In the following video I explain briefly why this is such a destructive myth and why this country desperately needs to learn that the burden we leave our children is not a debt burden, but a certain living standard. It’s true that spending money at the government level could reduce this living standard and we could certainly leave our children with a standard of living that is below our own, but what we won’t leave them with is a bill that they need to pay off in the form of some debt burden.

See the following video for more and read the following links if you’re still confused:

Understanding the burden we leave our grandchildren: http://pragcap.com/the-burden-we-leave-our-grandchildren

Why government debt matters: http://pragcap.com/debt-matters

Understanding the modern monetary system:http://pragcap.com/resources/understanding-modern-monetary-system

I feel that the core operational aspects of MMT are among the most important ideas in the world and my goal here has always been to help promote those ideas.   Because I believe in those ideas I will not stop promoting them.  So I’ve been working with Michael Sankowski, Carlos Mucha (who most of you probably know as reader Beowulf) and several others to help formulate our thinking.  I’ve also been in detailed talks with Warren Mosler over the last several weeks hashing out some differences.  It’s safe to say that we have his blessing even though he’s not 100% in agreement with all we’ve concluded.

Importantly, I want to be clear that I do not view Modern Monetary Realism as a competing idea to MMT.  Rather, it is merely the form of Mosler Monetary Theory that I wish to promote (without confusing readers into thinking that I am promoting the exact MMT ideas and prescriptions).  After all, Warren is still the father of the theory and it’s incredibly important to note that he is, by far, the most influential thinker in this offshoot of MMT.   If anything, I hope that by focusing on the operational realities of MMT via Modern Monetary Realism that I will bring even greater credibility to MMT and its operational realities.  The fact that we have differences regarding prescriptive uses, in my opinion, gives the idea even greater credibility.  But in the end, it should be clear who gets the credit for these ideas – Warren and the other developers.  Modern Monetary Realism is merely standing on their shoulders.

You can find my revised paper on Understanding the Modern Monetary System here.  We will also be running a new website at www.monetaryrealism.com (not yet activated) to update our ideas and help to promote the heterodox movement.

“WITH little fanfare, a dangerous notion has taken hold in progressive policy circles: that the amount of money borrowed by the federal government from Americans to finance its mammoth deficits doesn’t matter.

Debt doesn’t matter? Really? That’s the most irresponsible fiscal notion since the tax-cutting mania brought on by the advent of supply-side economics. And it’s particularly problematic right now, as Congress resumes debating whether to extend the payroll-tax reduction or enact other stimulative measures.

Here’s the theory, in its most extreme configuration: To the extent that the government sells its debt to Americans (as opposed to foreigners), those obligations will disappear as aging folks who buy those Treasuries die off.

If that doesn’t seem to make much sense, don’t be puzzled — it doesn’t. Government borrowing is still debt that must eventually be paid off, just as we were taught in introductory economics.”

Most introductory economics is wrong.  Debt always matters.  But it impacts different entities in different ways.  For a currency user (like a household, business, state government, or European nation) debt always involves borrowing dollars from someone else and eventually having to repay debt.  In order to service this debt you must obtain dollars to meet the repayments over time.  Therefore, these entities are always constrained in their ability to pay back debt.  They have a real solvency constraint.

This is not the situation for an autonomous currency issuer.  The USA for instance, has no constraint in its ability to issue US Dollars.  It doesn’t call China to borrow money first.  It doesn’t check tax receipts.  The USA, with its printing press, just adds dollars to the economy when it wants.  It can help to think of the USA like a scorekeeper at a football game.  They don’t have a pile of points sitting around waiting to use.  They just credit and debit the scoreboard when they want.  But they never take points from one team in order to give them to another team.  That’s just not how autonomous fiat currency systems work.

The USA doesn’t repay the debt as Rattner says he learned in econ 101.  There’s simply no such thing.  That’s why your grandmother never says “I wish Uncle Sam would pay off the national debt so I could get rid of these damn savings bonds!”.  If you think about that for a second, you quickly realize that grandma’s savings is the government’s debt.  The governments deficit is the non-government’s surplus.  This is an accounting identity.  If the US government creates no money then there are no dollars for the private sector to use.  If the government spends $100 into the economy then the government has a $100 deficit and the non-government has a $100 surplus (excuse the simplicity of the example here).   Remember, as the currency issuer, the US government has to make US Dollars available before anyone can use them.  It doesn’t borrow first to then be able to issue US Dollars.  In fact, if the US government made no dollars available to currency users then there would be no dollars in existence to buy US government bonds in the first place.  So the mainstream has the entire concept backwards.   Rattner is comparing a household to an autonomous currency issuer when the fact is they are apples and oranges.

So what’s the bottom line – debt matters!  For an autonomous currency issuer, debt doesn’t create a solvency constraint.  After all, there is no such thing as the US government “running out” of US Dollars.  That’s impossible.  So it can always service its debt needs by creating more dollars.  But what it could cause via the issuance of too many dollars is very high inflation.  Some will argue that inflation is a slow default, but that’s simply not true.  For instance, we often hear that the US Dollar has fallen 90% since 1913.  But that’s highly misleading.  What people always fail to note is the fact that living standards have soared in the USA since 1913.   So, while the CPI rises almost every year and the money supply grows with time, there’s no factual evidence for the idea that inflation destroys lives.  The last 100 years thoroughly disprove this notion.  What could happen with time is that the US government could print dollars in excess of our productive capacity and generate a sort of negative feedback loop perhaps leading to lower living standards and even hyperinflation.  This would surely be disastrous for the USA, but that’s a very different phenomenon than benign inflation or default….

