[H] Deductive Theory of Modern Money (1) — An Attempt to Trace the Modern Monetary System from Scratch

This series on the "Deductive Theory of Modern Money" has been rewritten to be more compact as a [Definitive Edition] on my site below. Please feel free to view it there. This article corresponds to the first section of the linked article.

This article is the first in a series titled "Deductive Theory of Modern Money."

What I call "Deductive Theory of Modern Money" here is an attempt to take the modern monetary system as a premise, start from a point where money does not exist, and trace one by one the various transactions through which money is born, circulates, and disappears, in order to firmly understand how money is born, circulates, and disappears in the modern monetary system.

In a form like "deduction," where various theorem-like propositions are derived from fundamental axioms, I would like to take the current monetary system as a premise and derive the various movements of money within it.

Through this, I aim for my own principled and comprehensive understanding of modern money.

I am an MMT sympathizer who accepts MMT-based monetary theory. One of the characteristics of MMT is that it incorporates accounting recognition. However, since I do not have a background in accounting, it is hard to say that I have truly digested the accounting arguments of MMT yet. To resolve this situation, I would like to develop the modern monetary system from scratch by myself while tracing accounting thinking.

In this attempt, I assume the monetary system that is actually working in the modern era. Therefore, the main participating entities are also assumed. The participating entities for the time being are government, central bank, commercial banks, private enterprises, and households.

In this first installment, we will trace the process until the monetary base, money stock, and cash are each born.

1. Until money (monetary base) is born

Now, how is money born?

Modern money is not a natural object. That is because it is not rice or gold. In other words, it is not created by the work of households or companies.

It is, after all, something determined by the government. For that reason, the starting point is the government determining the unit of money called the yen.

Now, assuming the government has determined the monetary unit to be the yen, how is that yen born?

In the modern era, the government does not issue yen directly. While the government determines the unit called the yen, it is not the government that issues the yen. Coins made by the government are no exception. The government makes coins, but it does not issue them as money that is actually in circulation. Details on this point will be described later.

It is the Bank of Japan that issues the yen. However, even if we say it issues it here, it does not print bills and hand them to someone to issue them. The Bank of Japan, as a bank, issues money in a bank-like manner.

Issuing money in a bank-like manner is either (1) receiving cash and issuing bank deposits in exchange, or (2) issuing bank deposits in exchange for a promissory note (a loan receivable from the bank's perspective). (2) is the so-called "credit creation" where bank deposits are issued at the time of lending.

Like the Bank of Japan's quantitative easing, when assets are purchased and bank deposits are issued as payment, it is considered a type of (2). In the case of quantitative easing, the assets accepted are mainly government bonds (government promissory notes), but in the general case of (2), the accepted assets are the promissory notes of the counterparty.

However, thinking about it this way, both (1) and (2) are essentially the same in that they accept assets and issue bank deposits in return. This must be the essence of bank-style money issuance.

Now, let's return to the main point. How is money issued? Since there is no cash yet, the Bank of Japan can only issue money through (2) at this stage.

Also, considering that direct lending from the Bank of Japan to the government is prohibited in the current system as "fiscal finance," and that ordinary individuals and general companies cannot have accounts at the Bank of Japan, the counterparty will be a commercial bank.

Therefore, the first transaction, the transaction by which yen are issued for the first time, is for a private bank to borrow yen from the central bank.In other words, it is to have central bank reserves issued in exchange for a promissory note (a loan receivable from the perspective of the Bank of Japan) to repay it. Let's assume this is 1 million yen.

If we express this on a balance sheet, it looks like the following.

Thus, yen were issued. The monetary base, which is the sum of cash and Bank of Japan current account deposits, became 1 million yen.On the other hand, the money stock, as the total money held by entities other than the government and financial institutions, is still zero.

Also, at this stage, private bank equity (i.e., own funds that are not debt) cannot exist, so we will not consider capital adequacy regulations. This is because it would inevitably become zero, meaning the bank could not operate.

