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Fiat Currency Economics: A Primer on Modern Monetary Theory


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).

(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.


John (author) from Cleveland, OH on April 11, 2015:

Yes, Stan, bank loans create far more dollars than deficit spending does. Bonds are sold in response to demand, whether or not we are running a deficit. Investors were screaming for govt. bonds during the Clinton surpluses.

stanfrommarietta on April 11, 2015:

John, I'm getting to think that the banks have created far more money than deficit spending by the government has. I was led to that view when I discovered that in 2010 the banks only held 4% of the Public Debt, the Fed 9%, and the 87% rest by investors. You would think that if the national debt (which includes the Public Debt plus intragovernmental series bonds) were generated by the Treasury borrowing to cover deficit spending, that those securities would be at the banks.

But only 4%! And the Fed's 9% just is a buying up in QE of those that matured from previous years. All we need to do now is add up the deficits for preceding years and see that they cannot account for all those investors' money in securities.

The banks' lending has been the basis for all that money, for the buying of imports, which then get converted into US

securities by the importers. So we see in that year that 47% of the securities constituting the public debt were held by Chinese and Japanese, who are importers to us. So, their dollars had to get into the economy other than from deficit spending.

John (author) from Cleveland, OH on June 02, 2014:

@Stan - it's all confusing as hell. I really prefer to "black-box" it, and just look at the net outcomes. The people I'm trying to reach aren't going to sit still for the details.

I like to approach the whole thing using accounting, which most people understand somewhat, and trust. (I'm just going to cut 'n' paste a bit I wrote on a debate board a while back:)


When a govt. creates money, it creates an asset and a matching liability. That's just double-entry accounting. With gold-backed dollars, the govt. held the gold (assets) and spent the matching liability (dollars) into the economy. If you, say, paid $100 in taxes, the govt. collects the $100 bill, and therefore has $100 less in liabilities (convertible dollars) to worry about. Both sides of the spreadsheet go down by $100, and $100 worth of gold (no longer needed to back circulating dollars) goes into another pile, a clear asset held by the govt.

With fiat dollars, there is no backing, so the govt. is not on the hook for gold or anything else. So on the same spreadsheet, the dollars spent into the economy are govt. liabilities, and the assets are merely numbers (no gold needed). If you pay $100 in taxes, the govt. again collects the $100 bill, and therefore has less in liabilities (paper dollars). Again, both sides of the spreadsheet (assets and liabilities) go down by $100.

When the govt. sells a bond, they exchange a bond for $1000. The bond - a promise to deliver $1010 in the future, is a liability for the govt. and (like $1000 dollars) an asset in the hands of whoever buys it. The govt. takes in your $1000 and gives you a $1000 bond, so its liabilities remain exactly the same. (You are still worth $1000, of course.) When that bond matures, you give the govt. the bond, and they give you $1010. You are now holding $1010, and the govt. has slightly increased it's total liabilities by $10. And, since you are part of the public, the public now has another $10 in assets. It all balances out.

Bonds outstanding, therefore, don't make the govt. poorer, or put them in debt. It is almost the same as simply leaving all of those dollars in circulation. "Paying off the debt," or exchanging dollars for bonds and eliminating the "national debt" would simply mean $18 trillion in dollars out there, instead of $17 trillion in bonds and $1 trillion in dollars. Either way, the govt. still has $18 trillion in liabilities. The only way to extinguish govt. liabilities is to tax dollars out of the public's pockets and back into the govt's pocket.


So to me, dollars and bonds are basically the same thing - govt. liabilities. A govt. can create either one out of thin air and increase their liabilities (and therefore the public's financial assets) whenever they wish. Restraints upon this creation of dollars & bonds are all self-imposed. That's why I don't concern myself too much with the details specific to America's system. All fiat currency regimes create currency in this general way, but the (self-imposed) details differ.

stanfrommarietta on June 01, 2014:

John, your essay above is excellent. However, some of what you describe about how the Congress "creates" money by deficit spending, will not be recognized as such. It is true that the Treasury will issue securities equal in value to the deficit spending required. This involves borrowing from banks, which came into being in 1917 when the Treasury was no longer allowed to simply create Treasury Notes in the form of dollar bills and spend them, but was required to borrow money from banks in the U.S. to get spending money. The banks got this provision in legislation so that they could earn interest from government borrowing. Up to that point issuing Treasury Notes did not require any interest payments. But there may be other good reasons for using a system involving interest, insofar as it creates new money to enter circulation to allow money to be available for the interest payments to banks on loans from private borrowers. Otherwise there would not be enough money in circulation to cover both the principal as well as the interest on bank loans to private borrowers.