That said, I wrote a lot this year.  A lot of the articles are junk, but once every blue moon I write something that I am really proud of.  Something that is substantive.  Something that even gets published elsewhere or makes a real impact on the way people think about money, finance, economics and life.  And ultimately, that is why I write.  We’re all on this journey together to find answers to seemingly insurmountable questions.  When I put a piece of that puzzle in the right slot it makes it all worth it.  That said, I’ve attached the 11 pieces that I am most proud to have published this year.   In case you missed any of them, here they are:

11.  The Fed Is Not Monetizing The Debt!

No article generated a buzz like the one where I claimed quantitative easing did not involve money printing or financing of government debt.   Most thought I had committed some sort of economic cardinal sin.  I had spent a huge amount of time boring readers to sleep over QE over the last few months and it all came to a head with this story.  The myth that QE was “money printing” ran to the very top levels of government.  And the public was 99% sold on the idea. It was a near universal opinion that the Fed was dropping money out of helcopters and doom via hyperinflation was imminent.  Except that all turned out to be wrong as I had tried to explain.  What ensued was a 600+ comment thread, multiple personal attacks on my understanding of the monetary system and ultimately, vindication as the U.S. economy sank back into the throes of the credit crisis in late 2011 and hyperinflation didn’t come close to developing.  But still the myth seems to persist….

10.  Understanding The Modern Monetary System

My paper on the monetary system (currently ranked #23 in the entire SSRN database) was probably my most substantial piece of work this year.  It is the cornerstone of my MMT work.  I owe it largely due to help from Scott Fullwiler and Warren Mosler although I hope I’ve made some contributions of my own.  I wrote the paper with the hope that simplistic terminology and a non-academic approach could help the layman better understand this complex monetary system in which we live.  Better yet, it helps to dispel so many of the myths that we are taught to believe mainly due to the extraordinary political bias that has poisoned so much of the world of economics.

9.  How The Republicans Can Win The White House

I’ve been accused of being an insider at the Fed.  I’ve been accused of writing the website on behalf of the Federal government.  But this one got people thinking I was secretly a strategist for the Republican Party (nothing fills the email box like an article that appears politically biased).  The plan to win the White House – simple.  Just block any government spending bill that would come down the line.    The macro thinking – in a balance sheet recession the spending cuts would do exactly what they’re doing in Europe – crush the domestic economy.  And at times, it’s looked like the Republicans were using that exact strategy.  Thankfully, I’m not involved in strategy for any political party and no one is silly enough to actually execute a strategy I claim will work….

8.  Hyperinflation – It’s More Than Just A Monetary Phenomenon

The hyperinflationists have been on the wrong end of a great deal of my jokes (see here & here).  I had long predicted that hyperinflation was not coming to the USA, but I hadn’t been quite so precise about it as I was in this piece. I knew banks didn’t lend reserves and I knew that QE didn’t do much (and that it certainly wasn’t “money printing”).  But I had never articulated that point so precisely.

I was on a ski lift in Idaho last winter thinking about historical cases of hyperinflation (what else would I be doing on vacation?).  The conclusion I came to was something I had personally never seen before – none of the hyperinflations were actually caused by money printing, but were actually caused by exogenous circumstances that result in money printing.  Even more interesting, none of the historical cases had anything in common with the current economic state of the USA.  That hasn’t stopped anyone from making hyperinflation predictions although some certainly seem to be questioning their calls or changing their stories….

7.  Keynesians, Austrians & Monetarists Oh My!

I spent an inordinate amount of time this year debating the merits of MMT versus the approaches of other schools of economic theory.  In this piece I did what few people can do.  I pissed off Keynesians, Austrians and Monetarists all in the same story….

6.  The Destabilizing Force Of Misguided Market Intervention & Misunderstanding The Monetary System Is Bad For Your Portfolio

I get plenty of things wrong in the course of a year.  But overall, I’m pleased to look back and say that I nailed many of the larger moves in terms of monetary policy and global macro moves.  In this piece I said the Fed’s misguided QE2 policy had caused a disequilibrium in the markets (primarily many commodities).  And as QE2 ended the markets quickly came to the conclusion that QE2 had indeed done little to nothing for the US economy….

5.  Being The Currency Issuer Matters

No story dominated 2011 like the Euro story.  And if you understood the story from an MMT perspective you had a huge leg up on other investors.  Understanding the solvency risk and currency issuers versus currency users was absolutely vital in navigating the sovereign debt crisis.  I would argue that few analysts and market pundits did a better job of communicating these important concepts than MMTers (many of whom predicted the Euro crisis 20 years ago).  And if you understood the global government put making money off the crisis became as predictable as the persistent failures to solve the crisis….

4.  The Role Of The Entrepreneur In A Capitalist Economy

As the OWS movement has persisted, many have lost site of the great engine that is capitalism.  Entrepreneurs and capitalists helped give us many of the things we take for granted today.  More importantly, they’ve given us time, time to live fuller and more meaningful lives than anyone could have ever imagined….

