Vertical/Horizontal vs Exogenous/Endogenous

In Modern Monetary Theory (MMT), a distinction is made between ‘vertical’ and ‘horizontal’ transactions. The former refer to transactions between government and non-government; the latter to transactions within non-government. I thought it might be helpful to clarify the significance of this distinction, and also what it does and does not imply about the modern monetary system and real economy.

Vertical transactions and the Level of NFA

In MMT, government money is depicted as vertical whereas bank money is considered horizontal. The reason for this does not concern the question of endogeneity or exogeneity of money but rather the fact that both the level of reserves and the level of net financial assets (NFA) – the sum of currency on issue, reserve balances, and oustanding government bonds – can only change through vertical transactions.

Whereas horizontal transactions always involve both a non-government asset and a non-government liability, netting to zero, a vertical transaction involves a non-government asset or liability that is not offset within non-government, but instead has its accounting offset in the government sector.

For example, if the government pays a pensioner, it credits the reserve account of the private bank at which the pensioner has an account (the newly created reserves are an asset of the private bank and liability of government) and instructs the private bank to credit the account of the pensioner (the deposit is an asset of the pensioner and liability of the private bank).

In this example, the new deposit in the pensioner’s account nets to zero for the non-government sector as a whole. It is an asset of the pensioner and liability of the bank. In contrast, the additional funds in the bank’s reserve account (the bank’s asset) has no accounting offset within non-government. Rather, it is matched by a liability held within the government sector. The newly added reserves are the government’s liability to the private bank. Overall, the effect of this particular vertical transaction, a pension payment, is to add to the net financial assets held by non-government.

More generally, government spending increases net financial assets and tax payments reduce net financial assets. A fiscal deficit corresponds to an increase in net financial assets, a fiscal surplus corresponds to a reduction in them, and a zero fiscal balance leaves them unchanged.

Although it is true to say that government spending causes an increase in net financial assets and tax payments cause a reduction in them, when discussing the government’s fiscal balance, the language adopted needs to be more circumspect. Without further information, we can only say that a government deficit corresponds to an increase in net financial assets and a government surplus corresponds to a reduction in them.

The reason for this more circumspect choice of words is that the government’s fiscal balance is endogenous. This is the case even though some components of fiscal policy are exogenous. Most obviously, government expenditure is exogenous. Its level is not dictated by current income. In addition, decisions over tax rates and the types of taxes and spending programs to introduce are exogenous.

Even so, the fiscal outcome itself is endogenous. For given tax rates and other exogenous policy settings, tax revenue varies with economic activity. This is because of the automatic stabilizers. When income rises, tax revenues rise automatically. This will reduce the government deficit. When income falls, tax revenues fall automatically. This increases the government deficit.

Since the fiscal outcome changes endogenously with income, so too does the level of net financial assets. In fact, changes in net financial assets mirror changes in the fiscal outcome. As a matter of accounting, the government deficit (surplus) equals the non-government surplus (deficit).

The relevance of this is to highlight that the vertical/horizontal distinction in MMT does not correspond to the exogenous/endogenous distinction. Some aspects of vertical transactions are exogenous (e.g. government spending, setting of tax rates), but other aspects are endogenous (e.g. tax revenue, the fiscal balance).

Because the fiscal balance and level of net financial assets are endogenous, they can be influenced by both government and non-government behavior.

The government exerts both a direct and an indirect influence on the level of net financial assets through its spending. Public spending affects the level of net financial assets directly (as the government credits reserve accounts) and indirectly through its impact on income, which influences the level of tax payments (the debiting of reserve accounts).

Non-government, for its part, can only affect the level of net financial assets indirectly through its influence on economic activity. For example, an exogenous change in private investment, initially financed through private credit creation, will alter income, tax revenues, and the fiscal balance.

Despite the indirect influence of horizontal transactions on the fiscal balance, there is an important sense in which vertical transactions are key to the maintenance of financially sustainable prosperity. The key point is this: only government can enable a change in net financial assets alongside stable income. If non-government attempts to alter net financial assets through its own actions, it can only do so in ways that cause income adjustments.

By way of illustration, suppose there is unemployment. This is evidence of a non-government desire to net save (accumulate net financial assets) at a rate that is inconsistent with full employment given the government’s current fiscal policy settings. Non-government is powerless to realize both its desired financial surplus and full employment through its own actions.

If non-government attempts to increase its saving ratio, for instance, this will weaken demand and cause falling income unless the government counters the effect with greater net spending. Similarly, if firms cut back private investment, this will only achieve a larger non-government financial surplus at the cost of negative income adjustments unless government offsets the effect through extra net spending. So, the effect of non-government attempts to increase net saving is to cause negative income adjustments.

The two objectives – more net financial assets and higher employment – cannot be met through non-government activity alone since getting closer to one goal moves the non-government further away from the other goal.

In contrast, government, as issuer of the currency, is uniquely positioned to render non-government net saving behavior consistent with full employment. By increasing its net spending – which entails vertical transactions – government can stimulate income growth alongside higher non-government net saving.

Money is endogenous

In light of the above discussion, the ‘vertical money’/’horizontal money’ distinction – or, equivalently, the ‘government money’/’bank money’ distinction – should not be conflated with the ‘exogenous money’/’endogenous money’ distinction. Government money and bank money are both endogenous. The rate at which each is created is determined endogenously by the level of economic activity.

The endogeneity of bank money follows from the analysis of the circuitists and horizontalists. On the basis of credit-worthiness, subject to capital constraints, private banks issue loans and create deposits (bank money). In doing so, they are not constrained by reserves. If caught short when it comes to settlement or meeting reserve requirements, they can always borrow in the interbank market or from the central bank, which stands ready to accommodate all such demands on terms of its choosing.

Under present institutional arrangements, government, through its agent the central bank, does not directly control the supply of bank money. Rather, it sets the price of government money – in practice, usually the short-term interest rate, though it can set other rates as well if it wishes – and then accommodates whatever demand for liquidity eventuates. Since credit-worthiness, as assessed by the private banks, will be strongly influenced by the state of the economy and the prospects for income growth, the supply of bank money is endogenous.

The endogeneity of government money (comprising currency and reserves) follows from the endogeneity of vertical transactions and the endogeneity of the fiscal outcome. All vertical transactions either create or destroy reserves. Although some vertical transactions can be regarded as exogenous, mostly those relating to government spending, others, such as tax payments and sales of government bonds, are endogenous. Overall, the net creation of government money is endogenous.

Central bank operations, while not directly altering net financial assets, do affect the rates of government money creation and destruction. Central bank lending creates reserves while sales of government bonds destroy them.

The extent to which reserves, once created, remain in the system will depend on the central bank’s preferred method of interest-rate setting. If the central bank pays its target rate of interest on reserves, reserves once created remain in the system until extinguished through tax payments or some other payment of non-government to government. Alternatively, if the central bank is targeting a rate of interest above the rate paid on reserves, it issues or purchases bonds to drain or add reserves. The extent to which the central bank has to do this is dictated by the endogenous fiscal outcome.