Looking at Exchange Rates in a Scientific way

Through out this forum, I have seen many posters engage in pissing contests about which system, method, M.O, Way of trading....etc. The names for how we trade vary as much as the triggers we use to enter the markets. I however am still hungry after what will be my second year trading the markets for a more empirically based, more scientific approach to trading. This Thread will be for those who want to enter intelligent discussions on on the matter. This will not be a place to show your set ups....because "IF" you do I will expect solid, statistical, mathematical, falsifiable, replicable, and testable data with a well thought out rationale behind it.

I am not a guru and do not purport to be one, Cult mentality, superstitious and irrational thinking should only belong in RELIGION, not trading.

Before we get to statistics= charts
probabilities
risk models
and all the other good stuff myself and other traders want to jump to....I want to make sure that we understand the concept behind what we do everyday in the markets.

I am not claiming to teach you how to trade but I do want to dispel a lot of the B/S in this forum or corroborate that b/s with good rational thinking behind why certain things work.


to start of the thread here is a piece written by Showbik Karla from Harvard Business School, regarding exchange rate determinants.

http://people.hbs.edu/mdesai/IFM05/Kalra.pdf



December 13, 2005

SHOWBHIK KALRA

Note on Determinants of Foreign Exchange Rates

Exchange rates are relative prices of national currencies, and under a floating rate regime
they may be viewed as being determined by the interplay of supply and demand in
foreign exchange markets. The exchange rate simply expresses a national currency's
quotation in respect to foreign ones. For example, if one US dollar is worth 100 Japanese
yen, then the exchange rate of dollar is 100 yen. Therefore, the exchange rate is a
conversion factor, a multiplier or a ratio, depending on the direction of conversion. Thus,
the exchange rate can also be considered a price of one currency in terms of the other.
Exchange rate regimes (fixed or floating) are chosen by central banks (or governments).
It is important to distinguish nominal exchange rates from real exchange rates. Nominal
exchange rates are established on currency financial markets. Rates are usually
established in continuous quotation (they maybe fixed). Real exchange rates are nominal
rates corrected by inflation measures.

The next section presents some determinants of the nominal exchange rate. These
determinants could lead to changes of a floating exchange rate or put pressure on a fixed
exchange rate. The purpose of the note is not to determine how to forecast changes in
exchanges rates but is an attempt to discuss why exchange rates change.
Determinants of the Nominal Exchange Rate

1. Trade Balance

Exports, imports and the trade balance can influence the demand of currency aimed at
real transactions. An increasing trade surplus will increase the demand for country's
currency by foreigners (e.g. if the United States is running a trade surplus, there will be
demand from overseas for the USD to pay for these goods), so that there should be a
pressure for appreciation. A trade deficit should lead to the currency weakening.
If exports and imports largely determined by price competitiveness and the exchange rate
truly sensitive to trade imbalances, then any deficit would imply a depreciation followed
by booming exports and falling imports. Thus, the initial deficit would be quickly
reversed. Trade balances would almost always be zero.
But exports and imports are not only determined by price competitiveness (and the
exchange rate is not truly sensitive to trade imbalances), therefore trade imbalances can
be quite persistent (as is the case with the current trade deficit in the United States).

One reason is tariffs and quotas that exist to protect a country’s foreign exchange by reducing
demand. For e.g. till before liberalization, India followed a policy of tariffs and
restrictions on imports. Very few items were permitted to be freely imported.
Additionally, high customs duties were imposed to discourage imports and to protect the
domestic industry. Tariffs and quotas are not popular internationally as they tend to close
markets. Quotas are not restricted to developing countries. The United States imposes
quotas on readymade garments and Japan has quotas on certain non-Japanese goods.
Capital movements of foreign currency are usually connected with international trade.
When India began its economic liberalization and invited Foreign Institutional Investors
(FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the
country strengthening the currency. In 1996 and 1997, due to the political situation, FIIs
took several billion US dollars (capital outflows) out of the country weakening the
currency.


2. Relative Purchasing Power Parity

Another form of real determination of exchange rate is offered by the "one price law" or
the “purchasing power parity”, according to which any freely good or service has the
same price worldwide, after taking into account nominal exchange rates. But in order to
equalize the price of several goods, more than one exchange rate may turn out to be
necessary, or an exchange rate that represents a tradable basket of goods and services.
The purchasing power parity exchange rate (PPP) between a foreign currency and the
U.S. dollar can be defined as:
PPP = (Cost of a Market Basket of Goods and Services at Foreign Prices) / (Cost of the Same Market Basket of Goods
and Services at U.S. Prices)

This gives us the exchange rate in terms of the units of foreign currency per dollar. The
dollars per unit of foreign currency is just the reciprocal.
The exchange rate between countries, therefore, should be such that the currencies have
equivalent purchasing power. For e.g. if a hamburger costs 3 US dollars in the United
States and 100 yen in Japan, then the exchange rate must be 100 yen per dollar. The
foreign exchange market would adjust, over the long term, to permit the functioning of
the "one price law", because the purchasing power of one currency increases (or
decreases) relative to another currency.

3. Relative Interest Rates

Interest rates on treasury bonds will influence the decision of foreigners to purchase
domestic currency in order to buy these treasury bonds. Higher interest rates will attract
capital from abroad, thereby increasing demand for the currency, and therefore the
currency will appreciate. Note, what is important is difference between domestic and
foreign interest rates, thus a reduction in foreign interest rates would have a similar effect.
Accordingly, an increase of domestic interest rates by the central bank could be
considered a way to defend the currency.
But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this
were the strongest component of currency demand, then an increase of interest rate may
even lead to the opposite results, since an increase of interest rate quite often depresses
the stock market, leading to share sales by foreigners. A restrictive monetary policy
(increasing interest rates) usually also depresses the growth perspective of the economy.
If foreign direct investment are mainly attracted by future growth prospects and they
constitute a large component of capital flows, then this FDI inflow might stop and the
currency could weaken. Therefore, interest rates do have an important impact on
exchange rate but one has to be careful to check additional conditions.
Capital from abroad ↑; Demand for currency ↑;
Currency appreciates
Stock market ↓; Capital from abroad ↓;
Currency depreciates
Economic growth prospects ↓; FDI ↓; Currency
depreciates
Impact on the exchange rate when interest rates are raised
Interest Rates ↑

4. Relative Price Changes

The inflation rate is also considered to be a determinant of the exchange rate. A high
inflation rate should be accompanied by depreciation of the exchange rate. The more so if
other countries enjoy lower inflation rates, since it should be the difference between
domestic and foreign inflation rates to determine the direction and the scale of exchange
rate movements.
Therefore, if a hamburger costs 5% more in Japan than a year ago, while in USA it costs
8% more, then the dollar should have been depreciated this year by about 8%-5%=3%.
Here we have used the hamburger as a general example. The relationship between real,
nominal exchange rates and inflation can be expressed as the following approximation
(which can be applied to any two countries, not just the United States and Japan):
%ΔReal Exchange Rate (¥/$) ≈ %ΔNominal Exchange Rate (¥/$) – (Japanese Inflation % - U.S. Inflation %)
In reference to the overall price level of the economy, if exchange rates would move
exactly counterbalancing inflation dynamics, then real exchange rates should be constant.

