Modern Money Theory

1. Sovereign Currency: The Ultimate Financial Freedom

A government that issues its own currency can always afford to hire unemployed labor.

Operational reality. A sovereign government, one that issues its own floating-rate currency, fundamentally operates differently from a household or firm. It is the monopoly issuer of its currency, meaning it can create as much of its currency as needed through simple keystrokes to credit bank accounts. This operational reality means that financial affordability is never a constraint for such a government when spending in its own currency.

No external limits. Unlike entities that use a currency, a sovereign issuer faces no external financial limits on its spending capacity. It does not need to "raise" money through taxes or borrowing before it can spend. This principle applies universally to nations like the United States, Japan, and the United Kingdom, regardless of their economic size or development status.

Real resource constraints. While financially unconstrained, a sovereign government is still bound by real resource constraints. It can only purchase what is available for sale in its currency. If resources (labor, materials, technology) are scarce or fully employed, excessive government spending can lead to inflation or divert resources from other desirable uses, highlighting the importance of prudent policy choices.

2. Taxes Drive Money, Not Fund Spending

All that is required is imposition and enforcement of a tax liability to be paid in the government’s currency.

Creating demand. The primary purpose of taxes for a sovereign currency issuer is not to raise revenue to fund spending, but to create demand for the government's currency. By imposing tax obligations (or fees, fines, tithes) payable only in its own currency, the government ensures that its currency is desired and accepted by the population. This mechanism gives the currency its fundamental value and utility.

Logical sequence. The logical sequence of government finance is "spend first, tax later." Government must first spend its currency into existence (by crediting bank accounts) before individuals and firms can acquire that currency to pay their taxes. Taxes then effectively "redeem" the currency, removing it from circulation and fulfilling the obligation.

Beyond revenue. Beyond driving the currency, taxes serve other crucial functions:

• Stabilizing aggregate demand: Taxes can reduce private spending, helping to control inflation when the economy is overheating.
• Redistributing income and wealth: Progressive taxation can address inequality.
• Discouraging undesirable activities: "Sin taxes" on pollution or unhealthy products aim to alter behavior, not maximize revenue.

3. Sectoral Balances: An Inescapable Accounting Identity

If we sum the deficits run by one or more sectors, this must equal the surpluses run by the other sector(s).

Macroeconomic truth. The economy can be divided into three sectors: domestic private (households and firms), domestic government, and foreign (rest of the world). A fundamental accounting identity dictates that the sum of the financial balances of these three sectors must always equal zero. This means one sector's deficit is always offset by surpluses in one or more other sectors.

Interconnected flows. This identity reveals that a government budget deficit is not an isolated event but is intrinsically linked to the financial positions of the private and foreign sectors. For instance, if the private sector desires to save (run a surplus) and the foreign sector is balanced, the government sector must run a deficit of equal magnitude to satisfy that private saving desire.

Causation complexity. While the identity is always true, the direction of causation is complex. MMT argues that aggregate spending largely determines aggregate income. Therefore, a sector's decision to spend more than its income (run a deficit) can be the initiating cause of financial wealth creation for other sectors, rather than being constrained by pre-existing savings.

4. Government Deficits Create Private Wealth

Government IOUs, in turn, are accumulated by the private sector when the government spends more than it receives in the form of tax revenue.

Net financial assets. When a sovereign government spends more than it taxes, it runs a budget deficit. This deficit directly results in a net increase in financial assets held by the non-government sector (private households, firms, and foreign entities). These assets take the form of government currency (cash, bank reserves) and government bonds.

Private sector's gain. For the private sector, government debt is not a burden but a financial asset. If the government consistently runs a balanced budget, the private sector's net financial wealth from government IOUs would be zero. A government surplus, conversely, would mean the private sector is running a deficit, reducing its net financial wealth.

"Outside wealth." The private sector cannot create net financial wealth for itself; every private financial asset is offset by a private financial liability ("inside wealth"). To accumulate net financial wealth ("outside wealth"), the private sector requires financial claims on another sector, primarily the government. Thus, government deficits are the source of the private sector's net financial savings.

5. Bonds are Monetary Policy, Not Borrowing

For this reason, bond sales are not a borrowing operation (in the usual sense of the term) used by the sovereign government, instead they are a tool that helps the central bank to hit interest rate targets.

Reserve management. When a sovereign government spends, it credits bank accounts, simultaneously increasing bank reserves at the central bank. If these reserves exceed what banks desire to hold (e.g., for clearing or reserve requirements), they will lend them in the interbank market, driving down the overnight interest rate below the central bank's target.

