Understanding The Modern Monetary System

Cullen O. Roche

Orcam Financial Group, LLC

August 5, 2011


This paper provides a general understanding of the workings of the modern fiat monetary system in the United States within the context of the global economy. The work is primarily descriptive in nature and takes an operational perspective of the monetary system using the understandings of Monetary Realism.

Understanding The Modern Monetary System – Introduction

The principal aim of this paper is to objectively describe the operational realities of the modern fiat monetary system in the United States using the understandings of Monetary Realism. The paper seeks to provide the reader with a better overall understanding of money, the macroeconomy and how the monetary system as a whole can be used to achieve prosperity. Although this work will focus primarily on the USA this subject can be applied to many other nations throughout the world.

Overview – Monetary Realism

Monetary Realism (MR) is a description of the fiat monetary system applicable to nations who are issuers of their own currency, but have outsourced the broader money supply to the private banking system. Monetary Realism describes the complex institutional relationship between the government (public sector) and the non-government (private & foreign sectors) and how the monetary “machine” works to contribute to economic prosperity.

Monetary Realism is based on the following principles:

  • The primary role of “money” is to serve as a means of payment. Money can take many forms, but in the modern money system the final means of payment comes primarily from within the private banking system in the form of bank deposits. In other words, the dominant form of money in the modern monetary system is issued almost entirely by the private banking system.
  • The monetary system exists primarily for private purpose in order to create a system for efficient exchange of goods and services. The private sector plays the lead role in helping to advance the well-being of the society in which money is used.
  • In many market based systems such as the USA, the money supply is essentially privatized and controlled by private banks that compete to create loans which create deposits (money). Contrary to popular opinion, governments in such a system do not directly control the money supply nor do they create most of the money.
  • The public sector (the government) plays a facilitating role in helping to regulate and manage the infrastructure within which the money system operates. If properly utilized the government can be an extremely powerful tool in helping to stabilize and create efficiencies within the money system.
  • The Federal Reserve (the central bank in the USA) and the government have a symbiotic relationship and together are issuers of the currency to the monetary system. Currency, or what MR refers to as “outside money” (because it comes from outside the private sector), accounts for bank reserves, cash notes and coins. In addition to the Fed, who issues bank reserves, the US Treasury is the other issuer of outside money in the form of cash and coins. Households, businesses and state governments are users of public sector supplied currency and also private bank issued monies (i.e. bank deposits or inside money because it comes from inside the private sector).
  • The private banking sector issues bank deposits (“inside money”) and the public sector issues coins, paper cash and bank reserves (“outside money”). Nowadays most means of payment involving private agents are transacted in bank deposits and, as such, the ins and outs of “inside money” are vital to understanding how the modern monetary system functions. While the private sector component of the monetary system takes center stage in the daily business of market exchanges and economic progress, the public sector also plays an important role.
  • As the issuer of currency, the government need not have a solvency constraint as there might be for a household or business. In this regard, one must be careful comparing the federal government to a household because the federal government has no solvency constraint (i.e., there’s no such thing as the federal government “running out of money” as it can always call on the Central Bank to serve as agent of the government to create money for its own spending needs). Households, on the other hand, have a very real solvency constraint as they can quite literally “run out of money” since they cannot always obtain funding from the private banking system.
  • The federal government’s true constraint is never solvency, but inflation and foreign currency risk. The government must manage its policies so as to avoid imposing undue harm on the populace via mismanagement of the money supply or via inefficient use of government taxing/spending. Although insolvency via inflation or foreign exchange is quite different from a true solvency constraint it should not be confused as necessarily being less harmful.

The Dismal Science & Getting Back to a Da Vinci Methodology

The primary purpose behind the formation of Monetary Realism was to formulate a better understanding of the monetary system at its operational level without emphasizing the role of policy. Therefore, one of the key elements of Monetary Realism is its political agnosticism. MR is a blend of many different economic schools and takes this broad understanding to offer an explanation of how the economic system—the machine—works within the existing set of institutional practices. The purpose of MR is not to offer a political or policy bias, but rather to describe the operational realities of a fiat monetary system in an attempt to better educate the reader and provide them with the understanding to make their own informed decisions as to how this system might be utilized and optimized.

One of the great problems with the economics profession is that there is no firm foundation of understanding from which analysts can build their policy prescriptions. Further, one tends to find schools of thought based on normative rather than positive thinking; prescriptive rather than descriptive. The MR approach is similar to that utilized by Leonardo Da Vinci regarding medicine and human anatomy. Da Vinci viewed the human body as a machine and as one of the first anatomists he provided the world with a better understanding of how that machine functioned (e.g. how its pieces worked together, how it was built, etc). To Da Vinci, it was all about finding out what is and not what can be. It was only through rigorous analysis of how the machine worked that he and others were able to be in a position to offer advice on medicine and surgery.

The “dismal science” need not be so unscientific. Unfortunately, most of its practitioners are trying to be Hippocrates and not Da Vinci. And like the surgeons of the days of Hippocrates, they do not fully understand how the system works and while they might believe they will “do no harm”, too many are too often working from a false premise or a false understanding of the system due to a preconceived ideology. It is my hope, through MR and a true focus on understanding how the system works at an operational level, that we can provide a primarily positive (descriptive) approach to money, economics & finance.

Modern Monetary System