The Greek Crisis and Monetary Sovereignty

Note: This post only really makes sense as a continuation of the argument in this one.


It's a general rule that the internal logic of a system only becomes visible when it breaks down. A system that is smoothly reproducing itself provides no variation to show what forces it responds to. Constraints are invisible if they don't bind. You don't know where power lies until a decision is actively contested.

In that sense, the crises of the past seven years — and the responses to them — should have been very illuminating, at least if we can figure out what to learn from them. The current crisis in Greece is an ideal opportunity to learn where power is exercised in the union, and how tightly the single currency really binds national governments. Of course, we will learn more about the contours of the constraints if the Syriza government is more willing to push against them.

The particular case I'm thinking of right now is our conventional language about central banks "printing money," and the related concept of monetary sovereignty. In periods of smooth reproduction we can think of this as a convenient metaphor without worrying too much about what exactly it is a metaphor for. But if Greece refuses to accept the ECB's conditions for continued support for its banks, the question will become unavoidable.

We talk about governments "printing money" as if “money” always meant physical currency and banks were just safe-deposit boxes. Even Post Keynesian and MMT people use this language, even as they insist in the next breath that money is endogenously created by the banking system. But to understand concretely what power the ECB does or does not have over Greece, we need to take the idea of credit money seriously.

Money in modern economies means bank liabilities. [1] Bank liabilities constitute money insofar as a claim against one bank can be freely transferred to other units, and freely converted to a claim against another bank; and insofar as final settlement of claims between nonfinancial units normally takes the form of a transfer of bank liabilities.

Money is created by loan transactions, which create two pairs of balance-sheet entries — an asset for the borrowing unit and a liability for the bank (the deposit) and a liability for the borrowing unit and an asset for the bank (the loan). Money is destroyed by loan repayment, and also when the liabilities of a bank cease to be usable to settle claims between third parties. In familiar modern settings this lack of acceptability will be simultaneous with the bank being closed down by a regulatory authority, but historically things are not always so black and white. In the 19th century, it was common for a bank that ran out of reserves to suspend convertibility but continue operating. Deposits in such banks could not be withdrawn in the form of gold or equivalent, but could still be used to make payments, albeit not to all counterparties, and usually at a discount to other means of payment. [2]

To say, therefore, that a government controls the money supply or "prints money" is simply to say that it can control the pace of credit creation by banks, and that it can can maintain the acceptability of bank liabilities by third parties — which in practice means, by other banks. It follows that our conventional division of central bank functions between monetary policy proper (or setting the money supply), on the one hand, and bank regulation, operation of the interbank payments system, and lender of last resort operations, on the other, is meaningless. There is no distinct function of monetary policy, of setting the interest rate, or the money supply. "Monetary policy" simply describes one of the objectives toward which the central bank's supervisory and lender-of-last-resort functions can be exercised. It appears as a distinct function only when, over an extended period, the central bank is able to achieve its goals for macroeconomic aggregates using only a narrow subset of the regulatory tools available to it.

In short: The ability to conduct monetary policy means the ability to set the pace of new bank lending, ex ante, and to guarantee the transferability of the balances thus created, ex post.

It follows that no country with a private banking system has full monetary sovereignty. The central bank will never be able to exactly control the pace of private credit creation, and to do so even approximately except by committing regulatory tools which then are unavailable to meet other objectives. In particular, it is impossible to shift the overall yield structure without affecting yield spreads between different assets, and it is impossible to change the overall pace of credit creation without also influencing the disposition of credit between different borrowers. In a system of credit money, full monetary sovereignty requires the monetary authority to act as the monopoly lender, with banks in effect serving as just its retail outlets. [3]

Now, some capitalist economies actually approximate to this pretty closely. For example the postwar Japanese system of “window guidance” or similar systems in other Asian developmental states. [4] Something along the same lines is possible with binding reserve requirements, where the central bank has tight operational control over lending volumes. (But this requires strict limits on all kinds of credit transactions, or else financial innovation will soon bypass the requirements.) Short of this, central banks have only indirect, limited influence over the pace of money and credit creation. Such control as they do have is necessarily exercised through specific regulatory authority, and involves choices about the direction as well as the volume of lending.  And it is further limited by the existence of quasi-bank substitutes that allow payments to be made outside of the formal banking system, and by capital mobility, which allows loans to be incurred, and payments made, from foreign banks.

