Stephanie Kelton, a prominent Modern Money Theory (MMT) proponent, has a new book out, The Deficit Myth, and it is finally making the rounds of reviews by economists and commentators. As to be expected, there are some whataboutisms. In the case of Josh W. Mason’s largely positive review in the American Prospect, the question is: what about the banks?
I guess something that needs to be stressed here is that The Deficit Myth isn’t meant to be “the” book on MMT that explains all aspects of economics. MMT as a body of work is a vast literature for which Kelton is attempting to condense a few very basic arguments for a general nonacademic audience. The confusion around public finance is hard enough to disentangle without bringing banks into the picture. However, it is one question, among other critiques made by Mason, worth addressing if only to take the opportunity to educate those that might have similar questions.
Mason makes three main critiques to Kelton’s arguments in The Deficit Myth that I want to respond to. But for the purposes of this article, I will only address the issue of private bank money. For a complete response to other critiques, click here.
According to Mason, the existence of banks creates a “problem” for MMT’s central claim that the government is the monopoly issuer of the currency. “Banks are money issuers every bit as much as the government,” Mason argues. “[The] Government has tools to influence how much money is created by private banks, but its control isn’t absolute. And when its control is effective, that’s a function of the regulations and institutions of the financial system; it has nothing to do with the government monopoly on currency…Little is said about the private financial system.” He also says that “Kelton, to be clear, never says anything factually untrue, but she gives the strong impression that the government is the only source of money that we use for transactions, which is not true at all.”
The first thing to note is there is a difference between the currency proper and other forms of private “money.” (That is a financial liability that exhibits money functions, a means of payment/exchange, and a store of value). The federal government is the only issuer of the currency proper. Full stop. It decides what the unit of account is — the dollar — and it creates tokens that represent the unit of account. It is illegal to counterfeit those tokens — Federal Reserve notes (bills) or coins. That includes electronic dollars generated by the Fed, i.e. reserves.
Banks, as well as other financial institutions, do issue various forms of debt contracts that differ in conditions of maturity (when the money has to be paid back), negotiability (transfer of ownership), and convertibility (to another asset).
Bank deposits are a special sort of debt instrument. Their maturity is zero. You can redeem them any time in payment of debts to the bank. They are also negotiable, you can change the name on a checking account to someone else or add someone to it. And most importantly, they are convertible on-demand to hard currency (bills and coins) or in reserves (electronic dollars) for settlement with another bank through the Federal Reserve System. To be clear, you as a customer cannot request that the bank give you electronic Fed reserves. Customers are only entitled to hard currency. Fed reserves would only be used when settlement between banks is required or when you pay your taxes to the government through your deposit account. (For that reason, Fed reserves might be better understood as settlement balances than reserves to distinguish them more clearly from reserve cash and coins banks must also keep on hand.)
Now, not all cases of settlement between deposit accounts have to be done through the Fed. For example, if two customers have deposit accounts at the same bank, settlement occurs within the bank itself marking one account down and another up by the same amount on the liabilities side of its balance sheet — no exchange of reserves required. Some banks might also have deposit accounts with each other, and allow some limit of continuous overdraft credit, which at some point still must be settled. This arrangement is called net clearing, or net settlement. For example, many large banks are also members of the New York Clearing House which is a wholesale net clearing institution between banks, but one in which Fed reserves still play a role as any differences in credits and debits are turned over to the Federal Reserve Bank of New York for reserve settlement. Most transactions between banks, however, occur through Fed reserve settlement.
What about bank loans? Don’t loans create money? Yes, when banks make a loan, they create a deposit, which we noted exhibits the core functions of “money.” This is what Mason is referring to when he says the government is not the sole issuer of money. This is true. And in theory, there is no limit to the quantity of deposits a bank can create. You may have seen mailer ads, for example, from local banks offering some amount of money for setting up a checking account with them. I recently received one from Citizens Bank for a generous $400. Where does that money come from? The bank can simply create it as a deposit. But there is a practical limit to how much they are willing to create because deposits come with this condition of convertibility on-demand to government money, which they do not create.
