How to Pay for Progress

Public Finance and Modern Monetary Theory

(Chapter 9 of The Utopia Thieves)

N earlier posts in this series, I’ve emphasised the complementary nature of public and private investment in bringing about transformation and the conquest of scarcity. The metaphor of everyone’s shoulder to the wheel is, I think, a good one to describe how all the big stuff is brought about in practice.

The need for the required levels of investment, however much they pay off in the long run, tends to impose an increasing cost burden on the state. This is a well-known issue in public finance; one that dates back to the nineteenth century in the form of Wagner’s Law of Increasing Public Expenditure.

Basically, so the economist Adolph Wagner argued, in the bucolic days before the Industrial Revolution, people had tended to provide for their own needs at the village level. But with the coming of larger, industrial cities, industry, commerce and trade all increased, in ways that led to an explosion in private-sector economic growth.

Wagner’s point, which may seem logical to the reader who has followed the argument thus far, was that this private-sector growth demanded a complementary growth in public spending: on schools, libraries, drains, roads, pensions, and so on.

And the demand for public expenditure does seem to keep on increasing. As the economists Joseph Stiglitz, Todd Tucker and Gabriel Zucman note in a recent issue of Foreign Affairs,

In today’s innovative economy, governments will need to spend more on basic research and education (12 years of schooling might have sufficed in 1950, but not today). In today’s urbanized society, governments need to spend more on expensive urban infrastructure. In today’s service economy, governments need to spend more on health care and caring for the aged, areas in which the state has naturally played a central role. In today’s dynamic and ever-changing economy, governments will have to spend more to help individuals cope better with the inevitable dislocations of economic transformation. Addressing the existential problem of climate change will also require large amounts of investment in green infrastructure.

There are two ways in which the funding of the economy, not only of the government but also the private sector, can be organised.

The first is perhaps the most familiar, in part because it is the most traditional. In this method, a mediaeval goldsmith in possession of, say one hundred ounces of gold, issues paper notes signifying a loan of, say, 90 ounces of gold to a borrower, who uses the paper notes to purchase something from a seller.

These paper notes are technically known as promissory notes. They bear (or bore) words to the effect that the bank promised to pay the bearer, on demand, so many gold pieces. These days, we’d call them IOUs.

The promissory notes equal to ninety ounces of gold are deposited by the seller with another banker, who then requests ninety ounces of physical gold from the first banker to settle the amount and fulfil the promise.

The original customer now has a loan worth ninety ounces of gold with goldsmith number one, and the seller has a deposit worthy ninety ounces of gold with the goldsmith number two.

The ninety ounces of gold that have changed hands between the two goldsmiths — or perhaps even just re-labelled in some central vault — are not necessarily taken out and spent by the seller in physical terms. Instead, the seller may from time to time withdraw promissory notes from goldsmith number two.

In fact, for reasons that will become apparent in a moment, the second goldsmith actually prefers that the seller obtain promissory notes in dribs and drabs, and simply leave the gold in safe hands.

For, the second goldsmith is then able to issue paper notes worth another nine-tenths of the gold in store as a loan, in this case to the value of eighty-one ounces. The process of lending, buying, selling and depositing with paper notes repeats itself and because I have just decided that in this example there are only two goldsmiths, eighty-one gold pieces are eventually re-deposited with the first goldsmith.

In other words, the gold has gone out, and most of it has come back (or been twice relabelled), and yet a sum total of loans equal to 90 + 81 = 171 gold pieces, and an identically-sized sum total of deposits, have both been created out of thin air, without any change in the amount of physical gold.

This process, technically known as a credit multiplier, continues until loans and deposits equal to many times the value of the original store of gold have been created.

As to the government, it appropriates some of the loans and deposits to pay for its own activities. This, too, will be paid out in the form of promissory notes. Indeed, there is a theory that the difference between paper money and a merely private IOU is that paper money is the kind of IOU or promissory note that the government accepts in payment of taxes.

Over time, in the course of history, the original mediaeval goldsmiths have become known as bankers, a reference to the fact that they originally traded behind a bench (bank is an old word for bench). And the process of issuing promissory notes slowly became more regulated and centralised over time, until the promissory notes bore government insignia and no longer looked anything like the original, rather informal IOUs. At the same time, the financial system grew more complex, with a second layer of credit multiplier now layered on top of the government notes. And maybe even a third and a fourth, what we now call ‘derivatives’.

All the same, the underlying logic of the system remained the same — the US Federal Reserve, for example, is in fact owned by the banks — and, until quite recently in historical times, it was normal for the government-regulated bills to still bear the legend of promising to pay the bearer, on demand, in gold, though hardly anyone ever took the government, or the US Federal Reserve, up on this. Dead presidents and their equivalents in other countries were good enough for most people, most of the time.

These days the promise to pay the bearer in gold no longer is no longer present on most banknotes; but to reiterate, the logic of the system otherwise remains the same, that is to say, of a mostly private system of credit-multiplication into which the government dips for its needs, to the extent that it can: for the taxation of privately-created money is widely resented, and often successfully avoided and evaded.

