Since I am in the Modern Monetary Theory (MMT) camp, I cannot write a book on baking without covering some of the critiques of MMT and banking. I wrote about this topic in Section 5.7 of my earlier book, Modern Monetary Theory and the Recovery. In this section, I am give a minimal explanation of the topic, without covering too much of the same ground of that earlier text.
Note: This is a draft of a section that will go into my banking primer manuscript.
As I described in my earlier book, MMT is an offshoot of pre-existing post-Keynesian economic theory. It is a relatively modern school of thought that was deliberately created to be an internally-consistent “story” — as opposed to the fragmented post-Keynesian theory. Given this heritage, MMT “inherited” the post-Keynesian arguments with mainstream economics about banking.
There are a number of self-identified MMT proponents working in academia, with associated academic publications. However, most debates revolve around the more basic ideas one finds in MMT primers — although critics have a distressing tendency to make stuff up. In this text, I am only aiming at this basic level, and not attempting to discuss the academic literature.
Chapter 3 of L. Randall Wray’s Modern money theory: A primer on macroeconomics for sovereign monetary systems covers how the domestic banking system interacts with the government in a fiat currency. It offers a parallel treatment to many of the topics in this book. Section 3.2 discusses the “pyramiding” of money within the economy. On page 84, Wray introduces the section as “Now we examine bank clearing and the notion of a ‘pyramid’ of liabilities with the government’s own IOU’s at the top of the pyramid.”
(Interestingly, Wray puts the government at the top, while I would interpret his writings as the government being at the base.)
To summarise the discussion, the argument is that bank and other private liabilities can be converted upon demand into governmental liabilities. In particular, the government has made banks a quasi-utility, giving bank money legal privileges — bank money clears at par. This greatly simplifies commerce for the rest of the private sector, but also necessitates regulation to prevent banks from abusing their privileges under this system.
I do not worry about the valuation of my Canadian bank deposit based on what the bank is doing, rather I view it as a Canadian dollar, whose value I can track versus foreign currencies or domestic prices. I generally view the value of the dollar as being driven by macroeconomic forces, with government policies being an important input.
This is different than a purely private currency, like a crypto-currency. It has an exchange rate that varies versus the Canadian dollar on a nearly continuous basis. (Some crypto-currencies attempted to peg versus the U.S. dollar, with generally poor results.)
The private sector “pyramids” its liabilities upon governmental money, typically creating money market instruments that are more and more speculative. These growing private financial assets allow the financing of capitalist activity during an expansion. The problem arises when these money market assets get too speculative — when confidence is lost, there is a dash for high-quality cash, leaving a liquidity crisis. (This is the interpretation of the lead up to the Financial Crisis.)
In summary, “private money” (including bank deposits) are ultimately claims on “government money” within a fiat currency economy. (Purely private money using other units of account might exist, but are of negligible macroeconomic importance.)
Fiat Currencies Different Than Commodity Currencies
A country with a commodity currency (or currency based on a foreign currency) is in a different position. If all monetary claims are convertible into gold, then both “government money” and “bank money” have a value based on the credibility of their gold backing.
If we want to discuss historical developments — including the historical origins of the current system — this distinction matters. However, no developed economy uses a currency that is convertible into commodities (or whatever else), so this is an academic point that does not matter for discussing domestic macroeconomics.
I keep running into a three critiques of MMT and banking.
“There is no MMT theory of banking!” Since I just gave a reference to one, this is obviously silly.
“MMT ignores bank money.” As far as I can tell, this is based on reading primers of government finance, where “money” is used as a shorthand for “government money.” The reality is that shorthand is common throughout macroeconomic texts across schools of thought. You just need to learn to read text in context.
“Most money is created by banks and is used to pay taxes!” This is the most common I see, and it takes a bit of an explanation to rebut.
The rebuttal to the third point has two legs.
The first point to note is that academic MMT proponents are well aware of the nature of money supply data — they are generally of the generation that had to deal with the nonsense spewed by Monetarists. Private money is “pyramided” on government money, right? There is nothing stopping the volume of private money from being larger than government money (which might explain why Wray put government money at the top of the pyramid, since the base layer has a larger volume than the top layer).
The second point is that even though the taxpayer may write a cheque to the government (or do a bank transfer, which is more common in Canada now), the taxpayer’s bank has to make a transfer of government money (e.g., “reserves”) to the government in order for the cheque/transfer to clear. Banks can create deposits “out of thin air” — but not reserves.
The people I have seen making this third argument have been arguing in bad faith, and deliberately ignore the issue of clearing. They will say something like “The taxpayer’s tax obligation is extinguished by writing a cheque against their bank deposit.” That is only true if the cheque clears. If the cheque is not cleared — including by having the taxpayer’s bank fail due a lack of government money — the tax obligation is not extinguished.
My book is hopefully compatible with MMT writings on banking, but I would not describe it as a “MMT text.” If the reader is interested in what MMT academics have to say about banking, I list some references below.