Insights from a Diagram-Machine

By J.D. ALT

I’ve spent the last month or so tinkering with and observing a diagram-machine representing the workings of the U.S. monetary system. In the process, I can see that I’ve bored a lot of people beyond their capacity with the tedium of the tinkering. I apologize for that, and I’ll hereby discontinue the torture. Nevertheless, I’d like to share a few insights the tinkering revealed—at least to me—that made the exercise worthwhile.

1. Money-creation is a response to what the American people decide they want to produce and consume.

This, it seems to me, is a crucial insight because it reverses the way we habitually think about and visualize “money.” The habitual frame is that money exists first, then we decide what we want to spend it on—and then we determine if there is enough of it available for us to get what we want. While this is certainly true for the individual family or business, the diagram-machine revealed very clearly that, for society as a whole, this is a false framing. Actually, it works the other way around: We, as individuals, decide we need new shoes, and the private banks—through a process of accepting Promissory Notes in exchange for bank-dollars—create the “money” that will enable the shoes to be both manufactured and purchased. The Federal Reserve (FED) then issues the Reserves, as necessary, to back up those bank-dollars during the “clearing” process that happens at the Central Bank at the end of each business day. In other words, the amount of money in the system expands, as necessary, to meet the consumption decisions made by American society. (Of course, individuals, families, and businesses each have to strategize how they’ll earn or otherwise acquire some share of the money that’s created by this process—but that’s a separate issue from the question of whether there’s enough money available, or how it’s created.)

Or, on the other hand, we determine as a collective society that we need something big that will benefit our society as a whole (like an asteroid-blasting satellite laser-cannon) and the U.S. Treasury responds by issuing future Reserves—which it then trades for existing Reserves—enabling it to issue payments to the satellite and laser manufacturers who will build and deploy the city-saving weapon.

In each case, the money is created after and in response to an acknowledgement of the need. In each case, whether the need can, in fact, be met is NOT determined by “how much money is available” to meet the need, but rather by two other factors which will determine whether the required money shall be created—either by the private banks, or by the U.S. Treasury (in concert with the Federal Reserve):

1. In the case of the shoes, the determining factor is whether the shoe production/consumption can be executed at a profit—meaning there is a buyer who is willing and able to pay more than the cost of production. If there is no demonstrated buyer who meets these requirements, the private banks will not accept the Promissory Note, the bank-dollars will not be issued, and the shoes will neither be produced or consumed.
2. In the case of the collective good, the determining factor is whether the collective, democratic process can reach consensus that a satellite laser-cannon is a genuine need that will benefit American society. If that consensus cannot be reached, the Treasury will not issue the future Reserves and the satellite laser-cannon will not happen.

In the first case, the decision is a diffused, aggregate process guided solely by the principle of profit-making. In the second case, the decision is a political process of advocacy guided by the competition of interest-groups—many of which strategically confuse the debate by loudly (and bogusly) claiming “there is not enough money” available to go forward.

These are not really new or profound considerations, but it was interesting to observe how the diagram-machine made them operationally “visible.”

2. Treasury bonds (future Reserves) are different than corporate or municipal bonds

There is a profound difference between a treasury bond and a corporate, or municipal, bond—and tinkering with the diagram-machine made this very clear.

For a corporation or municipality to redeem its bond—and pay the promised interest—it must “earn” enough bank-dollars (claims on Reserves) to make the payments. The corporation must earn enough profits—and the municipality must collect enough local taxes or fees—to redeem the bond’s face value and pay the interest. This requires (a) a lot of work and effort on the part of employees and taxpayers, and (b) a lot of things must go “right” in the profit-making arena of private commerce (market demand, real-estate values, tax-base growth, etc.) which could go wrong. These factors create a substantial risk that when the corporate or municipal bond comes due, the dollars necessary for redemption and interest payment may not exist! Because of this risk, it is neither reasonable or logical to think of corporate or municipal bonds as guaranteed “future dollars”—because they might well prove not to be.