On the other hand, a country that does not have its “own” currency still will have some tools to influence the pace of credit creation and to guarantee interbank payments, as long as there is some set of banks over which it has regulatory authority.

My conclusion is that the question of whether a country does or does not have its own currency is not a binary one, as it's almost always imagined to be. Wealth takes to form of a variety of assets, whose prospective exchange value can be more or less reliably stated in terms of some standard unit; transactions can be settled with a variety of balance-sheet changes, which interchange more or closely to par, and which are more or less responsive to the decisions of various authorities.  We all know that there are some payments you can make using physical currency but not a credit or debit card, and other payments you can make with the card but not with currency. And we all know that you cannot always convert $1,000 in a bank account to exactly $1,000 in cash, or to a payment of exactly $1,000 – the various fees within the payment system means that one unit of “money” is not actually always worth one unit. [5]

In normal times, the various forms of payment used within one country are sufficiently close substitutes with each other, exchange sufficiently close to par, and are sufficiently responsive to the national monetary authority, relative to forms of payment used elsewhere, that, for most purposes, we can safely speak of a single imaginary asset “money.” But in the  Greek case, it seems to me, this fiction obscures essential features of the situation. In particular, it makes the question of being “in” or “out of” the euro look like a hard binary, when, in my opinion, there are many intermediate cases and no need for a sharp transiton between them.



[1] Lance Taylor, for instance, flatly defines money as bank liabilities in his superb discussion of the history of monetary thought in Reconstructing Macroeconomics.

[2] Friedman and Schwartz discuss this in their Monetary History of the United States, and suggest that if banks had been able to suspend withdrawals when their reserves ran out, rather than closed down by the authorities, that would have been an effective buffer against against the deflationary forces of the Depression.

[3] Woodford's Interest and Prices explicitly assumes this.

[4] Window guidance is described by Richard Werner in Masters of the Yen. The importance of centralized credit allocation in Korea is discussed by the late Alice Amsden in Asia's Next Giant. 

[5] Goodhart's fascinating but idiosyncratic History of Central Banking ends with a proposal for money that does not seek to maintain a constant unit value – in effect, using something like mutual fund shares for payment.

A Response to Tom Palley

Tom Palley wrote a strongly worded critique of Modern Monetary Theory last year, which got a lot of attention int he world of heterodox economics. He has just put up a second piece, MMT: The Emperor Still Has No Clothes, reiterating and extending his criticisms.

Palley is a smart guy who I've learned a lot from over the years. But this is not his best work.

By way of preliminaries: MMT consists of three distinct arguments. First is chartalism, the claim that the value of money depends on its acceptability to settle tax obligations. This goes back to G. F. Knapp. Second is functional finance, the claim that government (conceived of as a consolidated budget and monetary authority) seeks to adjust the budget balance to achieve full employment, it can never be prevented from doing so by a financing constraint. This goes back to Abba Lerner and Evsey Domar. And third is the employer of last resort (ELR), a proposal for a specific form of spending to be adjusted under the functional finance rule. This seems to be an original contribution of Warren Mosler goes back to Hyman Minsky.

Personally, I find it useful to set aside the first and third of these arguments and focus on the second, functional finance. My own attempt to restate the functional finance claim in the language of contemporary textbooks is here. In my view, the essential difference between functional finance and orthodoxy is that the assignments of the interest rate and budget instruments are flipped. Instead of setting the interest rate to keep output at potential and setting the budget balance to keep the debt on a sustainable path, we assign the budget balance to keeping output at potential and the interest rate to debt sustainability.

Palley wants to knock down all three planks of MMT. What are his objections to functional finance?

