ABC’s of Modern Monetary Theory (MMT)

{} I was overwhelmed by the level of ignorance displayed by distinguished economist Raghuram Rajan in his article entitled “How Much Debt Is Too Much?” published recently in Project Syndicate on Nov 30, 2020. I had meant to write a critique of the article, but to do so requires starting from the very beginning. In this post, I go over some basic MMT concepts, in order to prepare the ground for this critique. (The follow-up post is “Differentiating Social, Market, and Government Debts“. ) There are now many good videos explaining these basics. I will go over six questions discussed in the first ten minutes of “Modern Money & Public Purpose 1: The Historical Evolution of Money and Debt” by Professor L Randall Wray. Learning the answers to these questions provides foundations for understanding MMT which are evidently missing in Rajan’s paper. Professor Wray asks us to decide on True/False for the following six statments:

  • Q1:Just like a household, a nation has to raise money to finance its spending through income or borrowing.
  • Q2:The role of taxes is to provide finance for government spending
  • Q3:The national government borrows money from the private sector to finance the budget deficit
  • Q4:By running budget surpluses, the government takes pressure off the interest rates because more money is available to the private sector for investment projects
  • Q5:Persistent budget deficits will burden future generations with inflation and higher taxes
  • Q6:Running budget surpluses will provide the government with the resources needed to finance spending on retirement benefits for the ageing population in the future

It is easy to score the quiz because each of these statements are false. In the remaining post, I will explain why. Very briefly, government spending CREATES money. The government pays in IOU’s – promises to pay. Like most currencies, a note for 1000 Pakistan Rupee carries a solemn promise bearing the signature of the governor of the State Bank of Pakistan to the effect that “The Bank promises to pay the bearer of this note 1000 Rupees”. What can this mean? The holder of the note already has what has been promised.  It should be clear that the bank can print as many of these notes as it wants, since what is promised in the note is another equivalent note – printing such notes creates no liabilities for the government. {A1: Government is not like households, and does not face a budget constraint}

The next question is: why do these empty promises carry value? Why do people accept them, hold them, and use them? An important part of the answer is “taxes”. When the government imposes taxes which must be paid in the government currency, then everyone needs the currency to pay taxes. When everyone can rely on finding people who want the currency, this creates value which can be used in all other transactions as well. Thus, taxes do not provide revenue for the government. In fact, as shown in the picture, the government can take money collected in taxes and shred it, without any economic consequences. The function of taxes is to create value for money, and also to soak up excess of money as a means of lowering aggregate demand and hence inflationary pressures. Taxes can also be used to create greater equity in wealth and income distributions. {A2: Role of taxes}

The Tax Shredder

Since the government is freely able to create money, it does not need to borrow any amount from the private sector. Also, at any moment of time, the government can pay off the entire debt to private sector simply by printing the required amount of money and paying it. {A3: The government does not need to borrow to finance the deficit}.

However, MMT emphatically does not say that the government SHOULD create money in arbitrary amounts. Money creation ALWAYS has economic consequences, since money is never neutral (contrary to common misconceptions created by the quantity theory of money). It is essential to consider these impacts in arriving at a decision about how much money should be created. The most important of these impacts is one which is completely absent from conventional textbooks. That is why it came as a huge surprise to me when I learned the following accounting identity from MMT texts. It is worth taking time out to understand this identity, because one cannot understand the role of government surpluses and deficits without it.

The private sector of an economy consists of households and firms. For any accounting period, like one year, let MH0 and MF0 be the amount of money held by households and firms at the beginning of the period. Let MH1 and MF1 be the amount of money in their hands at the end of the period. Then MH1-MH0 = HS is household savings over this period of time; it is the addition to their cash balances. Similarly MF1-MF0 = BP is the monetary profits of business over the year; it is the net addition to their cash balances. Now consider an economy where no money flows into or out of the private sector. Then it is clear that at the end of the year, the total amount of money will remain the same: MH0+MF0 = MH1+MF1. This can be re-written as (MF1-MF0)+(MH1-MH0)=0 or BP + HS = 0. Since the amount of money remains constant, the only way for business to make profits is if they acquire extra money from households, which requires negative savings for households. On the other hand, if households succeed in saving money, this can only happen if business as a whole makes losses, so that money is transferred from firms to households.

