've seen, both Keynesians (current mainstream economics) and Austrians believe MMT is wrong.

That's the problem. If one has a simple question like "what is money?". You get one answer from one school and
a different one from the others. 

The people in power (Bernanke, Obama, Krugman, etc) are apparently Keynesians, so at least for trying to figure
out what they will do next, that's the place where to look.

[melveyr]

It doesn't matter who says what because accounting is not a matter that can be debated. There are surely some conclusions that have to be agreeable just on the basis of how a fiat currency operates.

In the first year of a fiat government, how does money enter the economy?

Government spending is the only way. We have to use this as our starting point, from which we can build upon. The government cannot tax, because the private sector does not have your currency. The government cannot borrow money from the private sector because the private sector does not have currency.

The money must come into existence through government spending. Also, this first year must be a deficit. How can the government take more money out of existence than it brings in? The implications of the reality of this first year can help us understand what our sustainable options are.

Lets hypothetically say that our brand new government runs a deficit for 20 years and $20,000 of currency in circulation is the result. If the government runs a surplus for the next two years of $10,000 then ALL of the money has been taken out of the system. There are no more dollars in our economy and the government is forced to run a deficit the next year if it expects its imposed taxes to paid. Surpluses are NOT sustainable. Its accounting, not an ideology.

Note, no debt was issued in this example. Debt does not have to come into existence for a fiat government to have a deficit.

[Tortoise]

melveyr, the idea that tax revenue effectively extinguishes some of the currency that has been created out of thin air by the government makes sense.

I'm just not sure I agree that the same idea applies to Treasury bonds. Yes, they may extinguish currency at the time they are issued, but they must then create new currency on their maturity date since the principal must be repaid on that date. In other words, change in the supply of money due to the issuance of a bond must be only temporary--not permanent as it is in the case of taxes.

If currency can be removed from circulation through taxes, then why does the government need to introduce the additional--and more complicated--mechanism of issuing debt instruments? Why can't it remove all the currency from circulation it needs to simply by setting an appropriate level of taxation?

Also, you did not address any of my points regarding the actual introduction of fiat currency into the U.S. by the Federal Reserve System in the early 1900s. If what you're saying is correct, please help me understand how it applies to the specific example I provided.

[melveyr]

I just don't understand how your Fed example disagrees with MMT. Your saying the creating of new notes did not automatically create debt. I agree with that statement entirely. The government can spend without going into debt because they have the power to issue currency.

You raise a perfectly valid point about the exclusive use of taxation rather than government debt. On paper it could entirely work. But the creation of government debt offers one huge advantage, speed and flexibility.

Taxes cannot be raised one night, and then lowered the next. People would be confused and an army of accountants would be required to sort out the mess.

However, the Fed can trade debt second by second. The fed has enormous control of the money supply and they can be net buyers of bonds one day, and net sellers on the next. Its behind the scenes and its fast. For these reasons I think its useful.

Finally, you are entirely correct about the principal re-entering the economy when the bond matures. Let's say you are not excited about the prospect of this money re-entering the economy and you are the head of the fed. The moment the bond matures you could simply sell a bond from your portfolio to offset the bond that just matured. If you run out of bonds, you yell to the treasury "Make more bonds!" The role of the treasury is to create bonds that the fed trades. The treasury is an extension of monetary policy, not fiscal.

[Lone Wolf]

The best way to learn more about a fiat currency is to research "modern monetary theory". The MMT wiki is a good place to start. http://mmtwiki.org/wiki/Main_Page

With respect, I believe that this is only a good way to learn about your article and the controversial MMT interpretation of fiat currency.  It is not, however, a good way to learn the general principles of fiat currency.

You're pointing someone trying to learn the basics toward a theoretical framework whose prescriptions for fiat currency management have never been tested in practice in any way, ever.  And from my own perspective, it's a theoretical framework that makes some extremely strange and extremely shaky assumptions about money.  Caveat emptor.