5. Speculators, Traders and Financial Instruments

George Soros is most famous for his single-day gain of US$1 billion on Sept 6, 1992, which he
made by short selling the British pound. At the time, England was part of the European Exchange
Rate Mechanism, a fixed exchange-rate system which included other European countries. The
other countries were pressuring England to devalue its currency in relation to the other countries in
the system or to leave the system. England resisted the devaluation, but with continued pressure
from the fixed system and speculators in the currency market, England floated its currency and the
value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10
billion short position on the pound which made him US$1 billion. This trade is considered one of
the greatest trades of all time.
Past and expected values of the exchange rate itself may impact on current values of it.
The activities of foreign exchange traders, speculators and investors may turn out to be
extremely relevant to the determination of the market exchange rate. Financial
instruments like futures and forwards may also play an important role on the
determination of exchange rates.
A foreign exchange speculator who expects the spot rate of a foreign currency to be
higher in three months can purchase the currency in the spot market today at today's spot
rate, hold it for three months, and then resell it for the domestic currency in the spot
market after three months. If he is right, he will make a profit; otherwise, he will break
even or incur a loss. On the other hand, a foreign exchange speculator who expects the
spot rate of a foreign currency to be lower in three months can borrow the foreign
currency and exchange it for the national currency at today's spot rate. After three
months, if the spot rate on the foreign currency is sufficiently lower, he can earn a profit
by being able to repurchase the foreign currency (to repay the foreign exchange loan) at
the lower spot rate. (NOTE: To make a profit, the new spot rate must be sufficiently
lower to overcome the excess interest paid on the foreign currency borrowed for three
months, over the interest received on an equal amount of the national currency deposited
in a bank for three months.)
It is important to note that foreign exchange speculation usually takes place in the
forward market because it is simpler and, at the same time, involves no borrowing of the
foreign currency or tying up of the speculator's funds. Actions in foreign exchange
options markets can also influence exchange rates, especially in the short-term. To
understand the dynamics between spot rates, interest rates and forward rates it is
interesting to understand the mechanics behind covered interest arbitrage.

5.1. Covered Interest Arbitrage
Covered interest arbitrage is the transfer of liquid funds from one currency to another to
take advantage of higher rates of return or interest, while covering the transaction with a
forward currency hedge. Since the foreign currency is likely to be at a forward discount,
the investor loses on the foreign transfer currency transaction per se. But if the positive
interest differential in favor of the foreign money center exceeds the forward discount on
the foreign currency (when both are expressed in percentage per year), it pays to make
the foreign investment.
For e.g., when interest rates in the United States are greater than in Brazil (or elsewhere),
a Brazilian investor can exchange reals for dollars today and use these dollars to buy a 3-
month T-bill in New York at 12%. She earns 4% more per year (or 1% more per 3
months) than if he had used his reals to buy a 3-month T-bill in Brazil at 8%. If the spot
rate today is 3.0 real/$ and the spot rate in three months is 2.97 real/$, she will lose .03
reals or 1% on the foreign exchange conversion. The annualized 4% gain from the U.S.
T-bill is just offset by the annualized 4% currency loss. She breaks even.
If, on the other hand, the 3-month forward rate is between 3.0 and 2.97, the investor can
cover her foreign exchange rate risk by buying a forward contract to sell dollars in 3
months in exchange for reals. E.g. if the forward rate us 2.985:

Foreign currency loss = (3-month forward rate - spot rate)/spot rate
= (2.985 real - 3.0 real)/3.0real = -.015/3.0 = -0.5%

If the 3-month interest differential is 1% and the foreign exchange differential is only
0.5%, the investor nets 0.5% and should undertake the investment. This return (0.5%)
annualized is 2% per year. As long as the interest rate differential is greater than the
forward exchange rate differential, the Brazilian investor profits from buying U.S. T-bills
and selling forward dollars. In the process, she raises his return from 8% on the Brazilian
T-bill to 10.30% on the U.S. T-bill plus the foreign currency translation.
As funds are transferred from Brazil to the U.S., the supply of funds is reduced in Brazil
and increased in the US.
This tends to put upward pressure on interest rates in Brazil and
downward pressure on interest rates in the US, so that the positive interest differential of
4% per year will tend to fall toward 2% per year.
At the same time, the increased demand for dollars in the spot market tends to raise the
spot rate for dollars and the increased forward supply of dollars tends to push down the
forward rate. For both reasons, the forward discount on the dollar will tend to increase,
pushing it up to the interest rate differential.
Under normal conditions, the relationship between spot and forward rates is determined
largely by covered interest arbitrage (this relationship is known as the interest rate parity).
If interest rates are higher abroad, covered interest arbitrage tends to keep the foreign
currency at a forward discount (and the domestic currency at a forward premium) equal
to the positive interest differential in favor of the foreign monetary center. If domestic
interest rates are higher, covered interest arbitrage tends to keep the foreign currency at a
forward premium relative to the spot rate (and the domestic currency at a forward
discount) equal to the domestic positive interest differential. However, this may not hold
even approximately when covered interest arbitrage is forbidden or with large
destabilizing speculation taking place.

5.2. Interest Rate Parity

Interest rate parity is a relationship that must hold between the spot interest rates of two
currencies if there are to be no arbitrage opportunities. The relationship depends upon
spot and forward exchange rates between the currencies. It is:
• s is the spot exchange rate, expressed as the price in currency a of a unit of currency b
• f is the corresponding forward exchange rate
• ra and rb are the interest rates for the respective currencies
• m is the common maturity in years for the forward rate and the two interest rates.
The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign
exchange markets, enforcing an essential link between short-term interest rates, spot
exchange rates and forward exchange rates.

5.3. Influence of the FX Options Market on Short-Term Exchange Expectations

Implied volatility is one of the key variables used to calculate the price of an FX option.
It is often interpreted as the market’s measure about possible future movements in spot
(related to the standard deviation of returns over a sample period). In the FX options
market, the preference of calls (right to buy a currency) over puts (right to sell a
currency) is measured by an asset class called risk reversal skew (RR) which is
mathematically defined as:

D delta Risk Reversal Skew = Implied Volatility of a D Delta Call – Implied Volatility of a D Delta Put

The FX market closely watches these risk
reversals. A positive RR, for example,
indicates preference for calls over puts, a
signal often perceived as bullish by the
market, leading to overbought positions in
the underlying currency, that further
exacerbate the RR. This is a par excellence
example of a self-fulfilling prophecy. A
defining example of this phenomenon was
the trend up in EUR from the lows in 2002
that saw the risk reversal continually
favoring EUR calls (see figure on left).

FX Option positions also give rise to a
phenomenon referred to as strike gravity. As the FX option trader deals in the spot market
to hedge a significant FX option position against a counterparty that is not an active
market participant, the spot gravitates towards the strike of the option as the trade
approaches maturity. This effect is more pronounced when the said position is an exotic
option with a digital payout and both the participants have access to liquidity in the cash
market to actively manage the exotic option. These FX flows arising from aggressive
hedging by the FX Option market players often dictate short-term currency moves.


6. Political and Psychological Factors

Political or psychological factors are also believed to have an influence on exchange
rates. Many currencies have a tradition of behaving in a particular way such as Swiss
francs which are known as a refuge or safe haven currency while the dollar moves (either
up or down) whenever there is a political crisis anywhere in the world. Exchange rates
can also fluctuate if there is a change in government. A few years back, India’s foreign
exchange rating was downgraded because of political instability and consequently, the
external value of the rupee fell. Wars and other external factors also affect the exchange
rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the
Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November
1999), the Pakistani rupee weakened.

sources

Historical chart of USD PKR exchange rate (01/01/1998 – 01/01/2002)
References
[1] Economics Web Institute (2001)
[2] Explaining Exchange Rate Behavior, Menzie D. Chinn, National Bureau of Economic
Research, Spring 2003
[3] The Determinants of Exchange Rate Movements, OECD, Economics and Statistics
Department, Graham Hoche, June 1983
[4] Macro for Managers, Harvard Business School, David Moss, January 2005
[5] Foreign Exchange Markets and Transactions, Harvard Business School Case, Mihir
Desai, October 2004
[6] Exchange Rate Policy at the Monetary Authority of Singapore, Harvard Business
School Case, Mihir Desai and Mark Veblen, January 2004
[7] Foreign Exchange Markets, San Jose State University, Economics Department,
Thayer Watkins
[8] Interviews with FX Options structuring group at Citigroup
Military coup in Pakistan


I hope with this thread to move past simple lines on a chart to make better sound, and intelligent decisions on our speculative activities.