In a capitalist economy, firms are driven by the desire to make profits. Households are driven by the desire to save, to build up wealth as protection against future needs. The accounting identity shows that such an economy cannot function without increases in the money stock which allow both firms to make profits and households to make savings. In modern economies, there are two major sources for such injections of money into the private sector: the government and the foreign sector. First let us consider the role of the government. Taxes reduce the amount of money available in the private sector, creating greater obstacles in the path of firms seeking profits and households seeking to save: BP + HS = -T. Households will lose savings and businesses will make negative profits in order to pay taxes. Government spending into the economy (G) – whether it buys goods, invests, or pays wages, — creates additional money which is available for profits and savings. The accounting identity now becomes BP+HS = G-T. The term G-T is called the Government Deficit. This is misleading terminology borrowed from the false analogy that governments are like households and face budget constraints. The preferred term for G-T in the MMT literature is Government Injections (of money into the private sector). A capitalist economy can only function smoothly if the government continuously injects money into the economy by running deficits. The amount of the deficit must equal BP+HS – businesses can make profits, and households can create savings only if government runs deficits, creating money to allow them to do so. The overall profitability of business (calculated in terms of money only) has nothing to do with how efficiently or competitively they run their businesses. Instead, it is bounded and partially determined by the amount of monetary injections into the economy created by government deficits.

Another way to increase the money in the economy is by foreign injections, which is (X-M). This is the money earned from sales of goods to foreigners minus the money spent on purchases from foreigners. The accounting identity for an economy with government and a foreign sector is: BP + HS = (G-T) + (X-M) which can be written out as

Business Profits + Household Savings = Government Injections + Foreign Injections

This provides us with some understanding of export led strategies for growth. If countries earn foreign exchange from exports, this can (under appropriate monetary arrangements) increase the stock of money in the domestic economy, and create the room for profits and savings to increase. However, this cannot be a preferred strategy simply because overall global exports must equal overall global imports. A monetary injection into one economy comes from a reduction in money in other economies.

We can now answer the questions Q4, Q5, Q6, about the role of government deficits and surplus. A4: Government surplus reduces money available for domestic investors, and should lead to an increase in interest rates. A5: Persistent budget deficits provide ever increasing amounts of money to the private sector, and this is essential for economic prosperity (defined as business profits plus household savings). A6: The government does not need to save money for the future, since it can create money at will at any time.

This provides us with the background information, the ABC’s of Modern Monetary Theory needed to do a critique of the Raghuram Rajan article on “How Much Debt Is Too Much?” published on the web by Project Syndicate, on Nov 30, 2020. We will discuss the article in a later post.

LINKS: Even though mainstream economists like Raghuram Rajan appear to think otherwise, many leading economists and practitioners have acknowledged that the government can freely create money. See Essential Quotes for MMT. The next post in this sequence, preliminary to a critique of Rajan, is: Differentiating Social, Market, and Government Debts

POSTSCRIPT: Additional Materials about MMT are linked below:

  1. Key Insights from Modern Monetary Theory: Seminar at QAU on 2nd May 2019 – HTTP:/
  2. MMT for Pakistan: Sequence of Posts, starting with: HTTP://

21 thoughts on “ABC’s of Modern Monetary Theory (MMT)

  1. For those interested the image that Asad has called the tax shredder, it is on display in the Museum of Money of the Bank of Canada in Montreal if I recall where I took the picture correctly.

  2. Thank you for this excellent summary. Re: ” printing such notes creates no liabilities for the government” While it may not be a “liability” in the ordinary sense, would you agree that once the note is issued, it is carried as a liability on the books of the gov’t/central bank and that the liability is extinguished in only one way – by the imposition of taxes?

    1. That would the wrong terminology — A note in hands of public is not a liability of the government, but it does have economic effects. For instance, it increases the Aggregate Demand, which may have inflationary effects. If the government is concerned about these effects, then it may be able to tax away this money to prevent them.

      1. “…printing such notes creates no liabilities for the government.”

        “That would the wrong terminology — A note in hands of public is not a liability of the government, but it does have economic effects.”

        I agree regarding economic effects. Regarding the term liability, although I suspect I am missing something important (and would be grateful for knowing what that is!), given my current understanding, I respectfully disagree.

        On one hand, it’s obviously not a liability in the sense as currency users understand the term since, as long as the issuer exists, there’s no situation in which they can be forced to default (and therefore suffer the consequences for doing so). On the other hand, in order for our system of accounting to remain viable, and therefore our entire economy and society, it is incumbent upon the issuer to honor that obligation (such as to extinguish tax obligations). So, arguably, it is a liability in the same sense as currency users, although of infinitesimally-less burden.