Clarification: I didn't mean that the person to whom you are responding was necessarily trying to learn the basics.  Rather just that MMT is not the way to learn about "fiat currency".  It's like pointing someone trying to learn about physics toward M-theory.  It may be interesting to read about but it's controversial and has zero real data to back it up.  MMT is simply someone's ideas about how the world would work if they were in charge.  That makes for a lousy foundation, IMO.

[melveyr]

I am not at all close minded to new ideas if they make sense. Thats how I ended up with a PP.

How do you guys perceive our monetary system with respect to the role of taxes, government surpluses, and debt?

Where does a fiat currency come from?
Why does a government need a tax to finance its spending if it can create currency?
Why does a government need bonds to finance its spending if it can create currency?

These are the questions I am trying to answer in my head, and the points laid out in the article are how I have wrestled with these questions.

What are your answers?

EDIT: Btw, I totally understand the feeling of MMT stating "how the world should be run." Still, the discussions MMT is having are not a castle built upon air. They are building upon the foundation of the operations of a fiat currency, which we do have in the US. I have not seen anything thus far that cannot be applied to the US.

[rickb]

I am not at all close minded to new ideas if they make sense. Thats how I ended up with a PP.

How do you guys perceive our monetary system with respect to the role of taxes, government surpluses, and debt?

Where does a fiat currency come from?
Why does a government need a tax to finance its spending if it can create currency?
Why does a government need bonds to finance its spending if it can create currency?

These are the questions I am trying to answer in my head, and the points laid out in the article are how I have wrestled with these questions.

What are your answers?

The US system is explained quite fully in the book "The Creature from Jekyll Island, A Second Look at the Federal Reserve" by G Edward Griffin.  US dollars come from the Federal Reserve, which (contrary to most people's assumptions and contrary to its deliberately misleading name) is NOT part of the government but rather an independent entity which is a "bank for bankers" (central bank - another word for it is the "banking cartel").  The government can tax to finance its spending, or it can issue bonds - and since it can't directly create currency (only the Fed creates currency) it must do one of these.  The sinister beauty of this system is that deficit spending forces the government to borrow money which the Fed can create out of thin air in any amount it chooses and then the government must pay interest on this (ultimately worthless) money - which means the interest rate is effectively infinity.  The "too big to fail" banks must be prevented from failing not primarily because of their size, but because they are the very source of the money (in excess of taxes) that the government spends (and these banks then profit by lending/creating this money to/for the government).

Yes we have a fiat currency.  Yes the total money supply increases and (at least theoretically) decreases with the total amount of the federal debt.  But the role of the Fed and in whose interests it acts (hint: it's not "the people" or "the government") cannot be overlooked.

[melveyr]

Okay, I think I understand your disagreement with how I laid it out, now let me explain how I think your explanation is perfectly within the confines of MMT.
Basically, the idea that Federal Reserve is not part of the government has no operational basis. If you go to the Federal Reserves FAQ on their site, it clearly states that “After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.”? Combine this with the fact that the President appoints the head of the Fed and the idea that it is not part of the government is unfounded.

Yes if you really want to go through all of the technicalities we “borrow”? money from the Fed and then we “pay interest”? on that debt, but ALL of the profits go back to the Treasury. In an accounting sense, nothing happened. It would be like borrowing money from yourself and paying yourself back. I can say that I’m doing this right now if I want to! I just took out a loan from myself 10 seconds ago, and paid it back! It doesn’t have a material effect on anything though. Because the government receives all of the profits back, the government has an unlimited capacity to spend money.

The government doesn't need a source of external financing to spend. The Fed is a source of “internal financing.”? This internal financing is simple money creation.

Thus, external financing is only used to take money out of the system for a given period of time (until the bond reaches maturity).

[Lone Wolf]

I am not at all close minded to new ideas if they make sense. Thats how I ended up with a PP.