Interest rate control. To prevent the overnight rate from falling, the central bank (or treasury in coordination) sells government bonds. These bond sales effectively drain excess reserves from the banking system, substituting interest-earning government bonds for non-interest-earning (or low-interest-earning) reserves. This is a monetary policy operation to manage liquidity and maintain the target interest rate, not a fundraising exercise.

No "borrowing" need. A sovereign government does not "borrow" its own currency from the private sector to finance its spending. The currency it spends is created by itself. Bond sales are a voluntary operation to manage the financial system's liquidity and interest rates, offering the private sector an interest-earning alternative to holding excess reserves.

6. Fixed Exchange Rates Limit National Sovereignty

The floating exchange rate ensures that the government has greater freedom to pursue other goals—such as maintenance of full employment, sufficient economic growth, and price stability.

Policy space. The choice of exchange rate regime significantly impacts a nation's domestic policy space. A floating exchange rate, where the government does not promise to convert its currency at a fixed rate to gold or foreign currency, grants the most policy independence. This allows the government to prioritize domestic goals like full employment and price stability without being constrained by external reserve levels.

Constraints of fixed rates. Conversely, a fixed exchange rate regime (including currency boards or gold standards) severely limits policy space. To maintain the peg, the government must accumulate and defend foreign currency reserves. This often necessitates painful austerity measures (deflation, reduced imports) or borrowing in foreign currency, which can lead to solvency risks if reserves dwindle or foreign debt becomes unmanageable.

Risk of default. While a sovereign government with a floating currency cannot be forced into involuntary default on its own currency obligations, a government committed to a fixed exchange rate can default on its promise to convert. This risk makes fixed-rate countries vulnerable to speculative attacks and can lead to economic crises, as seen in historical examples.

7. The Euro: A Non-Sovereign Currency Experiment

From the point of view of the EMU, divorcing fiscal policy from currency issue was not perceived to be a flaw in the arrangement but rather a design feature—the purpose of the separation was to ensure that no member state would be able to use the ECB to run up budget deficits financed by “keystrokes”.

Designed to fail. The European Economic and Monetary Union (EMU) represents a unique experiment where member nations abandoned their sovereign currencies for the Euro. While monetary policy is centralized under the European Central Bank (ECB), fiscal policy remains largely decentralized among national governments. This structure effectively renders individual Eurozone nations as "users" rather than "issuers" of the currency, akin to US states.

Market discipline. The design intended to impose market discipline on national fiscal policies, with the belief that governments exceeding deficit or debt limits would face rising interest rates, forcing austerity. However, this created a vulnerability: when the Global Financial Crisis hit, periphery nations faced soaring borrowing costs and credit downgrades, leading to a debt spiral.

ECB's role. The ECB initially had strict prohibitions against directly financing member governments, exacerbating the crisis. It was only through emergency interventions, like Mario Draghi's "whatever it takes" pledge, that the ECB began to act as a de facto lender of last resort, stabilizing bond markets. This highlighted the inherent flaw: without a central fiscal authority or a fully empowered central bank, individual Eurozone members faced solvency risks that sovereign currency issuers do not.

8. Functional Finance: Policy for Public Purpose

First Principle: if domestic income is too low, government needs to spend more (relative to taxes).

Purpose-driven policy. Functional Finance, developed by Abba Lerner, argues that government fiscal and monetary policy should be judged by its ability to achieve societal goals, primarily full employment and price stability, rather than by arbitrary budget targets. For a sovereign currency issuer, the government's budget should be managed to serve the public purpose, not to balance accounts.

Two core principles:

• Full employment: If there is unemployment, government spending is too low (or taxes too high). The government should increase net spending until full employment is achieved.
• Interest rate control: If the domestic interest rate is too high, the government should provide more "money" (reserves) to lower it, ensuring portfolio balance.

Rejecting "sound finance." Lerner rejected the notion that government should manage its finances like a household or firm, which he termed "sound finance." He argued that balancing the budget or adhering to arbitrary debt ratios is "dysfunctional" if it prevents the achievement of full employment and other public objectives. The "correct" budget balance is simply the one consistent with full employment.

9. Job Guarantee: Full Employment with Price Stability

Indeed, a JG/ELR program designed along these lines can be analyzed as a buffer stock program that operates much like Australia’s wool price stabilization program used to operate.