        Regardless the case, it is indeed a liability in the accounting sense.

        As with many terms in the federal context (debt, deficit, borrowing), the problem seems to be that the listener can assume the term to be in whatever context they choose (issuer, user, or accounting) in order to twist the situation to their liking.

      2. Asad Zaman – no, LarryKaz & aliteralmind are right – ”printing such notes creates no liabilities for the government” is the incorrect, non-MMT terminology. In reality and in MMT a note in the hands of the public certainly is a liability, a debt of the government, a credit, an asset of the holder. That is at the heart of MMT, of the utmost importance to understand. But contrary to LarryKaz & aliteralmind, that IS the ordinary use of the word “liability”. Mainstream brainwashing is so thorough that it damages the ability to use and understand ones’ own native tongue correctly and consistently! What is mischaracterized as an artificial, accounting “on the books” sense is the core meaning, the natural sense, the dictionary meaning.

        A basic problem is that New Economic Perspectives is moribund. That was where people learned such points, if they didn’t read (and reread and reread) the MMT literature. Above all, the must (re)reads on that are the two papers of Alfred Mitchell Innes and the MMT volume of commentary on them – L. Randall Wray- Credit & State Theories of Money: The Contributions of A. Mitchell Innes- Edward Elgar (2004) (which one can freely download).

        The upshot is that what people understand as “MMT” is not MMT but more like what they have called Schumpeter’s (debased) Legal Tender Chartalism. I’ve been worried about this for a long time – just this week I’ve seen discussions by a number of academic adherents of MMT who have shown imperfect grasp of such points. One problem is that the core MMTers know many things so well – some from being educated by the last great American (old) institutionalist economists – that they don’t understand how badly people are taught or are unclear about some things. And as Geoffrey Gardiner notes in the Mitchell Innes volume – millions of accountants worldwide are taught to do things – but they don’t know why they’re doing them, why it MUST be that way.

        Why should anyone accept what I’m saying? Well, look at the archives of NEP or Mitchell Innes. But a couple of times, I’ve made comments on this matter or very close ones at this blog and another – that Wray liked so much that he wrote main blogposts at NEP as a commentary on my commentary. A good endorsement I think.

  3. Raghuram Rajan actually misunderstood the core idea of MMT that money is not neutral. In his article, he never considered about the amount of money circulating in the system and it’s consequences where he also, by default, believed that issuing treasury bills and central bank purchasing govt. bonds is the same thing by implying that new currency notes in the system = private saving, which is obviously pure non sense.

    1. I do not see a relevant quote at that site, nor would it matter. Central points in their academic works, amply explained by MMT founders once especially at NEP cannot be outweighed by some short quote. Everyone speaks in a possibly misleading, even thoughtless way sometimes, especially if they are quoted too briefly or out of context.

      Again, the accounting meaning and the English-language meaning here are absolutely identical. The mainstream, the commodity theory of money, the false idea of “medium of exchange” – confuse people so direly that they see nonexistent differences and consider something natural and universal, something that nobody can think about in a different manner – as a mere artificial or unnatural convention! And vice versa, that an artificial, arbitrary convention is natural. Aaargh! Perhaps another instance of weird WEIRD – Western, educated, industrialized, rich and democratic – psychology- at work. But so deeply that hardly anyone sees it.

      The most basic and central point in MMT is Mitchell-Innes’s “Money is credit and nothing but credit”. Credit/debt asset/liability, obligation, promise etc all being synonyms, with a changed perspective if necessary. So he could have said “Government notes are government liabilities and nothing but government liabilities.” And he and MMTers certainly did and do say this, usually less succinctly.

      The point is to study and define money – like government fiat money – non-circularly in terms of, as a form of a prior concept “credit” (= “debt” = “liability”). Which of course one cannot be founded in terms of money, in any way, as that would be circular, like Moliere’s satire of the doctor who ascribes the power of sleep medicine to its “dormitive virtue”. MMT is not only a state theory of money. Crucially, it understands the state theory of money as part of the credit theory of money, and this makes everything else in the theory natural and inevitable.

      1. In my opinion, an accounting liability could technically be considered the same as a liability in the dictionary/currency user/common-sense/colloquial sense. This is as I argue in my original comment. However, because the burden on the issuer is infinitesimally small in comparison, it is NOT meaningful to consider the term as the same in both contexts.

