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Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them? A Very Great Deal Indeed!

I have been asked by Economic Reform Australia for a response to a very recent John Jay College, CUNY working paper, entitled Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them? (Jayadev & Mason 2018).

The authors of the paper, who identify themselves as being sympathetic to modern monetary theory, although they are themselves mainstream economists, argue that the answer to this question is ‘not very much’.

Their view is that neither mainstream macroeconomists nor modern monetary theorists are correct to see modern monetary theory as a radical challenge to macroeconomic thought, and that instead the essential difference between the modern mainstream and modern monetary theorists is a debate about the relative effectiveness of monetary policy and fiscal policy as tools for stabilising the economy across the business cycle.

In their abstract, they claim that ‘while MMT’s policy proposals are unorthodox, the analysis underlying them is entirely orthodox’.
This would be correct if modern monetary theory equated to the old-fashioned 1950s and 1960s Neo-Keynesian economics of what is often described as ‘the first neoclassical synthesis’. But MMT does not fit that equation, and so the authors of this paper are incorrect.

In the early 1970s, James Tobin argued that the debate between the (Neo-) Keynesians, including Tobin himself, and Milton Friedman’s monetarists boiled down to the same issues the authors of this paper have chosen to raise in 2018 (Tobin 1971). It was all about whether changes in interest rates or changes in the fiscal balance were a more effective way of influencing total spending, output and employment, and this depended on the interest elasticity of investment spending by firms, and the interest elasticity of the demand for money. At the time, Friedman correctly argued that there was more to it than that. The idea that this is the key issue between mainstream economists, as the modern-day Friedmanites, and modern monetary theorists, as though we are channelling James Tobin, is deeply mistaken.

Space precludes me from discussing this in full in this piece. That will have to wait for another occasion, or more correctly a series of other occasions. But we can deal here with a few misconceptions and errors of emphasis in Jayadev and Mason’s paper.

They claim their goal is ‘not to make an assessment of MMT as a whole’ and they admit to making ‘only limited references to MMT literature’. How you are supposed to answer the question they set themselves without assessing MMT as a whole, and how you can imagine yourself able to answer this question without referring in depth to the relevant MMT literature I will leave to one side. Perhaps we should be grateful that they are engaging with MMT at all, and doing so in a way which is not entirely dismissive.

They choose to ignore the chartal or state theories of money on which MMT is founded, and do not discuss at all the role of an employment guarantee within MMT. Indeed they state, ‘It is unfortunate, in our view, that many MMT texts begin with discussions of endogenous money, chartalism, and the mechanics of government fiscal operations. These arguments are intended to make the case that modern states have the capacity to borrow without limit at an interest rate of their choosing, but there is no need to establish this. It is already implicit in the orthodox view that the central bank can set the interest rate.’

Without an understanding of fiscal operations within a modern monetary system, it is not clear that government financial liabilities are properly not viewed as debt in the conventional sense at all, but as net financial assets for the non-government (private) sector; it is not clear that the ‘money multiplier’ theory is based on misconceptions about how the monetary system works, so that the issuance of debt securities by a monetary sovereign running fiscal deficits is optional; and it is not clear that the fiscal balance and any government debt to GDP ratio you choose to define are never appropriate targets for policy makers.

Jayadev and Mason are right to say that modern monetary theorists ‘do not see the debt ratio as an important target for policy’. They are wrong, or at least misleading, to say ‘that most MMT advocates would probably agree that the debt ratio should not be allowed to rise without limit’. The debt ratio WILL not rise without limit, and should only rise if there is a demand from the non-government sector to net save domestic currency, while the economy operates at the full employment level of income. It is not that the debt ratio is not an important target for policy. It is NEVER a suitable target variable – important or not – and should evolve as necessary in response to the evolution of the fiscal balance, to maintain non-inflationary full employment.

They argue that modern monetary theorists argue interest rates should be kept low in order to prevent the government debt ratio rising. This also is misleading. Modern monetary theorists argue for low, or even zero, official interest rates, because the link between interest rates and total spending is unreliable, shifts over time as balance sheets evolve, and even has an uncertain sign; and because non-zero risk-free interest rates have adverse implications for the distribution of income. This has nothing to do with stabilising an essentially irrelevant debt ratio. The fact that a low or zero interest rate DOES prevent that ratio rising without limit is true, but the idea that this is the reason we advocate for low or zero and stable interest rates is false.

They claim ‘the limits of a central bank’s ability to control interest rates remains an open question’. Once again, it is a pity they have no interest in the ‘mechanics’ of fiscal and monetary operations, or it would be obvious that a central bank can always use its balance sheet to set risk-free interest rates across the yield curve. This is a matter of fact, and there are no limits to it. It should not be an open question.

Lower, or zero, interest rates do not necessarily imply higher private spending, and so do not imply a larger primary fiscal surplus (or smaller primary fiscal deficit) for non-inflationary full employment. Zero official interest rates reduce the flow of interest payments from the government to the private sector, for example, which depresses demand; interest payments within the private sector are transfers of purchasing power; and any impact of lower interest rates on private borrowing has balance sheet effects, which means that any stimulus is limited in duration.
This of course is why modern monetary theorists favour more extensive bank regulation, and in some cases bank nationalisation, to influence the direction of new credit creation, and to limit the amount of new lending over time. Higher interest rates are not the only available mechanism for limiting private sector indebtedness.

