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Fiat Currency Economics: A Primer on Modern Monetary Theory

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My obsession for the past two years has been economics, when I was introduced to Modern Monetary Theory on a debate board.


Fiat Money Is a Creation of the State

Fiat money has no intrinsic value—it is valuable because the state says it is valuable. At the most basic level, the state makes use of their currency necessary by demanding that taxes are paid in that currency. Also, the state (or their agent) is the monopoly issuer of currency.

A Bit of Accounting

In accounting terms, the creator of the note (the government) keeps the liability for the note on one side of the ledger (the governmental sector), and on the other side of the ledger (the non-governmental sector) gains the asset. As people, businesses and banks are on the non-governmental side of the ledger, government-created money in their hands is free and clear of any liability. And while we say that the government keeps the liability for the bills it has created, this is merely an accounting term—the government is under no obligation and owes no debt on the currency it has created. It is merely an entry on a ledger.

When the government runs a deficit, the dollars created enter the non-governmental sector as assets, and the same amount is added to the liabilities in the governmental sector. When the government runs a surplus (brings in more in taxes than it spends), assets are subtracted from the non-governmental sector, and liabilities are extinguished from the governmental sector.

Money Is Introduced Into the Economy by Deficit Spending

When the government spends money, whether through paying the salaries of government employees or purchasing goods and services, the checks are drawn on the Federal Reserve, not private banks.

High-Powered Money (HPM) vs. Credit

This government-created money is sometimes called High-Powered Money (HPM), or vertical money, so-called because there is no liability attached to it. That is to say, if your government pays you a dollar, nobody but the holder (you) has any claim on that dollar. But bank-created credit, sometimes called horizontal money, always comes with an attached liability. Banks cannot create money, but they can leverage HPM by creating loans. In a 10% fractional reserve system such as ours, a bank with reserves of $1000 (HPM) can create a $10,000 loan with a $10,000 attached liability (plus interest, of course). If you take out that loan, you are not $10,000 richer, because you owe the bank $10,000 (plus interest). Once that loan is extinguished (paid off), the $10,000 worth of credit ceases to exist. The net transaction consists only of the interest you paid to the bank—some amount of pre-existing HPM has been transferred from you to the bank for the service of loaning you credit. No dollars have been created in the transaction.

This is why it is not accurate to say that the “money-multiplier effect” of reserve banking actually creates money. It only allows banks to create credit, which is an important distinction. As credit liabilities always match credit assets, there is no net creation of money when a bank makes a loan.

Dollars and Government Securities

Government bonds are not operationally necessary in a fiat currency economy, but they are often used anyway. Bonds are basically dollar equivalents—dollars can be described as bonds with an immediate maturity date. Both dollars and federal bonds are created solely by the government, and bonds, like dollars, become assets in the non-governmental sector (once introduced) and a liability in the governmental sector. When bonds are purchased, dollars from the non-governmental sector are exchanged for bonds from the governmental sector; there is no net change in assets or liabilities. And when bonds mature, they are exchanged for dollars from the governmental sector, again resulting in no net change, except for the interest, which becomes an asset in the non-governmental sector and a liability of the governmental sector. So the nominal value of all outstanding bonds plus the number of dollars in circulation will always be equal to the total number of dollars that have been created by federal deficits through the years, minus the number of dollars that have been removed from play by federal budget surpluses.

A Quick Lesson on How Banks Operate in America

Commercial banks have reserve accounts at the Federal Reserve. Reserve accounts at the Fed consist only of government-created HPM. A bank's total reserves consist of the money in their reserve account at the Central Bank, plus the cash every bank keeps on hand for their customers' use (vault cash). Reserve accounts are also how banks settle up at the end of the day. When Bank A owes Bank B money, the transfer is made by moving money between their accounts at the Fed.

Banks make a profit primarily by creating loans and collecting interest on those loans. America has a reserve requirement of 10%, so a bank with $10 million in reserves (reserve acct. plus vault cash) can create up to $100 million in loans. But since reserve balances are actually very fluid, it is more illuminating to think of how much a bank must have in reserve to account for 10% of their outstanding loans. This is because banks are not reserve constrained when making loans. They can create loans in any amount, then borrow or otherwise obtain the necessary reserves after the loan is made. There is a three-day grace period during which banks can obtain the reserves they need to meet statutory requirements. (ex. If a bank calculates that they have $120 million in outstanding loans on Monday, they must have $12 million in reserves on Thursday. If they create another $200 million in loans on Tuesday, they will simply borrow another $20 million in reserves ($32 million total) by Friday.)

Banks can obtain needed reserves quickly on the interbank market, where other banks can loan out their excess reserves. Or, in the event that there are no excess reserves to be had, banks can always borrow reserves from the Fed's discount window. So a bank can always create a loan, regardless of their present reserve position. The amount of savings deposited in banks in no way determines or limits the number or amount of loans that banks can create.

Loans are the most profitable use of a bank's reserves, but if they are unable to create enough loans, a bank can loan its excess reserves on the interbank market to other banks in need of reserves. Also, banks routinely purchase treasuries, which are risk-free and pay a small rate of interest. The yield on these treasuries determines the interbank interest rate, because a bank with excess reserves will try to maximize their return on them, and they have the choice of overnight loans or buying treasuries. Finally, reserves on account at the Fed earn a bit of interest, currently 0.25%.

Sectoral Balances

Once created, a dollar exists unless and until it is taxed away by the government that created it. (It is less confusing (and more accurate) to think of taxation as destroying dollars and spending as creating dollars, instead of taxation as a collection of old dollars to be spent later. The math works out the same in either case.)

Much of MMT's value is simply accounting. There are some very basic truths that become evident when one understands the flow of dollars into and out of our economy, and accounting helps in that endeavor. The concept of sectoral balances might seem simple (and it is), but it is still lost on many people.