The Microstructure of Currency Markets

Martin D. D. Evans􀁗
Department of Economics
Georgetown University
and NBER
July 2010
Abstract

This article summarizes exchange-rate research using microstructure models. It first lays out the key
features of the foreign exchange market and describes how they are incorporated into a canonical model of
currency trading. The empirical implications of the model are then examined. The article also discusses
how currency trading links spot rate dynamics to macroeconomic conditions, and how this link sheds light
on some long-standing puzzles concerning the behavior of exchange rates.

Key Words:
Currency Trading, Exchange Rates, Exchange Rate Puzzles, Exchange Rate Fundamentals, Foreign Exchange
Market, Microstructure, Order Flow, Risk Premium.

1 Introduction

Models of Foreign ExchangeMarketMicrostructure examine the determination and behavior of spot exchange
rates in an environment that replicates the key features of trading in the foreign exchange (FX) market.
Traditional macro exchange rate models play little attention to how trading in the FX market actually takes
place. The implicit assumption is that the details of trading (i.e., who quotes currency prices and how trade
takes place) are unimportant for the behavior of exchange rates over months, quarters or longer. Micro-based
models, by contrast, examine how information relevant to the pricing of foreign currency becomes reflected
in the spot exchange rate via the trading process. According to this view, trading is not an ancillary market
activity that can be ignored when considering exchange rate behavior. Rather, trading is an integral part of
the process through which spot rates are determined and evolve.
The past decade has witnessed rapid growth in micro-based exchange-rate research. Originally the focus
was on partial equilibrium models that captured the key features of FX trading. These models provided
a new and rich array of empirical predictions that are strongly supported by the data and provide a new
perspective on the proximate drivers of exchange rates over short horizons, ranging from a few minutes to
a few weeks. Recent micro-based research moves away from the traditional partial equilibrium domain of
microstructure models to focus on the link between currency trading and macroeconomic conditions. This
research aims to provide the micro-foundations for the exchange-rate dynamics that having been missing
from general equilibrium macro models.

I structure my discussion of micro-based exchange-rate research as follows: Section 2 first lays out the
key features of the FX market and describes how they are incorporated into a canonical model of currency
trading. I then discuss the empirical implications of the model. Section 3 examines research that links spot
rate dynamics to macroeconomic conditions via currency trading. Section 4 discusses how this research sheds
light on some long-standing puzzles concerning the behavior of exchange rates. Section 5 concludes with
some thoughts on the directions of future micro-based exchange-rate research.

2 CurrencyTradingModels

The goal of micro-based models is to build an exchange rate model from microeconomic foundations that
reasonably represent the key features of the FX market. In particular, the aim is to incorporate the institutional
implications of how information is transmitted from one agent to another as trading takes place, and
to study how this information is ultimately reflected in the spot exchange rate. The fact that the models
describe trading between agents does not mean that the researchers using these models are only interested
in trading. Their focus remains on understanding exchange rate dynamics, but they are using models that
make detailed predictions about trading activity as well.

2.1 Features of the FX market

No model can incorporate all the institutional features of trading in the FX market —— its far too complex.
Instead, micro-based models focus on a small number of features that are essential for understanding the
main economic mechanisms at work. I summaries the key features below:

•• The FX market is a two-tier market comprising the interbank and retail markets:

Trading takes place between dealers working at banks in the interbank market, and between banks and their non-bank
customers in the retail tier. Neither market has a physical location. Trading takes place by phone
or electronically between participants located all around the world, but most trading in the interbank
market takes place between banks located in a few financial centers: Tokyo, Singapore, Frankfurt,
New York, and particularly London. Trading can take place 24 hours a day, but activity is heavily
concentrated during the daytime hours of the main financial centers.
•
• FX dealers trade directly and indirectly in the interbank market.

Direct interdealer trades result from ““conversations”” between two dealers working at different banks in which they agree to exchange
one currency for another. This was the dominant form of interbank trading before the mid 1990s.
Since then most interbank trade has taken the indirect form in which dealers submit market and limit
orders to buy and sell currencies to electronic brokerages ( Reuters D2000-2 and EBS). These systems
prioritize the limit orders so that those with the best prices are matched first with incoming market
orders.
•• No FX dealer has complete information about the state of the interbank market. Electronic brokerages
provide market-wide information on transaction prices, but dealers do not observe the structure of limit
orders that determine market liquidity. Direct interdealer trading takes place simultaneously across
the interbank market. Dealers only have information on the trades they participate in.

•• FX dealers face constraints on both the duration and size of their FX positions. Dealers’’ overnight
positions are typically small or zero.

•• Banks fill customer orders for currency in the retail tier of the market. The customer orders received
by banks represent the most important source of private information to FX dealers. Dealers working
at banks with a large customer base and a world-wide reporting system have a potentially important
informational advantage over other market participants.
•
• Customer orders come from many different agent types and may be generated by allocative, speculative
and risk-management factors. Customer orders that are purely a function of current and past currency
prices are termed feedback orders.......................

please read the entire PDF file here, due to It would take me a long long time to fix all the bugs to post it.



Here is a paper that will explain to you what current environment the Federal Reserve is working under, and what is a "Liquidity Trap"



Here is an interesting paper regarding fx implied volatility




I am open to questions, discussions, and from anyone from newbie to pro....there are no dumb questions. The point of this thread is to learn and improve our trading based on testable, empirical hypotheses.

In order to understand the role of the United States Dollar in the global economy and on the world of currency exchange rates, it is imperative that we understand what is "reserve currency" and the Triffin dilemma

I looked through these articles in wikipedia and according to the research I have made on my own they do a great job of explaining it and looks to me to be reliable....feel free to check the sources at bottom of the articles by wiki pedia.


http://en.wikipedia.org/wiki/Reserve_currency

http://en.wikipedia.org/wiki/Triffin_dilemma

here is another empirical paper done regarding the fx micro structure


A further on liquidity traps by paul Mcculley



but to even begin understanding what is it that we are trading and how it derives it's value we need to understand Modern Monetary Theory.
and the Fiat system in which fx market operates in:

www.pragcap.com is a very good source of educational information on the subject.

Electronic copy available at: http://ssrn.com/abstract=1905625

Understanding The Modern Monetary System

Cullen O. Roche
August 5, 2011

ABSTRACT

This paper provides a very broad understanding of the workings of a modern fiat monetary
system that is applicable to countries with sovereignty and monopoly supply of currency in a
floating exchange rate system.
Electronic copy available at: http://ssrn.com/abstract=19056252

Introduction

In this paper I will explain why Functional Finance and Modern Monetary Theory best describe
most modern fiat monetary systems. The systems that are applicable to this discussion include
nations that are monetarily autonomous, are monopoly suppliers of their own currency and exist
within a freely floating exchange rate system. For this discussion, I will focus primarily on the USA
although this subject can be applied to many other nations throughout the world.

Overview
Modern Monetary Theory
Modern Monetary Theory (MMT) is based on the following principles:

1.The government is the monopoly supplier of currency.

2.The modern floating exchange rate system helps to maintain equilibrium and flexibility
in the global economy.