They are right to say that MMTists ‘pursue the fiscal balance consistent with price stability’, and that we accept the basic logic behind the Phillips Curve relationship between inflation and unemployment. They are wrong to confuse our definition of full employment, which is a situation where there is no involuntary unemployment, with the mainstream definition, of a so called ‘natural rate of unemployment’ (or NAIRU). They are locked inside the mainstream, general equilibrium view of capitalism, as are other mainstream economists. This is a view which both modern monetary theorists, and Post-Keynesians more generally, reject as unrealistic, unhelpful, misleading, and biased.

This is where their failure to consider a job guarantee is so unfortunate. The job guarantee is the automatic fiscal stabiliser which eliminates the Phillips Curve trade off and does away with NAIRU, because it acts an institutional mechanism to allow us to attain genuine full employment without inflationary consequences. Mainstream economists use a buffer stock of unemployed labour to control inflation. We advocate a buffer stock of equitably and productively employed labour as a superior tool of stabilisation.

Because Jayadev and Mason are locked into natural rate thinking and the associated Phillips Curve as immutable facts of life, their definition of potential output is different to ours. They define potential output as the level of output consistent with the NAIRU rate of unemployment, and see the task of the authorities as stabilising output at or close to this level. We define full employment output as the level of output consistent with non-inflationary full employment, when a job guarantee is in place. Just as the size of the job guarantee automatically sets the appropriate fiscal balance, so the level of output will be whatever it needs to be for there to be equitable and non-inflationary full employment.

It is unfortunate that they repeat the oft-stated claim that democracy imparts a bias towards deficits and inflation. It is surely increasingly difficult to argue that this is the case, given the history of recent years. The problems of the great democracies of the USA, Europe and Japan, and so many others, in recent times have hardly been indicative of a bias towards inflation. Democracy ought to impart a bias over time to effective government, in the sense that ineffective governments ought to lose elections, and be replaced. Where this is not the case, the model of democracy being used is at fault.

They conclude by saying, ‘What reason do we have to believe that an elected government that was free to set the budget balance at whatever level was consistent with price stability and full employment, would actually do so? This is where the real resistance lies.’ How unfortunate that they have no idea of the central significance of the job guarantee in modern monetary theory. It is also nfortunate that they do not ask, ‘What reason do we have to believe that a government irresponsibly pursuing an inappropriate policy target of a fiscal surplus will not drive the economy into increasing private indebtedness, financial fragility and a severe recession?’

I am grateful to the authors of this paper for their attempt to engage with modern monetary theory. That they have not been able to do so effectively is because they have not delved deeply into the inadequacy of mainstream (neoclassical) macroeconomics as a useful description of how monetary economies actually function. To do this, they would need to acquaint themselves with the work of a variety of Post-Keynesian economists, including Paul Davidson, Hyman Minsky, and the great Michal Kalecki, and then go back and re-read Keynes himself. They ought then to re-read Lerner and to study carefully Wynne Godley’s stock-flow consistent monetary models of the economy. They refer to a paper by Godley’s co-author, Mark Lavoie, but they ignore the much more important work Lavoie did with Godley on stock-flow consistent modelling, which is an important tool within MMT.

Actually, they could just read my book, Economics for Sustainable Prosperity (Hail 2018), which explains the philosophical and scientific differences between mainstream macroeconomics and modern monetary theory, and builds connections from MMT to both behavioural economics and ecological economics.

I am planning to summarise the chapters of this book for readers of the ERA Review over the next year or so, so that readers can fully answer the question Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them?

The brief answer is ‘a very great deal indeed’.

Steven Hail

Godley, W. and M. Lavoie. 2006. Monetary Economics. An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan. New York.
Hail, S. 2018. Economics for Sustainable Prosperity. Springer Palgrave Macmillan. New York.
Jayadev, A. and J. Mason. 2018. ‘Mainstream Macroeconomics and Modern Monetary Theory: What Really Divides Them?’ John Jay College – CUNY,
Department of Economics Working Paper 2018-8.
Tobin, J. 1971. ‘Friedman’s Theoretical Framework’. Cowles Foundation Discussion Papers 309, Cowles Foundation for Research in Economics, Yale University.
Wray, L. R. 2012. Modern money theory: A primer on macroeconomics for sovereign monetary systems. Springer Palgrave Macmillan. New York.

Reforming Australia’s banking system

The economist Hyman Minsky told us that stability is destabilising so how do we build an anti-fragile financial system that serves the real economy?

Scientists have told us that the degree of complexity and disorder in a closed system naturally increases over time, and that energy must be drawn from outside the system if one wishes to reverse the natural tendency to disorder and complexity.

This is true not only in the natural world, but also in economic systems, and especially in banking and finance, as we should surely by now have learned from experience.

By 2008, the global financial system had become so large and complex, with so many layers, types of institutions and contracts, and so many interactions, feedback loops and potential sources of contagion, complexity and even fraud, that virtually nobody fully understood how fragile and likely to crash the whole system had become.

The word ‘virtually’ is appropriate here because almost all of those who were aware of the causes and consequences of the evolution of the financial system into more and more complex states were people with a deep understanding of the life’s work of a single economist – Hyman P. Minsky. And by 2008 the work of this great economist, who had died in 1996, were almost universally neglected by economists and other who claimed to have expertise in banking and finance, and almost all out of print.

We all know what happened next.

A banking system resting on four pillars

But I don’t want to rehearse the causes and consequence of the Global Financial Crisis (GFC) here, rather I’d like to instead focus on Australia’s commercial banking sector.

You might think Australia’s commercial banking is a relatively non-complex sub-system. You would be wrong.