The operations of the diagram-machine made it easy to see that U.S. treasury bonds do not entail these risks. To redeem a treasury bond + interest: (a) nobody has to work and strategize to earn a profit, (b) taxes or fees do not have to be collected by the Treasury, and (c) nothing has to go “right”—except that the FED does what it was designed to do, and issues the new Reserves + interest promised by the treasury bond. And the only reason the FED might be prevented from doing that is if there were a willful and/or catastrophic undermining of America’s national sovereignty. Short of the collapse of America as a functioning nation, then, it is highly logical and reasonable to think of treasury bonds as “future Reserves”—because, operationally, that is precisely what they are.

In the same vein, and for the same reasons, while it is logical to view corporate and municipal bonds truly as a “debt,” it is illogical and inaccurate to view treasury bonds in the same way. Corporations and municipalities do not have the legal authority or mandate to create—out of thin air—that which they must use to repay their “debt.” The FED, in contrast, is designed specifically to do just that. When the Treasury issues its future Reserves, implicit within that act is the lawful promise by the U.S. sovereign government that when the future Reserves come due, the FED will make them “real”—and the FED can legally do that by simply crediting bank accounts with keystrokes. In that sense, future Reserves are Reserves, whereas corporate or municipal bonds are a debt that must be “worked off.”

I’ve written about this before—conceptually—so it was interesting to see how the operations of the diagram-machine reinforced the “truth” that treasury bonds do NOT represent a “debt” the U.S. government (or the American people) have to work, somehow, to pay off.

In this regard, the machine’s operations over and over led to the question: “Is this what they mean when they talk about ‘printing money’?” In each case, the implicit answer was, “No—it’s just the machine operating as it was designed to operate.”

3. Operating the machine-diagram creates a lot of “inflation fuel”!!

The biggest surprise (although, I suppose it shouldn’t have been) was to observe how rapidly the diagram-machine built up dollars in the spending accounts that fed directly into private commerce—a build-up that could, it seemed, create inflationary pressures. The most interesting aspect of this was to see which Production/Consumption Chamber—Private or Public—produced the greatest dollar build-up (and why).

Was money-creation by private banks responsible for the build-up? The machine-diagram made clear (for the first time in my mind, at least) that while private banking creates a lot of money, its very process inherently destroys most of the money it creates in an on-going, daily procession. When bank-loans are paid off, the principal (the bank-dollars borrowed) is, obviously, paid back to the bank. But what does the bank do with those bank-dollars? It simply cancels them—and is happy to do so, because what it is cancelling are claims on its Reserves (“real money”) at the Central Bank. The only bank-dollars that remain after a bank-loan is paid off are the interest dollars promised by the Promissory Notes. So private banking creates a lot of money, but in net-aggregate (at any point in time) the only money it’s really creating are the net profits of private commerce. That’s still a lot of money—but it’s only a fraction of what it appears the banks are generating.

On the other hand, looking at the direct spending by the Treasury to facilitate the building and deployment of an asteroid-blasting satellite laser-cannon, what we observed was that ALL of the dollars issued and spent were deposited in the private spending accounts of American businesses and citizens—and stayed there! The build-up of spending dollars directed at private consumption—dollars competing to buy goods and services in private commerce—was dramatic. And there was nothing that cancelled them out (except taxes, which we’ll get to in a moment).

This observation seemed like a red flag to me:  Did it give credence to the alarmist warnings that significantly increasing federal spending to address collective needs (as proposed by MMT) will lead to strong inflation pressures that could adversely affect private commerce? Did it support the arguments that federal spending should be minimized? —that government efforts to improve society should be checked? —that private enterprise should instead be given freer rein in the hopes it will provide the solutions to better the lives of American citizens? And what about the arguments being put forward by many—including myself—that government spending will have to dramatically expand to meet the new and unique challenges of climate-change and a robotic workforce?