Then you're right where you need to be.  From the way you phrased the article, you sounded "sold" that MMT was an authoritative \ definitive view of fiat currency (in this specific case, what the function of a Treasury Bond.)

Why does a government need a tax to finance its spending if it can create currency?

To avoid outrageous levels of inflation or hyperinflation as has occurred repeatedly throughout history.  I realize that the MMT view is that this occurs because there's too little taxation (and thus too much aggregate demand in the economy) but this seems like a backward way of viewing it.  I think it's simpler to just view it in plain old terms of supply and demand.  When you print, the supply of money soon greatly exceeds the demand for money.  Money loses value relative to "real stuff" and prices rise (sometimes crazily.)

Why does a government need bonds to finance its spending if it can create currency?
...
EDIT: Btw, I totally understand the feeling of MMT stating "how the world should be run." Still, the discussions MMT is having are not a castle built upon air. They are building upon the foundation of the operations of a fiat currency, which we do have in the US. I have not seen anything thus far that cannot be applied to the US.

The thing is, MMT prescriptions can't simply be applied to the US.  (IMO a good thing since I have huge reservations about their ideas and don't want to be the first country to test them.)

It's important to note that under our system we can't just "create currency" and somehow pound it into circulation.  The Federal Reserve "prints" when it buys government bonds with money conjured out of thin air.  Ostensibly, the Fed is an independent organ.  I realize that this is debatable, but understand that this is at least the intent and charter of the Fed.  Thus, the MMT prescriptions that the government print this or that certain quantity of money aren't something we could "just do".

What the Treasury does is place bonds on the open market.  They may be bought by you and me, by banks, primary dealers, or the Fed itself.  The Treasury does not control the rate of interest or who the ultimate purchaser will be (and thus the amount of "printing".)  The bonds come first.  The printing (maybe) comes later and from a different entity.

[melveyr]

Your inflation comment is entirely correct. Along with creating a demand for the currency, taxation helps moderate inflation. We have no disagreement here.

I think it would really help both of us understand your position if could outline me for the first year of a fiat government, with a government that is playing by the US rules as you see them. My understanding is that it is an impossibility for the bonds to come first because there is no currency to buy them with. It is an impossibility to have tax because there is no currency to pay the tax with. That is the fundamental logic that drives MMT and my understanding of Treasury bonds. It is crucial to remember that right when a fiat currency starts, none of the fiat currency is in circulation.

[MediumTex]

It is crucial to remember that right when a fiat currency starts, none of the fiat currency is in circulation.

What if the currency was 100% gold backed and the government sold off 10% of the gold without changing the money supply?

Wouldn't that mean that some (or all) of the currency already in circulation is now fiat?

Or are we talking about a scenario where a gold standard currency actually has only gold coins and no paper money at all (even if it is backed up by gold)?

It seems like the move to fiat is always incremental in the real world.

[melveyr]

MT: I guess I am more talking about when a currency is strictly fiat. Like what we have today. I am not sure I totally understand the implications of when a currency is in between stages.

However, lets say that all of the money in circulation that was backed by gold all of the sudden becomes fiat. Okay, so we DO have money in circulation to begin with, but it doesn't change anything about the long run. Budget surpluses will still draw-down the amount of money in circulation and they could not continue indefinitely. Bonds could be sold, but you could not issue more bonds than you have issued currency.

What I really like about the first year assuming no currency in circulation is that it gets at the root of what are the sustainable options. And it also gives you concrete numbers to deal with. Imagining that first year makes it crystal clear what the sustainable options are, and it helps you understand the impossibility of issuing debt to "finance" your initial spending. It also requires us to carefully examine the exact operations because there is no wiggle room.

Previous posts: For further clarity, the government borrowing money from the Fed brings money into existence. In no way is this a liability for the government. The fed creates dollars, loans it to the government, the government pays interest (perhaps taking out another loan to pay this interest) to the fed, but then the Fed gives ALL the profits (minus the trifling amount to pay for Bens nice office and salary) back to the treasury. As a consolidated government entity, the net effect is simple money creation. No liability at all for the government.

