What Rand Paul Republicans & Libertarians Are Missing About Balanced Budgets

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Modern Monetary Theory

With permission from Being Libertarian, I am reposting an important exclusive piece I wrote that lays out some fundamental changes in how I’ve come to understand the functioning of a fiat money economy, and its economic implications on debt, deficits, and other hugely important concepts:

For quite a while now I’ve been pretty unsatisfied with mainstream as well as Austrian economics-based takes on the global economic situation, in particular phenomena such as record low to negative interest rates in countries with record debts (such as Japan), massive excess reserves, and QE 1 through infinity without much consumer price inflation, etc. No economic school I had learned about offered fully coherent answers regarding those.

So I thought it may be worthwhile to throw another heterodox economic school of thought commonly labeled “Modern Money Theory” (MMT) into the mix.

In particular, I’ve been reading L. Randall Wray’s book Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems which I highly recommend. It’s also available for free in online only format.

I believe that a lot of what is being revealed in this book is of relevance to all of us, regardless where we stand politically. MMT offers prescriptions that can work within a libertarian context just as much as they can in the context of a more interventionist state. Most of all: MMT offers a plain and unbiased description of how fiat money systems actually work.

In this post I will provide a rough overview.

Spending and Taxation in a Sovereign Money System

MMT primarily describes a monetary system in which a country’s currency cannot be redeemed against anything else, such as a commodity or some other foreign currency, and in which the currency exchange rate floats freely on the foreign exchange market. Those are characteristics that apply to today’s US dollar for example. (MMT then also helps understand redeemable and pegged currencies, but first we need to understand the workings of an unconstrained currency system to get there.)

In such a monetary system, the government imposes a tax on the population it governs, that is, it claims the right to forcefully appropriate peaceful and innocent individuals’ property on a recurring basis.

It decrees, for example, that everyone shall owe an income tax in US dollars by year’s end. It then proceeds to create and spend those dollars in the form of paper bills and coins with numbers on them (or in the form of electronic bank entries called bank reserves that are convertible into bills and coins on demand, but more on that later) representing their tax redemption value in order to obtain products and services. It moves resources from the private sector into the so-called public sector.

Individuals who get paid in those dollars will then find ready acceptance of this money in the private sector, given that most individuals will need it to pay the imposed tax. Money prices and voluntary exchange in the private sector emerge as a result.

On a side note: There is indeed lots of historical evidence suggesting that money has been issued in this manner for millennia. In earlier days some of the tokens issued and accepted in taxes and fines for punishment were precious or base metal coins with the sovereign’s head minted on them (which would circulate at a significant premium on the metal value), or in some regions so-called tally sticks were used as money tokens by the king to obtain goods and services. Anyone possessing such a tally stick could return it to the crown in place of tithes which others would have to settle in real produce. The book I mentioned earlier also delves into commodity money (such as gold and silver coins) in that historical context, including redeemable token currency systems like the gold standard.

The important point that MMT makes here is this: Taxes drive money. The sovereign’s arbitrarily-imposed tax liability has to be discharged using the money tokens issued by that same sovereign. Government spending is a means of introducing money into the economy. Taxes then destroy that money. Spending and taxation are thus not fiscal, but rather monetary policy. The government doesn’t first raise taxes in order to obtain money to spend, it rather creates the money first by spending it into existence and then removes it from the economy via taxation.

The Central Banking System

The government’s treasury has a checking account bank, the so called central bank. In the US this is the Federal Reserve Bank (Fed). The US Treasury’s balance in this bank account is replenished to $5 billion dollars at the end of every day, but is generally not counted as part of the country’s money supply. The reasons behind this setup are of purely legal nature, but ultimately the processes of spending and taxing to create and destroy money respectively work exactly as outlined above.

(In order to understand this system better, initially it really helps to view the central bank and the treasury as one and the same institution: the government. Even if the legal nature and partial ownership structure of certain central banks, such as the US Fed, may lead one to believe that it operates “independent” from government, the end result is for the most part the same. For details I highly recommend the chapters 3.6 and 3.7 in the primer I mentioned above.)

Then there are the country’s private banks where people can hand in their money tokens for storage and safekeeping and write checks against their balances for convenience’s sake. As per the rules of the system, these banks also get to maintain their own checking accounts at the Fed. The money in these checking accounts is commonly referred to as “bank reserves”.

Say I present a $100 bill that was introduced via government spending into the economy to such a bank’s teller. The bank takes the bill, marks up my bank deposit by $100, hands the bill to the Fed, and the Fed then marks up the bank’s checking account at the Fed (its “bank reserves”) by $100 as well.

If I want to withdraw $25 in cash and the bank doesn’t have the cash on hand, it needs to ask the Fed for $25 in cash. The Fed will deliver the cash and mark down the bank’s reserves by $25. The bank hands me the $25 and marks down my bank deposit account by $25.