The other thing about your account is that people do not recognize Congress' deficits as creating new money. Congress doesn't actually run a mint, the administration via the Treasury Department does; and originally, after A. Lincoln the Treasury created the new money needed to match the deficit. Before then private banks created the money in the form of bank notes. Money has to be created somewhere in some physical form. Even digital entries in spread sheets are physical forms of money. Then when the Treasury was required to borrow money from banks, the banks ended up being the money creators again. However, the Fed ended up as the money creator. By being the borrower of money the Treasury just moved money created by banks to Treasury and its account at the Fed, from which it drew money to cover spending into the private sector. Treasury does not sit on the money it gets from banks, but spends it immediately into circulation. And that money ends up back in the banking system almost immeditely.

So the question people will ask is where is the government creating new money in physical form? Obviously, Congress is the creator. But at that point the dollars are not Federal Reserve or Treasury Notes, the recognized physical forms of money. So, when does the Fed, as creator of Federal Reserve Notes enter the picture, just as the Treasury was the creator of Treasury Notes (greenbacks) in Lincoln's fiat money system?

It has taken me some time to reconcile what I see described about actions of the Treasury, the banks, and the Fed. Frank N . Newman was an Undersecretary of the Treasury in the Clinton administration. And he has essentially an MMT account of how our economy works. But he points out that the national debt, the securities sold to banks to cover deficits, as well as to serve as CD's for foreign and private investors wishing to invest excess and idle dollars in a low risk investment earning interest, often do not get redeemed but rolled over. The money received for these investors' securities do not get used to pay government operations. So, the principal is there to pay back most of these 'loans'. So, it looks like the government is building up enormous debt it never pays off. Well, it is true that since about 1791 the government has been rolling over the debt by Treasury issuing new securities to swap with banks for their mature securities plus interest, which effectively puts off the redemption of the debt to the infinite future, like never. That is the primary way in which the debt is managed, even today.

So, is there a way that the government's debt for deficit spending is actually redeemed? It has taken me a while to see that the Fed does this when it buys T securities at public auction. It is done is such a way that you see very little connection between the deficit's being ultimately covered by the Fed's buying back the securities. It may not even be buying the securities issued for deficit spending. This is all part of the Fed's wishing to appear independent of the Treasury in its actions. But whenever the Fed buys a T security from a bank by creating money out of thin air for it and depositing that in a the bank's reserve account at the Fed in return for the security, that redeems the government's debt to the bank. And a consequence of this is that the money originally lent to the Treasury and spent on the deficit becomes debt-free, as if the Treasury created it itself originally. And by the fungibility of money, I don't think the Fed has to actually buy the physical securities used to cover deficit spending to effectively make the deficit spending money debt-free and equivalent to the new money created by the Fed used to buy the securities. All the Fed has to do is buy T securities equal in value to the deficits to make an equivalent amount of money debt-free in circulation. The securities bought could be just excess bank reserves invested by the banks in T-securities. The bank gets back its investment plus interest and is back to where it was before investing the money in the securities. Any other money in circulation originally lent to Treasury and then spent into circulation via these securities can be equated to this new money. This seems to be the counterpart to the idea that the banking system can be regarded as if it is a single bank. The money in circulation, regardless of the banks interacting with it, is also monolithic, and the fungibility of money allows us to equate any money with any other money in circulation. This is a new idea, I hope I have gotten it right, because it becomes a new principle or theorem of MMT, the fungibility theorem.

stanfrommarietta on December 30, 2013:

John: "banks do not create money". When banks loan money, they do not loan out their deposits but create new money which is deposited into a debtor's account at the bank. The debtor will then draw out some or all of that money and spend it, and it will end up in other banks. It is true that when the debtor gathers enough surplus money from what is in circulation, he will pay back the loan, which erases the money created. But in the meantime the money created and lent is circulating in the economy and if more has been created that can be absorbed or matched to goods and services and wages at current prices, there can be inflation. That is what happened in the housing market. Excess money was circulating from loans driving prices up for homes. When it collapsed from people being unable to pay back their loans on their mortgages, money went out of circulation and by a kind of inverse multiplier effect all the money that had been created from the initial loans circulating, collapsed as well.

Does this make sense? You can't say that there was no new money circulating causing the inflation of the housing market. Builders were building new homes with money they got for building earlier ones, and demand was rising as more and more loans to subprime owners was lent out. Inflation takes excess money in circulation (as opposed to gone into savings, buying imports, drained from bank reserves by selling Treasury bonds. But private bank lending does create debt, whereas the Federal Reserve creates credit, meaning the money it creates doesn't have to be paid back to the Fed (except for transaction fees).

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