Australia’s banks are, today, in some ways less connected to the rest of the global financial system than they were before the GFC, and are therefore in some ways insulated from international financial crises. Less connected in the sense that they rely less heavily on the short-term international money market for funding, and more on their domestic deposits, and in addition they have reduced their international investments (for example, NAB sold off its Scottish subsidiary Clydesdale Bank in 2016).

But Australia’s financial system is more concentrated, complex and fragile than it needs to be, and has been becoming more and more of an oligopoly. We now have one of the world’s most concentrated banking systems, with a four firm concentration ratio of about 80%. If you are an Australian, you might not even be aware that you bank with the ‘big 4’. You may not know Bank West is owned by the Commonwealth Bank. You may not realise that St. George’s (once Australia’s fifth largest bank), Bank SA, and the Bank of Melbourne are now just Westpac, by another name. Or that UBank is owned by NAB.

The UK and US banking systems are much less concentrated than ours, but of course they are far bigger systems, with more banks of systemic importance to not only their national economies, and to the global economy. And in 2008, those systemic banks needed saving, and in most cases were saved and revived with government money, with little or no significant reform.

Australia missed the worst of that crisis, but now has a potentially fragile system likely to turn what should be relatively mild economic shocks – small increase-es in interest rates, a minor recession in a trading partner, a minor inflation uptick, or a not unprecedented increase in unemployment – into a major crisis.

Or perhaps even cause the crash with no external stimulus? We are close to the point now where the scale of our mortgage lending and the size of the property bubble alone could trigger an economic downturn, without requiring any discernible external shock. These concerns are shared by Australian economist Prof Steve Keen (formerly Head of Economics, History and Politics at London’s Kingston University), who claims, in Debunking Economics, that the banking system itself could be the cause of the downturn. We may be close to that point in Australia, in that defaults may rise without there being an obvious cause, and this could trigger a recession on its own.

Australian banking is dominated by four megabanks which are essentially financial supermarkets, whose influence is found all over the financial and political systems. The ‘four pillars’ policy design-ed to prevent the four oligopolies from merging encouraged their diversification, so that there is now no sector of the Australian economy in which they are uninvested. Consequently, there is no sector of the financial system which has not been designed to be consistent with their interests.

Politicians and a range of investigative bodies will, from time-to-time investing-ate, castigate and where unavoidable, regulate (at least superficially) these four very profitable and enormously powerful institutions. Occasionally they might even be taxed.

The problem is that no new tax, or even the recent Royal Commission, will be able to change Australian banking in any good or fundamental way.

Government has become a commodity in and of itself. The Big Four banks (plus Macquarie) are so deeply invested and tightly connected to it and the Opposition through funding, lobbying, political donations, think-tanks and enticements of well-paid post-Parliamentary positions, that the banking industry has bought itself a get out of jail free card. It has bought for itself between $1.9 billion and $3.7 billion get-out-of-jail-free cards, according to a 2015 report of the Reserve Bank of Australia, (RBA).

The Big Four are among the largest companies listed on the Australian Securities Exchange, and feature heavily in the asset portfolios of most superannuation funds. We are (nearly) all their customers, and many of us are their shareholders. The banks are at the very heart of our monetary and financial system, from running the payments systems on which the entirety of our economy depends, to providing essential credit money to households, to small and medium-sized businesses, and for some purposes to large corporations.

They are too big to be allowed to fail, as has often been said. They are also too influential for politicians on the whole to confront, except in extremis. Most, if not all confrontation is designed to placate the public, forever seeking re-election, rather than for the purpose of any real and significant systemic reform which might make our financial system less fragile. Even the long – and in many respects explosive – Royal Commission revelations does not seem likely to lead to any significant restructuring or re-regulation of the major Australian banks beyond selling off some of their more peripheral and embarrassing interests.

There is as little genuine desire to reduce household debt and to promote business growth and the capital development of our economy (i.e. capital investment in business) as there is to make transparent to voters the workings of our monetary system.

To reduce the complexity and fragility of our financial system, we must necessarily facilitate a transition away from an economy based on household debt and towards an economy in which a greater number of people are invested in gain-full employment.

Commercial banking in Australia requires fundamental reform, in a way which might seem shocking.

Back to basics

Traditionally, the purpose of commercial banking has been to administer the payments system and to decide which businesses and households should be advanced credit.

Hardly anyone seems to have noticed, but we no longer need banks for the first of these two functions.

It is perfectly feasible for the Reserve Bank of Australia (RBA) to offer every Australian the opportunity to hold transaction, saving and term deposit accounts directly with itself.

It would be relatively easy to achieve, and while not advocating that Australia should emulate Ecuador’s financial system, if something like this can be done in Ecuador – as it has been – then it is certainly possible for Australia. Why would it not be?

If the RBA administered the payments system instead of the commercial banks, our transactions with each other could be cleared person to person, or business to business, in real time. The technology to do this already exists. It would not be difficult to do.

I repeat: we no longer need to use our massive commercial banks to run our payments system. If this was their main function, then they would be seen as a tremendous waste of this country’s national resources. The banks have privatised a public service that could be more easily and efficiently handled centrally by a public institution.

Within the confines of commercial banking activities, beyond controlling payments systems, the only significant purpose the banks serve is underwriting of private credit (‘underwriting’ in this context means assessing the default risk of potential borrowers, and then once credit has been created, carrying that risk until a loan is repaid).