3.The currency unit created by the state via deficit spending can only be extinguished by
payment of taxes. Therefore, a modern monetary system can best be thought of as a
system of debits and credits where government deficit spending credits the private sector
and payment of taxes debits the private sector.

4. The government of the currency issuer must remain monetarily autonomous.
Functional Finance


Functional Finance is an economic theory based on the following principles:

1. The government is an entity created by the people and for the people. It exists to
further the prosperity of the private sector - NOT to benefit at its expense. If this entity is
allowed to exist for its own benefit or becomes corrupted by a concentration of power, it
will become susceptible to dissolution via the populace's rejection of that government.

2. Governments should be actively involved in regulating and helping build the
infrastructure within which the private sector can generate economic growth. The
economy is a complex dynamical system with irrational participants. It cannot be
expected to regulate itself or behave rationally at all times. Therefore, some level of
government intervention and involvement is not only beneficial, but necessary. Ultimately,
it must be the private sector that is the driver of economic growth. While government can
aid in this process it cannot be expected to be the primary driver of innovation,
productivity and growth.

3. Money is always created by the state and must therefore be regulated by the state;
however, ultimately the private sector must accept this legal tender as the currency unit.
Therefore, the private and public sectors should best be thought of as being in
partnership with one another and not opposing forces. Government by the people and for
the people is not the antagonist in this story, but rather an entity that should be best
utilized to maximize private sector prosperity.

4. Government deficit spending and tax collection should be maintained at a rate that
does not impose financial hardship on the private sector. Because the Federal
government is not a state or household it should not manage its balance sheet for its own
benefit. Rather, taxes and government spending should be managed in a way that most
benefits the private sector and encourages private sector prosperity, productivity,
innovation and growth.

What is MMT?

Modern Monetary Theory (MMT) is a description of the monetary system within a nation operating
a fiat currency that involves an autonomous monetary system, monopoly supply of currency and
floating exchange rates. MMT describes how a government creates, destroys and utilizes its
monetary unit and also how the private sector utilizes the state's monetary unit for its own benefit.
Brief Historical Background
MMT is based on the state theory of money that says that modern fiat money is always a
"creature of the state". The theory was first introduced by GF Knapp as "Chartalism". This is
derived from the Latin word "charta" which means token. This is used to describe the reality of
modern fiat currencies as nothing more than a state issued token with no linkage to commodity
based money. We do not reside in a system in which currencies have any linkage to metals
therefore, such thinking is not applicable to a modern fiat monetary system, although this thinking
has persisted and still clouds much economic thinking to this day.

Significant contributions to Chartalism were made by Alfred Mitchell-Innes and Abba Lerner. The
gold standard, however, rendered much of their work incomplete as governments were still
constrained in their ability to issue currency. This changed in 1971 when Nixon closed the gold
window. Since then, Chartalism has undergone a significant revival although much of the
economic thinking based on the gold standard continues to this day. The work of Hyman Minsky,
Wynne Godley, Warren Mosler1 and Randall Wray have been particularly central to this revival
that has come to be known as "Neo-Chartalism" or Modern Monetary Theory (MMT).

Is It Just A "Theory"?

The name MMT is a bit of a misnomer as it is really just a way of describing how modern
monetary systems work and is not necessarily a theory. The theory is all in its application. Some
believe government should be highly involved in managing its currency while others believe it
should be involved to a lesser extent. It’s important to note that the core component of MMT is
merely descriptive. The theoretical portion is more prescriptive.

MMT's Political Agnosticism
One important element of MMT is its political agnosticism. There are components of MMT that
tend to be left leaning, however, there are also components of MMT that are right leaning. For
instance, MMT is agreeable to many right leaning economists because it favors lower taxes,
reducing (or ending) the Fed's role in the monetary system and focusing on efficiency of
government (reducing wasteful spending and malinvestment). MMT is also agreeable to left
leaning economists because it favors government deficits, tighter bank regulations and a focus on
full employment via government hiring. Importantly, it is neither an offshoot of Keynesianism,
Monetarism nor Austrian economics, though there are components of each involved to some
extent. Rather, MMT is an offshoot of many different theoretical frameworks with GF Knapp, Abba
Lerner, Hyman Minsky and Wynne Godley playing central roles in helping to craft it.

MMT As A Heterodox Economic Theory

Learning MMT can take some significant time as it turns most of modern economics on its head,
but understanding MMT is vital in comprehending how the modern monetary system works and is
particularly important at this juncture as many of its most controversial elements have been
proven correct during the economic crisis of 2008. MMTers have experienced remarkable
success predicting much of the economic outcomes over the last 20 years. This is not surprising
as MMTers tend to view other economists as seeing the world through a largely defunct prism - a
prism based on a fixed exchange rate world that became inapplicable in 1971, but whose thinking
continues to poison the economic thinking to this day.

How Vertical And Horizontal Money Functions
MMT is based on a horizontal and vertical view of money. This is important in differentiating
between the public and private sector and how each impacts the money supply. The vertical
component describes how the consolidated government (Fed and Treasury) transacts with the
banking system in an exogenous form. The horizontal component describes how the banking
system utilizes state issued money to transact within the banking system. It's very important to
make this distinction because only the consolidated government can create net new financial
assets. All horizontal banking transactions net to zero. As Randall Wray says:
"Credit money (say, a bank demand deposit) is an IOU of the issuer (the bank), offset by
a loan that is held as an asset. The loan, in turn, represents an IOU of the borrower, while
the credit money is held as an asset by a depositor."
Banks merely leverage the currency introduced into the system via vertical transactions. The
following description of this horizontal and vertical relationship comes courtesy of Warren Mosler:
“When the government “spends,” the Treasury disburses the funds by crediting bank
accounts. Settlement involves transferring reserves from the Treasury’s account at the
Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has
no corresponding liability in the banking system. This creation is called “vertical,” or
exogenous to the banking system. Since there is no corresponding liability in the banking
system, this results in an increase of non-government net financial assets.
When banks create money by extending credit (loans create deposits), this occurs
completely within the banking system and results in a liability for the bank (the deposit)
and a corresponding asset (the loan). The customer has an asset (the deposit) and a
corresponding liability (the loan). This nets to zero.
Thus vertical money created by the government affects net financial assets and
horizontal money created by banks does not, although its use in the economy as
productive capital can increase real assets.
The mistake that is usually made is comparing what happens in the horizontal system
with what happens at the level of government accounting. At the horizontal level, debt is
the basis for horizontal money creation. Therefore, it is often assumed that debt must be
the basis for the creation of money by government currency issuance. This is not the
case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability”
is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting
relationships is apt. Since a husband and wife are responsible for each others debts,
neither can be indebted to the other. That is to say, reserve accounting is a fiction that
does not represent real relationships, such as exist between a creditor and debtor in the
horizontal system.
Moreover, government debt is not true debt either. At the macro level, the reserves that
are transferred to banks through government disbursement are used to buy Treasury’s.
That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s
bank’s reserve account at the Fed to the government’s account (consolidating Central
Bank and Treasury as “government”).
When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are
simply switched back, creating a deposit again. It’s pretty much the same as buying and
redeeming a CD. It’s just a switch from demand to time back to demand in a bank
account, and a switch between reserves and securities at the government level. That is to
say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its
“debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on
the (consolidated) government books, even though it may appear that there is a financial
relationship occurring between the CB and Treasury due to the accounting. However, it’s
just a fiction.
Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal
relationship. When one understands this, then Abba Lerner’s principles of functional
finance become obvious.

(1) Currency issuance through government disbursement is
used to increase non-government net financial assets, and taxation withdraws net
financial assets from non-government.