        Therefore, I agree with Professor Zaman. For the issuer it is an accounting liability but not colloquial liability. For the currency user it is both accounting and colloquial.

    2. The government’s liability is its duty to accept its notes in satisfaction of its demands for revenue.

      Its notes are zero-interest perpetual bonds able to satisfy demands for revenue by their redemption. Using them to purchase term-limited interest-bearing bonds can then clearly be seen as the liability swap – not funding – operation that it is.

      When the Rajans of this world address “the debt”, they should always be asked “do you mean treasury debt plus central bank debt, or just treasury debt?”

      Better to teach a person to swim than keep her away from the water. Better to teach that every debt/liability has an asset on the other side of the ledger than to avoid the D & L words.

    1. Mostly, it is for foreign currency to pay for imported goods which are not produced domestically. However, there are certain other types of projects also, which require foreign expertise

  4. I took a number of accounting courses 50 years ago and remember being surprised that the terms ‘asset and liability” had nothing to do with who owed who what but rather on which side of the balance sheet they needed to be entered. It was difficult to remember because accounting didn’t use common sense meanings of those two terms.

  5. I am surprised by this extensive discussion and controversy regarding “liability”, on what seems to be a trivial point to me. Let me try to state more clearly my own understanding. First, we understand that the context for this discussion is whether governments are like households. If a household issues and IOU for $100 this is a liability — On demand, the household must provide goods and services (or equivalent cash) worth $100 – this will reduce goods available to the household, and this limits the ability of the household to issue IOUs. If the household issues too much debt, it can go into bankruptcy, being unable to pay the liabilities generated by this debt. On the other hand, If the government issues a note saying I OWE the bearer of this note $1000, this is not a liability in the same sense. If the bearer goes to the government and demands payment, the government can print up another note and give it to him, essentially costlessly. There is no reduction in goods and services in possession of the government as a consequence of having issued the IOU (unlike households). Also, there is no limitation on the government in terms of how much debt it can issue – it is not constrained by what it owns or expects to earn in the future. The government can never go bankrupt by issuing IOUs in the sense of not having the resources to be able to pay the liabilities created by these IOUs.

    1. Agreed, the household is restrained whereas the sovereign government is not. However, what must be added is that while the government can refuse chickens or gold in payment of taxes, it is obliged to accept its own liabilities, its own IOUs. A more detailed discussion of this type of liability can be found in this blog by L. Randall Wray:


      "All money, save bananas in your monkey republic, is debt. It is on the liability side of issuer and asset side of holder. You cannot change that through confusing semantics. If all you want is zero interest on government liabilities that is easy to arrange. You do not have to pervert either accounting or language."
  6. Many laps on a fairly obvious topic. Extended circular capitalism requires the monetization of the surplus so that production and investment decisions can flow. There is a convention that money requires social credit that manifests itself through its demand from the public as the basic monetary asset on which all financial transactions are built. The day that society no longer believes in this money, it will disappear with the loss of its value with hyperinflation.

  7. Why is it so hard to accept the best wisdom or R Reich & EF Schumacher (et moi)?
    After all, if gov. is a service/maintainer of justice & equity for all, ‘debt’ can be replaced by investment in the wellness & good quality of life for all. After all, if that is so–and we want a stable, reliable economy & currency for the Good of all participants–then ‘funding’ worthy, viable programs, projects, and growth (in direct proportion to actual increase of population & our cultural activity) can be done without interest. Why? Because valid, viable gov. should be a not-for-profit service that benefits all citizens, not just a ‘power elite’ and kleptocrats. Right?
    In other words, why should we charge ourselves interest on investments in ourselves and the quality of life for all generations? So, if gov. really is by, for & of We the People, we can eliminate debt+liablity for the sake of real equity for all + valid monetary policy + debt-free currency + economic stability (managed by the only possible impartial, truly ethical, ‘disinterested’ party: an ethical AI-Auditor+accountant+mint manager system). Also, since–with the exception of US gov.’s IT–IT is now nearing final transition to a logical and truly secure global ecotecture (ala Estonia, etc.), there is no good reason to reject a superior, bio-ethically viable, AI-enhanced monetary credit ecotecture (for all participants).
    Indeed, at the rate this phase of civilization’s (Civ. 2.0) karmic consequences are catching up to its ecocidal obliviousness, not co-creating the optimal alternative (ASAP) would be a symptom of terminal ecocidal mass-mania. I hope I have made the case simple enough for easy understanding of the basics, yet not too simple. So, I look forward to your comments, etc.

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