Whether they do a good job of this, in the light of increasingly risky lending practices in what appears to be a property bubble (at least in parts of the Sydney and Melbourne markets), is a perfectly legitimate question. It isn’t obvious the banks are doing a great job of assessing credit risk. It’s not clear that the regulator APRA sees things that way at all. For example, only this February the chairman of APRA felt the need to remind the banks they should be ‘under no illusion’ that regulatory intervention would be necessary if lenders continued to increase growth in their interest-only mortgage lending. Fund managers have described many of these mortgages as ‘Australia’s sub-prime mortgages’, in a reference to the triggers for the US property crash which triggered the GFC, and at least one such fund has recently backed out of Australian investments, due to the risk of an ‘impending calamity’.

In principle, there is no reason why credit cannot be created by a public institution, in which case there is very little left for Australia’s big four banks to do, in terms of their core functions. Perhaps we don’t need them. Maybe they are obsolete. I would certainly advocate the formation of at least one public investment bank, like the government-owned KfW in Germany, with the role of providing funding for business investment within specific sectors of the economy.

However, it is generally accepted that properly regulated for-profit commercial banks play a useful role in business finance more generally, and in lending to the household sector (who wants public servants deciding on loan applications?). But this role can best be played by relatively small financial institutions. The small, local banks are more likely to provide finance to small businesses and to develop long-term relationships with those they support.

This is consistent with research in 2015 based on the Sageworks Bank Information data set indicating that larger US banks (those with assets of over $1bn) devoted less than 30% of their assets to small business lending, while smaller US banks (assets below $1bn) often had 30-60% of assets in this market. This indicates the relative significance of small businesses to these banks.

Such small banks would allocate credit while simultaneously creating deposit liabilities for themselves (as banks do now), backed by a supply of liquidity at the cash rate from the RBA.

In return for this supply of cash – which is more or less how the current system works anyway – these banks would be closely regulated in terms of what they are permitted to do. Their role in the economy would be very clear.

There should be a cap on the size of the balance sheets of any new banking organisations who should, naturally, be tightly regulated. I won’t speculate as to what that limit should be, but in my view no Australian bank needs to be larger than the Bank of Queensland, Bendigo and Adelaide Bank are today. We don’t need megabanks the size of the ANZ, CBA, Westpac, or NAB any more. They should be broken up. They are not champions of the Australian economy, needing to compete on the world stage. It’s not what our banks should be doing.

Not just Australia

This is not just a problem confined to Australia. It is one which exists in all modern economies. Immediately after the Financial Crisis, there was talk of limiting bank size in the USA, and a number of other countries, including Switzerland. But it never happened. As Robert Reich said, in a blog post on 21st October 2008,

“The business models and financial activities of the big banking companies are simply riskier than those of smaller, more traditional banks”.

He put the optimal size of a commercial bank at an asset value of between $500m and $1bn. Just in terms of loans made, the Commonwealth Bank is about 500 times this size. Even the relative ‘minnow’ Bank of Queensland is perhaps 30 times as big as this. Gary Stern and Ron Feldman, in Too Big to Fail: The Hazards of Bank Bailouts, said ‘policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.’ Even if Professor De Young is grossly under-estimating economies of scale in banking, it isn’t clear that banks need to be as large as they are.

Banks exist to assess who should-and-should-not be given credit. They exist due to a belief that it can be done more efficiently in the private sector, by for-profit institutions. In a system working to protect the interests of customers, the banks would still have depositors, but they would always have the option of holding deposits directly at the RBA. Smaller banks would always have the option of being partially funded from the RBA, as long as their balance sheets were strong enough to meet regulatory requirements.

Securitisation of finance contributed to the GFC and should simply be banned. There is no justification for its continued existence, particularly in Australia which likes to pretend it is more tightly regulated than the US but is actually just as vulnerable to an economic event of unprecedented proportions. However, at the moment there is, comparatively speaking, very little securitisation in Australia, and the market for asset backed securities was greatly reduced as a result of events elsewhere in the world in 2008/9. It isn’t the main issue in Australia in 2019. The main issue in Australia is the unnecessary size and scope and excessive power of the major banks, and the impact they have on our economic discourse and our policies, and the direction of our asset markets and economy. The Royal Commission has suggested nothing which would change this.

An economy replete with upper, middle and working-class financial insecurity (particularly one leveraged up to the eyeballs in private debt) likewise makes the impact of a crisis more crushing, more widely felt and would likewise take longer to recover from. Moreover, economic insecurity prevents more people from even having the capital to create businesses in the first place.

We certainly do not need mortgage backed securities, or any other form of securitised bank lending. In this model, all bank loans would remain on bank balance sheets, banks would engage in derivatives transactions only when meeting the legitimate risk-management needs of business customers, and such derivatives would be both limited in scope and highly regulated.

As for the areas of financial services beyond narrow commercial banking into which the long tentacles of the ‘Big Four’ still stretch, I won’t address them here – but they would best be separate-ed from commercial banking itself and provided through independent and separate institutions.

What I have described above is a far simpler, less complex, more easily regulated and supervised system. No bank would be ‘too big to be allowed to fail’, and no single institution or group of institutions would be in a position to intimidate governments or excessively influence government policies.

And who is at the peak of the Australian monetary pyramid would be crystal clear to everyone – who rules the roost in our monetary system. The answer to that question is ‘the owner of the central bank’. The Australian Commonwealth Government owns the RBA and therefore sits at the top of our monetary system. The Australian Commonwealth Government is the monetary sovereign, currency-issuing central government, and the only institution with a limitless ability to create Australian dollars. The same applies to the Bank of England – the UK government owned central bank. And the Federal Reserve in the US, despite its unusual legal status, is also a ‘creature of Congress’, and part of the state.

This shocking fact is obscure to most people today, but it is a fact, even now. If we could summon the energy outside our banking and financial system, to simplify and demystify the workings of Australian banking, we could make this crystal clear to all.