As explained in the first section, at the most basic level, we have a governmental sector and a non-governmental sector, and the two sectors, as a matter of accounting, must always be in balance. When the governmental sector creates a dollar and spends it into the economy (the non-governmental sector), it is balanced out by a corresponding liability in the governmental sector. And when a dollar is taxed out of the non-governmental sector, the corresponding liability in the governmental sector is extinguished. The only way to extinguish all governmental-sector liabilities would be to remove all dollars (and bonds) from the non-governmental sector. This is a matter of double-entry accounting, and it is therefore not debatable (unless you think the accounting itself is incorrect).

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(net dollars created by the government) = (dollars in the non-governmental sector (i.e. the rest of the world))

This is true over time. Over the years in the United States, the sum of all federal deficits and surpluses is about $15 trillion. And this is the exact number of dollars (plus the dollar value of govt. bonds, a dollar equivalent) in existence today.

This is also true on a year-by-year basis:

(federal deficit, year XXXX) = (net new dollars in the world for year XXXX)

If government spending = G and taxation = T, we can say it this way:

(G-T) = (net new dollars in the world)

Now, let's split up the whole world into our own country and the rest of the world...

(G-T) = (net new dollars in our country) + (net new dollars in the rest of the world), or...

(G-T) = (net new dollars in our country) + (imports – exports)*

*In reality, other dollars flow into and out of the country in the form of investment, plus dollars move across the border in people's pockets. The total flow of money, including the balance of trade, is called the Current Account Balance, but in America this is very close to the balance of trade, so for simplicity's sake I'll just use (imports - exports), since it's easier to understand.

When we run a trade deficit and net dollars flow out of the country, that means the rest of the world is choosing to save some of the dollars they earn rather than spend them. (Otherwise, if they chose to spend all of their dollars on American goods and services, we wouldn't have a trade deficit.) So dollars that flow out of the country are savings held in the non-governmental sector. (I will explain what happens to these dollars later.)

There is also domestic savings. In most years, Americans hoard some amount of dollars, holding cash and not spending it. An equivalent form of cash hoarding is buying federal bonds, because 1) the cash used to purchase these bonds is returned to the governmental sector and removed from play, and 2) those dollars, now out of the non-governmental sector, are not used for spending or investment.**

**To illustrate the difference between holding cash or federal bonds and investing dollars in some other vehicle, let's say you instead buy shares of stock with your dollars. If you buy shares secondhand (the normal scenario), you are buying them from the previous owner, who then holds your cash, which remains in play to be spent. Or, if you buy shares directly from the company, that company now holds your cash, and they can do with it what they wish. Even though you have “saved” your money in the form of stock, the dollars you used are still available for spending in the economy.

Savings can be difficult to understand. We normally think of savings as dollars that we don't spend, but at any single moment in time, all dollars exist in somebody's hands and are not being spent. One moment, you have $5 in your hand, and the next moment you buy a hamburger, and the restaurant is holding your $5. So “savings” in this context just means the dollars and federal bonds in the non-governmental sector. Owning a valuable asset (like a house) is therefore not savings, even though you could exchange that asset for money. We are talking strictly about monetary accounting, and only dollars and bonds count.

Of course, some of those dollars move faster than others. Once dollars are exchanged for bonds, they normally aren't ever converted back into dollars, in a net sense. The amount of bonds outstanding (our “national debt”) normally increases, which means there is a net conversion of dollars to bonds happening almost all the time, removing currency from play.

What Happens to “Excess” Dollars?

The actual amount of currency in circulation is about $1 trillion, about half of which is held outside of the country. This number remains fairly steady and rises slowly over time, even though the government has run a deficit of about $1.5 trillion just this past year. How can this be?

By law, our government issues treasury bills to match the new dollars created by deficit spending. This law is a holdover from the gold standard days, when we could not increase the number of dollars without also increasing our gold holdings. The sale of bonds actually borrowed dollars (or other currencies), allowing the government to create dollars while holding our gold reserves steady. Since we went off the gold standard in 1971, this step was no longer operationally necessary to create new dollars, yet the rule remains in place.

So today, new treasuries issued act to “sop up” dollars that are not being used elsewhere. The amount of currency in circulation is really a product of supply and demand – when you deposit dollars in your bank, they become bank reserves. If there is insufficient demand for loans, and insufficient demand on the interbank market for the bank's excess reserves, they will buy treasuries with that money in order to maximize their returns. And when there is enough demand from their customers for cash (you want to get cash from the ATM, for instance), banks use their excess reserves to to buy currency from the Fed.

Dollars earned by exporters overseas are exchanged for their own currency, ultimately ending up in the hands of their governments or central banks. Those governments, with nothing better to do with those dollars, usually buy our treasuries and hold those instead of dollars, since treasuries earn a bit of interest. China, Japan, and Saudi Arabia are the biggest holders of U.S. bonds. Since China and Japan both base their economies on exports, they are not interested in spending those dollars on U.S. goods, and they continue to amass bonds with no end in sight.


The government creates dollars out of thin air for use in the economy. Those dollars enter the non-governmental sector by government spending. Dollars work their way through the economy a number of times until they are eventually hoarded, and those hoarded savings are largely converted into government bonds, either directly (by the savers) or indirectly (by banks). More deficit spending is then necessary to replace those hoarded dollars in order to keep the supply of dollars in circulation relatively steady, as demand dictates.

This is simply an overview of the monetary accounting side of fiat currency economics. There are some policy implications that will be addressed in another article.

This content reflects the personal opinions of the author. It is accurate and true to the best of the author’s knowledge and should not be substituted for impartial fact or advice in legal, political, or personal matters.

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