3.  I Want To Come Back As The Federal Reserve!

The calls for surging interest rates in the USA have been persistent.  And if you don’t understand the relationship between the Fed and the bond market then you likely missed the massive 30%+ rally in bonds last year.  James Carville was wrong.  You don’t want to come back as the bond market.  You want to come back as the Fed.  Then, you can intimidate everybody….

2.  10 Economic Myths That Persist

I did a lot of myth busting in 2011.  These videos get right to the point dispelling 10 of the most prominent myths that poison economic thinking today….

1.  Where Is The Excessive Risk Right Now?

After all the macro wonk talk, behavioral discussions and economic babble, I am still just a market guy.  Ultimately, none of this matters if you can’t put it all together into one easily decipherable strategy that helps you to avoid risks and make money from the markets.  I pride myself on being a risk manager.  Remember, it’s not the butterflies and rainbows that ruin your trip to the top of the investment mountain.  It’s the loose stones that send you falling down.  In this piece I did something rare.  I posted the markets that I saw as the biggest risks given the unusual environment surrounding QE2.  I said silver, Chinese equities and European equities were all “excessive risks” before they each fell 30%+.  That sort of fall requires a 45% appreciation just to get back to even!  We sidestepped those loose stones giving us a better chance of reaching the peak of the mountain when expected….

Macro Outlooks and Predictions

Predictions are hard, especially about the future….

Top equity strategist outlooks for 2012 –  Business Insider

Difficult 2012 for fixed income?   -  Morgan Stanley

How to trade emerging markets in 2012 – CitiGroup

2012 global strategy – Bank of America

2012 Market outlook – Ed Yardeni, Yardeni Research

10 surprises for 2012 – UBS

Recession in 2012?  Flip a coin – SF Fed

2012 Forex shocker – Nomura Research

Will 2012 Be Europe’s Minksy Moment?  – PIMCO

2012 outlook – Jim Rogers

5 key questions for 2012 –  Goldman Sachs

2012 – the year of diminished expectations – Mark Zandi, Moodys

2012 Global outlook – Morgan Stanley

2012 – The Year of the reckoning – Peter Schiff

The 6 biggest questions of 2012 answered – Bob Janjuah, Nomura

Richard Bernstein’s favorite picks for 2012

Bob Doll – 10 predictions for 2012 - BlackRock

Will the shorter business cycle lead to recession in 2012?  -  Deutsche Bank

Continued volatility, but no recession in 2012 – Jeff Saut, Raymond James

5 Consumer challenges heading into 2012 – Gluskin Sheff

2012 outlook on China – The Telegraph

Forecasting Italy’s Borrowing needs in 2012 – Sober Look

The three recession risks – Credit Suisse

Europe to double dip in 2012? – Capital Economics

Sluggish growth to continue –  CEO & CFO surveys

The “Doomsday view of 2012″ – Binghamton University

Eurozone debt redemptions will force Europe to act in 2012 –  Credit Agricole

Depression will lead to collapse of the Euro – Felix Zulauf

Recession is still coming – Lakshman Achuthan, ECRI

No way to avoid recession in 2012 –  Hoisington

2012 will mirror 2009 –  Societe Generale

The global economy to slow in 2012 – ScotiaBank

5 important global trends to watch in 2012 – Nomura Securities

Moderate economic expansion to continue – FedEx Corp

The risk of recession has come down – Goldman Sachs

Still no recession in the foreseeable future, but a balance sheet recession – Cullen Roche

Growing signs of a disinflationary 2012?  -  Cullen Roche

The 2012 earnings outlook – Zacks.com

5 macro trends for 2012  - Council on Foreign Relations

Strategy, Risks & Top Trades for 2012

Bridgewater – buy treasuries and gold, sell stocks…

7 Calls for 2012 – Nomura Securities

15 surprises for 2012  - Doug Kass

A bullish outlook for gold in 2012 – Deutsche Bank

House prices to drop 30% in 2012?  -  RBC

8 Risks to equity markets in 2012 – Morgan Stanley

10 outrageous predictions for 2012 – Saxo Bank

4 risks in 2012 – Bank of America

Oil to rally again in 2012  - CitiGroup

10 market risks in 2012 – Nomura

2012 is shaping up to be a good year for equities – David Kotok

Stay in the equity game – PNC

The Dow:Gold ratio will hit 1:1 – Bob Janjuah, Nomura

10 for 2012 - Byron Wien, Blackstone

Gold is the ultimate bubble and could be on the verge of massive bear market – George Soros