(2) Debt issuance by the Treasury is a monetary
operation for draining reserves to permit the Central Bank to hit its target rate.
These principles are then applied to Y=C+I+G+NX to balance nominal aggregate
demand with real output capacity in order to achieve full capacity utilization, hence, full
employment, along with price stability. This is based not on theory requiring assumptions
but on operational reality that can be represented using data, standard accounting
identities, and stock-flow consistent macro models.”

The key takeaway here is that there is an important distinction between the currency users within
the monetary system and the currency issuer. The government balance sheet is not like that of a
household or a state government (which is also a currency user, i.e., can’t print). It does not
finance spending via revenues or debt issuance. The US government, as a monopoly supplier of
currency in a floating exchange rate system never really has nor doesn't have money.
It might help to think of the US government as the scorekeeper. Like a scorekeeper at a football
game, the US government never has nor doesn’t have money (points). They don’t have a big
bowl of money that they reach into or count before spending occurs. Because they are the
monopoly supplier of currency they can simply create money as they please. Like the
scorekeeper, they add points by spending money and remove points by taxing (or “unprinting”
money). The key point in this regard is that there is no such thing as the scorekeeper running out
of points. The government could print so much money that inflation results, but there is no such
thing as the currency issuer “running out of” money.
In addition, we must understand that banks merely leverage government money. When we go
through business school we are taught that banks obtain deposits and then leverage those
deposits up by 10X or so. This is why we call the modern banking system a "Fractional Reserve
Banking" system. Banks supposedly lend based on their "reserve" position. There's just one
problem here. Banks are never reserve constrained! Banks are always capital constrained.
Reserves are used for only two purposes – to settle payments in the overnight market and to
meet the Fed’s reserve ratios. Aside from this, reserves have very little impact on the day to day
lending operations of banks in the USA. The money multiplier is a mere myth. This was recently
confirmed in a Fed paper:

"Changes in reserves are unrelated to changes in lending, and open market operations
do not have a direct impact on lending. We conclude that the textbook treatment of
money in the transmission mechanism can be rejected."
This is very important to understand because many have assumed that various Fed policies in
recent years would be inflationary or even hyperinflationary. But all the Fed has been doing is
adding reserves to the banking system. As we learned above, this doesn't lead to more lending
and will not result in the private sector being able to access more financial assets. Because
banks are not reserve constrained it can only mean one thing - banks lend when creditworthy
customers have demand for loans.
Lastly, this also shows that banks create money entirely within the banking system. As was said
above:
"When banks create money by extending credit (loans create deposits), this occurs
completely within the banking system and results in a liability for the bank (the deposit)
and a corresponding asset (the loan). The customer has an asset (the deposit) and a
corresponding liability (the loan). This nets to zero.
Thus vertical money created by the government affects net financial assets and
horizontal money created by banks does not, although its use in the economy as
productive capital can increase real assets."
So, contrary to what we are all taught in school, loans actually create deposits and not the other
way around as the money multiplier would have us all believe. When a bank makes a loan it
debits the Loans Receivable account on its books. To balance this transaction it will create a new
liability in the name of the borrower. This loan will create a deposit somewhere else in the
banking system (possibly at the same bank) that will cause this new bank to also account for its
new liability (the deposit) and change in reserves at the Fed.
A Fiat System Where Everyone Still Thinks We Have A Gold Standard Constraint
Why has this thinking never changed in the USA? Despite the dramatic changes in the monetary
system after the Nixon shock neo-liberalism came to dominate economic theory in the 70's and
80's. After the economic successes of the Reagan and Clinton eras there was little doubt that
such thinking was accurate. Of course, we all know what happened next and now many of these
neo-liberal beliefs have been pointed to as causes of the recent credit crisis.
More important is the fact that investors and economists have simply ignored the fact that the
USA underwent drastic changes in 1971 when Nixon closed the gold window. In essence, the
system underwent this dramatic overhaul, but the economic thinking never changed all that much.
Overnight, theories and thinking should have been rewritten, but never truly were. Whether one
likes it or not, we are operating in a truly fiat world. Therefore, the thinking and theories that are
derived from the era of the gold standard are largely defunct. MMT fills this void
by describing how a state issued fiat monetary system operates.

This misconception exists even at the highest levels of government and has been propagated by
many of the world’s most prominent economists. I believe most people in power do not
understand exactly how our monetary system works due to this fundamental flaw in our
educational system - in fact, I believe 99% of the lawyers in Congress know far less than anyone
thinks in terms of economics. The same can be said for many of the officials in Fed and Treasury.

But people always ask: "how could these people not get it? How can the brightest minds and the
leaders of our country not understand all of this?" It certainly sounds hard to believe. But if we
review the past actions of Alan Greenspan and the actions of Ben Bernanke leading up to and in
response to the credit crisis we can see that they have substantially misinterpreted how a modern
monetary system functions. In fact, in a 2008 Congressional hearing Alan Greenspan admitted
that the ideological framework he had based his entire life's work on, was "flawed":

“REP. HENRY WAXMAN: Do you feel that your ideology pushed you to make decisions
that you wish you had not made?
ALAN GREENSPAN: Well, remember that what an ideology is, is a conceptual
framework with the way people deal with reality. Everyone has one. You have to -- to
exist, you need an ideology. The question is whether it is accurate or not.
And what I'm saying to you is, yes, I found a flaw. I don't know how significant or
permanent it is, but I've been very distressed by that fact.
REP. HENRY WAXMAN: You found a flaw in the reality...
ALAN GREENSPAN: Flaw in the model that I perceived is the critical functioning
structure that defines how the world works, so to speak.
REP. HENRY WAXMAN: In other words, you found that your view of the world, your
ideology, was not right, it was not working?
ALAN GREENSPAN: That is -- precisely. No, that's precisely the reason I was shocked,
because I had been going for 40 years or more with very considerable evidence that it
was working exceptionally well.”

So you can see that the man running monetary policy in the USA for 18 years was working under
a "flawed" framework. If the Fed chief, one formerly deemed “The Maestro”, has a flawed
understanding of our economic system then who can we really expect to understand all of this?
It's clear to me that no one really does understand it completely and that explains, in large part,
why the USA is in the position it is in today.

Much of this confusion is also derived from the Euro system, which is also a single currency
system (like the gold standard). The EMU is often confused as a flaw in fiat money. In reality, the
Euro proves why single currency systems are inherently flawed when they do not involve a truly
autonomous monetary issuer with monopoly supply of currency within a floating exchange rate
system. The nations within the Euro are analogous to the states within the USA. In this regard,
they are currency users and not currency issuers. Without floating exchange rates and/or a
central treasury there is no balancing mechanism that allows this currency union to function as
the USA does. The gold standard imposed similar constraints on the world and put trade deficit
nations at inherent risk. We can see from the Euro crisis that this sort of currency union causes
massive imbalances within such currency systems. Therefore, the ideas of the gold standard and
the Euro are not applicable to the monetary system in which the USA exists.

How Could It Be Possible That Our Leaders Don't Understand This?
I believe these misconceptions persist due to three primary reasons:
First of all, this is all highly counter-intuitive. Understanding the functions of an entire monetary
system is high finance. We cannot expect everyone to understand it and we should expect most
theories and outlines of the modern monetary system to be somewhat incomplete due to the
dynamic existence of modern economies.
Second, this system in its current format is not very old and most of the people in power currently
were educated by a generation in which this system was not largely applicable. Despite the fact
that the world changed dramatically in 1971 when Nixon closed the gold window, we continue to
work under theories and textbooks that don't fully account for this change. Therefore, the theories
of old run rampant in modern economic circles.
Thirdly, politicians and ideologues have a vested interest in keeping the American public from
understanding that the government is fundamentally different from a household, state or
business. If the American public understood Modern Monetary Theory they might be more
inclined to demand greater change - particularly in the ways that our banking system is designed.