As you can see, cash and bank reserves are interchangeable. Together they form what is called “high powered money”. They are the only means of payment that the treasury will accept in tax payments.

Let’s say I owe $75 in taxes to the government and make payment via check. The treasury will ask the Fed to mark down my bank’s reserves by $75 and the bank will mark down my demand deposit by that same amount. The money has disappeared from circulation. I have been made poorer in comparison to the sovereign currency issuer but the money didn’t really “go anywhere” other than the treasury’s account at the Fed which gets replenished anyway, no matter what taxes get collected or not. (By the way: If you were to withdraw your money and make tax payment in old paper bills, the money would simply get shredded!)

Or let’s say I bank at bank A and I make a check payment of $75 to Bob who has a checking account at bank B. Bob presents my check to bank B, bank B presents it to the Fed, and the Fed will mark down bank A’s reserves by $75 and mark up bank B’s reserves by that same amount. Bank A marks down my deposit account and bank B marks up Bob’s deposit account in turn.

So you can see that banks need bank reserves in order to (a) facilitate tax payments, (b) meet interbank settlement requirements, and (c) facilitate cash withdrawals. If a bank doesn’t have the necessary reserves it’ll incur an overdraft on its reserve account at the Fed and needs to obtain the reserves after the fact to cover that deficit. This is what’s commonly referred to as the Fed’s “lender of last resort” function.

The bank obtains such reserves by offering savings accounts and CDs to individuals looking to earn interest instead of holding cash. Furthermore it can also borrow reserves for a short period from other banks who don’t need them at the moment on the interbank lending market. Finally, it can also borrow reserves from the Fed directly, and generally only against safe collateral, such as treasury securities, or sell those securities to the Fed outright.

Government Bonds and Interest Rates

Cash currency in circulation and the aforementioned bank reserves at the Fed generally pay low to no interest. Thus banks like to move some of those reserves into interest bearing securities. Private individuals have that same option. This is why the government sells bonds of varying maturity. Ultimately government bonds are nothing but savings accounts or CDs at the Fed. All that happens when a bank or an individual buys a government bond is that bank reserves are debited and a securities account is credited with said treasury security.

When an interest payment on a bond is made the Fed marks up the bond holding entity’s bank reserves electronically. When the bond matures, the bond is removed from the securities account, and reserves are credited with the bond’s face value amount via keystrokes. There is no tax money that the Treasury needs to raise anywhere to make this interest or principal payment.

Since the private banks can always move their reserves into bonds of any maturity and since there is no default risk, the interest paid on those bonds constitutes a bottom level for interest rates. There would be no point in loaning out money to private borrowers at lower rates. Thus the Treasury and the Fed can manipulate the overall term structure of private loans by setting a floor below which rates won’t go. This is most commonly the case for very short term instruments, such as Treasury Bills (1 year or less), which the Fed sells to private banks to move bank reserves away from the private banks if the overnight interest rate on the aforementioned interbank lending market drops below the desired policy rate.

It should be noted that a few years ago the Fed started paying 0.25% on reserves, effectively making the sale of short term credit instruments obsolete. But the economic effect is ultimately the same: The interbank lending rate won’t drop below this level.

Why manipulate these interest rates in the context of this overall framework you may ask? That’s a good question, and indeed, MMT suggests that in a sovereign money system there’s really no reason to do so. If the Fed stayed out of it, the short term interest rate on the interbank lending market would probably tend towards zero, since banks will always want to get rid of their excess reserves to maximize interest earnings.

Why sell longer term government bonds like the Treasury does, effectively setting a risk free rate and thus a floor for longer term loans? Again a good question! In fact, MMT ultimately suggests that beyond very short term Treasury Bills at most there’s really no reason for the government to be floating long term bonds.

Within the confines of today’s fiat money system, MMT actually offers the most libertarian alternatives regarding interest rate management and government bonds: let the overnight rate go wherever market conditions amongst private banks let it go, and don’t issue any long term government debt at all!

Private Bank Lending

As outlined above, private banks make it more convenient for people to store and use their money. When I deposit cash in my bank account, then the bank essentially writes me an IOU, saying that it owes me cash on demand, in the form of a checking account. The government, which can always create new bank reserves via spending, guarantees those IOUs via deposit insurance in case the bank runs out of reserves due to mismanagement, which is why they are widely accepted and generally considered as good as cash or “liquid”. It is thus not a coincidence that checking accounts are generally considered part of the money supply. You can say that private banks are in reality public/private partnerships where the bank’s deposit liabilities are publicly guaranteed and the rest (liabilities to bondholders, shareholders, etc.) is private. This explains why when a bank goes under its stock price tends towards zero (the shareholders lose), yet deposit holders are made whole by government’s deposit insurance.