That might well be the greatest benefit of all, from greatly simplifying and strengthening our national financial architecture.

Steven Hail

Bank income and spending

One of the most common difficulties many people encounter in understanding the mechanics of the financial system lies in their failure to understand the difference between stocks and flows.

For example they have difficulty understanding why commercial bank interest income is a flow while at the same time the credit money created by banks is a stock.  One difference lies in the fact that bank credit money creation entails no change in bank equity (= assets – liabilities, also known as net assets, or net worth), while bank interest received represents at least a temporary increase in equity. That temporary increase in equity enables a commercial bank to spend in order to accommodate its many costs – including such things as interest paid to depositors, shareholder dividends, government tax, salaries and overheads – and to acquire new investments.

Bank equity is not money 

Bank equity may be visualised in terms of some combination of (a) loan securities, (b) investment securities, and (c) reserves. The loan and investment securities are bank assets, and also liabilities of the borrowers and/or security issuers. Reserves are also bank assets.  However none of these assets are directly matched by bank liabilities.

One should be aware of the difference between an operating account (which does not contain entities which can function as money) and a transaction account (which always deals with money). In order for something to function as money, it requires a marketplace of players who have access to it, who accept it, and who use it for transactional purposes.

When a bank wishes to spend into the real economy in order to accommodate any of its costs, it creates new credit money. Commensurately, it marks down its operating account , which reduces its equity. Bank equity is not money, so when a bank spends there is no monetary transfer within the real economy. That is, bank equity does not make up any part of the monetary aggregate M1. Any expectation that if something can be given a monetary value then it can function as money is unwarranted. When a bank lends or spends, the money supply temporarily increases. While when a bank receives a retail payment, the money available to the public is temporarily reduced.

One should also recognise that commercial banks have no need for bank credit money and do not store it. Banks can create or destroy credit money by simply adjusting the entries in the accounts of bank depositors.  If these entries are in credit, then they are at the same time depositors’ assets and banks’ liabilities.  For this reason, a deposit (of credit money) in a bank is not a loan to the bank, as some people suppose. Anything that is borrowed is necessarily an asset of the borrower.


Lending and spending by a bank are facilitated in large measure by the volume of the bank’s equity in relation to the totality of the bank’s risk-weighted assets.  Bank lending and spending also effectively transfer reserves between banks. We have used a broad definition of the word “reserves” in this explanation, which can embrace such things as (i) cash held in bank vaults and tills (currency reserves), (ii) exchange settlement funds (or creditary reserves), and (iii) bank-held short-term government securities (“near money”). The first two may be thought of as “narrow” state fiat money, while the last may be thought of as a component of “broad” state fiat money.

Reserves held within the banking system are not part of the money supply and are not interchangeable with bank credit money. We have a dual monetary system consisting of state fiat money (banking reserves plus currency) and bank credit money. These two forms of money tag along with each other with every transaction involving a bank, but they never mix. Members of the public and non-bank businesses have no access to banking reserves. Banks never lend or spend their reserves into the real economy – never. The line is never crossed. Bank reserves created by the central bank remain within the banking system, and are transferred between banks as and when required.

For countries like Australia and Canada which possess no formal requirements for reserves holdings by banks (other than that their credit balance must remain positive as a condition for the continuation of their depository facility with the central bank), the commercial banking institutions have no incentive to hold more creditary reserves than they require to satisfy their expected exchange settlement operations and their liquidity management. This is especially the case if they can obtain better interest returns  from holding investments.

Investment securities

Lets us suppose that a bank uses part of its income to purchase an investment security from a bond dealer. The  bond dealer might have purchased it from another dealer. Pursuing the sequence of such buying and selling by various dealers, we arrive ultimately at a first transaction in which a dealer purchased a newly created security from either (a) a corporation, (b) a government agency, or (c) the central bank in association with its open market operations.  In some of these transactions, reserves were returned to the government or the central bank.  And in particular the return of reserves to the government will have facilitated government spending and/or lending into the real economy.

The various operations described above occur as a result of the temporary increase in bank equity derived from interest payments and are monetary flows. Implying that bank interest income is not a static entity and is therefore a flow.

Retained earnings

It is sometimes supposed that the portion of bank income which is held in the form of “retained earnings” or “retained profit” represents a withdrawal of money from the real economy, thereby appearing to justify (at least in part) the claim by advocates of the “debt virus hypothesis” that money needs to be created specifically in order to accommodate the interest paid to banks for the loans they advance. However this claim may be shown to be illusory, when the various monetary flows associated with the creation of this component of bank equity are carefully investigated.

Bank retained earnings are part of a bank’s equity. Those assets overwhelmingly take the form of purchased Treasury securities.  This is because, as mentioned previously, banks prefer not to hold on to more than a very minimal level of reserves, and to retain only the estimated cash (coins and notes) required for the immediate requirements of their customers.

The purchased securities may be subdivided into those that are purchased directly from Treasury and those that are purchased from a securities dealer.  Direct Treasury purchases free up government fiscal space, thereby facilitating government spending into the non-bank private sector (limited only by the necessity to constrain undue inflationary pressures).  Purchase from a dealer enables that dealer to purchase more securities from another source, with the intention of making a profit from the interest margin.  In addition, a certain fraction of these assets also will be purchased by the central bank, as part of its open market operations. In practice a sequence of borrowing and lending operations by security dealers will occur, providing each dealer in the chain with substantial income, and the money thus obtained will be largely spent into the real economy in order to accommodate the dealer’s many living costs.

