Funding in an Endogenous Money System (Nerdy)

(I come across this topic quite a bit and I think it’s hard for some people to understand so I am going to get a little nerdy here and see if I can clarify how financial instruments are created and used in the process of “funding” the economy’s needs). 

Endogenous money is an essential understanding for anyone who wants to better comprehend how the monetary system works. Okay, okay. Let me step back a second. First, what is endogenous money? Endogenous money refers to money that grows from within. Our entire monetary system is something

that is conjured up from our imaginations. Every single financial asset is something that was produced

endogenously from thin air.

You can think of endogenous money much like cell separation. You might remember from grade school learning about “mitosis” or the process by which cells grow and separate into new cells. This is basically how our monetary system works. When economic agents take in new resources their biology changes and they become stronger. This allows them to multiply their balance sheets and expand and grow. They undergo a process of mitosis whereby the new strength of the balance sheet allows for an endogenous expansion and as the new cells grow and bring in their own new resources they too get stronger and multiply.

Now, what confuses people about this process is that we generally think of our balance sheet as needing existing funds to undergo this process of growth. But that’s not really how it works because the new funds that feed the economic system come from the endogenous growth of the system itself. So, for instance, let’s pretend I invest in becoming a world class massage therapist. I exercise my hands and learn all these new techniques to provide massages. These skills are endogenous in that they required no outside real resources to generate. They came into existence by sheer will and desire. Now, if I start a massage parlor and business booms then other economic agents might look at my new endogenously created company and say that it has contributed new value to the entire economy. They might even want to invest in it or lend me new money so I can expand my massage empire and add even more value to the economy. Any new economic growth or financial asset expansion that funds and helps achieve all of this is 100% endogenous.

We shouldn’t confuse endogenous to mean that it came from nowhere. As I wrote in my book, everything that goes somewhere comes from somewhere. In the case of our massage parlor, the new economic growth and business value came from ME. It came from my desire to invest in a new talent and add value to other people’s lives. This is important because it is this capital base from which all things grow in our economy. We are, in effect, always multiplying the capital base that we grow. The more we invest in our capital base the more it can grow and multiply. Investment, as in, spending for future production, is the fuel that allows our entire economic system to undergo its process of mitosis. In the case of the massage parlor the capital base is my newly created skills.¹

Let’s bring this all back to the real world. When I borrow money from a bank the bank creates that money endogenously. But the money didn’t come from nowhere. It came from the bank’s assessment that I have a capital base and degree of credibility that made that loan viable. So, if I want to pay new employees I don’t necessarily have to have the funds NOW to “fund” that new spending. I can borrow it from a bank that creates it endogenously if the bank assesses my credit and finds me credible. But that doesn’t mean I didn’t have to be able to “fund” my new spending or that I won’t have to in the future. In fact, I am able to fund that loan because I am viewed as being credible. I very much need to “fund” the loan and the strength of my balance sheet is how the bank assesses whether that process will be sustainable.

Importantly, this concept of funding is true for all economic agents, including governments. We all need assets, income and credibility to fund our capital base and any expansion of it. Some endogenous money theorists, like the relatively new Modern Monetary Theory school, argue that governments are “self financing”. This is a bit misleading. Governments are highly diverse economic entities that generally have high degrees of credibility and many income streams. They “fund” their balance sheets just like everyone else does – by having a credible capital base that makes their financial assets reliable and sustainable. When this capital base is credible and sustainable the government will better be able to fund their spending in real terms because their counterparties will gladly hold those safe assets.

It’s helpful to think of the government’s balance sheet as a leveraging of the economy’s capital base. The bigger and better that capital base the bigger and more sustainable our government can be. The smaller and less efficient that capital base is the less credible the government is in leveraging its balance sheet and the higher the probability that you will consistently look like Greece or Zimbabwe with continual failures in maintaining credible holders of government assets thereby coinciding with high inflations.² Importantly, MMT’s claims that “taxes don’t fund spending” is a rather basic misunderstanding of this concept since taxes and income are evidence of strong demand and output in exactly the same way that someone with a high credit score has credibility (and borrowing power) because of their evidence of demand for their output.

This concept of government funding is somewhat related to the way banks expand their balance sheets. Some people think that banks need to bring in deposits to be able to make new loans. This is actually backwards. Banks “fund” their new loans by having a credible capital base. Part of the way they maintain a credible capital base is by having the least expensive liabilities which directly adds to how much capital they can retain and grow. In other words, banks want to attract deposits because they’re a cheap liability which helps fund the balance sheet. And when a bank’s capital base is strong they can expand their balance sheet endogenously.

Anyhow, this is a very brief overview, but I hope it helps clarify some confusion over the topic of endogenous money. If you want to get a bit deeper in the weeds you can see my overview of banking here.

¹ – Just to be clear, I do not run a massage parlor, nor do I have good massage skills so don’t go getting any bright ideas about what I can or cannot do for you. 

² – It’s important to note that governments don’t go bankrupt in nominal terms like a household does. Yes, they can run out of creditors, but those creditors don’t take governments to bankruptcy court and the government usually has a central bank that can “fund” its spending. So, instead of literally running out of money, you see government insolvency occur in real terms with a currency crisis or a high inflation. It’s also worth noting that I specifically said that this funding constraint “coincides” with high inflation rather than necessarily causing it.³

³ – High inflations and hyperinflations are relatively unusual and generally have different causes than a household insolvency. After all, a high inflation is a macro event, not a micro event. For instance, hyperinflations generally occur during devastating macro events like the loss of a war, foreign currency borrowing, collapses in production, etc. Households go bankrupt in more micro events like a specific entity failing. In other words, we can think of hyperinflation as an entire economic system failing whereas household insolvencies are parts of a microeconomic system failing. It’s VERY important to understand the different causes here when assessing how risky the governments debt and balance sheet is.