by
Robert Cauneau – MMT France
Ivan Invernizzi – Rete MMT Italia / MMT France
7 june 2020
The authors would like to thank Andrea Valentini – MMT France – for his very helpful comments on this article.
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A previous article presented the importance of the exchange rate regime for MMT (Modern Monetary Theory), and defined and compared the floating exchange rate regime with the fixed exchange rate regime. He referred to the fact that MMT recognizes that the floating exchange rate regime provides governments monopolists of their currency with more policy space.
The purpose of this article is to develop the main implications of the floating exchange rate regime. These different implications are only related to each other through the fact that they are the consequences of this type of regime. But they constitute fundamental elements of MMT, which are presented here in a very synthetic way, and which will be developed in future articles. Many references are however suggested in the « Notes » at the end of the article to the reader who would like to go deeper into the subject.
The second part of the paper will outline the reasons why most economists and public policy makers continue to reason, wrongly, in the logic of a fixed exchange rate regime, whereas most of the world’s industrial economies, including the Eurozone, operate under a floating exchange rate regime.
1. Implications of the floating exchange rate regime
1.1 Government insolvency is never a problem.
Insofar as, under a floating exchange rate regime, the relationship between the maintenance of a buffer reserve (gold standard or other) and the ability to spend is abandoned, and the State is the monopolistic creator of its currency, its expenditures are not only not financed by its taxes, but also are not limited by them. The government therefore has no nominal limit on its spending. It can spend as much as it wants, without any financial restriction, provided that real goods and services are available for sale. This government is never financially constrained in its currency. Its capacity to spend is therefore unlimited in nominal terms, but limited by the availability of real resources (technological resources, natural resources and labor power).
In this logic, a State that has a monopoly on the creation of its currency under a floating exchange rate regime cannot go bankrupt, unless it wants to. And the fact that a state sets limits on its spending is purely voluntary.
1.2 The interest rate is a discretionary policy variable whose « natural » amount is zero
MMT understands that a permanent interest rate of 0% is the base case, where the State does not put anything in place to support this rate. Indeed, when one holds currency, there is nothing to make the price of this currency increase by itself, in a spontaneous way. For this to happen, there must be an allocation possibility that allows the currency to increase itself, nominally, in an automatic way. This possibility must be created, which then gives rise to an opportunity cost of not leaving the currency in the position it is in and choosing an alternative allocation, for example, the choice for the State between issuing government securities or building up reserves1.
The idea that interest on national debt is fixed in private credit markets is not applicable to states that monopolize their own currency while operating under floating exchange rates. The interest on the national debt of an issuer of its own currency at a floating exchange rate is a discretionary political variable and not a rate fixed by the market2. It is the government that provides the opportunity to purchase government securities that carry an interest rate. However, it is important to bear in mind that, according to MMT, public debt represents all the deficits, all the sums that the State positions in the private sector, in the form of Net Financial Assets3, and that it does not take back. The public debt is presented in 3 forms: cash, reserves and government securities (all the liabilities of the public debt). Government securities are only one form of government debt. When the central bank buys government securities, it does not cancel the public debt. It only changes the form of the debt.
1.3 Central bank intervention changes its nature
MMT argues for reverse causality from the orthodox analysis that would be applicable under a fixed exchange rate regime, which is constrained by the reserve-based view, and argues that instead of adjusting the supply of reserves to meet its interest rate, as a monopolistic creator of reserves in a floating exchange rate regime, the central bank, in practice, serves as a price setter for the level of reserves by the banking system. The central bank thus intervenes on the price (the interest rate), and lets the quantity adjust (the money supply).
1.4 Capital does not flee
The reading of capital movements under a floating exchange rate regime is not the same as under a fixed exchange rate regime. When a private sector agent buys foreign currency, the transaction is reflected in accounting entries that certainly change the name of the owner of the currency concerned, but in no way the position of the currency itself, which as a national currency does not move. For example, in the case of the purchase of Swiss francs with euros, these two currencies remain in the accounts of the banking system on which they depend. The only thing that changes is the name of the owner. What we call euros, or Swiss francs, or any other currency, are only entries in the banking system of a country in the euro zone and Switzerland. So there is no capital flight.
