“Modern Monetary
Theory” or “MMT” is the theoretical framework for virtually all monetary policy
in the world today. Even those who
reject MMT do so within the context of the very system they reject.

Irving Fisher |

If that sounds
paradoxical, it’s because it is. The
paradox can be traced directly to the most fundamental principle of modern
monetary theory (note the absence of capitals; we do not mean Modern Monetary
Theory, but monetary theory in modern times) is the “Quantity Theory of Money”
equation,

**M x V = P x Q**

This equation,
first formulated by Irving Fisher (1867-1947) using concepts that appear to
have been suggested first by Sir William Petty (1623-1687), states the
relationship between the variables involved in the interactions of economic
activity. The usual interpretation of
the theory is that the
money supply and the price level in an economy are in direct proportion to one
another. When there is a change in the
supply of money, there is a proportional change in the price level and

*vice versa*.Sir William Petty |

To understand why the usual
interpretation is half-wrong (which is far more damaging than being completely
wrong), we first have to understand the equation. It is straightforward algebra:

·

**M = the quantity of money in the economy,**
·

**V = the velocity of money,**
·

**P = the price level, and**
·

**Q = the number of transactions in the economy.**
As for what this special
language means, M is the quantity of things recognized as “money” in an
economy. V is the average number of
times each unit of money is spent during a period. P is the total amount spent in an economy
divided by the number of transactions. Q
is just what it says, the total number of transactions in the economy.

Now here is where things get
interesting. There are two ways of
looking at the Quantity Theory of Money equation. One is called the Banking Principle, and the
other is called the Currency Principle.

Henry Thornton, "Father of Central Banking" |

Both principles are slightly
misnamed. This is because the Banking
Principle doesn’t necessarily involve banks but describes the banking function,
a minor semantic issue. The Currency
Principle does involve currency but limits the definition of money to currency
and currency substitutes — and that leads to some serious problems.

Despite modern commentators
who insist on misstating the Banking Principle in terms of the opposing
Currency Principle (we did mention that this gets interesting, didn’t we?),
both principles can be stated and understood very easily, given the Quantity
Theory of Money equation:

·

**Banking Principle**: The number of transactions, the price level, and the velocity of money determine the amount of money in an economy.
·

**Currency Principle**: The amount of money determines the number of transaction, the price level, and the velocity of money in an economy.
Anyone who
remembers anything at all of high school algebra should now already see the
fundamental serious problem with the Currency Principle. Should, of course, but probably won’t. It’s human nature not to see something so
obviously wrong. Besides, no teacher
would ever dare put this question on a test for fear of getting run out of the
classroom with an angry mob of students hot on his or her trail because it is so obvious it turns into a "trick question."

Here is the
problem, and it’s a doozy.

There is one
equation with four variables. One of the
first things people learn in algebra is that you cannot have more than one
unknown or “dependent” variable per equation, or the equation cannot be solved
in one dimension, and one dimension is the only thing that makes sense in
monetary theory.

Of course, if you
have one equation and two dependent variables you can get a range of possible
answers in two dimensions, and with one equation and three dependent variables
you can get a range of possible answers in three dimensions, and so on . . .
but what good does that do anyone?
Monetary policy needs to answer only one question in one dimension: How
much money is needed in the economy?

The Banking
Principle answers that question very readily, and then moves on to other
questions, such as how best to ensure that the amount of money in the economy
is uniform, stable, “elastic”* and asset-backed. These are all essential characteristics of
money, regardless how much there is or what form it takes.

*”Elastic”
in monetary theory refers to a money supply that expands and contracts directly
with the needs of the economy, so that there is neither inflation nor
deflation. If prices change, it is
because of changes in supply and demand, not because someone changed the unit of measurement.

"A small error in the beginning. . . ." |

As far as the
Banking Principle is concerned, the question “How much money is needed in the
economy?” actually answers itself.
Assuming the system has been properly designed and is operating within
established parameters, exactly enough money will be created as is needed. Under the Banking Principle, “money” — the
medium of exchange — is created when people enter into agreements to exchange
goods and services and is cancelled when the goods and services are delivered.

Thus, looking at
the Quantity Theory of Money equation from the perspective of the Banking Principle,
there is only one dependent variable in the equation, and it is one that takes
care of itself. How much money does
there need to be? As much as is needed,
of course, and given that money is

*only*created by entering into actual transactions and*only*cancelled when the transaction is completed, there is always exactly enough money in the economy to do the job.
And the Currency
Principle? As both Aristotle and Aquinas
agreed, a small error in the beginning can lead to great errors in the
end. This is not, however, a small error
that leads to great errors. It is a
great error that leads to cosmically huge errors.

". . . leads to great errors in the end." |

Under the
Currency Principle, which is the theoretical basis of Modern Monetary Theory,
the question “How much money is needed in the economy” is answered by saying,
“Gee, I dunno. Let’s make a guess, fiddle
with things, hold our breaths, and hope it comes out right.”

This is because
under the Currency Principle, instead of having one dependent and three independent
variables that you have for the Quantity Theory of Money equation under the
Banking Principle, you have one independent and three dependent variables.

One equation and
three dependent variables? Check your
high school algebra textbook — you cannot solve that equation in one
dimension. You can only solve it for a
range of answers in three dimensions . . . and even then, only if you know how
the different variables relate to one another within the equation itself.

And that’s
another problem. The so-called Keynesian
Money Multiplier claims (based on some

*very*flawed assumptions, by the way) that increasing or decreasing the amount of money in the economy will affect V, P, and Q in some mysterious way that has more exceptions than you can shake a stick at. Does doubling M mean doubling T? Or does it double P, cut V in half, or some combination thereof? Cross your fingers and hope for the best.
To try and make
the equation work, different definitions of M have to be tried, different
relationships between the variables assumed, and the characteristics of money
manipulated,

*e.g*., should the money supply be asset-backed or debt-backed? Privately issued or government issued? Gold, silver, dirt, or political whim? Elastic or inelastic? Stable or constantly changing? Uniform or variable?
And so on,

*ad infinitum*. . . and all to try and answer a question that the Banking Principle answers automatically."Like, Dude, . . . ." |

Ironically, all
the gyrations people have been going through for almost two centuries trying to
come up with the magical incantation that will make the Quantity Theory of
Money equation work under the Currency Principle could have been seen as
completely unnecessary by any high school student who has taken algebra. And why?

**Like, fer shure, Dude, you can’t, like, you know, have more than, like, one dependent variable in an equation and hope to make, like, sense, you know?**

Given that rather
enormous problem with Modern Monetary Theory, you can argue all you like about interest
rates, inflation, deflation, trade imbalances, reserve ratios, fractional
reserve banking (which doesn’t mean what most people think, anyway), sterilization
of exogenous money (no, we didn’t make that one up), and so on, so forth . . .
but it doesn’t mean a thing because MMT is based on a flawed assumption to
begin with. Yes, people might by chance
manage to create the right amount of money for an economy without causing too
much damage (although don’t hold your breath), but that’s the point —

**!**__it would be completely by chance__
Can the world
today really risk its economic wellbeing on the chance that the politicians
people curse for their stupidity and the bankers they excoriate for their
villainy are going to make a good guess about something for which they cannot
even state the basic principle?

Or is there a
better way?

That is what we
will look at in the next posting on this subject.

#30#