(1) In the absence of economic growth, government deficits will lead to inflation regardless of the output gap. This claim is asserted rather than argued for. [1] It's not clear what the relevance of this point is, since he agrees that deficits are not inherently inflationary when there is positive growth. Perhaps more importantly, this is a rejection not just as of MMT but of almost all policy-oriented macroeconomics, mainstream and heterodox. Whether you're reading David Romer or Wendy Carlin or Lance Taylor, you're going to find a Phillips curve that relates inflation to current output. There are plenty of disagreements about how expected inflation comes in, but nobody is going to include the budget balance as an independent term. In his eagerness to debunk MMT, Palley here finds himself reasserting Milton Friedman-style monetarism.

(2) If we assume an arbitrary floor on spending and an arbitrary ceiling on taxes, then it may be impossible to achieve both full employment/price stability and a sustainable debt path with interest rates fixed at zero. Yes, this is true. But it proves too much: If we impose arbitrary constraints on tax and spending levels then there is no guarantee that we can achieve debt sustainability and price stability with ANY interest rate. At any given interest rate, there is minimum primary balance that must be achieved to keep output at potential. There is also a minimum primary balance that must be achieved to keep the debt-GDP ratio constant. There is no a priori reason to think the first balance is higher than the second. So Palley's argument here could just as well be a proof that there is nothing government can do to prevent public debt from rising without limit. In any case, these arbitrary limits on taxes and spending are not a feature of standard macro models (including Palley's own models elsewhere), so it's hard to justify bringing them in here.

(3) MMT lacks a theory of inflation. On the contrary, MMT has exactly the same theory of inflation as orthodox macro: High or rising inflation is the result of output above potential, disinflation or deflation the result of output below potential. In other words, MMT is consistent with a standard Phillips curve of the same kind Palley (and almost everybody else) uses. To be fair, the Wray and Tymoigne piece Palley is responding to is not as clear as it might be on this point. But Palley is supposed to be writing a critique of MMT, not just of one particular article. And people like Stephanie Kelton state unambiguously that MMT shares the orthodox output-gap story of inflation; see for instance slide 13 here.

(4) MMT doesn't work in open economies because it requires persistent interest rate differentials between countries. Palley claims that the idea that you can hold interest rates in a given country at zero indefinitely is inconsistent with covered interest parity, a "well-established empirical regularity" that "states there is no room for systematic arbitrage of cross-country interest rates." It seems that Palley has confused covered and uncovered interest parity. CIP is indeed well established empirically, but it only says that there is no arbitrage possible between the spot and forward markets for a given exchange rate. It does not rule out interest-rate arbitrage in the form of the carry trade, and so does not have any implications for the viability of MMT. If UIP held, that would indeed rule out a persistent zero interest policy in the absence of an equally persistent currency appreciation. But UIP, unlike CIP, gets no empirical support in the literature. Japan has sustained the near-zero interest rates that Palley says are unsustainable for 15 years now, and in general, persistent interest rate differentials without any offsetting exchange rate movements are ubiquitous. Furthermore, if financial openness rules out a policy of i=0, then it equally rules out the use of interest rates as a tool for demand management. The best thing you can say about Palley here is that he is parroting orthodoxy; otherwise he is thoroughly confused.

There is one thing that Palley is right about, which is that substantially all of MMT can be found in the old Keynesian literature. This isn't news -- in the same Stephanie Kelton slideshow linked above, she goes out of her way to say that there is nothing "modern" about MMT. And so what? There's nothing wrong with updating insights from the past. In my opinion, most useful work in economics is about pouring old wine in new bottles.

I don't write this from a position within MMT. I tend to feel that the genuine insights of Lernerian functional finance are obscured rather than strengthened by basing them in a chartalist theory of money. It's fine if Tom Palley disagrees with our friends at UMKC and the Levy Institute. But he needs to put down the blunderbuss.