And there are a couple other issue with the creation of credit by the financial sector. The first is to do with the fact that gold, the original ultimate store of value and means of settling accounts, could become either too scarce or too abundant in local banks as a result of international trade deficits and surpluses settled in gold. These trade-driven fluctuations in reserves would, in turn, lead to slumps and bubbles in the domestic economy, which relied on bank lending backed by gold.

The domestic economy was thus hostage to foreign trade, which was constantly increasing in importance. And foreign trade, constantly increasing in importance, was in its turn hostage to whether the goldminers had found any more gold lately!

But all that’s a bit of an anachronism, insofar as monetary system of the world and its countries has not been based on physical gold since the Great Depression of the 1930s. The increasing capriciousness and instability of a gold-based system in a modern trade economy does, however, help to explain why we went off physical gold in the 1930s Depression. Instead of physical gold, which Keynes dubbed a “barbarous relic,” most banks now hold securities issued by their own domestic governments as their ultimate store of value and their ultimate means of settling accounts.

But we’re still stuck with another issue, not so easily fixed without another great advance in state control of the monetary system. And this is that the credit created by the banks seldom goes into committed, fixed investments of the kind that build wealth long-term, but only into things that already exist and that can be bought and sold easily. That is to say, into what Keynes dubbed the “liquid” sector. And that’s for the rather obvious reason that the banks might want the money back in a hurry, in which case it helps if the thing that’s been purchased on credit can be sold quickly.

Consumer debt aside — where there’s less chance of getting the money back, but where interest rates are higher to compensate — the fetish of liquidity means most bank credit-creation goes toward the purchase of financial paper and real estate. From the banks’ point of view these asset classes are doubly attractive, because not only are they highly liquid, but also, the more the banks lend, the more their price goes up.

As one New Zealand investor has put it,

Land, land, land is the only long term holding. It is not subject to fashion, styles and renovation.

This is completely the opposite state of affairs to transformative industries, where the money is tied up for long periods, at risk of being entirely lost if the technological project doesn’t succeed. And if the project does succeed, the price of the product goes down! The entrepreneur may then make money for a while by selling a cheaper product than the competitors. Or then again, maybe not.

Unsurprisingly, most banks display little interest — no pun intended — in the financing of transformative industries. But then again, as Keynes came to realise, this is all perfectly rational from the point of view of a traditionally-organised financial and banking system.

As Keynes also came to realise at the same time, anyone who invests in transformative industries ultimately does so for reasons that aren’t strictly rational from an economic point of view; whence his famous allusion to the “animal spirits” that were supposedly the ultimate fuel of all transformative enterprise.

Animal spirits personified by such heroes of capitalist labour as Isambard Kingdom Brunel, a Victorian engineer whose financial fortunes were as wobbly as his projects were bold, and who ultimately worked himself into an early grave; but who does enjoy the posthumous accolade of being apparently the second most recognisable Briton after fellow cigar-smoker Winston Churchill, and having an engineering university named after him.

Isambard Kingdom Brunel in front of the launching chains of the SS Great Eastern. Photo by Robert Howlett, albumen print, November 1857 NPG P112. National Portrait Gallery, London, UK, CC BY-NC-ND 3.0.

Before Keynes, Karl Marx said something similar about the seeming paradox that the most useful sorts of entrepreneur actually don’t seem to be motivated, primarily, by profit. Though, as a stronger critic of capitalism than Keynes, Marx went on to argue that many Brunel types were actually inclined to over-reach and go bust in the end, their enterprises subsequently picked up at bargain-basement rates by “wretched and worthless money-capitalists,” who then proceed to run them into the ground by cutting back on long-term investment of the kind that was seen to be the founder’s folly, thus going from one extreme to the other.

Indeed, the more emphasis that is given to overt economic rationality of the kind often demanded by conventional finance, the more a technically sophisticated enterprise is likely to run up what’s been called ‘technical debt’. That is to say, sweeping long-term technical problems under the carpet while loudly proclaiming how much money management has managed to save, by not spending money on fixing those problems. This approach, the managerial equivalent of Oscar Wilde’s story about the picture of Dorian Gray, ‘works’ because everyone can see the money that is saved, while only a few backroom types understand the peril of the corners that are being cut.

Of course, sometimes, a spectacular disaster like that of the Boeing 737 Max brings everything out in the open. But then again, it’s surprising for how long it is possible to go on flirting with disaster, as the title of one recent book has it. Indeed, technical debt and the continuous pressure from bean-counters to ignore the concerns of knowledgeable people in the backroom, and flirt with disaster instead, is one of the major issues of the present age.

For instance, the habit of flirting with disaster explains the present coronavirus pandemic, which would have never happened if governments hadn’t commissioned pandemic preparedness plans, and then proceeded not to fund them.

All these modern organisational dysfunctions can be traced back, at least in part, to a financial system that is no longer fit for service.

