Originally posted on May 13, 2019 at the New Economic Perspectives blog.
OPERATION #2—The federal government buys something big for the collective good.
NOTE: A much appreciated comment at Naked Capitalism re: Post#1 suggested that the term “Combustion Chamber” was misleading since the “fuel” (money) put into the chamber is not burned as in a motorcycle engine but is redistributed to other accounts. I was planning to point this out further into the narrative but the comment showed that would be too late. So, beginning now, I’ve changed the name “Combustion Chamber” to “Production/Consumption (P/C) Chamber,” of which we have two: a Public P/C Chamber and a Private P/C Chamber.
OPERATION #1 looked at a transaction in private commerce—an exchange of money occurring in the Private P/C Chamber of our diagram-machine. OPERATION #2 will observe a transaction in the Public P/C Chamber. Before we start, this is a good time to address a question you may already have asked: Why does our diagram-machine have two Production/Combustion Chambers? Why can’t all the Production and Consumption that American citizens need take place in just one?
The answer is this: The Private P/C Chamber that we just observed, by its very nature, will only produce certain kinds of goods and services—namely, those goods and services that can be produced—and marketed—for financial profit. The money-issuing mechanism for the Private P/C Chamber is driven exclusively by a profit formula requiring there to be a market willing and able to pay a price (in U.S. dollars) for what is produced that will cover the cost, overhead, and profits of the production. When that condition is met, the diagram-machine can produce the required fuel by the mechanism of exchanging Promissory Notes for new bank-dollars, as we’ve just observed. If that condition cannot be met, the goods or services will simply not be produced.
There are, however, many non-marketable goods and services required for people to lead safe, healthy, lives in the pursuit of happiness and relative comfort. These are goods and services for which there is no market either willing or able to pay the cost (in U.S. dollars) required to produce them—yet which are necessary or highly desirable for the collective good of American society. These “non-marketable” goods and services fall into two categories, depending on how they are produced:
- Goods and services produced by a state-owned or managed enterprise. The state produces them “at cost,” i.e. there is no overhead or profit. An example would be law-enforcement and the court system.
- Goods and services produced by private enterprise but paid for by the state. The private enterprise charges the state overhead and profit—the same as if the state were a buyer in the private market. An example would be B-1 bombers built by Lockheed.
The distinction between these two categories is extremely important so far as capitalism-versus-socialism arguments are concerned (which we can explore later). As far as our machine-diagram is concerned, however, it doesn’t matter if it’s producing fuel for a state-owned enterprise (like the court system) or a state-paid private business (like Lockheed). All that matters to us, at the moment, is to see why producing these kinds of goods and services requires a second P/C Chamber with a different formula for producing fuel (money).
To observe this different formula in OPERATION #2 let’s imagine a very large non-marketable challenge that collective society might confront: engineering and deploying a Satellite Laser-Cannon to destroy incoming asteroids larger than a football field. (This is the size that could vaporize a major city.) Clearly, private commerce is not going to generate the money (fuel) necessary to build and deploy the asteroid-blasting weapon for the simple reason there is no market willing or able to pay for it. It will have to be undertaken and accomplished in the Public P/C Chamber.
STEP #1: Congress appropriates U.S. dollars and directs the Treasury to spend them to cause a Satellite Laser-Cannon to be engineered, deployed, and operated.
- To get the satellite laser-cannon built and deployed, Congress (which, let’s don’t forget, represents all of us collectively) appropriates $100 that the Treasury is directed to spend to pay American businesses to accomplish the job. What exactly does “appropriate” mean? It means that Congress makes a claim on $100 Reserves at the Central Bank and directs the Treasury to spend them for a specific purpose.
- Right off the bat, we have a problem, right? In our diagram-machine, Treasury doesn’t have $100 Reserves in its spending account at the Central Bank! Looking at the fuel-meter status of our diagram-machine, we see that the Treasury Reserve account only contains $10. How can our diagram-machine handle this situation? Can it do a “tax-collecting” operation to transfer Reserves into the Treasury’s account?
- If we test that scenario, we quickly observe that bank accounts#1 and #2, together, cannot be taxed enough to meet the Treasury’s spending needs. Even if they were taxed 100% and drained completely (which would be a political catastrophe for the elected government dictating the tax-rate) only $40 would be credited to the Treasury’s Reserve account—leaving it still $50 short of its spending mandate to get the Satellite Laser-Cannon built.
- It would appear our diagram-machine is not capable of producing something that might, just maybe, result in averting the annihilation of a major American city! That’s a discouraging thought. But “fiscal analysis” seems to indicate it’s simply a reality: Our machine just doesn’t have enough fuel to produce something big (but non-marketable) that American society has decided it really needs. So, are we just stuck?
NO!! We are not stuck!
Imagining we are stuck sells our diagram-machine short—far short of what it’s capable of accomplishing. As we’ll now see, if the labor, expertise, technology, and materials necessary to build the Satellite Laser-Cannon exist—and can be purchased with U.S. dollars—our diagram-machine is fully capable of producing the fuel necessary to marshal those resources to accomplish the task. Let’s observe now how our machine does it.
STEP #2: The Treasury issues future Reserves.
- As we’ve already noted (and explained in the inset on page__) future Reserves are commonly called “treasury bonds” because they pay interest. Because Reserve dollars normally do not pay interest, banks would much rather hold future Reserves (that do pay interest) in order to increase their revenues and profits. A bank therefore readily (even greedily) exchanges Reserves in its Reserve account for the future Reserves issued by the Treasury.
- Looking again at our diagram-machine, the Treasury issues $100 in future Reserves @ 3% interest.