[1] In fact it's a bit hard to understand what Palley is claiming here. First he says that "money financed deficits" must lead to inflation in a static economy, even with a zero output gap. He adds in a footnote that money-financed are not inflationary in a growing economy; in that case, for price stability "the high-powered money stock must grow at the rate of growth." Then when he writes down a model, this has become the condition that government budget must be balanced, which is something different again. Also, I must say I can't help wrinkling my nose a little, when I read about the "stock of high-powered money," at the smell of a musty antique.


EDIT: Thanks to Daniele Santolamazza for correcting me on the origins of the ELR proposal.

Don't Start from the Coin

Schumpeter:

Even today, textbooks on Money, Currency, and Banking are more likely than not to begin with an analysis of a state of things in which legal-tender ‘money’ is the only means of paying and lending. The huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption is then built up step by step by introducing claims to money or credit instruments that act as substitutes for legal tender... Even when there is very little left of [money's] fundamental role in practice, everything that happens in the sphere of currency, credit, and banking is construed from it, just as the case of money itself is construed from barter. 

Historically, this method of building up the analysis of money, currency, and banking is readily understandable… Legal constructions, too, … were geared to a sharp distinction between money as the only genuine and ultimate means of payment and the credit instrument that embodied a claim to money. But logically, it is by no means clear that the most useful method is to start from the coin—even if, making a concession to realism, we add inconvertible government paper—in order to proceed to the credit transactions of reality. It may be more useful to start from these in the first place, to look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences—so that ‘money’ payments come in only as a special case without any particularly fundamental importance. In other words: practically and analytically, a credit theory of money is possibly preferable to a monetary theory of credit.

Perry Mehrling quotes this passage at the start of his essay Modern Money: Credit or Fiat. If you're someone who worries about the vexed question of what is money anyway, you will benefit from the sustained intelligence Perry brings to bear on it.

Readers of this blog may not be familiar with Perry's work, so let me suggest a few things. The Credit or Fiat essay is a review of one of Randy Wray's books, but it makes important positive arguments along with the negative criticism of MMT. [1] A good recent statement of Mehrling's own views on the monetary system is The Inherent Hierarchy of Money. Two superb essays on monetary thought in the postwar neoclassical synthesis are The Money Muddle and MIT and Money. [2] The former of these coins the term "monetary Walrasianism." This refers to  the idea that the way to think of a monetary economy is a barter system where, for whatever reason, the nth good serves as unit of account and must be on one side of all trades.  This way of thinking about money is so ingrained that I suspect that many economists would be puzzled by the suggestion that there is any other way of thinking about money. But as Perry shows, this is a specific idea with its own history, to which we can and should imagine alternatives. Finally, The Vision of Hyman Minsky is one of the two best essays I know giving a systematic account of Minsky's, well, vision. (The other is Minsky as Hedgehog by Dymski and Pollin.) Anyone interested in what money is, what "money" means, and what's wrong with economists' answers, could save themselves a lot of trouble and wrong turns by reading those essays. [3]

But let's talk about the Schumpeter quote.  I think it is right. To understand the monetary nature of modern economies, you need to begin with the credit system, that is, the network of money obligations. Where we want to start from is a world of IOUs. Suppose the only means of payment is a promise to pay. Suppose it's not only possible for me to tell the bartender at the end of the night, I'll pay you later, suppose there's nothing else I can tell him -- there's no cash register at the bar, just a box where my tab goes. Money still exists in this system, but it is only a money of account -- concretely we can imagine either an arbitrary unit of value, or some notional commodity that does not circulate, or even exist. (Historical example: non-circulating gold in medieval Europe.) If you give something to me, or do something for me, the only thing I can pay you with now is a promise to pay you later.

This might seem paradoxical -- jam tomorrow but never jam today -- but it's not. Debts in this system are eventually settled. As Schumpeter says, they're settled by netting my IOUs to you from your IOUs to me. An important question then becomes, how big is the universe across which we can cancel out debts? If A owes B, B owes C, and C owes A, it's not hard to settle everyone up. But suppose A owes B who owes C who owes …. who owes M who owes … who owes Z, who owes A. It's not so easy now for the dbets to be transferred back along the chain for settlement. In any case, though, my willingness to accept your IOUs depends on my belief that I will want to make some payment to you in the future, or that I'll want to make some payment to someone who will want to make a payment to someone …. who will eventually want to make a payment to you. The longer the chain, the more important it is for their to be some setting where all the various debts are toted up and canceled out.