Back To Basics
Getting back on track though - let’s understand a few things first:

1. We tax in order to create demand for the currency. In addition, it controls aggregate
demand or effectively, the money supply.
2. The bond market is a monetary tool. NOT a fiscal financing tool.
3. Foreigners do not fund our spending.
4. Money must be created before government bond auctions can occur and before taxes
can be enforced. Otherwise, there is no currency in the system to tax and no money to
raise via bond auctions. This is just basic logic in terms of the way the current system
works. It can be no other way.
5. Households, states, Europe and the gold standard are not remotely similar to the
modern monetary system in which the Federal government of the USA functions.
A Simple Example Of A Modern Monetary System

The following example should help clarify some of the concepts mentioned above. Please excuse
the simplicity, but this can be a mind-bending concept if you are textbook taught (trust me, I know
the feeling) so I will keep it simple:
On a journey around the world with members of the US Navy we become shipwrecked and find
ourselves on a beautiful island. There is a wonderfully productive citizenry there and they are
accepting and generous of us. They are impressed by our combat training, weaponry, etc and
hold us in high regard. We form a pact and what will later be known as a "government" whereby
my men offer protection and safety in exchange for acceptance into their society. We agree to a
government by the people and for the people and I am elected as their President. Economic
activity is the heart of this country and the people are innovative, enjoy hard work and reap the
benefits of their labor.

The people of this island once transacted using various items such as seashells that represented
debts amongst members of the society. Luckily, these innovative folks were wise enough to
create a computer system just recently. I propose that we modernize our economy and begin
transacting in a fiat currency so as to make trade more convenient and efficient. Lugging around
seashells grew tiresome and while they were quite pretty, they are largely useless. I issue
"reserve" notes and initiate an electronic system that tracks each citizen's transactions. These
notes, on their own, are not worth more than the paper they're printed on. However, they serve as
a convenient medium of exchange.
It's not free to live on the island, however, with all of these new resources and organized services.
So, we create a tax. This acts as the glue that binds our monetary system together. This makes
the citizens beholden to government via the "reserve" notes. They MUST have them in their
account on April 15th of every year. I’ve created demand while also fulfilling their desire to
transact conveniently and reliably. Why would they agree to this? Because I am offering them
protection among various other services in exchange for this small tax burden. Because this
island has a long standing feud with a neighboring island they are happy to pay this tax and sleep
well at night. Our currency union is bonded by this pact that was created by the people for the
people’s benefit.
This is exactly what the US government does. In return, they spend money on public works,
create jobs, spend money on furthering our nation's prosperity (in theory at least) and protection
of the nation (a military). It is essentially an acknowledgment that we are stronger as a united
state. As highly social animals, humans must recognize that there is a certain level of common
sense behind the formation of these nations that are ruled by “governments”. We form groups
because we are more likely to ensure our survival through cooperation. We don’t live in solitude.
The formation of governments is nothing more than a manifestation of this fact. The evolution of
the fiat monetary system is a step in this natural progression as the global economy has become
increasingly complex and dynamic.
As the services offered by the state increase and grow it's possible that this tax burden could
increase. It's important, however, that the role of the government not infringe on the prosperity of
the private sector to an undue extent. Remember, government is a tool that is to be utilized by the
citizens to further the private sector's prosperity. If the citizens on my island are productive and
innovative we can expect our overall quality of life to increase. If, however, I am corrupt,
mismanage my currency or produce currency in excess of my island's productive capacity I risk
currency collapse in the form of the public's rejection of my currency system.

What Gives Fiat Money Its "Value"?
What backs these notes we created? What gives them value? Ultimately, these notes represent
some amount of output and productivity that can be purchased. The notes in and of themselves
have no intrinsic value, but serve as a medium of exchange that allows the citizenry to exchange
various goods and services. The willingness of the consumers in the economy to use these notes
is largely dependent on the underlying value of the output and/or productivity, the government's
ability to be a good steward of the currency and the ability to enforce its usage. I like to think of
this as an interconnected bond between these various forces. If any link in the bond is broken the
nation's currency is at risk of collapse.

(Figure 1 - The fiat currency linkages)

The government cannot force the "value" of its currency on its citizens. The value of these notes
is ultimately determined by three key linkages:
1. Productivity
2. Currency management
3. Taxes & regulation
P
roductivity is vital in giving any currency its value. The goods and services that are produced by
the citizens and the value that other citizens are willing to pay for these goods and services is
what ultimately makes any fiat currency valuable. Therefore, government has an incentive to
promote productive output and maintain sound stewardship of its currency. Otherwise, they risk
devaluing the currency and possibly threaten the stability of their currency system. Paying its
citizens to sit at home doing nothing, buy cars they don't need or purchase homes they can't
afford are unproductive forms of spending. If government is corrupt in its spending and becomes
an institution that is mismanaged and detracts from the private sector's potential prosperity then it
is only right that the citizens revolt, denounce the nation's currency and demand change.
The autonomous nation's government, which is the organized body formed through
representation of the private sector, deems what is acceptable as currency. In the USA our
representatives have deemed that the currency is the US dollar.

This means that taxes are
payable only in the currency that the Federal Government deems it to be. When you consume
and produce in the USA you will incur a tax liability. As the state defines, this liability can only be
extinguished in the currency that the government deems as legal tender. This is important
because taxes act as a binding force in any fiat monetary system. You will attempt to obtain the
currency of the state in order to relinquish your tax liability.
While money is a creature of the state (that is, it can only be created and destroyed by the state)
this money is not necessarily valuable only because the state says it is valuable. The “value” of
the currency involves other linkages. Keynes once compared money to a theatre ticket:
“money is the measure of value, but to regard it as having value itself is a relic of the view
that the value of money is regulated by the value of the substance of which it is made,
and is like confusing a theatre ticket with the performance”.
This is an accurate portrayal of currency in a modern fiat monetary system. Government issued
fiat money, in and of itself, has no intrinsic value. The theatre ticket has no value aside from the
paper it is printed on, however, given the value of the performance citizens will be eager to
attribute a certain value to these tickets because they are deemed by the theatre as being the tool
of entry into the show. If the theatre mismanages the number of tickets in circulation they will
devalue the tickets. In much the same way, the US government deems the US Dollar to be the
ticket with which we can see (and interact in) the US economy. If the show is good (productivity is
high), the number of outstanding tickets are not mismanaged (government doesn't spend in
excess of productive capacity) and the tickets are sustained as the only form of entry into the
show (the tax system sustains itself) then the currency remains a viable medium of exchange. So
we can see how the linkages shown above work in tandem to give a fiat currency a particular
value.

There is one important fact here that cannot be overlooked, however. In order for the citizenry to
transact in my currency (and ultimately pay their taxes) I must spend some amount of currency
into existence FIRST. This is important to understand because I must issue notes BEFORE I can
tax. Therefore, you can see that I am not funding my spending by taxing. In fact, it is exactly the
opposite. I am funding the private sector's ability to pay their taxes when I spend money into
existence. When the citizens pay their taxes, the government doesn't "have more money". After
all, they have a computer system that credits accounts and prints up bills. It is impossible for them
to "run out" of money. So, from a very technical perspective, it is better to think of the government
as never having money.