This is where the Fed comes in. As banks expand deposit creation through loans, the Fed has to respond by creating adequate reserves so banks can service those deposits and ensure the payment system runs smoothly, so payments clear and checks don’t bounce. This does not mean there needs to be a one-to-one relationship between the quantity of deposits and quantity of reserves in circulation, it simply means the banking system requires sufficient reserves circulating in the interbank lending market to ensure banks can maintain parity (equal value) between bank money and government money. This institutional configuration is by design—think of it as the ultimate public-private partnership. The implication of this arrangement is that the Fed follows the lead of the private banking system to supply credit as needed to the public. The Fed supervises the banking system, and the financial system more broadly, and sets a target interest rate of interbank lending to increase or decrease the cost of funds to banks, which influence the cost of credit to consumers and businesses. Certainly, the banking system can get overzealous and create too much credit without adequate regulatory supervision resulting in episodes such as the 2008 Great Financial Crisis.
So while it is true that bank liabilities function as “money,” as a store of value and means of payments/exchange, it is important to note that confidence in the use of that money is contingent on its convertibility on-demand from bank liabilities (bank deposits) to government liabilities (bills, coins, or reserves). If at any point a bank cannot convert your deposits to cash because, say, a bank run from a loss of confidence in the bank, the bank fails; if it cannot obtain reserves to settle up with other banks, the bank fails. The former scenario was common before the advent of federal deposit insurance which insures your deposits will be convertible to government money up to a certain limit, usually $250,000. The latter was the problem during the Great Financial Crisis as interbank lending of Fed reserves came to a near halt and the Fed had to intervene as the lender-of-last-resort.
For the uninitiated, what I have just described is called endogenous money theory in heterodox economics. Endogenous money theory flips the conventional wisdom that the Fed creates reserves, reserves create deposits, which banks then loan out to customers. In reality, bank loans create deposits, and the Fed responds by creating reserves. So endogenous money creation doesn’t break the link between deposits and Fed reserves, it merely reverses the direction of causation from the conventional wisdom generally described in textbooks.
Endogenous money theory is also a credit theory of money which postulates that all money is an IOU, a debt, which anyone can create. “The problem is getting it accepted” as the late economist Hyman Minsky once said. But some proponents of this view lean too heavily on the “anyone can create money” insight, and forget or breeze through the rather hard problem of “getting it accepted.” In our modern financial system, most privately created financial instruments promise to pay government money or its practical equivalent, bank deposits. This equivalence is accepted predominantly because of their convertibility to government money. And the government has set an expectation it will act as a backstop to this arrangement through deposit insurance and by the Fed acting as a lender-of-last-resort to banks. Increasingly, the Fed has shown it will go even further than that, for example, by providing back-stop to other forms private money such as money market funds.
So while banks can leverage government money in all sorts of ways that increase the “money” supply, the fact remains that banks are a user of government money just like any other non-government agent of the economy. They must have a regular flow government money to provide the services people and businesses expect of them. The legal bank charter granted by the government which gives banks their special access to Fed lending only reinforces this fact.
Despite Mason’s argument, the existence of bank money has not been overlooked nor does it undermine MMT’s central claim about the sole currency issuer status of the federal government. Such statements, rather, suggest a certain level of ignorance of the endogenous money literature, let alone the broader MMT literature.
L. Randall Wray, for example, a founding MMT economist and the first to author a book on the subject back in 1998. He also happens to be one of the foremost scholars on endogenous money theory. He has written dozens of articles and a book on the subject. I myself first learned of endogenous money from Wray’s 2012 primer on MMT, Modern Money Theory: A Primer On Macroeconomics For Sovereign Monetary Systems. So for as long as I have been studying MMT, I have also been studying endogenous money. And if there is a theoretical flaw to be found in the foundation of MMT, it is not the existence of bank money.