Fallacies of Modern Monetary Theory (MMT)

Fallacies of Modern Monetary Theory (MMT)

Taxation does not fund government spending

It does! Governments can fund public spending in just three ways: 

  1. Through taxation;
  2. By borrowing from the private sector;
  3. By borrowing from its banker (the central bank).

The last option on this list is forbidden in most advanced economies. This leaves taxation and borrowing from the private sector as the only available funding sources.

Money is a liability of the government

No it’s not! Customer deposits held by retail banks are liabilities of those retail banks. These customer deposits are not liabilities of the government or of the central bank. As an aside, money deposited with these banks is an asset to the depositor (customer).

Government spending precedes taxation

This could be true if money was created and injected into the economy by the government. But this condition does not hold. Most money in circulation is created and injected into the economy by private banks. 

Taxation alone determines a currency’s value

It is true that governments require taxes to be paid in the national currency and this creates demand for the currency. However, a nation’s international trading performance and capital flows also affect demand for a nation’s currency and its value. So tax is not the sole determinant. 

Conclusion

The “magic money tree” does not exist!

Ricardian Equivalence is dead. Long live Keynes!

Introduction

In this piece, I show how government spending on capital projects can be beneficial to the private sector. The demonstration shows the oft-cited objection to government spending, so called Ricardian Equivalence, is not correct. I use an example, which hints at the proposed HS2 rail project, to make my point. I also use accepted investment appraisal techniques.

An example

A government proposes to invest in a high speed rail line which will cost £30 billion to build. The government will commission a consortium of private sector firms to undertake the work. The consortium will be paid £30 billion and this will be treated as income in their financial accounts and for GDP measurement purposes.

The government proposes to fund the project by borrowing £30 billion from the City at a rate of 6% per annum. The bonds must be repaid at the end of 20 years. Once built, the line will be operated by a private rail company. The line is expected to last for 50 years after which time it must be replaced.

Methodology

A prudent government should ensure the borrowed money will be repaid to the lenders when due and that interest payments are met. This can be done by calculating an “annual equivalent” of the interest payments and the loan repayment. The government can then levy the amount of the annual equivalent as an annual taxation charge on the private sector over the 20 years of the loan. This stream of annual tax receipts, which are additional to other tax receipts, will then be sufficient to pay the annual interest charges to the lenders and to repay the amount initially borrowed (the principal) when it falls due at the end of 20 years. In short, the government will be able to break even.

Annual Equivalent

The annual equivalent is obtained from a formula which converts an uneven stream of cash flows into an even stream of cash flows (an annuity). In this particular case, there are 20 payments of £1.8 billion for interest (6% p.a. x £30 billion) and a final payment of £30 billion by way of repayment of the principal to the lenders. The annual equivalent is £2.616 billion (3 d.p.).  So this amount should be the additional annual tax charge to fund this particular project. It will be enough to provide for the annual interest charge of £1.8 billion for 20 years plus £30 billion repayment of principal. See appendix.

Schedule of cash flows

To see how the annual equivalent calculation clarifies and makes tractable the analysis, here is a summary of the cash flows between the government and the private sector using the facts of this example.  Outflows are shown in brackets and inflows without brackets.

Cash Flows

Comment

At this point, a reader may observe that the government and private sectors are mirror images of each other; the flows in and out of the private sector being exactly matched by the flows out and in of the government.  This may induce  the same reader to consider that government spending does not benefit the private sector since the additional tax charges (20 x £2.62) exceed the £30 billion income received at the outset of the project.

Time value of money

However, this conclusion takes no account of the TIME VALUE of money. Very simply put, the time value of money is the preference to receive money sooner rather than later. Most people prefer to receive money sooner rather than later. There are several reasons why individuals, households and firms prefer to receive money sooner rather than later. The list of reasons includes inflation, risk, need and so on. For example, a starving pauper would prefer to receive £1 now, rather than in one week’s time, for otherwise he or she may not be able to eat for a week. The poorer an individual, the greater their time value of money; a millionaire does not really care if they receive  £1 now or in one week’s time since it will make virtually no difference to his or her life.

Discount rate

This is the time value of money expressed as an annual interest rate. The higher a time value is, the higher the discount (or interest) rate. The discount rate allows someone’s preference for immediate money to be linked to future money. For example, someone with a discount rate of 25% would see £125 receivable in one year’s time as having an immediate value of £100. Someone with a higher time value, say with a discount rate of 30%, would value the same £125 as having an immediate value £96.15. The immediate value is called the PRESENT VALUE. In general, the poorer an individual, a household, or a firm is, then the higher their time value of money and their discount rate. The higher the discount rate the stronger the preference to receive a given sum now rather than in the future.