It is a round about way of creating money, but the net effect is simply money creation. The mechanics of how it is done confuse us as to the simplicity of its effects.

However, when the government is borrowing money from an external source money is taken out of the system for the period of the bond, and brought back into the economy when the bond is mature.

Is this agreeable? I think this all fits in within the confines of reality in the US.

EDIT: I hope my tone is as friendly as I am in person! I really am enjoying the debate and it is helping me clarify my own thoughts  :)

[Lone Wolf]

I think it would really help both of us understand your position if could outline me for the first year of a fiat government, with a government that is playing by the US rules as you see them. My understanding is that it is an impossibility for the bonds to come first because there is no currency to buy them with. It is an impossibility to have tax because there is no currency to pay the tax with. That is the fundamental logic that drives MMT and my understanding of Treasury bonds. It is crucial to remember that right when a fiat currency starts, none of the fiat currency is in circulation.
...
What I really like about the first year assuming no currency in circulation is that it gets at the root of what are the sustainable options.

I guess you could call this the "bootstrap" situation.  I think that this is another area where MMT's highly "theoretical" nature and ahistorical focus get it into some trouble.

Ignore for a moment how we might go about creating a fiat currency in theory.  Look at how this has actually happened in practice.  Most fiat currencies attach semi-parasitically to another existing currency.  Today's dollar derived its value from the gold standard dollar, which in turn derived its value from gold (real money.)

The Euro derived its value by having the participating currencies decommission themselves into a fixed exchange rate system in which they each became some fractional part of a Euro.

I think that the burden is on MMT to address history, not the other way around.

Budget surpluses will still draw-down the amount of money in circulation and they could not continue indefinitely. Bonds could be sold, but you could not issue more bonds than you have issued currency.

I disagree.  Budget surpluses could be sustained until the entire national debt was eliminated.  This will never happen but nothing prevents it from happening.

Remember that while the Federal Reserve usually purchases Treasury securities, it is not required to do so.  It can buy whatever assets it wishes.

If a strange new breed of fiscally responsible politician one day emerges and the national debt is paid off in the far future, Ben Bernanke's great-great-grandson Helicopter Bernanke can just buy gold, private debt, or foreign currencies.  Heck, the Bank of Japan buys stocks!

So budget surpluses are sustainable in our system.  You will not see them for a very long time (if ever) but they are sustainable.

However, when the government is borrowing money from an external source money is taken out of the system for the period of the bond, and brought back into the economy when the bond is mature.

I'd more say that money and purchasing power is lent by the buyer of the bond to the government.  The money isn't removed, simply moved around.  The government now has access to a greater fraction of the national output.

[melveyr]

Fiat currencies do have a fundamental value that is often forgot about.

I had a history teacher that said that a fiat currency is based solely off of faith, but that is not correct. The idea that people use it because other people use it is circular logic. Circular logic cannot sustain itself because all it takes is someone asking "why?" and then the bubble bursts. People bought tech stocks that were worthless because other people bought tech stocks that were worthless. It worked until someone asked "why?"

Fiat currencies derive the value from the ability of the government to levy a tax. The government is an eternal source of demand. No matter what faith the public may lose in the dollar, the government will still demand dollars when tax time goes. You may be the biggest gold bug in the world and think the dollar is a worthless piece of paper, but when tax time comes you better find yourself some dollars or you will get thrown in jail for evading taxes.

A fiat currency is the only thing that a citizen can use to extinguish their tax liability. That is not faith based, but a value imposed by the government.

Secondly, it is just not mathematically correct to say that surpluses are sustainable in a fiat economy because government is the only source of the currency.

Let's look at a gold standard to understand how its different. If a government continually ran a surplus, acquiring more and more gold, than less and less gold would be in the private market. The market clearing price for gold would be continually going up the longer surpluses went on for. Gold mining would become more and more profitable and deeper mines could be profitable that were not at a lower price.

