State Money and Prices – Modelling Errors at the Heart of Monetary Theory

The lack of consensus at the heart of modern monetary theory debates is obvious to anyone.

Debates have become reduced to a series of Ad Hoc assumptions about the effect of changes to monetary aggregates to prices and demand.

The creation of the ‘fiscal theory of the price level’ a few years ago – in its modern form by Williamson and Cochrane seemed to offer hope of a deterministic approach.  You could plug in the numbers and out would come a price level without the uncertain assumptions about velocity which was the downfall of old monetarism.

In the FTPL it was the level of government debt which set the overall price level – or to be precise it was the Net Present Value of the future primary government surpluses ‘necessary’ to pay the debt which set the price level.

The theory has been highly controversial since it was first set out.  Wilhem Buiter and Nick Rowe both think it nonsense (for different reasons) as do MMTs who argue with its neoclassical assumption of a ‘government budget constraint’ the idea that government budgets are constrained in the same way as households.  Indeed chartelists argue that it is government deficits which give money its value in the first place.

There are aspects in which the FTPL are appealing though because prior to neoclassical economics has some big problems with money – apart that is from ignoring banking and money creation in its core conceptual foundations.

The biggest problem was the equations of general equilibrium were indeterminate.  It might show that the price of an ice cream in August in New York was Y and an ice cream in August in San Fransisco was 1.n Y but what is Y?  It had no system for determining the unit of account.  At least classical economics with its monetary dualism had the quantity theory to do this.  At least the FTPL work of Williamson and Cochrane offered to bring the numeraire issue within equilibrium theory.

Various heterodox theories as well tackled the issue of unit of account.  A strand of monetary thinking from real bills to the more modern ‘backing’ theory of money took serious the ‘I promise to pay the bearer’ on the front of bank notes, and the sovereigns had on the back of coins which was a shorthand way of saying the same thing.

For all antimonetarists it was the debt obligation aspects of money which was paramount.  It return for a debt obligation a certain amount of real goods purchasing power was created.

What I am suggesting here is that we remodel from first principles the asset liability relationships of modern money and see where any errors and corrections creep in to the FTPL etc.  This is a much larger exercise than a single blog post so here I will confine myself to pointing out some easily spotted errors and one or two easy corrections rather than mounting a whole all encompassing equation.

Heterodox economists often get bogged down with whether to model the state and central bank separately or consolidated.  A diversion.  In accounting you only need to consolidate when a body is closing or closing its accounts. Central Banks aren’t closing down any time soon.

The starting point in my model is state which exactly balances its income and expenditures and has no  debt repayments.  This produces exactly the kind of model created by the French Circuitists where taxation debits money balances in the private sector and government spending creates them.  Government spending is simply the electronic crediting of a government account allowing it to spend and taxation the debiting of private sector balances.  Private sector money (bank loans) creates an asset liability pair and when a loan is repaid the money is destroyed, when a loan created money is created.  State money liabilities are different, but the effect is the same.  State money would not circulate unless it is redeemable. What the state is saying is that you can exchange the token of money for an equivalent number of real goods and those real goods can be used to pay a debt liability (taxation).  Historians of money are now in wide agreement that it was the state forcing these debt liabilities that led to the creation of money.      Hence net overall taxation destroys units of account and government spending creates them.  The total amount of all units of account in circulation at any one time is the sum of all nominal state deficits + net private debts (that is debt creation by banks minus debt repayments).

This is the first correction to the FTPL – past state debts plus net private debt is the divisor in the formula.

Now lets look at the numerator of the FTPL equation.  The FTPL uses the NPV of primary surpluses.  Primary surplus is taxation minus expenditure not accounting for interest on debt.  This has all kinds of problems.  Firstly it assumes a fixed end date for repayment of all state debts.  But we know from functional finance that a state can run a deficit forever providing the real value of its debts (after inflation) grows less than the rate of growth.  Lets get real.  There is also the issue that Buiter raises that it implies falsely that a currency in default has no value.

The problem lies in aggregating assets and liabilities on the state side of the balance sheet.  Future taxation and future public spending have different term structures and need to have their NPV calculated separately.  The FTPL assumes the formula is NPV (taxation minus gov spending), and covers only the primary deficit; no the net intertemporal change in unit of account is NPV taxation/NPV gov spending.  Where spending is all government spending including interest on the national debt.  Hence if taxation is exceeding spending the government is net decreasing the unit of account (deflation), but with gilts/treasuries financed nationally the converse is not necessary true as these are straight transfer payments.  Today’s deficit in the government sector is paid for by todays surplus in the private sector. Government deficit is something we owe to ourselves and own as a financial asset in the private sector ourselves.

It is the net-change in government debt that is paid for by future generations, but for debt issued in a sovereign currency only under the most extreme mathematical conditions (in terms of change of debt) will there be any kind of budget constraint on the state.  Those conditions being where the change of debt approaches total income in the private sector – a taxation constraint or a bond issuance constraint depending on the means of financing.  Taxation greater than government spending  can be seen as reducing the total equity value of the private sector – hence the means of financing tax or debt has no impact on that value via the MM theory.

Of course a government can always issue helicopter money (or even its inverse depreciating currency) to finance deficits, this by increasing the money denominator reduces the purchasing power parity of the currency and puts that currency under threat of devaluation.  This is not necessarily  ‘currency wars’ zero sum game.  If the total burden of state debt forces countries to devalue through debt monetarisation then inflation will reduce the real costs of debt – both to the public and private sector (this is Hawtrys monetary parable of fishing boats all moving together to avoid a storm – the gold standard).

All that matters to the purchaser of a treasury is the net present value (including anticipated inflation) of the value of the bond measured in the unit of account.   For a sovereign currency not at risk of default this will always be positive.  If the unit of account stays positive and anticipated inflation is not hyperinflationary then required coupon on the treasury will be within realistic limits.  There is absolutely no need for a primary government surplus to ensure government financing.

The framework set out here can be further elaborated with a proper set of T accounts and modelling of the relationship between sectors.  It offer promise for the modelling of different forms of QE.


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