2012 investing outlook – Kiplinger

How to invest in 2012 – JP Morgan

Oil prices just can’t fall much –  Barclays

Europe’s banks are insolvent - Michael Platt

Credit strategy 2012 – CitiGroup

2 bullish drivers for 2012 – Credit Suisse

Morgan Stanley 2012 commodities outlook – Morgan Stanley

6 reasons to remain bullish –  Jeff Saut, Raymond James

The 2012 commodities outlook – Diapason Commodities

Is QE3 on the way?  -  Cullen Roche

Still long gold and copper – Goldman Sachs

A sober look at natural gas – Sober Look

5 Investment themes for 2012 – Richard Bernstein

The consensus gold outlooks – Zero Hedge

7 investment ideas for 2012 – David Rosenberg, Gluskin Sheff

5 Risks heading into 2012 - David Rosenberg, Gluskin Sheff

Key Euro Crisis milestones ahead – DJ FX Trader

5 reasons to overweight the UK relative to EMU - Goldman Sachs

Top trades for 2012 - Goldman Sachs

I agree with John that there are more overlaps than most presume.  But the largest hurdle is substantial.  MMT is based on the state theory of money.  We acknowledge that anything can be money.  Gold can be money, pieces of paper can be money, credit cards can be money, a simple promise can be money.  But what MMTers are very precise about is the fact that a sovereign nation with monopoly supply of currency in a floating exchange rate system names that which is money as defined in economic terms within that particular nation.  In the USA, the US government deems “money” to be the US dollar.   You might claim that gold is money (and it certainly is in some regard), but if you take a bar of gold to the IRS on April 15th they will request that you exchange that gold into US Dollars before they can extinguish your tax liability.  In other words, while gold might be money to you and your neighbor, it is not money when it comes to extinguishing your liabilities to the Federal government.  When it comes to transacting within the US economy, this is the crucial distinction when it comes to “money”.  But there is a more complex disagreement in these schools of thought.

MMTers understand that “money” is always a social construct (whether it be gold, pieces of paper, social agreements, etc).  In the same regard, money is always a debt that helps fulfill some particular social construct.  And since “money”, in a modern society, is always a creature of the state (as described above) then the “money” that a government creates is merely a social construct of the society that creates that government.

As human beings we have evolved to the point where we reside in these incredibly vast and complex societies.  We are, after all, the ultimate pack animals.  We like to think we’re these independent creatures, but we’re actually incredibly dependent on one another for our survival and success.  And as a society, we choose to maintain some semblance of order, rules, law, social structure, nationality and economic coordination through a centralized government.  We can quibble over the size of that government (I tend to prefer less government than most other MMTers), but we cannot ignore the reality that governments exist for very practical purposes and will likely always exist in some form (if for no other purpose than to provide a legal system and a coordinated military).  Austrians tend to veer towards the misconception that governments are these exogenous entities that infringe on our personal liberties when the truth is that we create governments for some public purpose.  We do not create governments to impose hardship on ourselves.  That’s not to say that governments can’t become corrupt or excessive, but it’s rather naive to claim that a moderately sized government cannot provide some level of services that benefit the society as a whole.

The most hardcore of Austrians take this myth to another level in believing we can reside in these “Crusoe Islands” where no government is necessary at all.  Never mind that no such fantasy island exists in reality….The problem is, this totally misunderstands the evolutionary aspect of society, government, money and why we have the social constructs and infrastructure that we do today.  Austrians want to attach “money” to a shiny rock or the detach it from the reality where humans reside in complex social structures which require complex entities to help these societies achieve goals.  Both ideas are misguided as they misinterpret the intricate link between money and society.

Ironically, the greatest strength of Austrian economics is also the cause of its broadest misconceptions.  Ultimately, they misinterpret human nature and the very nature of the societies in which we reside.  The idea that the human being can survive and thrive entirely independent of complex social constructs is a sheer myth.  Even worse, they assume that small factions of the society can regulate and behave rationally and responsibly enough to eliminate the need for government.  As I often say, government becomes corrupted when the power of the many falls into the hands of the few.  This applies to the small factions on Crusoe Island as well.  The point being, in trying to prove this ideological argument they create myths that lead people to believe that we do not need strict social constructs to survive.   In doing so, they try to separate a society from the social constructs (thereby breaking the links between society and money) that make up its very essence.

This idea of money being a creature of the state is a substantial hurdle that some Austrians like John Carney are willing to overcome.  But I fear most Austrians cannot overcome their political biases that lead them to conclude that government is always bad and therefore, the state issued fiat money is always bad.  And in doing so they misinterpret the nature of society, the role of government in society and the “money” that governments create.

“Look, the Austrian/Ron Paul types made some very strong predictions about inflation — and rightly, given their model of how the world works. In their version of reality, it really isn’t possible to triple the monetary base without dire effects on the price level. In my version of reality, of course, that’s not only possible but what the model predicts in a liquidity trap.

So since we did indeed triple the monetary base with nothing much happening to inflation, the right lesson to draw is that their model is all wrong. Unfortunately, I see no hint that anyone in that camp is prepared to consider that possibility.”

This of course implies that Dr. Krugman is working under the correct model.  And while he and I arrive at many of the same conclusions (primarily that monetary policy is inept in this environment and fiscal policy is far more effective), we arrive at these conclusions from very different perspectives.

He has been working under the old “liquidity trap” theory while I have been working under the balance sheet recession theory or, as I more appropriately call it, the “consumer credit recession” theory.  Dr. Krugman notes that “a liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal rates are at or near zero – so that injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.”   Said differently: “in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy.”   This is really not all that different from what we hear out of the monetarist camps these days with their NGDP arguments.  In essence, money is just being hoarded so the Fed can keep “printing” and the private sector will just keep hoarding.