In a sense, during a deflationary time period on a gold standard, the private market helps remedy the situation. The private market has the ability to bring more currency (gold) onto the market place.

Thus, on a gold standard a government could run a surplus until the world literally ran out of gold.

Fiat currencies are different because the private market cannot remedy the deflationary situation. When the price of the dollar is going up, there are no "dollar miners." No one can do anything about it. The government is the only source of dollars. If the government is taking in more dollars than are coming out, eventually the private market will hold no dollars. It really is that simple. I wouldn't define that as sustainable at all because when the private market holds no dollars it is impossible for a government to have a surplus the next year. They would have to have a deficit the next year to re-introduce currency into the economy.

[Lone Wolf]

Fiat currencies do have a fundamental value that is often forgot about.
...
Fiat currencies derive the value from the ability of the government to levy a tax. The government is an eternal source of demand. No matter what faith the public may lose in the dollar, the government will still demand dollars when tax time goes. You may be the biggest gold bug in the world and think the dollar is a worthless piece of paper, but when tax time comes you better find yourself some dollars or you will get thrown in jail for evading taxes.

This gets talked about really often in MMT circles.  While I suppose having a gun to your head is some small part of a currency's "value", I don't buy this argument.

People use money because it functions as a medium of exchange.  It allows for vastly more efficient trade.  More efficient trade yields vastly more efficient wealth.  People deal in money so that they can participate in this system.  Whatever currency allows them to most effectively participate in this efficient trade (and thus fulfill their needs and desires) is the one that will be used.

The idea that people use it because other people use it is circular logic. Circular logic cannot sustain itself because all it takes is someone asking "why?" and then the bubble bursts.
A fiat currency is the only thing that a citizen can use to extinguish their tax liability. That is not faith based, but a value imposed by the government.

This is simply not true.  Mediums of exchange emerge time and time again, tax liability or no.  Always hanging over such a system is the question of "what if other people stop believing in this currency?"  Always.

I feel like MMT often gets into this trap where it acts like the world was created the moment Bretton Woods collapsed.  No, money has existed for thousands of years.  It emerges independently, over and over and over again time after time.  What you're pointing out are basic properties of money.  If MMT claims that these behaviors only exist because of the authority to tax, they'd need to show why currencies have emerged in the past all on their own.  (Legal tender laws would be a much better argument IMO.)

It's illustrative to watch money and commerce emerge in this 1945 report from a POW camp.  Cigarettes became the currency, even for non-smokers.  Money happens.

Secondly, it is just not mathematically correct to say that surpluses are sustainable in a fiat economy because government is the only source of the currency.
...
They would have to have a deficit the next year to re-introduce currency into the economy.

Perhaps you are using a different meaning for the word "government", because this simply isn't correct.  Consider the example that I gave you before.

Let's say that the Treasury clears out the debt and stops issuing bonds of any kind.  (Remember, we're in fantasy land here.)  Dollars can still be created by the Federal Reserve.  Bernanke can purchase gold, Yen, whatever with dollars created out of thin air.

Are you considering the Fed's balance sheet to be some kind of "deficit" or part of the national debt?     The Fed has a printing press.  It creates money out of thin air.  It no more has a deficit than a counterfeiter would.

[melveyr]

I think you get it. Everything you said in that post illustrates that you get it entirely.

Currencies can be anything as long as there is demand for them. With cigarettes, the smokers are the demand, so non-smokers still see them as valuable because they can always trade them to a smoker.

With the dollar, the government is the underlying demand. A foreigner in Europe still sees the dollar as having value, because the US government demands dollars from its citizens. There are other demand sources obviously. But even if they evaporated the government will always demand dollars from its citizens.

The second part about the Fed, I'm scratching my head because you are saying to me what I have been saying to you in all of my posts. I think you just don't like thinking that fed is part of the government entity. When you see that the Fed is part of the government (it is independant within government) your statement is within the structure of MMT. All of the Fed's profits go back to the Treasury. That crucial detail is what drives the nail into the coffin about the Fed not being part of the government.