But importantly, when I tax I am reducing the amount of currency in circulation by exactly the
amount of the tax. In this sense, taxes "unprint" money. A tax reduction is the accounting
equivalent of spending more money (except the money doesn't necessarily get allocated via the
government political process as directly as it would via spending). So, we can see that spending
is like a tax cut (both tax cuts and spending add net financial assets to the private sector) and
spending cuts are the accounting equivalents to tax hikes (as both reduce net financial assets to
the private sector). Treasury Secretary Timothy Geithner directly stated this in a recent media
appearance:

"Spending cuts are the same thing as a tax increase."
How do I enforce your use of these "reserve" notes? I create jobs via a military and a police force
and pay them well (notice that when government spends money they are simply buying up private
sector productivity). Don’t want to pay your taxes? Say hello to officer Joe. A group doesn’t want
to pay their taxes? They can protest, but if you get out of control I will throw you in jail. In other
words, don’t question the currency or else. This might sound harsh to some, however, any sound
currency system must have rules and regulations that dictate proper use of the nation's currency.
Without rules and regulations that help sustain the fabric of the monetary system the government
that Americans have built long and hard to create would become increasingly fragile. The United
States Secret Service was in fact created specifically for this purpose - to protect the US Dollar.

There is arguably, nothing more important to government stability than maintaining the value and
faith in the nation's currency.
If an economy is productive, the autonomous nation can enforce the use of said currency, and as
long as we are sound stewards of the currency there should always be demand for it. In other
words, trust in the national currency is safe as long as the rule of law is maintained, government
is a good steward of the currency, citizens are productive and I maintain my ability to tax you. If
my government becomes corrupt, spends well in excess of productive capacity or mismanages
the economy then there is an increasing chance of currency collapse (hyperinflation).
Inflation becomes problematic when a nation’s spending outstrips productive capacity. This is a
real reduction in our standard of living. Ultimately, the real benefit of our labor is the time it
provides us. Adam Smith once said:
“The real price of everything, what everything really costs to the man who wants to
acquire it, is the toil and trouble of acquiring it.”
There is a theoretical level of infinite demand in a capitalist economy. What I mean by this is that,
in an extreme sense, we can consume all that time will allow. If you were unconstrained by time
you could, in theory, consume all that the entrepreneur can produce. Theoretically, this chicken
and egg story can go on forever. Of course, the greatest luxury of all is quite finite. We are
always constrained by time. The entrepreneur offers us the opportunity to take advantage of the
ultimate luxury by giving us more time.
How does the entrepreneurial process work to create real wealth?
The best way to envision this idea is to use an example. Alexander Graham Bell is one of the
greatest innovators in American history. So what did Mr. Bell do exactly? He created a more
efficient way to communicate by inventing the telephone. Clearly, communication is vital part of
human life. And in theory, there is infinite demand over the long-term to communicate.
At some point in his life, Mr. Bell sat down and probably said something to the extent of – “it
would be far more efficient if I could talk to Mr. Smith immediately as opposed to sending him a
telegram”. Clearly, this desire was not unique to him. And all Mr. Bell did was fill a demand by
inventing a product which helped consumers meet this demand. But the important role that Mr.
Bell played in the job creation process is not that he necessarily created jobs independent of his
consumers (as we showed above, they are interdependent). After all, there were plenty of
messengers already employed and working before the telephone came into being (Mr. Bell
actually destroyed their jobs).

What Mr. Bell did is give his consumers more time to consume other goods and services. He
reduced the toil and trouble of having to acquire things by providing them with a product that
made their lives more efficient and productive. Just imagine all the ways that the telephone
improves our quality of life and makes us more efficient. The businessman in NYC no longer had
to wait for the telegram from his business partner in Chicago to discuss their new business
decisions. Instead, he picked up a telephone and a decision was made in a matter of minutes.
There are innumerable (better) examples of the way that a simple innovation such as Mr. Bell’s
helps us to improve productivity, efficiency and ultimately our standard of living.
It’s not uncommon to hear that the US dollar has fallen 90% since the Federal Reserve was
created. This is technically true, but despite its decline in purchasing power, our real standard of
living has increased dramatically because we have become so much more productive.

The key point here is that improvements in our standards of living provide us with the ultimate
form of wealth – they give us more time to do the things we think will help us achieve happiness
(whatever that might be to any particular person). This is the ultimate form of wealth. The
entrepreneur gives us more time to consume more goods and services and do the things we want
in our lives. If we look at the modern economy we can see how streamlined this process has
become. For instance, last night at 7 PM I put my laundry in the wash, I put the dishes in the
dishwasher, ordered dinner from a local restaurant and went upstairs into my office where I did an
hour of work. At 8 PM my dinner arrived, my laundry was done, I ate dinner on a fresh clean
plate and I had done an hour of work in this period. Imagine trying to do all that 100 years ago?
How long would it take you? Days? Perhaps even weeks? That is a remarkable increase in
living standards. And why are we able to do all these things in such a condensed period of time?
Why am I able to consume so much more than I could have 100 years ago? Because
entrepreneurs created a machine that cleans my clothing for me, they created a machine that
cleans my dishes for me, they created an oven that cooks my dinner, a car that allows the
deliveryman to deliver my dinner, and invented a computer which allows me to efficiently and
effectively accomplish work. We live in a remarkable world. If, as a people, we are not
productive and our government is a poor steward of our currency then it’s not unimaginable that
our real living standards will stagnate or even decline.

Hyperinflation is a very different phenomenon from inflation (which is quite normal in a fiat
currency system). In recent years we have heard many hyperinflation predictions based on
misunderstandings of banking and the monetary system. Hyperinflation is a disorderly economic
progression that leads to complete rejection of the nation's currency. It is not merely a monetary
phenomenon, but a political phenomenon as well. Throughout history, hyperinflations have
tended to occur not because the state prints money, but because of exogenous factors. The
primary causes have been decline in productivity, corruption, regime changes, ceding of
monetary sovereignty and loss of a war. These rare events have tended to lead to a decline in
tax receipts or an increase in the money supply ultimately resulting in decline of the currency.9
Just to recap - on my island I do not borrow from governments or tax to spend as I would if my
currency were backed by gold. Interestingly, I can’t TAX you until I’ve credited your accounts with
"reserve" notes. There is no money to be taxed otherwise. So, in effect, I have to SPEND in order
to TAX (counter-intuitive to what you have been taught). Taxing debits your accounts (saps
liquidity) and spending credits your account. On my island, I am never revenue constrained. If you
don’t pay your taxes I will throw you in jail and confiscate your money. But that doesn’t mean I
can spend more when I tax. What do I care if you send me your "reserve" notes? I can just press
a button and credit my “spending” account right after I shred your tattered looking cash. This is
what the US government actually does. Taxation is essentially a form of maintaining control of
private sector spending. In this sense, taxes serve no funding purpose, but merely serve to
regulate aggregate demand. In fact, if you pay your taxes in cold hard cash the IRS will most
likely shred those dollars. They don’t put them in a bag and mail them to the Treasury so they can
go “spend” it. The only reason they might keep the dollars is if they are in good condition so they
can go back out into circulation. When the US government wants to spend money they simply tell
men and women to walk into a room and credit accounts in a computer system.
What's The Catch? This Sounds Like A Free Lunch


So what’s the bogey here? What’s the catch? Because surely you must be asking yourself why
this sounds like a free lunch. We can just spend to our hearts content, right? Absolutely not. The
bogey here is inflation which is constantly moving up and down with the amount of money in the
system based on my tax rate, spending, borrowing, etc. Thus, government cannot just spend
and spend and spend or the extra dollars in the system will chase too few goods and drive
up prices. It’s important to understand that government cannot just spend recklessly. This
is important so I’ll say it again. This does not give the government the ability to spend and

spend and spend. If they spend in excess of productivity and tax too little they can create
mal-investment and inflation. Likewise, if the government taxes too much and spends too little
they create a government surplus and private sector deficit (by accounting identity). This can
result in deflation and/or excess private sector debt levels as the private sector literally suffers a
dollar shortage.

