Menu Close

Does central government spending create new money?

John Hermann

It is unfortunate that the advocates of Modern Money Theory and various monetary reform movements including New Currency Theory and Sovereign Money often seem to misunderstand each other’s positions. Some important truths are to be found in each viewpoint, moreover I don’t believe there is any essential contradiction between the main thrusts of their respective stories.

A very interesting paper published in Real World Economics Review [1] by Prof Joseph Huber – a primary advocate of NCT – takes MMT to task on several matters, even though he agrees with much of their analysis.

In my opinion Huber’s primary criticism of MMT is unjustified and the assertions and arguments he has given in this regard are flawed. To critique Huber’s paper in detail would require considerable effort, however I would like to draw attention here to one section where his assertions are incorrect and misleading. Let me quote the section:

“ Don’t let yourself be fooled. The biggest part of government expenditure is funded by taxes. Tax revenues represent transfers of already existing money. The money that serves for paying taxes is neither extinguished upon paying taxes, nor is it created or re-created when government spends its tax revenues. In actual fact, this is all about simple circulation of existing money. “

Firstly, the matching of government spending to taxing plus borrowing is a convention which governments adopt in order to manage aggregate demand and inflation, leaving the tuning required for ensuring net growth in the money supply without undue inflation/deflation to the nation’s central bank (CB), which it accomplishes endogenously via open market operations. But this division of responsibility is only a convention; there is no necessity to do it this way.

Secondly, the MMT position is that the government injects new money into the real economy when it spends, and with- draws money from the real economy when it taxes and borrows, implying that Treasury’s account with the CB is not composed of money at all and is therefore merely an operating account.

In order to make sense of this, one should distinguish between state fiat money (currency & reserves) and bank credit money. At a technical level there can be no doubt that new bank credit money is created in an account of the payee (the money supply temporarily expands) whenever a sovereign government spends, and that the money supply is temporarily reduced when a sovereign government borrows from or taxes the non-bank sector.

Clearly the credits within Treasury’s CB account do not form part of the money supply. However the manner in which government’s various fiscal operations accommodate the flow of state fiat money is less transparent. Is there an argument for regarding the credits in Treasury’s CB account as a form of state fiat money?

In my view, one of the characteristics of an entity which is entitled to be called “money” is that it is used by a set of marketplace players (traders) and may be transferred and loaned between those players. For example, the credits that banks maintain within their CB accounts (reserves, or exchange settlement funds) can be regarded as a form of money because – apart from satisfying the usual criteria of medium of exchange, store of value, and unit of account – they may be freely loaned between those players and directly transferred between their CB accounts.

However the credits held in Treasury’s CB account are not loaned to others. Treasury borrows from, but has no incentive to lend to, financial markets (i.e. it sells bonds but has no interest in buying bonds). And unlike commercial banks, Treasury offers no depository facilities. These features distinguish the operations of Treasury from those of banks, and is grounded in the fact that Treasury is not in competition with other institutions holding CB accounts. Its CB account is not associated with profit making activity, and serves a very different (public) purpose.

To summarise, when central government spends, credit money is created by the payee’s bank and matching new reserves are created in that bank’s CB account. Banking reserves are not transferred, because the definition of reserves excludes Treasury deposits.


Leave a Reply