The important consequence of all this is that, one way or another, the purchase and repurchase of these assets assists the flow of money through the economy, rather than having the money saved or stored in some way.

Bank interest income

Let’s consider the repayments on a loan made by a commercial bank to a retail borrower.  One might ask why the loan interest received increases the bank’s equity while the loan principal received does not.  In order to fully understand this, one should carefully examine the way in which the respective transactions are accounted.

The simplest conceivable model for demonstrating the financial mechanics would have an economy containing a single commercial bank (and note that for such an idealised single-bank economy there will be no need for creditary reserves).

Let us suppose that the borrower possesses a loan account (account 1, into which the bank creates the initial demand deposit) and a savings account containing previous savings (account 2, which pays interest on deposits). In this simple model, the borrower does not actually spend the newly created bank credit money, but uses it to create a deposit in account 2 as collateral in support of business activities for a convenient period of time, after which time the full payment of principal and interest will have been made.  It should be recognised that the original creation of each of these accounts entailed no change in bank equity.

The original bank loan advance created two assets and two liabilities; thus the loan security is the bank’s asset and the borrower’s liability, while the deposit of bank credit money is the borrower’s asset and the bank’s liability.

Repayment of principal using bank credit money   The repayment of principal is an exact reversal of the original creation of two assets and two liabilities. The net result is that there is no change in bank equity.

Repayment of interest using bank credit money   The repayment of interest entails a reduction in the borrower’s assets and in the bank’s liabilities. This reduction in bank liabilities without a commensurate reduction of bank assets implies an increase in bank equity.

Repayment of interest using currency (coins and banknotes)   The borrower will withdraw from account 2 at some stage in order to obtain the currency (which withdrawal entails no change in bank equity) and at a later time will pay that currency to the bank as loan interest. There are two possibilities here. The first is that the two transactions will occur within the timeframe allocated for the bank to compute its equity (the accounting period), and for this case the net result is a reduction in the level of bank liabilities without a commensurate change in bank assets. The second possibility is that the borrower withdraws currency from account 2 and places it in a wall safe for a period of time exceeding the bank’s timeframe for computing its equity, before using it to pay the interest. In the latter situation, arguably the interest payment may be identified with an increase in the level of bank assets (more specifically, currency reserves) without a commensurate change in bank liabilities.

Analysis of the accounting procedures will be obviously more complicated for a multi-bank system, particularly if the existence of creditary reserves and the operations of a central bank are taken into account.  The model for a two-bank system is a little more complicated but still straightforward, and the transfer of reserves between the spending bank and the payee’s bank must be taken into account.

John Hermann

The biggest intellectual scandal of our time

If mainstream economists had thought and behaved differently after 1980, then arguably the world would not be in its current state of disarray, and much of the social and environmental dislocation that we have witnessed over that time-span would not have occurred. In a nutshell, these economists uncritically accepted as true the false analyses, promises and prescriptions of neoliberal ideology. The destructive outcomes of their attempts to implement those  prescriptions were greatly enhanced by their profound ignorance of the operational dynamics of finance, banking and credit money creation. To this day they continue to hold to barter-based models of economic activity, to the extent that money, credit and banking are missing from their considerations.

Mainstreamers possess several major blind spots. Firstly a failure to recognise the important role that the creation and flow of bank credit money plays in the evolution and development of every modern economy, through its essential contribution to income, aggregate demand, employment and economic performance. Secondly, they think that private debt growth does not affect economic performance. Thirdly, they think that every economy tends towards a stable equilibrium configuration. Fourthly, they think that private borrowing, spending and saving are always driven by “rational expectations”. Fifthly, they think that public debt (i.e. deficit spending) should be minimised, consistent with what they imagine is the universal validity of  the “crowding out” hypothesis – which falsely asserts that public borrowing always crowds out private borrowing, leading to rising inflation and rising interest rates.

And lastly, they hold to the idea that commercial banks do not create the money they lend and spend into the economy. But rather, they hold to the “loanable funds” hypothesis, which asserts that banks are able to on-lend their depositors’ funds. The reality however is that neither bank credit money nor reserves are ever loaned out to a bank’s retail customers. Moreover bank credit money creation occurs endogenously, meaning that banks lend or spend first and look for the regulatory reserves they might happen to need later. Central banks are always able and willing to provide the reserves that the aggregate of commercial banks require for their business operations. Flying in the face of this reality is the belief of mainstream economists that reserves are created proactively – under the discretionary control of the central bank – rather than reactively in association with their open market operations.

It seems that central bankers know a good deal more about these matters than do mainstream economists. This is evident from a 2017 monthly report on the dynamics of bank money creation produced by the Deutsche Bundesbank and also a similar 2014 report produced by the Bank of England The BoE report referred to here was discussed in a previous issue of ERA Review [v7, n4, 2015; p15]. The  findings of these reports are quite inconsistent with the false beliefs held by mainstream economists that we have listed above. Unfortunately, if their past history is anything to go by, that is unlikely to change the views of many of the (neoclassical) mainstreamers, who will simply adopt the tactic of ignoring the existence of these reports.

John Hermann

Reserve Bank decision time: good luck Australia!

On the first Tuesday of every month (except January, when they are all off on their holidays) the governor of the Reserve Bank of Australia (RBA) meets with the deputy governor, the Treasury secretary and six other worthies (all appointed by the government) to decide what to do about something called “the cash rate“.

It’s been a long time since they last raised it and, instead, since 2011, there has been a long series of cuts to an all-time low, in a forlorn attempt to get us all to spend a bit more.