There are many holes in these ideas.  The most glaring is where we’ve seen Dr. Krugman make the same fatal flaw as David Beckworth by saying that aggregate debt levels aren’t the driving factor because there is a “debtor for every creditor”.  He said:

“I agree with David Beckworth that Richard Koo is wrong to insist that monetary policy can’t do anything in a balance sheet recession. But I think Beckworth introduces unnecessary complications; also, Koo isn’t entirely wrong.

Koo’s argument is that interest rates and monetary policy don’t matter because everyone is debt-constrained. That can’t be right; if there are debtors, there must also be creditors, and the creditors must be influenced at the margin by interest rates, expected inflation, and all that.”

This is a colossal error as I’ve previously explained, but the issues go even deeper than this.  Not only are creditors and debtors different in an economy (today the debtors just so happen to be the ones that generally drive economic growth so their lack of spending and paying down debt is having an unusually high impact in depressing economic growth), but there is a rather fundamental misunderstanding of banking occurring here.

There is this perception that modern banking involves banks firing money out of their vaults based on how much base money they have at any given time.  And as Beckworth incorrectly notes, this implies that money fires back into vaults when it is paid back or when base money expands.  This is the basic myth surrounding QE which leads people to conclude that it involves “money printing”  (see my primer on QE if you’re confused here).  Given the colossal failures of QE2, it should now be abundantly clear that my initial analysis of QE was almost perfectly correct, but the myths live on.

The rather basic error being made here by some prominent economists is that their model is in fact broken even if they arrive at logical conclusions.  The central bank controls interest rates by altering reserves in the system.  It does this by swapping assets with banks.  It communicates to the market what the target interest is and intervenes in altering reserves as stated.  Open market operations are nothing new even though QE is given some special meaning (perhaps it’s the fancy sounding name, I don’t know).

The myths surround the duration of the paper being swapped.  Because the Fed is buying long dated maturities it is seen as acting in an unusual manner because bonds are not seen as “money” by most economists.  ”Money” is a tricky term for reasons that I often note, but in a sovereign fiat monetary system such as the USA the “moneyness” of Treasury Bonds is no different than the “moneyness” of cash.  Of course, you can’t run out and buy your groceries with Treasury Bonds, but that doesn’t mean they’re not “money good”.  When you count your money do you exclude money in a savings account?  If you transfer cash from a checking account into a savings account do you suddenly subtract from your net worth?  Of course not.  So what differentiates a private sector corporate bond and a US Treasury Bond?  What makes them “money good”?  As an asset issued by the currency issuer, Treasuries have no default risk.  The market knows this and that’s why we’re not seeing a sovereign debt crisis in nations where debt levels are high, but printing presses are functional (Japan, UK, USA vs Europe).

As we’ve noted on so many occasions, there is no solvency risk in the USA so there is no such thing as the USA not being able to pay its bills.  This is why the market for US bonds is so deep.  Market makers understand that the probability of prices collapsing is close to zero because the government can’t “run out” of money.   This is also why we see Treasury prices surge whenever crisis is in fashion.  To a bank, the “moneyness” of bonds is at times better than non-interest bearing notes.  In a modern banking system Treasury bonds serve the same purpose as cash – they serve as a form of payments and risk free holdings.  In fact, if you hold a healthy portfolio of Treasury bonds there’s very little that you can’t buy as a consumer.  Of course, you’d have to buy it with a credit card, but with a highly liquid multi-trillion dollar market for government bonds there is no such thing as you not being able to settle your payments in a timely fashion.  Seeing as all money is debt, there’s very little difference between buying something with a credit card and buying it with the same notes that say “this note is legal tender for all debts public and private” (open your wallet if you don’t trust me).  The difference between the debt in your wallet and the debts in the form of Treasury Bonds is merely the duration and interest rate.  But the myth persists – a savings account is not money, but a checking account is….Of course, if you buy assets from the private sector then you’re dealing in an entirely different form of “money” which is by no means risk free as all private sector entities are currency users.

Interestingly, the Europeans are finding out what this means today.  And this brings us back to broken models.  In 2009 Dr. Krugman didn’t make this distinction when he stated (referring to the USA):

“Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession. “

As I recently discussed, he has since found the answers to the questions that my colleagues Warren Mosler and Stephanie Kelton found over a decade ago – being the currency issuer matters!   But it shows that misunderstandings of the idea of a sovereign currency issuer can lead to misguided thinking and confusion.  Of course, with regards to the above quote, there is no such thing as comparing a currency user such as Ireland to the currency issuing USA.  The comparison is entirely illogical and shows that the author is working from his own flawed model which states that a country with a printing press functions in the same way as a country without one.  The reality is that eliminating solvency through being the currency issuer is a game changer.  Now, I’ve discussed insolvency in other forms such as hyperinflation (please see here for more details), but that’s a very different form of insolvency and one which I believe most hyperinflationists and modern economists have greatly misunderstood.

