Sunday, June 10, 2012

Understanding Modern Money: Introduction.

Understanding Modern Money: The Key to Full Employment and Price Stability. L. Randall Wray. Cheltenham, UK: 1998. Pp. x + 198.

Chapter 1: Introduction
Chapter 2: Money and Taxes: The Chartalist Approach (coming soon)
Chapter 3: An Introduction to a History of Money (coming soon)

His phrasing is more scholarly, but in his introduction, University of Missouri, Kansas City professor of economics L. Randall Wray begins Understanding Modern Money by claiming that everything we know about money is wrong*. According to Wray, Governments can run a balanced budget only in the perfectly ideal case; in practice, a government must run a deficit, and there is no a priori optimal deficit or debt limit (1). It is not the monetary policy of the central bank but the fiscal policy of the Treasury that determines the value of money (1-2). The central bank does not determine the inflation rate by controlling the amount of money in circulation; indeed the central bank cannot control the money supply; the only effective tool the central bank has is determining the interest rate at which it supplies short-term bank reserves (2). The Treasury need not "finance" government operations with bond sales; bond sales serve only to "drain" excess bank reserves and the central bank effectively determines the bond interest rate (2). Just as Marx did to Hegel, Wray and the Modern Monetary Theorists want to turn our upside-down understanding of money back on its feet.

*with apologies to Firesign Theater

With this new understanding of money, Wray offers some alternatives to present economic and political policy. Rather than trying to manage incentives to achieve full or nearly full employment in the private sector (and provide welfare, because the private sector never actually manage to achieve high employment), the government can act as "'employer of last resort' by offering a job to anyone who wants to work at a nominal wage fixed by the government" (2-3). Instead of fixing the quantity of government purchases by direct policy and paying market rates for those purchases, the government can fix the anchor price of a key commodity, i.e. labor, and let the quantity consumed float, thus maintaining a "buffer stock" to maintain overall price stability (3). Wray believes this approach would deliver price stability and zero involuntary unemployment (3).

Wray continues by sketching a simple model. A government enforces a tax liability on its citizens, and determines "that which is necessary to pay taxes, (twintopt)." All governments today use "money" as twintopt; the terms are interchangeable. The government then purchases goods and services from its citizens in exchange for money, and the citizens supply goods and services so they can pay their taxes. People must receive enough money to have enough to pay their taxes, so total government purchases must at minimum equal the tax liability; in the long run, the government must at least operate a balanced budget and cannot operate a long-run surplus. Even if the government were the only consumer of goods and services, people would probably want to hoard some money, so they could be assured of paying future taxes, and some money will probably be "lost in the wash", so realistically, the government ought to operate a long-run deficit (4). The key points here are that tax liability precedes government purchases, and payment of money by the government precedes the collection of taxes.

The government can adjust the value of money in two ways: changing the nominal amount it demands in taxes and changing the nominal amount it pays for goods and services. If the government were to double its prices, while holding the tax liability constant, it should see a reduction in supply, as people would then be required to work half as hard to fulfill their tax liability. We would see a similar effect if the government held prices constant while halving the tax liability. Changing prices or liabilities in this way would generate "inflation" instead of increasing the quantity supplied (Wray 5). Fundamentally, the value of money is the relation between the tax liability and the prices paid by the government.

Of course, the government is not the only consumer of goods and services. Not everyone will need to pay taxes, and not everyone who needs to pay taxes will have goods and services the government wants. So people will also exchange money for goods and services among themselves (hence, as noted earlier, it behooves the government to supply more money by purchases than it demands in taxes, so they will have the money to do so). There can even be other forms of money (bank money), but there must be some correspondence between bank money and government money, i.e. twintopt (Wray 5). Even if the government is only a small part of the economy, its purchases and taxes will have an direct effect on the value of all kinds of money, bank money as well as twintopt (6). It is the special nature of government, its exogenous supply of money in exchange for goods and services to satisfy its exogenous imposition of tax liabilities that fundamentally sets the value of money.

The government can use its exogenous pricing power to control the aggregate price level. Wray argues that the government should not set the money price of each and every good independently; unless it matches those prices perfectly to the private market, private prices will have to deflate every time the private sector switches from the most efficient product to the next most efficient. But neither should the government accept market prices for everything; it can then control the price level only indirectly, by creating unemployment and underutilization of capital (7). Instead, governments can set the "anchor" price of one good and maintain a "buffer stock" of that good to support the price, and let other prices adjust around the anchor price. Historically, governments have used gold as the anchor price, but Wray argues that the poor substitutability and limited industrial use of gold renders it an inferior choice. A better choice would be oil; an even better choice would be unskilled labor (8-9).

Maintaining a buffer stock of unskilled labor to establish an anchor price has many benefits. All economic activities use some sort of labor, and even unskilled labor has high substitutability: unskilled labor can be trained, or processes using skilled labor can be reworked to use unskilled labor (9); rather than adjust aggregate price levels, the private economy can change how it uses labor. Unemployment by itself causes a number of social problems, and using unskilled labor as an anchor directly creates "full employment" (9): everyone who wants to work at the anchor price can do so; someone who can work but chooses not to is by definition not unemployed. Using unskilled labor will act as a "powerful 'automatic stabilizer'" (10). In recessions, more people would be employed by the government, pushing more money into the overall economy; during boom times, fewer people would be employed by the government, reducing the money the government pushes into the system (10-11). No system would be perfect (and the gold standard was so imperfect it was completely abandoned in 1971), but if Wray is correct, using unskilled labor would give us a satisfactory level of price and business-cycle stability while having many beneficial and few negative side effects.

You can read L. Randal Wray and other Modern Monetary Theorists at their blog, New Economic Perspectives

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