The other approach to the funding of government and transformative enterprise and the issue of technical debt is less mediaeval and haphazard in nature. Quite simply, the government simply issues whatever money is needed to pay for its own projects and operations, long-term social needs, and a range of welfare benefits or UBI.

This money is no longer backed by gold, not even in theory. But rather, by the aforementioned fact that money is, ultimately, whatever the government accepts in payment of taxes. Taxes are still collected, but their function is now fundamentally that of curbing inflation, encouraging the sorts of things that the government wants to encourage, and discouraging the things the government wants to discourage.

As for the banks and other private sector financial institutions, their ability to multiply credit is now severely curtailed: a state of affairs they grumblingly refer to as ‘financial repression’.

It is evident that the first system is appropriate to an era of small and limited government, and the second to an era of larger, more activist government. The first system doesn’t have a name, but the second is usually referred to as Modern Monetary Theory (MMT), though we are not really talking about a theory so much as a practice.

And not one that is really all that new, either. Abraham Lincoln’s US Civil War-era were a form of MMT currency, as were the still earlier Revolutionary War-era Continental dollars; though, the problem of inflation tended to plague these earlier forms, whence the expression ‘not worth a Continental’.

During the Great Depression of the 1930s, MMT currencies became quite common, with many governments severing the links with gold and just printing whatever it took to get the economy moving again. This was the decade in which the first truly sovereign money was minted and printed for New Zealand, for example.

The notes were covered in Māori scrollwork and included a representation of a kiwi and a portrait of the ‘rebel’ Māori king Tāwhiao, who had spent the early part of the 1860s fighting Queen Victoria — a magnanimous gesture akin to putting a portrait of Geronimo on every American banknote — just in case anyone should mistake them for British pounds!

Source: Reserve Bank of New Zealand

The new notes included a promise to pay the bearer the face value if they took the note to the headquarters of the Reserve Bank in Wellington, in amounts of not less than five thousand pounds at a time (which pretty much ruled out convertibility for the average person). As to what the merchants who handed in the New Zealand notes in five thousand pound lots would receive, this was actually now ambiguous: what was offered in exchange was British currency at a rate to be determined by the Reserve Bank itself! Certainly, gold was no longer mentioned.

The New Zealand Government issued as many of these notes as it took to end the Great Depression locally. Many first saw the harsh light of a New Zealand day on removal from the pay packets of workers employed on public works schemes and the construction of state houses. Those familiar with the history of the Great Depression will appreciate that potential inflation was the last of the government’s worries back then.

In today’s world, the old system, of which neoliberalism is in many ways the last gasp, has become highly dysfunctional. Much of the credit created by the multiplier effect circulates in channels that are resistant to government taxation. And on top of that problem, this credit also tends to be used to bid up the price of rentier assets such as urban location value, or as a form of abusive footloose capital, in preference to being invested long-term and productively: for the latter increasingly requires a government guarantee, these days. Everything that Keynes said about the antisocial character of the fetish of liquidity applies to the persistence of the old system today.

Sooner or later, MMT will prevail both generally and permanently. Indeed, many other policy initiatives intended to overcome current social and economic problems depend on such a fundamental reform for their own permanence.

But finally, however public expenditure is funded, we should not lose sight of the fact that it is in many ways complementary to private-sector activity or even an infrastructural prerequisite. Public underspending leads to a downward spiral of disintegration of roads, bridges, public services and every other public thing, in ways that eventually make productive investment more risky for the private sector as well.

For that reason, says the New Zealand economist Keith Rankin, there is a case for extensive public borrowing even within a conventional financial framework:

Whenever capitalist economies face high levels of risk, banks prefer to lend more to governments. There is an ensuing natural feedback mechanism, in that non-corrupt government spending facilitated by increased government debt serves to reduce the amount of risk in the wider economy. The reduced risk then facilitates renewed lending to non-government unsecured and semi-secured debtors. The resulting private spending then results in more (tax) revenue to governments, and government debt to bankers automatically falls relative to the size of the economy.

One of the most destabilising types of event in financial history occurs when governments try to upset this benign arrangement by repaying debt to their banker creditors who do not want to be repaid, and who do not have enough good unsecured and semi-secured alternative debtors lined up. In this situation, economies may directly go into a state of depression — as in the 1930s, and as in the European Union in the early 2010s. Or, to forestall economic depression, banks may be induced into more of the speculative secured lending that creates financial bubbles, financial instability, and eventually economic depression.

Whether we embrace MMT or not, there is certainly no case for austerity.

Reference: The quote about “Land, land, land . . .” comes from a 3 June 2012 online comment by ‘John’, ‘a property investor since 1974’, to Bernard Hickey, ‘All our eggs are in the wrong basket’, New Zealand Herald, 3 June 2012.]

Click here for Chapter 10

Jump back to the start of Chapter One



I am an urban historian from New Zealand with a special interest in New World cities. Somewhere along the line I picked up a PhD on planning and economics.

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
Chris Harris

I am an urban historian from New Zealand with a special interest in New World cities. Somewhere along the line I picked up a PhD on planning and economics.