Every month, the RBA board has been torn between a temptation to cut even further and an urge to leave the cash rate where it is. On the one hand, they need us all to borrow more, but on the other hand they are worried about us having too much debt already. What’s more, they are scared that one day the cash rate will reach zero and uncertain about what that will mean. It is all a terrible muddle.

The economy hasn’t been growing quickly enough to provide enough full time jobs for people and there seems to be no risk of runaway inflation any time soon. Everyone knows that really the government ought to be spending rather more than it has been doing and not matching this spending with higher taxes. But nobody is allowed to say this. It would contradict what Scott Morrison, Malcolm Turnbull, Joe HockeyTony AbbottUncle Tom Cobley and all have been saying for years now about “balancing the budget” and “living within our means”.

They have backed themselves into a corner. It’s all been political machismo. There is no budget emergency and there never has been.

And all this machismo is damaging the country.

The politicians would like the RBA to keep cutting in the hope that this will help, but there is nothing useful the RBA can do. They are out of bullets. Interest rates are already close to zero and although several other central banks have shown in recent years that zero isn’t a boundary you can’t cross – and have introduced negative interest rates for the first time in history – that hasn’t been a great success. It seems that the private sector, and in particular households, are up to their necks in debt and don’t want to borrow much more. Interest rate cuts are at most a very short-term sugar hit. The drug doesn’t work anymore. It might even further weaken the patient.

What is this thing called the “cash rate”? Just as you and I have deposits at our banks, so the banks themselves have reserve accounts at the RBA. The way our system works at the moment, the cash rate is the rate of interest at which the banks – the ANZ, Westpac, and so on – lend to and borrow from each other the digital “cash” they hold at the RBA. These reserves are used to deal with the millions of transactions that take place every day between account holders at the different banks.

In the run of things, on any particular day, some banks will gain reserves and others will lose them as a result of all this activity. It is normal for a bank with excess reserves at the end of the day to lend those reserves to a bank which is running short. This happens at the “cash rate”.

In principle, the cash rate is supposed to be determined by the private banks themselves — in other words, in the money market. In practice, in recent years, the banks have always used the RBA’s target rate. The RBA, in return, makes sure that the total supply of reserves in the system is exactly what the banks need.

The way they do this is a little bit more complicated these days than it used to be (involving things called “repos“) but the textbook story of the RBA buying government bonds from the private sector when it needs to feed cash into bank reserves and selling bonds when there is too much cash in the system, is still essentially accurate.

If there was too much cash in the system, the cash rate would fall below the RBA’s target; if there was a short-age of cash, it would rise above the target. To control the cash rate, the RBA has to make sure banks have just the right amount of cash in their reserve accounts. It is all a bit “Goldilocks” but the RBA and the banks are in constant touch and the system works pretty well.

So much so that all the RBA board has to do is to announce a change in its target for the cash rate on the first Tuesday of the month and, as if by magic, the cash rate used by banks automatically changes the following night. The RBA doesn’t have to do anything, except make the announce-ment. The banks then automatically fall into line with its wishes, as long as the supply of cash into their reserve accounts is “not too hot and not too cold but just right”.

That’s the story, really – simplified a bit. The cash rate is the key interest rate in our financial system. Short term rates are linked to it very closely. Long term rates, like those on fixed-rate mortgages, depend largely on what banks expect to happen to the cash rate in the future.

There is only one problem with all this, as we said. Using the cash rate to manage total spending and inflation doesn’t work anymore. Household debt has trebled since the 1990s. People can’t or won’t borrow ever more, whatever the interest rate. What’s more, for everyone with a mortgage who benefits from a lower mortgage rate, there is a saver who loses out on a term deposit.

The low interest rate drug doesn’t work anymore. To the extent it ever did, it did so by loading the private sector up with more and more debt, and making our financial system increasingly fragile.

The rate of interest, as a tool for pushing the economy forward, appears to be kaput!

I’ll let you in on a secret. They all know this. Everyone in the know understands that the government should be stepping up to the plate, and doing the extra spending itself. Everyone in the know understands that the Australian Government can’t run out of Australian dollars. The RBA Governor knows. And the Treasury Secretary knows. They must know.

These people know all of this – but they don’t dare say anything. Remember the machismo: they have painted themselves into a very awkward corner. Nobody wants to appear irresponsible, so nobody takes responsibility.

It is all a terrible muddle. And mean-while, the threat of a property bubble is still hanging over us. Good luck, Australia. You are going to need it. 

Steven Hail

Creation and destruction of bank credit money

It is well known and understood that the nation’s money supply overwhelmingly consists of deposits within bank accounts of an intangible entity known as bank credit money. This form of money is interchangeable with currency (coins and banknotes) on demand. It fluctuates according to economic circumstances, and its dynamic is one of continuous creation and destruction.

However there is a widespread belief that credit money is only created by commercial banks when they lend to their retail customers. The reality is that bank credit money is created and destroyed by a variety of routes. These include:

Credit money creation:

(1) Retail bank lending
(2) Bank spending into the real economy
(3) Bank purchase of assets from the non-bank private sector
(4) Government spending
(5) Government lending to the non-bank private sector
(6) Reserve Bank purchase of assets from the non-bank private sector

Credit money destruction:

(1) Repayment of bank retail loans (principal and interest)
(2) Any other payment to banks from the non-bank private sector
(2) Government sale of Treasury securities to the non-bank private sector
(3) Taxation receipts obtained from the non-bank private sector
(4) Bank sale of assets to the non-bank private sector
(5) Reserve Bank sale of assets to the non-bank private sector
(6) Repayment of government loans by the non-bank private sector

John Hermann






Federal Treasury finances: a functional perspective

Modern monetary theory (MMT) offers an analysis of the flow of money within our economy, and in undertaking this task it proceeds from some basic assumptions, including the propositions that bank credit money and banking reserves are (a) destroyed when federal taxes are paid and when Federal Treasury securities are issued to the non-government sector, and (b) created when the Federal Government spends into the non-government sector. This article examines what the analysis implies within an Australian context, although the ideas and conclusions are more generally applicable. However we must firstly define what is meant by money.