But a much larger function of banks is lending. Lending occurs when a bank identifies a creditworthy borrower who is offering his rather illiquid IOU (in the form of the promise of future payments) to the bank, while the bank in turn offers its own very liquid IOU (a government insured promise to convert into cash on demand) in exchange. In return for offering a more liquid IOU the bank charges interest. The differential between the interest it pays to depositors and other creditors and the interest it charges on its loans determines its profit.

In a very simplified yet relevant model of an economy with only one bank, you can think of a bank extending a loan to an entrepreneur, marking up his checking account by say $100,000. The entrepreneur then uses that money to pay sellers of labor (employees) and of commodities (vendors), marking down his own checking account while marking up the others’. (You can see here by the way how for every loan, there is a matching bank deposit. Not because the bank had to obtain deposits first, but rather because every loan generates a matching bank deposit.) He then produces widgets that he sells to those same people, so that ultimately his bank checking account is marked up again while the buyers’ checking accounts are marked down. He can now repay the bank loan which ends the loan cycle and withdraws the previously issued money from circulation. We can see here that much like taxes do for high powered money, bank loans create a drain on and thus a demand for checking account money.

However, if the entrepreneur is unable to sell the widgets (while the recipients of his payments hold on to their checking account money) he defaults on his loan. The bank needs to write it off and lose out on expected interest revenues, yet it still owes cash to the deposit holders on demand. If some deposit holders were to demand cash (or write checks if we add more banks to the model) then the bank would have to sell assets to the Fed to obtain the reserves needed. If it has no more assets to sell it would have to obtain a reserve loan from the Fed that it needs to repay at some point or face insolvency. So even if a bank can create new checking account money into existence without any bank reserves at all, it is only interested in extending loans to creditworthy borrowers or else it may face insolvency. This model can be easily extended by adding more banks and borrowers with the same net flow of funds over time.

We draw two important conclusions: Banks don’t wait to obtain bank reserves and then lend those reserves out later. They rather identify creditworthy borrowers first, create loans, and then obtain bank reserves from the Fed later if and when they’re needed. Furthermore, in spite of their ability to create money out of thin air, banks have no incentive to create an indefinite amount of loans. Rather loans are made when willing and able individuals stand ready to make successful investments. If loans go sour, the bank is on the hook (as it should be).


To summarize, the most important things I took away from this exercise are:

  • In a free floating irredeemable fiat currency system the government cannot be forced to default on its debts (it could of course choose to suspend interest and/or principal payments, but that would be a policy choice, not one of financial necessity)
  • In such a fiat money system the government creates money by spending and destroys it by taxing
  • Taxes drive money
  • Government bonds are basically just like savings accounts at the central bank
  • Private banks lend first, then obtain reserves
  • Fractional reserve lending is naturally constrained by the creditworthiness of borrowers

In my opinion MMT helps us explain and understand the current fiat money system much better than conventional or Austrian economics. This is coming from an Anarcho-Capitalist who has read books like Mises’ Human Action, Theory of Money and Credit, Socialism, and many others, so don’t think I say this lightly!

Even if we find moral or economic flaws in a system, it is better for us to understand how it actually “works” right now in order to make policy recommendations down the road. I believe MMT offers a lot of insight on that front and I will provide some contemporary and relevant examples in subsequent posts.

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What’s the Problem With Government Budget Deficits?

Government Spending & Taxation

A government is that group of people which periodically obtains goods owned by other people within a certain territory by means of theft, also called taxation.

Since theft is an act of aggression it violates the victim’s value preference. After the goods have been obtained the people in the government will put them to one or the other use. They will hire people, purchase arms, establish offices, give some money to people so long as they prove that they are not working, hire tax collectors, throw people in jail who sell or carry a certain vegetation, maintain those jails, send people in green costumes to countries overseas to aggress against and shoot people, etc. All these activities will ultimately serve those people in whose pockets the stolen money ends up, some more, some less, some sooner, some later. In general these will always be external businesses who bribed government officials, bureaucrats, and to a lesser degree welfare recipients.

Every time someone is hired and every time resources are purchased by government officials they will not be available to people who would have obtained them on a voluntary basis for other uses. It is at the very moment that the stolen money first exchanges hands after being stolen that it begins to exert the harmful effects that result from bureaucracy.

These are all just examples which are well known and nothing surprising or new. The fundamental fact about government activities is that they by necessity and by definition go against the value preferences of those who are not in the government, viz. the majority of the people. This is how they ultimately reduce the welfare of society, and thus ultimately the happiness of the majority.