The obvious question that arises from the QE and Fed “money printing” discussions is: “well, what happens if we swap all government bonds out with cash – what would happen then?”   Well, we asked the readers this question a month ago and the answers pretty much spoke for themselves.  I asked three questions and we received a very healthy response from an audience here that I would confidently conclude is up to snuff on market news and economics in general.  The three questions and the answers:

The first two questions and answers were most interesting.  What we found was that Fed decisions have almost no impact on the spending habits of readers.  A full 95% of readers said the FOMC decisions have no impact on their spending habits.  And that’s coming from people who actually know what the FOMC is!  I’d be willing to bet that if you sat on a street corner in most US cities and asked 100 people what the FOMC is 95 of them would look at you like you were insane.  The point being, if well informed people don’t base their spending decisions on the actions of the FOMC then what is the rest of the country doing?   Of course, this is not to imply that the Fed’s decisions have no impact on the economy, but we should be very careful when implying that the Fed’s communications with the public are highly impactful.  Rather, what guides spending is income relative to desired savings and this is where monetary policy in a balance sheet recession lacks a real transmission mechanism.

The second question exposed a further weakness in programs such as QE.  If the Fed bought all of the outstanding Treasury Bonds they wouldn’t be “printing money”.  They’d be swapping low duration paper with high duration paper as I’ve repeatedly shown.  They’d be stealing your chosen form of savings. They wouldn’t be printing money or making anyone richer.  This is why you never hear grandma say “I wish they’d pay off the national debt so I could get rid of these damn savings bonds!” (think about that one for a second as the implications are broad ranging).  A full 91% of the astute readers here said they would be no more inclined to spend if the Fed took their bonds away.  Of course they wouldn’t because their savings as a % of income is unchanged and this is the primary driving force behind spending decisions.  In fact, it’s interesting to note that 18% of readers said they’d be LESS inclined to spend.  Why?  I am willing to bet that those 18% represent people living largely off of savings and income from savings.  When the Fed reduces the term structure of rates through QE they’re subtracting interest income from the private sector!   Their income relative to savings desire just dropped dramatically if the government buys the bonds!  Imagine all those grandmothers who hear their local politicians proudly announce that the US government has bought back all of its debt and is letting it retire.  Of course, there’s no more risk-free interest bearing savings for grandma, but hey, what does she need the income for other than to survive?

The final question showed the true Achilles Heel in QE – there’s no meat.  It’s all about perception.  Tell a speculator the Fed is “printing money” and he buys stocks.  Never mind that the DCF of the underlying corporations doesn’t change.  Bid up those prices!  And as I predicted last year during QE2 – do it in enough size and all you do is create the perception that something has changed in the real economy which leads to disequilibrium in prices.  But alas, the equity market “wealth effect” turned out to be a myth and the once heralded positive impacts of QE2 turned out to be nothing more than a massive disequilibrium which I believe has now detracted from the economic recovery by creating uncertainty and asset price volatility.

We can circle back to our original topic of discussion by showing that all of the analysis about “liquidity traps” and “excess demand for money” is based on a similarly flawed model that has sunk the Austrian economics ship in recent years on the back of their epic failures in predicting hyperinflation.  When we see Dr. Krugman discussing the loanable funds market (see here) he is working from the same foundation that led to the misguided predictions from Austrian economists.  It is the belief that when the Fed changes the amount of base money that they are suddenly firing money off into the economy when the reality is that all they’re doing is changing a savings account into a checking account.  They’re changing the term structure of rates based on the mythical idea that in doing so they can change people’s desire to save relative to income.

This myth is propagated today based on the idea that these sorts of Fed policies are only temporarily ineffective because the money is being hoarded instead of spent.  Never mind that money is not being printed by the Fed.  These theorists genuinely believe the banks are just sitting on MORE money.  Of course, this is the old money multiplier model which the Fed itself has admitted is a broken model.  But myths about modern banking persist and as the trusted “market monetarist” Scott Sumner once proclaimed “It’s true I know little about banking”.   So it’s not surprising to see the quantity theory of money and various forms of its poisonous tentacles infecting economic theory on a daily basis (and ultimately hurting us all by leading to misguided policy).  The point is, the fact that loans create deposits and the fact that banks are never reserve constrained is not merely a temporary effect.  All that occurred in recent years is that the balance sheet recession exposed the banking system for what it really is as opposed to the normal functioning times where it really does appear as though banks multiply their reserves and the Fed is this omnipotent economic agent.  The problem is, none of that’s true and the myths of the liquidity trap, the quantity theory, national insolvencies and misunderstandings of money prove that, despite some sound conclusions, Dr. Krugman’s model is every bit as broken as the one leading Austrian economists to call for hyperinflation and market monetarists to call for jumbo QE….

* See my primer on the monetary system here if you’re still confused.  

In recent pieces on Business Insider and Bloomberg, Henry Blodget and Nick Hanauer argue that entrepreneurs and investors don’t create jobs.  Instead, they argue that jobs are created by consumers and demand for goods and services which enable entrepreneurs to create corporations, jobs and profits.  Unfortunately, this message gets bogged down in politics which misconstrues the facts and leads to misleading conclusions.

Politics always get in the way of sound thinking

The right wing uses the “job creator” argument to push the position that increasing taxes on the rich will burden job creators and deter from future job creation.  The argument by Blodget and Hanauer opposes this position in an attempt to show that we should increase taxes on the rich and reduce taxes on the real job creators – the consumers.  This is another common case of filtering economics through a political filter in order to validate a preconceived bias.  Let’s see if we can’t filter our economics through an economics filter to arrive at a logical conclusion.