  1. What is money?

Most economic textbooks tell us that money is any entity which (a) is accepted and used by the public as a means of payment for taxes and debts and for purchasing goods and services — in other words it behaves as a medium of exchange; (b) can be used as a store of value; and (c) possesses a unit of account (which in Australia is called the Aus Dollar). There is also an implication that the range of monetary transactions occurring and permitted within the real economy will embrace an adequately sized marketplace of players.

There exist three widely recognised forms of money:

(a) Currency, by which we mean coins and banknotes.

(b) Bank credit money, an intangible form of money created by commercial banks in the accounts of their retail depositors.

(c) Banking reserves (exchange settlement funds), created in the depository accounts of commercial banks with the Central Bank (CB).

Items (a) and (c) are collectively sometimes referred to as the monetary base. The “money supply” –  meaning money accessible and used by the nonbank sector – can be defined in various ways, the simplest definition (called narrow money) being the conjunction of bank credit money and currency in the hands of the nonbank sector.

  1. The Federal Treasury is not a bank

A number of economic commentators have suggested that the Federal Treasury behaves like a bank. In my opinion such a viewpoint is wrong, for the following reasons:

(a) Treasury does not take deposits from the public, or from the commercial banks.

(b) Treasury does not directly create credit money in the accounts of nonbanks (i.e. by contrast with commercial banks). When Treasury spends, it instructs the Central Bank to transfer reserves to the payee’s bank, which authorises that bank to create new credit money in the payee’s account.

(c) Unlike commercial banks, Treasury’s primary role is not the creation of financial assets via retail lending or the acquisition of commercial profit.

(d) Treasury does not lend reserves to commercial banks (i.e. by contrast with the latter, which often lend reserves to each other).

  1. Are Federal Treasury’s CB credits a form of money?

Given that the Federal Treasury is not a bank, the credits in its account with the Central Bank cannot be banking reserves (unlike those of commercial banks). And clearly these credits do not consist of bank credit money, which can only exist within the depository accounts that commercial banks make available to citizens and businesses. Neither is it currency, because it has no tangible form.  So the question arises, are these Treasury credits a form of money in any sense at all? Officially, they are not a form of money for the simple reason that they are excluded from the monetary base and also from every measure of the money supply.

The following propositions relate to this question.

  1. A monetarily sovereign entity, i.e. one which has the power to create and destroy money, has no use for that money — and in particular does not need to store it.
  2. If the Federal Government Treasury is not a bank, then its “deposits” in the Central Bank necessarily have a different status to the deposits of commercial banks in the central bank.
  3. One of the essential requirements of any entity entitled to be called money is that it is used by (traded, loaned/borrowed between) a sufficiently large number of marketplace players who have similar status and objectives in regard to those operations.  Bank deposits in the Central Bank satisfy this criterion, since all of the players are in competition with each other with the common objective of maximising their financial profit.  In contrast, the Federal Government maintains an account with its Central Bank for a quite different purpose, and its spending has a different objective.
  4. These days Federal Australian Treasury bond sales do match net spending (deficit spending), and so appear to top up the notional Treasury balance at Australia’s Central Bank – the Reserve Bank of Australia (RBA). However this is a relatively new development, having been introduced in Australia under the guise of ‘sound financial policy’ in 1982, and is not the practice in some comparable economies, such as Canada. Thus the Australian Treasury has not, since 1982, borrowed directly from the RBA – by selling bonds directly to the RBA or by using any other accounting mechanism (sometimes described as Overt Monetary Financing). Prior to 1982, it did sell bonds directly to the RBA, which meant – to take the logic to its obvious limit – that any number appearing within the government account at the RBA was rendered functionally meaningless.  The post-1982 voluntary constraint on government-RBA relations does not in any sense undermine monetary sovereignty, but it does appear to do so – by obscuring the fact that the Australian Government cannot ever become insolvent in its own currency, and is not limited by its ability to attract ‘money’ into its account at the RBA.
  1. The situation in the United States is a little different, in that the constraint on direct borrowing by the Federal Treasury is not voluntary, but is enforced by legislation. However even in this case the constraint may be easily bypassed if there happens to be a need to do so. Within Australia and the U.S. there exist statutory regulations to the effect that, whenever a difference over policy exists between Treasury and CB which cannot be resolved by negotiation, the will of Federal Treasury will ultimately prevail. So even if there happened to be a legislative constraint on direct borrowing, the Treasury could – if it so wished – issue a quantity of new bonds to the private sector and arrange for the CB to buy the same quantity of bonds from the private sector. The net result is obviously the equivalent of direct borrowing.
  1. The economic mainstream hold that the Federal Government’s “deposits” in its Central Bank account are a form of state fiat money, moreover one which is interchangeable with reserves. However the above propositions imply that such “deposits” are not money in any real sense of the word, but are merely accumulated credits in an operating account.  An operating account records a financial reality, but this does not imply that it is a form of money in a functional sense.

On this basis it may be held that the central government stands alone – that is, not in competition with any other entities possessing accounts with the central bank, and that the entries in the Government’s RBA account do not function as money.

John Hermann