Putting it all together

The above table of cash flows shows the cash flows of the government and private sector to be equal (but opposite). The PRESENT VALUE of the tax cash flows, which arise in the future, may differ between the government and the private sector. In short, the time value of money for the private sector may be different from the government’s time value. In reality, this is highly likely to be true. If the time values, and therefore the discount rates, are different then the PRESENT VALUE of the cash flows shown in the table will be different. We hence need to ascertain the PRESENT VALUE of these future tax payments if we are to conclude whether or not government spending increases private sector income.

We know the government’s discount rate in the example is 6% (its borrowing cost).  However, we do not know the private sector’s discount rate (or time value of money). But we do know the private sector is composed of many households as well as firms. Many households, perhaps the larger part, will struggle day to day to make ends meet. They will be at the poorer end of the income spectrum. Many individuals and households will be borrowing at annual rates in excess of 1000% via Pay Day loans. This fact alone signifies that many households have extremely high discount rates

Firms will often be under pressure from their shareholders to make short term profits. Moreover, firms race risk when investing funds and this risk increases their discount rate. These factors, among others, support a conclusion that the private sector will have a higher average discount rate than the government’s, although we may not be able to quantify it.

If the private sector’s average discount rate is assumed to be 18%, then the following summary table shows the private sector (and GDP) benefits from the government’s spending. This conclusion may run counter to some economists who argue that government spending does not promote growth or income. They believe the private sector’s response will be to immediately save the entire amount of the additional government spending and thereby withdraw the government injection totally and immediately. These economists believe the private sector’s response would be in anticipation of the government clawing back the additional spending via higher future taxation. This analysis shows the conclusion is wrong since it does not correctly adjust for the different time values of the parties to the transaction.

Investment decision summary

The net present value represents the surplus in present value terms. As planned, the net present value accruing to the government is zero (it has broken even). The NPV accruing to the private sector is positive. This means it has gained £16 billion as a consequence of the government’s capital spending of £30 billion. The size of the private sector’s surplus depends on the private sector’s discount rate. The higher the private sector’s discount rate then the higher will be the surplus. A surplus will arise so long as the private sector’s discount rate is higher than the government’s. As explained above, it is almost certain that the private sector’s discount rate is higher than the government’s.

Appendix: 

Repayment schedule for 6% government bonds with a term of 20 years

Repayment schedule

The repayment schedule assumes that surplus funds can be invested at 6% – a realistic assumption because the government will be repaying maturing 6% bonds continuously, thus saving itself 6%.on each bond redemption.

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Where does money come from?

Do Banks Create Money?

The tables shown below illustrate how banks create money. The tables show two hypothetical high street banks and a central bank.  In this scenario, I bank with My Bank and you bank with Your Bank.  The scenario shows what happens when My Bank grants me a loan which I then use to pay you for services rendered.

Row # 1

Both banks start identically with capital of £1,000 which they have deposited at the central bank (Bank of England). The central bank acts as the banker to the high street banks, so the two high street banks effectively each have a current account with the central bank. These current account balances are shown in the Central Bank table.

Row # 2

I apply for and am granted a loan for £100 from My Bank. My bank creates a current account in my name and gives me credit for £100. I am thus authorised to issue a cheque of up to £100 from this account. Note the absence of cash – the money credited to my account is purely electronic. At the same time, My Bank creates a My Loan account which shows I must repay My Bank £100. Money has been created immediately these two entries are posted to My Bank’s books.

Row # 3

I write a cheque in your favour for £100 drawn on My Bank to pay you for services rendered. You deposit this cheque with Your Bank which credits your current account and debits an account called My Bank with £100.  This debit to the My Bank account signifies how much My Bank owes Your Bank.

Row # 4

Your Bank then submits the cheque for clearing. When the cheque is cleared My Bank will reduce my current account by £100 and reduce its Central Bank current account balance by the same amount. At the same time, Your Bank will increase its Central Bank current account by £100 and reduce its My Bank account by the same amount. This is to show that My Bank has settled is debt to Your Bank through the current accounts held at Central Bank. The Central Bank transfers £100 from the My Bank current account to the Your Bank current account to reflect this settlement.

Row # 5

The closing balances show the balances held by the banks once clearing has completed.

Row # 6

This row shows the difference between the closing and opening balances. It shows that I owe My Bank £100 and that My Bank’s current account held at the Central Bank has reduced by £100. My Bank will expect to earn interest on the loan and to restore its current account balance when I repay the loan. You now have a current account at Your Bank with a balance of £100. This is money you can spend – it is yours, This money did not exist until My Bank made the loan to me. It hasn’t come from the current accounts at the Central Bank because the total held at the Central Bank has not changed. So where has the £100 come from? The answer is it has been created out of nothing by My Bank when it approved my loan.Where does money come from