The relationship between the entrepreneur and the consumer

A capitalist economy has, in the extreme aggregate, a theoretical level of infinite demand (stay with me here).  Entrepreneurs and capitalists meet that demand by creating goods and services with the hopes of generating a profit.  Importantly, the consumer and supplier are two sides of the same coin.  One does not exist without the other.  Henry Ford doesn’t exist without demand for automobiles.  Steve Jobs doesn’t exist without demand for tech gadgets.  Clearly, if there is no demand for the goods and services in a capitalist economy then there can be no capitalists and there can be no corporations that employ workers.  So, the argument over “job creators” is a chicken and egg argument.  Clearly, the capitalist needs the consumer and the consumers needs the capitalist.  That’s simply how the trade works.  You buy an iPhone from Apple corporation because the product will serve some role that you demand in your life.  This gives Apple Corporation the potential to generate a profit and leverage their business operation, expand their business, employ more workers and generate higher profits.  Mr. Hanauer succinctly makes this point:

“It is unquestionably true that without entrepreneurs and investors, you can’t have a dynamic and growing capitalist economy. But it’s equally true that without consumers, you can’t have entrepreneurs and investors. “

But what role does the entrepreneur serve in the capitalist economy besides meeting demand and generating profits?  Why is the entrepreneur so highly rewarded on an individual basis for his/her accomplishments?   Because entrepreneurs make our lives more efficient by providing us all with the ultimate luxury – time.

Toil and trouble

At this point, we could have all sorts of fascinating discussions here – what is money?  What is wealth?  What is happiness?  I don’t have the time nor the space to cover these important questions, but this subject intertwines all of these topics to some degree.  Some people believe money is wealth and that money will lead to increased happiness.  Of course, this confuses the idea of money.  Money is not wealth and money does not create happiness.  But how does this tie into our discussion above?    Stay with me here….

Adam Smith once said:

“The real price of everything, what everything really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.”

As I mentioned above, there is a theoretical level of infinite demand in a capitalist economy.  What I mean by this is that, in an extreme sense, we can consume all that time will allow.  If you were unconstrained by time you could, in theory, consume all that the entrepreneur can produce.  Theoretically, this chicken and egg story can go on forever.  Of course, the greatest luxury of all is quite finite.  We are always constrained by time.   The entrepreneur offers us the opportunity to take advantage of the ultimate luxury by giving us more time.

How does the entrepreneurial process work to create real wealth?

The best way to envision this idea is to use an example.  Alexander Graham Bell is one of the greatest innovators in American history.  So what did Mr. Bell do exactly?  He created a more efficient way to communicate by inventing the telephone.  Clearly, communication is vital part of human life.  And in theory, there is infinite demand over the long-term to communicate.

At some point in his life, Mr. Bell sat down and probably said something to the extent of – “it would be far more efficient if I could talk to Mr. Smith immediately as opposed to sending him a telegram”.  Clearly, this desire was not unique to him.  And all Mr. Bell did was fill a demand by inventing a product which helped consumers meet this demand.  But the important role that Mr. Bell played in the job creation process is not that he necessarily created jobs independent of his consumers (as we showed above, they are interdependent).  After all, there were plenty of messengers already employed and working before the telephone came into being (Mr. Bell actually destroyed their jobs).

What Mr. Bell did is give his consumers more time to consume other goods and services.  He reduced the toil and trouble of having to acquire things by providing them with a product that made their lives more efficient and productive.  Just imagine all the ways that the telephone improves our quality of life and makes us more efficient.  The businessman in NYC no longer had to wait for the telegram from his business partner in Chicago to discuss their new business decisions.  Instead, he picked up a telephone and a decision was made in a matter of minutes.  There are innumerable (better) examples of the way that a simple innovation such as Mr. Bell’s helps us to improve productivity, efficiency and ultimately our standard of living.

The key point here is that improvements in our standards of living provide us with the ultimate form of wealth – they give us more time to do the things we think will help us achieve happiness (whatever that might be to any particular person).  This is the ultimate form of wealth.  The entrepreneur gives us more time to consume more goods and services and do the things we want in our lives.  If we look at the modern economy we can see how streamlined this process has become.  For instance, last night at 7 PM I put my laundry in the wash, I put the dishes in the dishwasher, ordered dinner from a local restaurant and went upstairs into my office where I did an hour of work.  At 8 PM my dinner arrived, my laundry was done, I ate dinner on a fresh clean plate and I had done an hour of work in this period.  Imagine trying to do all that 100 years ago?  How long would it take you?  Days?  Perhaps even weeks?  That is a remarkable increase in living standards.  And why are we able to do all these things in such a condensed period of time?  Why am I able to consume so much more than I could have 1o0 years ago?  Because entrepreneurs created a machine that cleans my clothing for me, they created a machine that cleans my dishes for me, they created an oven that cooks my dinner, a car that allows the deliveryman to deliver my dinner, and invented a computer which allows me to efficiently and effectively accomplish work.  We live in a remarkable world.