- Bank#1 decides it would like to trade its Reserves for the future Reserves plus interest. But its Reserve account only has $10! How does it get the other $90?
(MOVE ONE)
- Bank#1 exchanges $90 collateral with the FED for $90 in new Reserves. (The collateral might be the deed to the bank’s office building on Main Street.)
(MOVE TWO)
- Bank#1 now has $100 in its Reserve account—which it trades to the Treasury for the $100 in future Reserves.
(MOVE THREE)
- Bank#1 trades $90 of its newly acquired future Reserves to the FED in exchange for the collateral the FED was holding. This exchange was planned in advance and is called a “Repo-Agreement.”
- Bank#1 now has its collateral back, plus $10 future Reserves (+ 3% interest) in its Reserve account. The FED has added $90 future Reserves to its Balance Sheet.
(MOVE FOUR)
- The Treasury now has $110 Reserves in its account—enough to fulfill Congress’s spending directive.
- The Treasury writes two checks for $50 each—one to New Jersey Satellites, and one to San Diego Laser Technology—to pay for the building and deployment of the Satellite Laser-Cannon.
- These two companies are now the holders of bank accounts #1 & #2 in our diagram-machine. They deposit the received Treasury checks in their bank accounts.
- The two checks from the Treasury are presented at the Central Bank for “clearing.” $100 Reserves are debited from the Treasury Reserve account. $50 Reserves are credited to Bank #1 Reserve account, and $50 Reserves are credited to Bank #2 Reserve account.
- Bank accounts #1 and #2 are each credited with $50 bank-dollars.
That’s the conclusion of OPERATION #2. The net result of all the accounting operations is that a Satellite Laser-Cannon is built and deployed—and now stands ready to deflect the course of any dangerously large asteroid that might threaten an American city. That, and the peace-of-mind it provides American society, is a big accomplishment!
There are several important things we should consider now about the operations we’ve just observed—but first let’s allow the diagram-machine to run a bit longer before we hit the pause button. (You will have noted that, since it is self-fueling, unless someone or some thing hits the kill switch, it will run on and on forever.) We want to look at two more quick operations in the next Post:
OPERATION #3—Promissory Note to Bank#1 is cancelled.
OPERATION #4—Promissory Note from Bank#1 to the FED is cancelled.
2 RESPONSES TO “ZEN AND THE ART OF MODERN MONEY—PART 3”
- David | May 13, 2019 at 9:17 am |I’ve followed your water tank analogy and thought it was perfect because it had no ‘fuel’ to be consumed.In an engine, Money is more like a lubricant than a fuel though when the oil level on an engine gets too high/low, the idea of inflation/deflation n doesn’t really follow.Hope to see stock and other asset markets in your new diagram, once it is revealed.
- Graham Paterson | May 18, 2019 at 8:26 pm |Sorry JD, if that is supposed to be a simplified explanation of MMT – or even the monetary system currently in place, I for one, find it difficult to grasp. The idea of illustrating the system as a machine is good but I got confused with your opening remark, “MMT does not propose a “new” monetary system, but simply that we truly understand the monetary system we are using every day. My goal, in the following pages, is to illustrate how that system actually operates.”
I missed the implication of that statement originally.
On reflection, are you implying that the current system used in the US is the equivalent of what MMT proposes?
As I understand MMT, it can only apply to a nation that has monetary sovereignty.
Is that correct?
If it is correct, then I believe the discussion on the subject of MMT would be more valuable if addressed to all the other nations with monetary sovereignty around the world rather than concentrating on the very complex and convoluted system used by the US.
The major issue that seems to be overlooked in the discussion about money is the reason and purpose for having a money system in the first place.
Obviously, unless the purpose of having any type of system is not clearly spelled out it becomes impossible to know if, and to what extent, the goals and intentions are achieved.
The reason we need a money system in today’s day and age is that “money” has become an essential tool for the survival of everyone. Society, as we know it today, could not exist without a supply of money.
If we cannot agree on that fact, then any further discussion is pointless.
I have given some thought to your idea of a simplified illustration but from the perspective of how a monetary system is SUPPOSED to work for the benefit of the society.
I offer the following illustration for your consideration.
A SIMPLIFIED DESCRIPTION OF HOW A MONETARY SYSTEM CAN WORK
To illustrate how a nation’s “money system” is supposed to work we need to imagine it as consisting of three houses.
One House is called the Government
Another House is called Production
And the third House is called Consumption
Each House is dependent on the other two – no House can function on its own. And each House must have a supply of “money” for the people who work in each of these Houses.
While only some of the people work in the Government House and some others work in the Production House, every single one of those people must always go home to live in the Consumption House.
Obviously, there is no point in producing anything, anything at all, unless it is going to be consumed. But, just as obviously, nobody can consume anything unless it is first produced and otherwise made available.
So, where do we start?
I think we have to start right here, right here and now, in the present day.
We need to put the past behind us and look at the reality of today.
That reality requires us to recognise that, in today’s day and age, people must have access to money because it has become an essential condition for everyone’s survival.
The essence of any monetary system should be to deal with the way the society’s necessary money supply is created and distributed to the people living and working in those three Houses of the society.
The idea of all “money” is a human construct and does not occur naturally in nature, even though some objects of nature can be used as “money”.
The crucial step in the illustration is to explain the way the money supply needs to be distributed for the benefit of the society.
That requires the definition of “What is money?”, “Where does it come from?” and “What is its fundamental use?”
As far as I can work out “money” has only one fundamental purpose and that is to act as a medium of exchange. If it can’t be exchanged for something that is needed or wanted, then it is virtually useless.
Your comments, if you would care to respond JD, would be appreciated.