Nominally, the currency in the system represents the public debt. The Net Financial Assets cannot leave the domestic banking system. They remain available for the economic fabric of the state concerned. And the fact that foreigners hold domestic currency is not a problem for the country concerned. On the contrary, it gives the country the opportunity to make net imports.
1.5 The floating exchange rate regime has important implications for the appreciation of the trade balance
1.5.1 The trade balance should be assessed not in financial terms but in real terms
MMT argues that the sole objective of the economic system is to satisfy the material needs of the resident population, which is primarily through consumption. The investments themselves have no a priori sense of their final utility for individual or collective consumption. In this logic, currency is considered an instrument, not an end. This instrument was invented by states to enable them to obtain real wealth. And this is true both for the state’s relations with the private sector and with the rest of the world.
Under a floating exchange rate regime, a negative trade balance is not a problem. The demand for foreign exchange savings is in fact a supply of real goods. Thus, a foreign demand for net savings in domestic currency leads to a negative trade balance, and, conversely, a domestic demand for net savings in foreign currency leads to a positive trade balance. This precision is important because, for MMT, a demand for foreign currency savings means the willingness to sell labor or goods or services in exchange for the currency4.
1.5.2 The trade balance is the expression of the FOREIGN NET saving desire5.
If foreigners want to save a domestic currency, the only thing they can do is sell goods and services to the country concerned. If residents of that country want foreign currency from another country, they must sell goods and services to that country. The trade balance is drawn between these two tensions. If there are net savings, this leads to a deficit trade balance. A deficit trade balance simply means that foreigners are saving more domestic currency than residents are saving foreign currency. It does not mean that there are still payments to be made. It means that there have been more payments made to foreigners than payments made by foreigners to residents. But the payments have already been made. There is nothing to offset. So the trade balance does not record debit/credit relationships. It records trade relationships, i.e. payments that have already been made. It is a record of payments, but not a record of debts. And it does not affect the level of foreigners’ desire to save domestic currency.
MMT argues, therefore, that under the floating exchange rate regime, the fact that a trade balance is in deficit or surplus does not lead to the need for offsetting debt or claim relationships between countries, and thus eliminates the foreign currency debt obligation. On the other hand, this obligation exists under a fixed exchange rate regime, in which, in order to maintain the fixity of this rate, a country is obliged to incur debt in foreign currency. Indeed, a fixed exchange rate will tend to lead to a negative trade balance, either under the pressure of speculation, or as a reaction to the fact that the price ratio between the two countries is no longer consistent with the exchange rate6.
The absence of an obligation to incur debt in other currencies leads to misinterpretation and confusion, such as the one that consists in considering that, because it has a negative trade balance with China, the United States is indebted to it, a situation that could certainly occur under a fixed exchange rate regime.
1.6 The Employment Guarantee can be used in a sustainable way
The employment guarantee is an instrument designed to maintain full employment within a functional finance approach based on the budget deficit7. Under a fixed exchange rate regime, it could only be considered temporary, in the best case scenario. But under a floating exchange rate regime, there is nothing to prevent the maintenance of full employment in a sustainable manner8. Indeed, countries with a freely floating currency have no solvency problems or technical constraints to finance these programs in a sustainable way.
1.7 Government deficits do not push up interest rates or crowd out private savings
MMT rejects the IS-LM framework that some economists use to demonstrate the conclusion that higher budget deficits put upward pressure on interest rates and, as a result, crowd out private investment.
This model remains the staple of many mainstream Keynesians. MMT considers it to be fundamentally flawed, designed for a fixed exchange rate regime, and not a coherent stock-flow model.
1.8 Base money is defined differently
The concept of base money is less important in MMT than in other monetary approaches. MMT uses the concept of Net Financial Assets, as explained in section 1.4.
With the floating exchange rate regime, « base money » can logically be defined as the total net financial assets of the non-state sectors (cash + bank reserves + government securities). This means that Quantitative Easing (QE) does not change base money as thus defined, which is consistent with the observation that, in the current context, it is nothing more than a tax that removes interest income from the economy.
