The Problem with Modern Monetary Theory – Frank Shostak (03/21/2019)

According to the Modern Money Theory (MMT), money is a thing that the State decides upon. Following the ideas of the German economist Georg Knapp, the MMT simply regards money as a token. For instance, when an individual places a coat in the cloakroom of a theatre, he receives a tin disc or a paper receipt. This receipt or a disc is a proof that the individual is entitled to demand the return of his coat. The token was labeled by Knapp as chartal or a pay token.

In this way of thinking, money is seen as a chartal means of payments. According to the MMT, the material used to manufacture the tokens is irrelevant — it can be gold, silver, or any other metal or it can even be paper. Hence, the definition of money according to the MMT is what the State decides it is going to be.1

According to this theory, the value of money is established because the State forces people to pay taxes with the money that the State has decided upon. The State taxes have to be paid with the money tokens issued by the State. The State also has the ability to control the value of money through its declaration of how much it is willing to pay for a certain commodity produced by the private sector. What we have here is a situation wherein the State exchanges empty tokens for goods and services produced by individuals. It then requires them to pay taxes with part of the tokens.

[RELATED: “The Upside-Down World of MMT” by Robert Murphy]

If one dissects the whole process, one discovers that it is about an exchange of worthless tokens for real goods and services (i.e. nothing for something).

In the MMT framework, the token money is seen as a receipt on the economy’s resources. A token money held by an individual is regarded like his claim on a portion of resources. Individuals have exchanged goods and services for a receipt given to them by the government. In this way of thinking, individuals who have generated goods and services are acknowledged for this by the tokens issued to them by the government. In short, individuals are the owners of goods and services and can exercise their claim over these goods and services whenever individuals deem it is required.

We have seen that according to the MMT, money is a means to pay taxes, which also sets the money’s purchasing power and in turn makes it an accepted means of payment throughout the rest of the economy.

Is it true, however, that money is simply a means of payment? Do individuals pay with money or the goods and services they have produced? To ascertain what money is all about we have to establish its essence — its definition.

Defining Money

To establish the definition of money we have to ascertain how a money-using economy evolved. Money emerged as a result of the fact that barter could not support the market economy. The distinguishing characteristic of money is its function as the general medium of exchange. It has evolved from the most marketable commodity. On this Mises wrote,


Similarly Rothbard wrote that,


In short, money is the thing that all other goods and services are traded for. This fundamental characteristic of money must be contrasted with other goods. For instance, food’s characteristic is that it supplies the necessary sustenance to human beings. Capital goods’ characteristic is that it permits the expansion of the infrastructure that in turn will permit the production of a larger quantity of goods and services. Contrary to the MMT then, the essence of money has nothing to do with tax payments to the government.

Furthermore, money’s function is not a means of payment as argued by the MMT but as a general means of exchange. People pay with goods and services for other goods and services with the help of money. Money facilitates the payments of one good for another good. Also, contrary to the MMT money is not a claim on resources but just the general medium of the exchange.

In addition, does it make sense that money emerged because of the need to pay taxes to the government? The State or a sovereign could by a decree force people to do what the State and sovereign wants. The sovereign does not require issuing some empty tokens in this regard.

Also, could the sovereign force individuals to use tokens in the transactions among themselves? Why would anyone accept a token as a payment because government accepts these tokens as tax payments?

Mises Explains How the Value of Money is Established

In his writings, Mises had shown how money became accepted.4 He began his analysis by noting that today’s demand for money is determined by yesterday’s purchasing power of money. Consequently for a given supply of money, today’s purchasing power is established in turn. Yesterday’s demand for money in turn was fixed by the prior day’s purchasing power of money.

So, for a given supply of money, yesterday’s price of money was set. The same procedure applies to past periods.

By regressing through time, we will eventually arrive at a point in time when money was just an ordinary commodity where demand and supply set its price. The commodity had an exchange value in terms of other commodities, i.e., its exchange value was established in barter. To put it simply, on the day a commodity becomes money it already has an established purchasing power or price in terms of other goods. This purchasing power enables us to set up the demand for this commodity as money.

This in turn, for a given supply, sets its purchasing power on the day the commodity starts to function as money. Once the price of money is fixed, it serves as input for the establishment of tomorrow’s price of money. It follows then that without yesterday’s information about the price of money, today’s purchasing power of money cannot be established.

With regards to other goods and services, history is not required to ascertain present prices. A demand for these goods arises on account of the perceived benefits from consuming them. The benefit that money provides is that it can be exchanged for goods and services. Consequently, one needs to know the past purchasing power of money in order to establish today’s demand for it.

Applying Mises’s framework, also known as the regression theorem, we can infer that it is not possible that money could have emerged as a result of a government decree or government endorsement or social convention. The theorem shows that money must emerge as a commodity.

On this Rothbard wrote,

In contrast to directly used consumers’ or producers’ goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold). Thus government is powerless to create money for the economy; the process of the free market can only develop it.5

But how does all this relate to paper money? Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services these certificates came to be regarded as money.

The Role of Central Banks

In a free-market economy, a bank that over-issues paper certificates will find out quickly that the exchange value of its certificates in terms of goods and services will fall. To protect their purchasing power, holders of the over-issued certificates would most likely attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market, then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold.

The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentives to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

In order to prevent such a breakdown, the supply of paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank — i.e., a central bank — that manages the expansion of paper money.

To assert its authority, the central bank introduces its own paper certificates, which replace the certificates of various banks. The central bank money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power on account of their historical link to gold, are exchanged for the central bank money at a fixed rate. The central bank’s paper certificates are fully backed by bank certificates, which have the historical link to gold.

It follows then that it is only on account of the historical link to gold that the central bank’s pieces of paper acquired purchasing power, not by government decree.

The MMT Framework and Wealth Creation

In the MMT world, given that money is created by the government and given that the government is able to print freely as much money as it requires, the government by implication has command over unlimited amounts of real wealth.

If the government determines what should be regarded as money and what is going to be its value, this also means that the government dictates the rate of exchanges between money and goods and services. This means that prices are set by the government and bypasses market forces. Economic theory shows that such conduct leads to the inefficient use of resources and in turn leads to economic impoverishment. An example in this regard is the collapse of the former Soviet Union and the inability of planned economies such as Cuba and the North Korea to feed its people.

  • 1. L. Randall Wray, From The State Theory of Money to Modern Money Theory: An alternative to Economic Orthodoxy, Levy Economics Institute of Brad College, March 2014.
  • 2. Ludwig von Mises, Theory of Money and Credit, pp.32-33.
  • 3. Murray N. Rothbard, “What Has Government Done to Our Money?
  • 4. Ludwig von Mises. 1998. Human Action, Scholars edition. Chapter 17.
  • 5. Murray N. Rothbard. 1990. What Has Government Done to Our Money?

Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies.


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