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Wednesday, September 14, 2016

Vertical / Horizontal Money What is That???

The ideas behind the post Keynesian notions of Modern Money Theory (MMT) hit me by surprise. They seemed counter intuitive given my own education on the history of the Breton Woods Agreement, structure of our Reserve System, etc... And some of the terms used throw me. My mind has to translate them to good Anglo Saxon terminology just to wrap my brain around them. In order to make other points, however, I need to both be able to wrap my head around these ideas and explain them to others. So if you are interested in the subject I invite you to puzzle through it with me. If not you might want to skip this post and come back to it when you are ready.

Veritical Money, what is that?

"In MMT, a distinction is made between ‘vertical’ and ‘horizontal’ transactions. The former refer to transactions between the government and non-government; the latter to transactions within the 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." Het Article

Vertical in Peter's explanation means "issued/created by Government." That refers to the action of government in spending money into existence or paying bills.

"The vertical/horizontal terminology is sometimes resisted by other economists working along Post Keynesian lines. I retain it here simply because it is the terminology currently used by the academic MMTers." Het Article

Note, not everyone accepts MMT definitions.

"In MMT, government money is depicted as vertical whereas bank money is considered horizontal. The reason for this" is "the fact that both the level of reserves and the level of net financial assets (NFA) – the sum of currency, reserves, and government bonds – can only change through vertical transactions." Het Article

That is a startling statement for neophytes to MMT thinking. It's like saying that the pirates gold is somehow not gold until the government issues it. But if you think of it, pirates gold was acquired from folks who originally minted it, or governments. So when you think of it stands to reason.

"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 the non-government, but instead has its accounting offset in the government sector." Het Article

They note that, while in the usual textbooks governments are constrained from spending money until after they collect taxes. When governments are sovereign, as the US is, that constraint is theoretical for the most part. Governments can spend appropriated money in vertical transactions. They are creating the money on the fly, and only later do they even try to worry about where it physically comes from.

"For example, if the government pays a pensioner, it credits the private bank account of the pensioner (asset of the pensioner, liability of the private bank) and credits the reserve account of the private bank held at the central bank (asset of the private bank, liability of the government)." Het Article

From the point of view of the Government they paid for this transaction by creating money! They won't admit this however, and so they issue treasury bonds to transfer the government money liability from the banks reserve account to a public debt. The banking system winds up collecting fees from the transaction and interest from the treasuries used to "cover the transaction."


"In this example, the private bank’s position is unaffected by the transaction. Its liability to the pensioner is offset by its asset at the central bank. However, the pensioner’s asset has no offset within the non-government. It is matched by the government’s liability to the private bank. So, overall, the effect of this particular vertical transaction is to add net financial assets." Het Article

The bank has benefited from the transaction, and now, thanks to our Fed Reserve the Federal Government owes two debts. One the original notes issued pursuant to the transaction and the other the treasury notes sold to cover "the deficit" created by spending money into creation. MMT notes that the government could simply treat the notes as an obligation of the USA government and then "deficit" spending would only apply when the money supply is out of kilter and inflation has started. All the benefits of the current system go to the banking system!

"More generally, government spending increases net financial assets and tax payments destroy them. A budget deficit corresponds to an increase in net financial assets, a budget surplus corresponds to a decrease in them, and a balanced budget leaves them unchanged." Het Article

Say what???!!! The point is that a certain portion of government spending is necessary to provide sufficient money to support a modern economy. Ironically this was Milton Friedman's observation, but he was wedded to the banks so he didn't carry the logic all the way. The MMT folks do!

He goes on to say:

"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 budget position, the language adopted needs to be more circumspect. Without further information, we can only say that a budget deficit corresponds to an increase in net financial assets and a budget surplus corresponds to a decrease in them." Het Article

In MMT theory banks don't create money, they move it around. The concept of vertical money is predicated on governments being sovereign over their money supply. There is also a lot more to the subject here. But that's all for now.

Correlation versus Causation

The causality of government revenues is based on the performance of the economy, which is the aggregate (sum) of the performance of all the economic actors in that economy, their output. That performance is directly related to how efficiently and effectively raw materials and labor are transformed into goods and services. Government spending has to be effective to cause an increase in output, but it directly causes an increase in financial assets, from the POV of non-Government and barring disasters, losses or other failures. They are related, hence the terms "correlation" and "correspondence". Causation takes a little more explaining to understand. It gets into the terms "endogenous"/"exogenous". And if you are like me you won't want to tackle that in one sitting.

To get into those reasons requires a whole 'nother post

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