The great fairs of medieval Europe were exactly this. During their normal dealings, merchants paid each other with bills of exchange, essentially IOUs that could be transferred to third parties. Merchants would pay suppliers by transferring (with their own endorsement) bills from their customers. Then periodically, merchant houses would send representatives to Champagne or wherever, where the various bills could be presented for payment. Almost all the obligations would end up being offsetting. From Braudel, Capitalism and Civilization Vol. 2:

... the real business of the fairs, economically speaking, was the activity of the great merchant houses. … No fair failed to end with a 'payment session' as at Linz, the great fair in Austria; at Leipzig, from its early days of prosperity, the last week was for settling up, the Zahlwoche. Even at Lanciano, a little town in the Papal States which was regularly submerged by its fair (though the latter was only of modest dimensions), handfuls of bills of exchange converged on the fair. The same was true of Pezenas or Montagnac, whose fairs relayed those of Beaucaire and were of similar quality: a whole series of bills of exchange on Paris or Lyons travelled to them. 

The fairs were effectively a settling of accounts, in which debts met and cancelled each other out, melting like snow in the sun: such were the miracles of scontro, compensation. A hundred thousand or so "ecus d'or en or" - that is real coins - might at the clearing-house of Lyons settle business worth millions; all the more so as a good part of the remaining debts would be settled either by a promise of payment on another exchange (a bill of exchange) or by carrying over payment until the next fair: this was the deposito which was usually paid for at 10% a year (2.5% for three months). 

This was not a pure credit-money system, since coin could be used to settle obligations for which there was no offsetting bill. But note that a "good part" of the net obligations remaining at the end of the fair were simply carried over to the next fair.

I think it would be helpful if we replaced truck-and-barter with something like these medieval fairs, when we imagine the original economic situation. [4] Starting from a credit view of money modifies our intuitions in several, as I see it, helpful ways.

1. Your budget constraint is always a matter of how much people will lend you, or how safe you feel borrowing. Conversely, the consequences of failing to pay your debts is a fundamental parameter. We can't push bankruptcy onto the back burner as a tricky but secondary question to be dealt with later.

2. The extension of credit goes with an extension of the realm of the market. The more things you might be willing to do to settle your debts, the more willing I am to lend to you. And conversely, the further what you owe runs beyond your normal income, the more the question of what you won't do for money comes up for negotiation.

3. Liquidity, money, demand, depend ultimately on people's willingness to trust each other, to accept promises, to have confidence in things working out according to plan. Liquidity exists on the liability side of balance sheets as much as on the asset side.

4. When we speak of more or less liquidity, we don't mean a greater or lesser quantity of some commodity designated "money," but a greater or lesser degree of willingness to extend credit. So at bottom, conventional monetary policy, quantitative easing, lender of last resort operations, bank regulations -- they're all the same thing.

When Minsky says that the fundamental function of banks is "acceptance," this is what he means. The fundamental question faced by the financial system is, whose promises are good?





[1] I don't want to get into Perry criticisms of MMT here. Anyone interested should read the article, it's not long.

[2] MIT and Money also makes it clear that I was wrong to pick Samuelson's famous consumption-loan essay as an illustration of the neoclassical position on interest rates. The point of that essay, he explains, was not to offer a theory of interest rate determination, but rather to challenge economic conservatives by demonstrating that even in a simple, rigorous model of rational optimization, a public pension system could could be an unambiguous welfare improvement over private retirement saving. My argument wasn't wrong, but I should have picked a better example of what I was arguing against.

[3] Perry has also written three books. The only one I've read is The New Lombard Street. I can't recommend it as a starting point for someone new to his work: It's too focused on the specific circumstances of the financial crisis of 2008, and assumes too much familiarity with his larger perspective.


EDIT: I removed some overly belligerent language from the first footnote.