If the government brought in no tax dollars, and Bernanke bought 100 dollars worth of gold, than the deficit for that year is 100 dollars. The government spent more than it received in tax revenue. The difference is a deficit.

I think you are confused because you associate deficits with debt. A fiat government can have a deficit without going into debt. Thats the whole point of having a fiat currency in the first place. Why else would you have a fiat currency?

These things take time to settle in. Its not fun thinking that the government can run a deficit without going into debt. Its a hard concept to grapple with because it means that the government can become as large a part of the economy as it wants. That doesn't sit well with people, including myself.

[MediumTex]

Can't private banks create money through fractional reserve lending?

It seems to me that the basic problem right now is that the private money creation function is contracting faster than the public money creation function can expand.

There is also the matter of the enormous gold holdings of the U.S. government (as well as all the other property owned by the U.S. government).  It seems like these holdings one way or another should be considered to be backstops to the public debt and currency value, right?

Great discussion.

[Lone Wolf]

Currencies can be anything as long as there is demand for them. With cigarettes, the smokers are the demand, so non-smokers still see them as valuable because they can always trade them to a smoker.

With the dollar, the government is the underlying demand. A foreigner in Europe still sees the dollar as having value, because the US government demands dollars from its citizens. There are other demand sources obviously. But even if they evaporated the government will always demand dollars from its citizens.

I think you're greatly underplaying these "other demand sources".  The motivation to participate in commerce is completely overwhelming.  The demand for tax purposes is such a small part of what gives a currency its power.

Take for example Saudi Arabia, where I spent six years of my childhood.  Taxes there are virtually nonexistent as most of the government's revenue comes from oil.  Yet the Saudi Arabian Riyal is still used as a currency throughout the land.

Simply put, people want to buy stuff and sell stuff.  The more smoothly you are able to trade, the richer you generally become.  Everyone wants some of that action.  Why such a fixation on taxes?  Aren't legal tender laws more important, if you're interested in government's role in pushing a certain currency?

If the government brought in no tax dollars, and Bernanke bought 100 dollars worth of gold, than the deficit for that year is 100 dollars. The government spent more than it received in tax revenue. The difference is a deficit.

Woo, this is bizarre to me!  Okay, so you are considering dollars printed by the Fed out of thin air to be part of the deficit.  This is a brand-new version of the concept of a "government deficit".  Where did you hear of this definition?  Is that standard MMT jargon?  Why the need to redefine this very standard statistic?

It's like the difference between me borrowing $100 from my loan shark and simply printing up $100 in a basement counterfeiting operation.  The first is a clear household deficit -- I'm going to owe somebody something.  The second is simple confiscation of the collective purchasing power, not a "deficit" per se.

These things take time to settle in. Its not fun thinking that the government can run a deficit without going into debt. Its a hard concept to grapple with because it means that the government can become as large a part of the economy as it wants. That doesn't sit well with people, including myself.

Nah, I think that we've all spent enough time thinking about gold to know that the governments with a printing press can do this.  A government that prints hard enough can confiscate by stealth the majority of its citizens' real wealth (and eventually blow up the entire economy.)  Weimar and Zimbabwe are almost cliche to mention.  We spend tons of time reminding ourselves to not freak out about hyperinflation.  :)

The thing that doesn't sit well with me is the redefinition of money created out of thin air as this year's "government deficit".  This is really, really nonstandard AFAIK.  And remember, MMT is used to rail against those who call for a balanced Federal budget or a reduction in government spending, so it is no small distinction.  A great number of people use MMT to defend the crushing deficits that we've taken on in the last few years and denounce as "fearmongering" any concerns about servicing the debt down the line.

Can't private banks create money through fractional reserve lending?