1.9 The concept of fractional reserve banking does not make sense
As discussed in section 2.3, the way banks actually operate is to seek to attract creditworthy customers to whom they can lend funds and thus make a profit. But these loans are made regardless of their reserve position. Thus, the idea that reserve balances are needed in the first instance to « finance » the expansion of banks’ balance sheets by increasing excess reserves is unworkable. A bank’s ability to expand its balance sheet is not limited by the amount of reserves it holds or by the fractional reserves it must hold. The bank expands its balance sheet by making loans. The lending process (credit) that creates new bank liabilities is not related to the bank’s reserve position.
This confusion is related to the one that prevails in the assessment of the concept of the money multiplier[12]. It is true that banks are obliged to set up a level of required reserves, which is very different from one country to another (O% in Canada, 1% in the Eurozone, 20% in China, for example). But these reserve requirements are not related to the level of credit granted by banks. They allow the central bank to control one of the interest rates with which it manages its monetary policy. The concept of fractional reserves is therefore inoperative.
It should also be noted that, contrary to what is often claimed, under a floating exchange rate regime, it is not reserves that discipline credit. It is equity[13].
2. Why do most economists and policymakers continue to think in terms of a fixed exchange rate regime, and wrongly so?
The confusion between fixed and floating exchange rate regimes is very common, both among heterodox or post-Keynesian economists and policy makers. In this logic, government budgets are drawn up according to the logic that government revenues are needed to finance government expenditures, as in the case of a firm or a household. The result is self-imposed limitations, notably in relation to the public deficit and debt, and therefore public policies that are largely sub-optimal, notably with respect to full employment and economic and social progress in general.
How can we explain such mistakes? One of the reasons may be linked to the fact that, while central bank technicians are perfectly familiar with the mechanics of exchange rates, central bankers are themselves rather political figures, which has a considerable influence on the logic and consistency of their decisions.
But this situation probably also has its origins in the fact that money is taught very little in universities, which leads most macroeconomists to consider that it plays a very minor role in the economy. The change in history, since the abandonment of the Bretton Woods system by President Nixon in 1971, makes most of the economic data in textbooks outdated and erroneous, in terms of how they describe the operations of the fiat monetary system14.
One question that will remain unanswered, however, is whether the confusion between these two exchange rate regimes is not maintained by policymakers and the economists who advise them, in order to keep in place policies that may have no technical justification, but which support their ideology.
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Notes
[1] See Mosler, Forstater: https://mmt-france.org/2019/04/23/le-taux-dinteret-naturel-est-zero-2/
[2] See Mosler, Forstater: https://mmt-france.org/2019/04/23/le-taux-dinteret-naturel-est-zero-2/
[3] The concept of Net Financial Assets (NFA), considered in the context of the State’s monopoly on its currency, is at the heart of MMT. It distinguishes MMT from all other monetary approaches, both orthodox and heterodox, which reason in gross terms and not in net terms. In the logic of MMT, NFAs are the financial base on which the economy rests; they are the financial wealth that remains to the economic agent once all its debts have been settled. They constitute the part of financial wealth that does not come from indebtedness (bank credit), but from final payments (in relation to the State).
[4] In the MMT logic, the concept of demand for currency savings has a different meaning than in other economic approaches. Indeed, MMT takes into consideration Net Financial Assets.
[5] The definition of « Foreign Net Saving Desire, » the concept used here, is the difference between the saving desire of non-residents in domestic currency and the saving desire of residents in foreign currency.
[6] See: https://fr.wikipedia.org/wiki/Parit%C3%A9_de_pouvoir_d.
[7] According to functional finance, full employment is found within an approach that uses the budget deficit as an instrument to achieve objectives in real terms. The deficit is therefore not an end, but an instrument.
[8] See: https://mmt-france.org/2019/04/07/maximiser-la-stabilite-des-prix-dans-une-economie-monetaire/
[11] See: https://mmt-france.org/2019/05/28/fiche-n-7-definition-de-la-base-monetaire/
[12] See: https://mmt-france.org/2019/04/08/multiplicateur-monetaire-et-autres-mythes/
[13] On this point, the insolvency risk of American commercial banks can be assessed on the basis of a series of indicators called CAMEL(S), which are capital adequacy, asset quality, management quality, earnings ability, liquidity position and sensitivity to market risk.
[14] See Bill Mitchell: https://mmt-france.org/2020/03/07/etalon-or-et-taux-de-change-fixes-des-mythes-encore-dactualite/
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MMT France 