Universal employment. The Job Guarantee (JG) or Employer of Last Resort (ELR) program proposes that the government offers a job to anyone ready and willing to work, at a uniform basic wage and benefits package. This ensures continuous full employment, addressing the fundamental problem of involuntary unemployment.

Price anchor. The JG program acts as an automatic macroeconomic stabilizer and a powerful price anchor. The fixed program wage sets a floor for wages across the economy, preventing a race to the bottom during recessions. In booms, the pool of JG workers acts as a "reserve army of the employed," dampening inflationary wage pressures as private employers can hire from this pool.

Multiple benefits. Beyond employment and price stability, the JG offers numerous advantages:

• Poverty reduction: Provides a living wage and benefits.
• Social amelioration: Reduces crime, improves health, strengthens communities.
• Skill enhancement: Offers training and work experience.
• Environmental improvement: Can direct labor to public service projects like environmental restoration.

10. Hyperinflation: A Complex Reality, Not Simple Money Printing

Hyperinflations are caused by quite specific circumstances, although there are some shared characteristics of countries and monetary regimes that experience hyperinflation.

Beyond simple monetarism. The common belief that hyperinflation is solely caused by governments "printing too much money" to finance deficits is an oversimplification. While rapid money supply growth and large deficits are observed during hyperinflations, they are often symptoms or effects, rather than the sole cause.

Specific circumstances. Historical hyperinflations (e.g., Weimar Germany, Zimbabwe) are typically rooted in a confluence of severe real-world problems:

• Supply-side collapse: War, natural disasters, or political upheaval destroy productive capacity (e.g., Germany's reparations, Zimbabwe's land reform).
• External debt: Large foreign currency-denominated debts that cannot be serviced through exports.
• Weak governance: Inability to impose and collect taxes effectively, or political instability.
• Indexing: Widespread indexing of wages and prices can create an inertial wage-price spiral.

Deficits as effect. In high inflation environments, tax revenues, which are often collected with a lag, fall behind rapidly rising government spending (especially if indexed). This creates or exacerbates budget deficits, making them an effect of inflation rather than its primary cause. Stopping hyperinflation requires addressing these underlying real and political issues, not just curbing money supply.

11. Quantitative Easing: A Misunderstood Policy

What QE comes down to, really, is a substitution of reserve deposits at the Fed in place of Treasuries and MBSs on the asset side of banks.

Asset swap. Quantitative Easing (QE) is a monetary policy tool where a central bank purchases financial assets (like government bonds or mortgage-backed securities) from commercial banks. In exchange, the central bank credits the banks' reserve accounts. This is fundamentally an asset swap: banks exchange interest-earning assets for reserves, which typically earn little or no interest.

Not "printing money" for spending. QE does not directly fund government spending or inject "money" into the broader economy in a way that causes inflation. The reserves created remain within the banking system, held at the central bank. They do not circulate in the real economy to fuel consumer demand.

Limited impact. The actual effects of QE are often misunderstood:

• Lower bank profitability: Banks earn less interest on reserves than on bonds, potentially reducing their incentive to lend.
• Reduced aggregate demand: Lower interest income for savers (due to near-zero rates) can actually reduce overall spending.
• Financial market instability: Prolonged low rates can encourage speculative borrowing, and a sudden reversal can destabilize bond markets and bank balance sheets, as seen with the Silicon Valley Bank crisis.

12. Exports are a Cost, Imports are a Benefit

In real terms, exports are a cost and imports are a benefit from the perspective of a nation as a whole.

Real resource perspective. From a purely real resource perspective, exports represent a cost to a nation because its domestic labor and resources are used to produce goods and services that are consumed by foreigners. The nation bears the production cost but does not enjoy the consumption benefit. Conversely, imports are a benefit because the nation receives goods and services without expending its own resources to produce them.

Economic caveats. While this real-terms view is contrarian, it acknowledges economic realities:

• Demand stimulus: Exports can boost aggregate demand, create jobs, and generate income, especially if a nation has underutilized resources.
• Strategic reasons: Nations may export for humanitarian aid, military alliances, or to acquire foreign currency for essential imports.
• Multiplier effects: Export-led growth can have domestic multiplier effects, increasing overall economic activity.

Beggar thyself. However, a relentless pursuit of trade surpluses (maximizing exports and minimizing imports) can be a "beggar thyself" strategy. If a nation is already at full employment, increasing exports means diverting resources from domestic consumption or investment, reducing the "pie" available for its own citizens. A better approach is to prioritize full employment domestically and let trade balances adjust naturally.

Last updated: December 14, 2025