To answer these questions, I put the diagram-machine through a few more operations to observe the options for removing the excess “fuel” generated by government spending for collective benefits. This led to some additional insights.

4. Tax-dollars really are spent by the Treasury—but they aren’t necessary to fund the Treasury’s spending.

Tax collections are obviously the first strategy for removing potential inflation-dollars from the spending accounts of private commerce. MMT enthusiasts (again, myself included) are fond of saying that tax-dollars aren’t used for federal spending—that the promissory note a dollar represents is simply cancelled when it is used to pay taxes; i.e. taxes “destroy” or “drain” money. When you observe the federal tax operation in the diagram-machine, however, a somewhat different perspective pops up.

Yes, when the taxes are paid, bank-dollars are debited (or “drained”) from private spending accounts—but the same operation also adds Reserves to the Treasury’s spending account. When the Treasury spends, those added Reserves get “spent”—along with the new Reserves generated by the Treasury’s operation of issuing future Reserves. The point isn’t that tax-dollars get “destroyed,” but rather that they reduce the amount of future Reserves necessary to undertake any particular spending for the collective benefit. The further point is that there is no inherent constraint on the number of future Reserves the Treasury must issue to achieve that particular spending goal. In other words, the spending could just as easily happen if zero tax-dollars were in the Treasury’s spending account.

The real effect of the tax-dollars becomes clear when the diagram-machine’s operation is completed by the Treasury’s spending: The Treasury’s Reserve account is debited, the Reserve accounts of private banks are credited, and bank-dollars are added to the spending accounts of private commerce. The net increase of spending fuel in those accounts depends on how much was “drained” out earlier by the tax payments. Whichever way you look at it, the net result of tax payments is a reduction of the potential “inflation-fuel” generated by federal spending for collective goods and services—the tax-payments, in other words, don’t “pay for” the spending, they reduce the net build-up of potential inflation-dollars created by the spending.

5. Inflation is still the problem

Despite the “fiscal space” created by taxation, a very high ratio of future Reserves to tax-dollars—as many of the spending programs advocated by MMT will require—still generates a lot of potential “inflation-fuel.” The question that arises, then, is how high can that ratio go—i.e. how many goods and services benefiting the collective good can be produced—before a level of problem-inflation is induced in private commerce?

Apparently, a formula or evaluation mechanism to answer that question has yet to be devised. In the meantime, it seems to be an argument between the alarmists and the optimists. Alarmists postulate horrific things will happen if the level of future Reserves issued exceeds a certain percentage of GDP. But this seems to have less to do with inflation than the hazy (and fundamentally incorrect) assumption that GDP somehow represents the amount of dollars available to “redeem” future Reserves: if future Reserves exceed that number of dollars, the thinking seems to go, it will be impossible to “redeem” them, thereby resulting in default and catastrophe for the U.S. economy.

As an optimistic architect, I look at the issue from what I call an “enabling strategy” for federal spending. By this, I mean that federal spending should be targeted toward the creation of goods and services that ENABLE private commerce to produce what American’s need—and ENABLES all American citizens to buy the needed things private commerce produces. What is a “needed” thing is negotiable, but it would certainly include healthy food and clean water, a safe and supportive dwelling, pre-K through college education, and life-time medical care. Designing, building, and deploying the “Enabling Structures” (including service structures) that accomplish this goal would—from my perspective—expand the markets of private commerce to absorb virtually all the potential inflation-dollars generated by the federal spending necessary to create them.

For me, personally, this feels like coming full circle from where I started, seven years ago, with my first MMT essay: Playing Monopolis Monopoly. The Enabling Structures I built in that essay, on the Monopoly game board itself—and actually photographed—I still consider my best explanation of what they are, what they are intended to do, and why they should be built. Full circle—but I think I understand the macro-economics of it much better now. It would be wonderful, from this point on, to focus exclusively on the strategy of Enabling Structures without having to endlessly search for explanations about why, as a collective society, we actually can afford to build them.