Right!  This is a much larger net effect.  It's less direct than my simple "let's print it up!" example but ultimately even more important.  After 2008, I think we all learned that a hard contraction in private lending can have a staggering deflationary impact.

Surely the expansion that MT is referencing is not a "government deficit"?

[melveyr]

Ok, let's say that legal tender laws are more important.

Now, other point: A deficit is different than debt.

Let's look at a gold standard.

A government could have 500 oz of gold in a vault as currency. They could spend 300 oz of gold and bring in 100 oz of gold in tax revenue. That year there is a deficit of 200 oz of gold. No debt is necessary for them to finance this deficit, because they have the 500 oz of gold in their vaults. However, even though they do have the gold to pay for this deficit, they could still choose to finance the deficit with debt.

A fiat currency functions exactly the same, except the country has effectively infinite reserves. They could choose to finance the deficit (if the currency is in circulation). Or they could draw from the pile of infinite reserves. Its still a deficit, they just choose whether to issue debt or draw from their infinite pile of reserves. But they always have the infinite pile of reserves. Which questions the necessity of "financing" with debt. Clearly government debt plays a different role than financing, because they have infinite reserves. Thus debt issuance is a way of controlling the effects of inflation. The debt is never a burden on the government, nor is external financing necessary for them to spend money.

Its not MMT jargon really, the principals are exactly the same. Its just a new situation because a fiat government has infinite reserves.

This infinite reserves concept also makes it very clear why your taxes dollars effectively vanish. So the government has infinite reserves, and you pay them taxes of $5,000, and so we add your $5,000 to their infinite reserves and we get infinity. Your tax dollars just vanished. Kind of a bummer? I guess, but thats what happened.

Phew. Its basically all laid out. I think I should stop posting I have laid out the basics of a fiat economy from every angle. I think its important to just take it for what it is because I am not saying it is the right way to do things. I am just trying to explain the system as I understand it.

Does what I am saying make sense to anyone else?

[stone]

Lone Wolf "It's like the difference between me borrowing $100 from my loan shark and simply printing up $100 in a basement counterfeiting operation.  The first is a clear household deficit -- I'm going to owe somebody something.  The second is simple confiscation of the collective purchasing power, not a "deficit" per se."

MMTers do count printing money as deficit spending. They say that what matters is the expansion of "net financial assets". If government bonds are sold $ for $ to match the "deficit" spending- then the expansion in net financial assets is in the form of bonds. If the Fed buys the bonds (QE) or if money is printed, then the net financial assets are in the form of bank reserves or notes. MMTers claim that it makes little practical difference whether net financial assets are in the form of bonds or bank reserves. Most of the money supply is not monetary base (M0) but rather bank created credit. MMTers say banks use bonds as collateral to create bank loans and so bank deposits and M1 money supply. MMTers say that M0 has little influence over M1. They say that the money multiplier model is nonsense and that what determines M1 is bank capital (Basel rules setting lending limits are based on capital) and banks' willingness to make loans based on whether banks believe the loans will be paid back. MMTers say that deficit spending (government spending above taxation) allows borrowers to pay back bank loans and that makes banking profitable, increases bank capital and so induces banks to make loans.

Personally I think MMT descriptions of how things work fit in with my (very limited) sense of what seems to be going on. That's not to say that I think it's a good system or buy into many MMT views as to what ought to be done.

To me a clear example of a tax inforcement based monetary system starting afresh is the hut tax system that was used many times by colonialists (eg by Britsh in West Africa and Germans in Namibia). In that system, the occupying force subjected the population to a tax on each home. The tax had to be paid in hut tax tokens. These tokens could only be obtained in return for coluding with the occupying force or by trade with people who had obtained them from the occupiers. The hut tax tokens became the money in those places. I agree that money can also get used with a basis that is purely  the speculation that there will always be a "greater fool" willing to accept your cowerie shell or piece of silver or whatever once you have a need to trade it for something of practical value. I do think tax does act to stabilize the value of money as value based purely on convention can be fickel.