The point here is not to prove that the consumer is the job creator or that the entrepreneur is the job creator.  Rather, the point is to show that they are two sides of the same coin and that real wealth is the product of increases in our standards of living.  What the entrepreneur does is help to increase the size of the coin by helping to meet demand through innovation which increases our productivity, ultimately allows us to consume more goods and services and results in more employment.   Without the role of the entrepreneur we are merely a society trading wealth amongst each other.  In other words, without the innovative process our real standards of living stagnate.  The true wealth in a capitalist economy is created by the entrepreneurs who allow us all to maximize the ultimate form of wealth – time.

The danger of the current political debate is that we are pitting the 1% against the 99% without understanding that we are the 100%.  Could the 1% afford to pay more in taxes and “redistribute the wealth”?  Probably.  Personally, I have been arguing for a middle class tax cut for a long time.  I am not in favor, however, of raising anyone’s taxes in the midst of a balance sheet recession.  And no, as a sovereign fiat currency issuer we don’t have to “finance it” by taking more money from someone else.  But more importantly, we should not demonize the entrepreneurs who help create goods and services which increase everyone’s standards of living.  We should applaud their efforts and encourage it. What we should demonize is the “entrepreneur” who innovates new and improved ways to gamble in the casino of Wall Street without actually improving the standard of living of his/her customers and instead retires to a far off land playing golf for the rest of his/her life after imploding their company and taking a government bailout.   But let’s not demonize the wealthy who have contributed to improving our standards of living.  In doing so, we only end up reducing the standards of living of us all.

This mess in Europe was caused by an inherent trade imbalance in the region. Since they’re all using the same currency there is no floating exchange rate to serve as a rebalancing mechanism between trade surplus and deficit nations. And unlike the USA, there is no federal government to help the trade deficit nations maintain their private sector surplus due to the trade leakage. So, what happened in Europe is essentially one huge transfer mechanism whereby the “reckless” periphery nations purchased goods and services from the “prudent” core nations and then financed their growing budget deficits by borrowing from the same people they were buying goods and services from. And as this trend became increasingly unsustainable (debt growth has its limits) the sovereigns in the south were forced into an ever increasing debt hole as they financed their “profligate” ways.

The great irony here is that someone had to lend them all of this money. And who was there with open arms to lend them this money so they could continue to boost the booming German trade surplus (which has helped lead to this great German economic boom of the last 10 years)? WHY, THE GERMANS OF COURSE! And at the time this all appeared entirely rational. After all, the yields of the periphery nations had become nearly perfect substitutes for the northern yields giving the appearance of being of equal credit risk. But as Stephanie Kelton so brilliantly wrote almost 10 years ago, this was merely one huge market inefficiency at work that was destined to break. And break it did. And when it broke the Germans suddenly woke up to realize that they were the ones on the hook for much of this profligate lending that they had done. It is eerily reminiscent of the credit crisis. Can you imagine Countrywide Financial coming out in 2009 and saying that they are not to blame for the bad decisions of the homeowners and that they should therefore not have to write down any mortgage losses? That’s essentially what the media is implying here by saying that Germany has been so well behaved in recent years. They have the whole story entirely backwards!

So, just how deep is the German (really the northern) hole? VERY deep. Germany’s banks are on the hook for 22% of the entire EMU’s debts. France is a close second at 16% and the Netherlands is in 4th place at 10%. In all, these three countries, widely viewed as the “prudent” nations in Europe, are on the hook for almost 50% of the EMU’s debts! *

This is why I keep saying these countries are inextricably linked. In fact, you could even make the argument that the periphery nations hold all the cards here because they’re the ones holding the northern banks by the throat via default risk. The periphery nations, ironically, could sink the German economy overnight if they wanted to. But let’s not get off track. The point is, blaming the Greeks and not the Germans is a lot like the husband who gives his wife a new credit card and then gets mad at her for going shopping. And just like any marriage, these countries must understand that their union via single currency makes them inextricably linked. They have two choices now. They can get a divorce (disband the Euro entirely) or recognize that one half’s problems are also the other half’s problems and move along in an effort to rectify the issues (via full fiscal union). But let’s stop pretending that Germany and the other northern nations are without blame in all of this. There is plenty of blame to go around. But bickering isn’t going to help anyone solve this crisis. And in fact, once Germany realizes that they have made enormous mistakes, they might finally come around to the reality that they need to make some concessions in these negotiations.

* German and French banks alone are responsible for 55% of the debts in Portugal, Ireland, Italy, Greece and Spain.

The key points Warren nailed:

1.  In a non-convertible fiat currency system with FX rates, the currency issuer is not constrained in its ability to create money.  As Warren said, the government is merely the scorekeeper and the scorekeeper can’t “run out” of points.

2.  Government money doesn’t “come from” anywhere.  Just like the scorekeeper doesn’t “get” points from anywhere.

3.  Taxes serve to regulate aggregate demand.   So, it’s best to think of the level of taxation like a themostat.  If taxes are too high the economy will run cold.  If taxes are too low the economy will run hot.  We need to find that optimal level.  We are currently overtaxed.

4.  The bogey is not the debt and whether we are going to “run out” of money.  Ie, the government isn’t like a household in that it can go bankrupt.  The bogey is always inflation.  So we must agree on a size of government that is in-line with our goals as a society.

5.  So, deficits most certainly DO matter!  They just matter in a way that the mainstream doesn’t propagate.

Listen to the full interview here or by clicking on the link below: