×

How the New Economics Explains Everything!

man-confused-with-wires-200.jpg
Mike Kemp | Rubberball | Getty Images

My title is a bit of an exaggeration, of course. But it’s intended to inspire you to head on over to the opinion pages of the Financial Times and read Cullen Roche’s excellent article on the contributions of the modern monetary approach to our understanding of economics in the 21st century.

Roche, a ridiculously prolific guy who runs two must-read websites (Pragmatic Capitalism and Monetary Realism), while also trading for himself and his clients, provides a very concise summary of the practical consequences of the theoretical insights of modern monetary economics.

I’ll sum them up quickly but I encourage you to read Roche’s FT article.

1. Currency independence matters. Europe’s ongoing crisis is driven by the fact that its nations converted themselves from currency issuers to users of a common currency. This means that their national governments can run out of money. It has left them in the economically devastating and politically humiliating position of being bond-market beggars, at the mercy of a central bank they do not control.

Meanwhile, the United States, Japan, and the United Kingdom—which have all preserved their monetary sovereignty—can expand their debt while keeping interest rates low. They can never run out of money because their governments can create whatever money they need. So long as they maintain some semblance of fiscal discipline, they need never worry about a debt crisis.

(Incidentally, this is not true of states and municipalities in the U.S. They are a lot like Europe’s national governments. They must use a currency they do not control, have debt obligations and spending obligations in that currency, and therefore can experience debt crises. They can run out of money.)

2. The schoolbook version of banking is dead. It is still widely believed that bank lending is dependent on the level of reserves in the system. As reserves increase, the capacity for lending is thought to increase (and vice-versa). So when the expansion of the balance sheet of the Federal Reserve resulted in exploding reserve levels, many believed that bank lending would grow (a good thing) and lead to high inflation (a bad thing).

A funny thing happened on the way to hyper-inflationary bank lending: it vanished from view, receding ever further as we marched up the mountain of banking reserves. It turned out that it was just the Yeti of economics.

Banks meet regulatory requirements for reserves by borrowing them in the federal funds market or from the Federal Reserve itself. Either the market or the federal reserve must always supply new reserves to any bank deemed open for operation by regulators, or the payment system will break down. As a consequence, this means that banks are always able to obtain required reserves. A corollary of this is that excess reserves do not enable more lending, because all viable loans that healthy banks wish to make and credit-worthy borrowers wish to take out are always enabled by whatever level of reserves exists.

3. Budget deficits aren’t always the enemy. A budget deficit is simply the difference between the amount of dollars the government takes out of the economy through taxes and the amount of dollars it adds to the economy through spending. Deficits must expand to facilitate continued economic growth, if private spending and borrowing is contracting.

“As banks and households have both reduced their debt level, government spending has proved to be essential. Austerity has failed miserably in many European countries, and further reductions in government spending risk turning a eurozone recession into a depression, hurting millions of people,” Roche writes.

I’ll add to this last point: it’s possible to hold the position that government should not facilitate economic growth if private spending and borrowing is contracting. Perhaps such an economy should be allowed to simply contract, market processes driving economic outcomes. The deficit spending advocated by the modern monetary approach is only mandatory if you hold—as most people of any political stripe seem to—that the government should facilitate economic expansion regardless of private spending habits.

Anyway, I haven’t really done justice to Roche’s essay, so go read the whole thing.

Follow John on Twitter. (Market and financial news, adventures in New York City, plus whatever is on his mind.) You can email him at john.carney@nbcuni.com.

We also have two NetNet Twitter feeds. Follow CNBCnetnet for the best of the days posts, including breaking news. Follow NetNetDigest for a feed of every single post each day.

You can also be our friend on Facebook. Or subscribe to John's Facebook page.

We're on Google Plus too! Click here and add NetNet to your circles. And here is John's Google+ page.

Questions? Comments? Tips? Email us atNetNet@cnbc.comor send a text message to: 9170740-8477.

Call us at 201-735-4638.