Budget Deficits

When that same group intends to employ more resources than it is able to fund from the money obtained in its regular annual extortion runs, it borrows additional money from certain people in a credit transaction, resulting in public debt. This additionally borrowed money is what is commonly referred to as a budget deficit.

When projects are funded via a budget deficit, the additional money is actually obtained in a voluntary transaction at first. An investor who is offered a better deal by the government than he might have found elsewhere, hands over money with no aggression involved. But he is promised repayment of his money plus interest through future theft from taxpayers. Instead of purchasing and putting to use factors of production in the service of consumers, as some other entrepreneur would have had the incentive to do with that same money, the government will fund the same kinds of consumptive or even destructive activities as described above with the borrowed money.

The fundamental difference in the case of the budget deficit is that at the moment of putting the funds to use, the money has, for now, been obtained from someone who voluntarily entered into this transaction, with the intention of sharing the future loot from the theft promised.

Thus taxpayers won’t immediately be forced to restrict their consumption because somebody else is doing it for them at the beginning. However, as the public debt interest has to be paid in the future, and the principal sum needs to be repaid, taxes will inevitably rise. Taxpayers will be more and more forced to restrict their future consumption in order for the government to pay off the investors who restricted their consumption in the present.

The burden of restricted consumption is thus shifted over time from the investor over to the taxpayer. However, the investor made the choice voluntarily, along with all the risk of default which comes with the contract. (In fact, a complete debt default is precisely what the investor would suffer for funding a comparable project on the market, ensuring corresponding and healthy incentives moving forward.) The investor’s time preference and value preference is at no point being acted against. Nothing is violently taken away from him or anybody else. He willingly participates in the transaction.

The taxpayer, however, never had any choice. He doesn’t necessarily realize that what the government consumes now will be funded by his restricted consumption in the future. Money that would usually have been used to fund the purchases and thus spur production of capital goods (whose employment would increase the production of consumer goods in the future), is now employed in fundamentally consumptive government activities which necessitates that the debts be paid off through the restriction of future consumption lest a default occur.

But the crucial point with the budget deficit is that, from the consumers’ (= the majority’s) point of view, the effects of deficit financing don’t show up until a later point in time. In the meantime it all appears to be taking its normal course as things would on the market. But when the debts need to be paid off, the expectation that the borrowed funds were used to obtain capital goods which would enable repayment through the production of more consumer goods with less labor input than before, turns out to be a completely false one. No new capital was generated from the projects in question and upkeep of existing capital was, as a tendency, being neglected. Capital consumption inevitably ensues.

Thus, with a budget deficit, and more broadly with the public debt, the fundamental damage occurs at the point where money is taken away from the taxpayer to pay off the investors who voluntarily funded unproductive and ultimately coerced projects in the past.

From the point of view of the majority of the people, the real problem in the phenomenon of the budget deficit lies in the fact that it adds to the public debt and that they or their progeny will at some point have to foot the bill for past expenditures and thus resource employments, again undertaken against their choosing, time preference, or value preference.

It is also important to consider that at any given point in time the current generation is already paying off debts for unproductive undertakings pursued by governments in the past, making the damage caused by deficits and public debt a lot more tangible and immediate, and conveniently ruling out significant tax cuts by the government.

This is very important: When people say something like “the deficit is damaging/bad/a problem/etc.” what it ultimately means is that the money used for more spending and favors and owed by the government to investors will be taken from you or your children in the future via the threat of kidnapping and imprisonment if you don’t comply. This is really at the root of all the problems around public debt owed, and the deficit that we hear about every year is just piled on top of that existing debt.

Due to the fact that the effects of deficits are not immediately noticeable to the general public they are an incredibly convenient way of funding government programs and shifting involuntary burdens on to future disenfranchised generations.  Thus public debts will always continue to grow along with rising taxes, until a level is reached where the required tax burden becomes untenable, where creditors can no longer be paid off, the government can no longer fund itself, where social tensions rise between recipients and payers, and where the whole superstructure that is the government collapses in its entirety.

“Solutions” to Deficits

As I explained, the ultimate damage caused by public budget deficits occurs at that point in time when taxpayers are forced to restrict their consumption and unjustly bear the cost of malinvestments from the past.

Ironically, when you look at the political stage, all you will hear in regards to “solutions” to deficits in the end, will for the most part be tax hikes. These are not solutions. They are the ultimate manifestation of the very problem at hand. They are, in fact, the precise opposite of a solution. Keep this in mind whenever you hear politicians talk about deficit solutions. Raising taxes to reduce deficits is absolutely and 100% an admission that one has completely failed to solve this deficit problem, and in fact laid the final brick that was missing in the very process of the public’s depredation via deficit spending.

A real solution would of course be to make investors suffer the consequences of their unproductive investments, default on the public debt, stop stealing money from people, and allow for voluntaryism to take the place of interventionism.

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