Understanding the Modern Monetary System – Part 1

As Monteary Realism (MR) is an evolving school of thought it’s useful to update our work and republish some of the key components over time.  I’m going to take the next few days to help readers digest the key components of MR so they can become reacquainted with some of the bigger components.   The full paper is rather dense and overwhelming in one reading so breaking it down over the course of the next week might be a helpful way to digest the full subject matter.  You can always find the complete paper here and if you have questions please feel free to ask in the comments or via email. I hope you find it helpful.

Part I – Introduction to Monetary Realism

In this paper I will explain why Monetary Realism best describes modern fiat monetary systems in which nations are autonomous issuers of their own currency and exist within a freely floating exchange rate system. For this discussion, I will focus primarily on the USA although this subject can be applied to many other nations throughout the world.  The principal aim of Monetary Realism (MR) is to objectively describe the operational realities of economies that operate on a fiat monetary system.

Overview

Monetary Realism

Monetary Realism (MR) is a description of the fiat monetary system applicable to nations who are autonomous issuers of their currency. Monetary Realism describes the complex relationship between the government (public sector) and the non-government (private sector) and how the “machine” works and prosperity results.

Monetary Realism is based on the following principles of an autonomous currency issuer:

• The Federal Reserve and the government have a symbiotic relationship and together are issuers of the currency to the monetary system. Households, businesses and state governments are users of public sector supplied currency and also private bank issued monies (i.e. bank deposits).

• The private banking sector issues bank deposits (“inside money”) and the public sector issues coins, paper cash and banking sector reserves (“outside money”). Nowadays most market exchanges involving private agents are transacted in bank deposits and, as such, the ins and outs of “inside money” are vital to understanding how the modern monetary system functions. While the private sector component of the monetary system takes center stage in the daily business of market exchanges and economic progress, the public sector also plays an important facilitating role.

• As the issuer of the currency, there is no solvency constraint at the government level as there might be for a household, state or business.  In this regard, one must be careful comparing the federal government to a household because the federal government has no solvency constraint (i.e., there’s no such thing as the federal government “running out of money” as it can always call on the banks and the Federal Reserve to serve as agents of the government).  Households, on the other hand, have a very real solvency constraint.

• The federal government’s true constraint is never solvency, but inflation. The government must manage the money supply so as to avoid imposing undue harm on the populace via mismanagement of the money supply.

• The modern floating exchange rate system helps to maintain equilibrium and flexibility in the global economy.

• The currency denomination of debt is very important to assessing the sustainability of public finances. When a government issues debt payable in the domestic currency unit these assets are essentially default-free. (The exceptions are when policymakers “self-impose” constraints that forbid the central bank from acting as the government’s banker as per Euroland).

Functional Finance

Functional Finance is based on the following principles:

• The government is an entity created by the people and for the people. It exists to further the prosperity of the private sector – NOT to benefit at its expense. If this entity is allowed to exist for its own benefit or becomes corrupted by a concentration of power or abuse of its currency issuing powers it will become susceptible to dissolution via the populace’s rejection of that government.

• Governments should be actively involved in regulating and helping build the infrastructure within which the private sector can generate economic growth. The economy is a complex dynamical system with irrational participants. The market cannot be expected to regulate itself or behave rationally at all times. Therefore, some level of government intervention and involvement is not only beneficial, but also necessary. While government assists in the economic process it is ultimately the private sector that is the primary driver of innovation, productivity and economic growth. It is the private sector that propels increases in living standards with its activities the most important factor in giving value and viability to the currency.

• The unit of account or medium of exchange within a specific nation is ultimately a creature of law.  It must therefore be regulated by the state; however, ultimately the private sector must accept this legal tender as the currency unit. Therefore, the private and public sectors should best be thought of as being in partnership with one another and not opposing forces. Government by the people and for the people is not the antagonist in this story, but rather an entity that should be best utilized to maximize private sector prosperity.

• Government deficit spending and tax collection should be maintained at a rate that does not impose financial hardship on the private sector. Because the Federal government is not a business or household it should not manage its balance sheet for its own benefit. Rather, taxes and government spending should be managed in a way that most benefits the private sector and encourages private sector prosperity, productivity, innovation and growth.

Brief Historical Background

Monetary Realism (MR) is based on the understanding that most modern fiat currencies eliminate the linkage between convertible currency systems and the constraints these systems impose on its issuer.  Systems such as the gold standard do not apply to the modern fiat monetary system.  We do not reside in a system in which currencies have any convertible linkage to metals therefore, such thinking is not applicable to a modern fiat monetary system, but this thinking has persisted and still clouds economic thinking to this day.

Although we no longer have a convertible currency system (where the currency was convertible into gold as was the case under the Gold Standard) much economic thinking remains clouded by the belief that we continue to operate on a comparable system when we do not. The monetary system underwent a paradigm shift in 1971 when Nixon closed the gold window although most of mainstream economics did not seem to recognize the importance of this event and has continued working under a false paradigm where autonomous fiat currency issuers are seen as having a true solvency constraint as opposed to an inflation constraint.  This leads to misguided policy and unnecessary public harm.

Monetary Realism’s Political Agnosticism

One important element of Monetary Realism is its political agnosticism.  MR is a blend of many different economic schools and takes this broad understanding to offer an explanation of how the economic system—the machine—works within the existing set of institutional practices.  The purpose of MR is not to offer a political or policy bias, but rather to describe the operational realities of a fiat monetary system in an attempt to better educate the reader and provide them with the understanding to make their own informed decisions as to how this system might be changed for the better.

The Dismal Science?  

One of the great problems with the economics profession is that there is no firm foundation of understanding from which analysts can build their policy prescriptions. Further, one tends to find schools of thought based on normative rather than positive thinking; prescriptive rather than descriptive. The MR approach is similar to that utilized by Leonardo Da Vinci regarding medicine and human anatomy. Da Vinci viewed the human body as a machine and as one of the first anatomists provided the world with a better understanding of how that machine functioned (e.g. how its pieces worked together, how it was built, how it changed, etc). To Da Vinci, it was all about finding out what IS, not what CAN be. It was only through rigorous analysis of how the machine worked that he and others were able to be in a position to offer advice on medicine and surgery.

The “dismal science” need not be so unscientific.  Unfortunately, most of its practitioners are trying to be Hippocrates and not Da Vinci.    And like the surgeons of the days of Hippocrates, they do not know how the system works and while they might believe they will “do no harm” too many are too often working from a false premise or a false understanding of the system due to a preconceived ideology.

It is my hope, through MR and a true focus on understanding how the system actually works, that we can provide as close as possible to a purely positive approach to economics.  I know this is a bold task, but through focusing on the understanding of the monetary system we can then provide others with a foundation from which our problems can be solved.

** Complete hard copy with all 6 parts here.  

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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