2. Until money (money stock) is born

Now, let's create money stock. Let's have a private company borrow from a private bank. When a loan is made, the bank creates a deposit of that amount by recording it in the private company's account.

However, a private bank must hold a certain percentage of Bank of Japan current account deposits as reserve deposits (to prepare for withdrawals and settlements) against the deposits it holds. In reality, this is at most about 1%, but let's assume 10% for this case. Then, the maximum loanable amount is 10 million yen.

In practice, since it only needs to maintain an average of 10% over a month, it is not that loans exceeding 10 million are completely impossible, but we will ignore this fine detail here. (Note)

In this case, let's assume the private company borrowed 5 million yen. Changes are shown in red.

At this time, the monetary base remains unchanged at 1 million yen. The money stock, as the total money held by the private sector, has become 5 million yen.

However, since there is a 5 million yen liability behind this 5 million yen asset, the "net worth," which is "assets minus liabilities," is zero. Furthermore, considering not just the private company but the entire diagram, the net worth is zero. A characteristic of bank-like money issuance is that because money is always issued with debt as its flip side, the net worth remains zero.

[Note: Since the reserve requirement ratio only needs to be achieved as a monthly average, it is possible for a private bank to lend to a private company before borrowing from the Bank of Japan. However, when a private company withdraws cash or sends money to another bank, reserves in the Bank of Japan current account are necessary. Without them, the bank cannot respond to withdrawals or transfers and would immediately default.]

3. Until money (cash = Bank of Japan notes and coins) is born

Now, the private company will likely develop its business. Assuming tools and materials are ready, let's hire people to build a house. We will hire people belonging to households to work. Let's pay 1 million yen as wages.

To do so, first, we will withdraw 1 million yen in bank deposits and convert it into cash to prepare for wage payments. The result is the diagram below.

(In the diagram below, some items are shifted to emphasize that the total amounts on the left and right of each entity match.)

The movement of the balance sheet when cash is withdrawn is somewhat complex. First, the private company's assets change from 1 million yen in bank deposits to cash. This part is easy to understand.

Commercial banks are a step more complex here.As bank deposits, which are liabilities, decrease due to withdrawals, the assets held as current account deposits at the Bank of Japan also decrease, maintaining the balance.A commercial bank's current account deposit at the Bank of Japan was a reserve deposit prepared for cash withdrawals and interbank settlements. Those reserves have been used.

And,regarding the Bank of Japan, its liabilities change from current account deposits to cash circulating in the market (Bank of Japan notes created by the BOJ and coins created by the government).

At this stage, cash is recognized accounting-wise and begins to function as money. Until then, it may be in a warehouse, but it is not recognized as money and does not function as money. What we can understand from this is that cash also enters the market as a substitute for current account deposits at the Bank of Japan, which were issued in exchange for the Bank of Japan's underwriting of assets (such as promises of repayment by banks).

This means thatin the current system, money is not issued like a magic mallet without any return.Of course, this is not to say that it cannot be done. It is merely confirming the fact that it is blocked in the current system.

By the way, if we look back at the situation at this stage, we can see that the commercial bank is in a pinch. After all,the current account deposits at the Bank of Japan, that is, the reserve deposits, have become zero.

Of course, the reserve requirement ratio, which is the reserve deposits divided by the deposits it holds on the liability side, is also zero. However, as mentioned earlier, regarding the reserve requirement ratio, it is sufficient if the average over one month meets the statutory reserve requirement, so a zero balance does not immediately cause a problem.

Nevertheless,having zero reserve deposits is still a critical situation.If even one more yen of cash is withdrawn, this commercial bank will not be able to meet it.It would be unable to fulfill its own obligation to respond to bank deposit withdrawals. In other words,it would fall into a state called default.

Let's leave it here for this time. Next time, I would like to think about how to avoid this bank default problem, and what kind of monetary movements will be generated when companies and households engage in realistic economic activities.

The continuation is here.

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