THE CONCEPT OF VERTICAL AND HORIZONTAL MONEY CREATION

There has been a great deal of confusion here in recent weeks in reference to several posts I have written about the solvency of the U.S. (see here), the credit worthiness of the U.S. and the actual way a non-convertible floating exchange rate currency system works.  I have found that the overwhelming majority of investors believe our government is revenue constrained and effectively believe we are living in a convertible currency system akin to the gold standard or a commodity linked currency system.  That couldn’t be farther from the truth. There are very important implications here in terms of what the government can do and how it will impact the future rate of inflation and the solvency of the United States. Warren Mosler was nice enough to forward this brief summary of the concept of vertical and horizontal money creation:

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”).

When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.

These principles are then applied to Y+C+I+G+NX to balance nominal aggregate demand with real output capacity in order to achieve full capacity utilization, hence, full employment, along with price stability. This is based not on theory requiring assumptions but on operational reality that can be represented using data, standard accounting identities, and stock-flow consistent macro models.

Perhaps most important in all of this is that it is not “theory” at all. This is actually how the banking system works in a non-convertible floating exchange rate system.  The United States government is never revenue constrained.  We do not “fund” our spending via taxes and debt issuance.  China is not our banker.  The fear mongering over government deficits and the issuance of government “debt” is built on a mountain of falsehoods by people who don’t understand how the monetary system works.

Of course, I don’t believe that this gives the United States a ticket to spend (or print or “button press” or whatever you want to call it) at will. That couldn’t be farther from the truth.   Spending has very real repercussions (though they’re misconstrued by most).  I have maintained and continue to maintain that government spending is not the solution to all of our country’s problems. We have a private sector that remains deeply indebted, a banking system that is highly unregulated, a flawed Central Bank and a government that continues to promote a supposedly Capitalist economy where the losers never lose.

While the private sector continues to de-leverage let’s hope that the government will play their role in helping to properly regulate the banking system in a fashion that ensures the U.S. public can never be held hostage by the big banks again. Unfortunately, it looks like that day could be a long way off.  In the meantime, the misconceptions about the U.S. being Greece or Weimar or Argentina will hopefully cease….

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