Some people claim that Modern Monetary Theorists say deficits don't matter. That is a vast
misrepresentation of MMT. No Modern Monetary Theorist would ever say such a thing. Deficits
most certainly do matter. Maintaining the correct level of deficit spending is, in many ways, a
balancing act performed by the government. It is best to think of the government's maintenance
of the deficit like a thermostat for the economy. When the economy is running cold the deficit can
afford to be higher. When it is hot the deficit should be lower. Because there is no solvency
concern in the USA (as there is in the revenue constrained European nations) the only concern is
inflation or possible hyperinflation.

It's also important to note that spending by the government must be focused on its efficiency. If
spending is misdirected or misguided there is a very real possibility that this spending will simply
result in higher inflation that is not offset by increased productivity. If you pay people to sit on
their couches all day long there is no reason to believe why this sort of government policy will not
result in long-term economic decline in the citizenry's standard of living. Living standards,
ultimately, come down to the private sector’s ability to produce and innovate. The USA is
extremely wealthy not because our government issues a lot of money, but because we are an
extremely productive nation. The power in capitalism is the ability to offer its users more time.
This occurs via innovation, creativity and productivity. In the USA we live much fuller lives than
we did 100 years ago. This is the power of innovation and productivity at work. What took many
days 100 years ago (doing your laundry for example) now takes a few hours (and you can spend
your time doing something else as the washing machine goes!). Therefore, government has an
incentive to promote productive output and maintain sound stewardship of its currency.
What Role Does The Bond Market Play In All Of This?
In terms of the bond market, the issuance of bonds does not serve the same purpose it did under
the gold standard. We actually issued bonds because we were revenue constrained (not enough
gold reserves at all times to fund spending without creating inflation). In the modern monetary
system bonds fund nothing. It's important to note that the bond market is largely a relic of the
gold standard. The system did not undergo the overhaul that would have been possible in 1971
when we became a completely autonomous currency issuer. Therefore, the system of old
remains largely intact and it remains widely believed that it serves the same function that it did
under a revenue constrained monetary system.
Bond issuance is a relic of the gold standard that serves only to help the Fed hit its target interest
rate (a pure monetary operation to control the Fed Funds Target Rate). It can also be thought of
as another form of government spending because a treasury bond is basically a savings account.
Disbursements in the form of interest on US government bonds add to the budget deficit and
increase private sector net financial assets. People think this is government "debt" because
Congress mandates the issuance of bonds (this is primarily due to misconception and the need
for accountability), but it’s not accurate to think of the government as having “debt” when that
liability is essentially issued to itself in a currency that it can willingly create. As I’ve mentioned
several times before, there is no such thing as the USA not being able to pay off the liabilities
which are denominated in a currency which it can create out of thin air. Warren Buffett recently
made this point at an investor conference:
“The United States is not going to have a debt crisis as long as we keep issuing our debts
in our own currency. The only thing we have to worry about is the printing press and
inflation.”

As a monopoly supplier of currency in a floating exchange rate system the USA simply spends
money when it wants to. Like it or not, men and women walk into a room and type numbers into
computers. There is no constraint in the government's ability to spend (except for the public's
willingness to allow this spending). The amount of spending that is done by the U.S. government
is intended to meet some public necessity or purpose (some of which is good and some of which
is not) – population growth, economic growth, public services, etc.
The issuance of government bonds is merely a monetary tool that helps the Federal Reserve to
control the overnight rate. It is not a fiscal financing tool. To understand this point we can review
government bond auctions in the USA. These auctions are carefully orchestrated events that are
designed not to fail – that’s why they never do. But don’t take it from me. Take it from the NY Fed:
“Staff on the Desk start each workday by gathering information about the market’s
activities from a number of sources. The Fed’s traders discuss with the primary dealers
how the day might unfold in the securities market and how the dealers’ task of financing
their securities positions is progressing. Desk staff also talk with the large banks about
their reserve needs and the banks’ plans for meeting them and with fed funds brokers
about activities in that market.

Reserve forecasters at the New York Fed and at the Board of Governors in Washington,
D.C., compile data on bank reserves for the previous day and make projections of factors
that could affect reserves for future days. The staff also receives information from the
Treasury about its balance at the Federal Reserve and assists the Treasury in managing
this balance and Treasury accounts at commercial banks.
Following the discussion with the Treasury, forecasts of reserves are completed. Then,
after reviewing all of the information gathered from the various sources, Desk staff
develop a plan of action for the day.”

So let’s connect the dots here. Treasury auctions bills, notes and bonds to “finance” its spending.
It announces these auctions periodically. In the case of bills it announces the auction each week
on Monday and the bills are auctioned that Tuesday. This is due to a Congressional mandate
because our politicians believe we must finance all of our spending via bond auctions – a myth
that has persisted since moving off the gold standard.
What’s important to note here, however, is that Treasury and the Fed are working in partnership
to track deposits and maintain a record of reserves in the system (Fed and Treasury are
essentially the same entity as far as operations are concerned). William McChesney Martin, the
longest ever serving Chairman of the Fed has actually said as much:
"There was a very real point . . .that the primary direction must come from the Treasury
and that anything done by the Federal Reserve must be coordinated with the
Treasury."

The whole myth of "Fed independence" generates a great deal of confusion. Make no mistake,
the Fed is not an independent entity. They pass close to 100% of their profits on to the US
Treasury and work in close coordination with the government in everything they do. The myth of
independence is intended to create the perception of no political bias. But do not be fooled - the
Fed is very much a part of the US government. They might maintain their political independence,
but they are very much a part of the US government.
This coordination is important because their reserve tracking and auction operations are actually
just a monetary tool and NOT a fiscal financing tool. In this regard, MMTers like to view the
Treasury and Fed as a consolidated entity. When the Treasury auctions off bonds it does so only

after discussing matters with the Fed’s reserve forecasters. In essence, the government is
soaking up reserves that had already been spent into existence in order to target the overnight
rate. It can be no other way. Without Treasury having first spent the money into existence there is
no money with which the Primary Dealers can “fund” the deficit.
This doesn’t mean auctions can’t fail. They can. But quite honestly, it wouldn’t matter all that
much as the reserve drain would simply take place at a later date. The auctions are designed to
succeed because they are merely targeting reserves that they KNOW are in the system. There is
no red phone at Treasury that Tim Geithner uses to call China before it spends money. No red
phone to Japan. There is only a phone to the Fed where reserve forecasters communicate with
the Treasury and the Primary Dealers to determine the size and scope of the necessary auctions.
If the Fed were to find that there were not enough reserves in the system to settle the bond
auctions, as the monopoly supplier of reserves, they would make them available. Thus, when
auctions are completed the reserve drain is accomplished, Congress thinks we have “funded” our
spending and we can all go along our merry way.

Most importantly though, these actions help the Fed to control its overnight target rate. Before
the Fed began paying interest on reserves the lack of auctions would have resulted in excess
reserves in the banking system and a loss of control of the overnight rate as banks bid down the
rate in an effort to lend their excess reserves. This would drive the rate to 0%. Now, with the Fed
paying interest on excess reserves, the Fed is able to maintain excess reserves in the banking
system by establishing a floor at the rate of interest it pays.
So you can see that this is all well orchestrated monetary policy. It is not a fiscal financing
operation. The Fed and Treasury are working in tandem with the Primary Dealers to track
reserves. After all, part of the agreement in becoming a Primary Dealer is to make a market
in treasuries:

“The primary dealers serve, first and foremost, as trading counterparties of the Federal
Reserve Bank of New York (The New York Fed) in its implementation of monetary policy.
This role includes the obligations to: (i) participate consistently as counterparty to the
New York Fed in its execution of open market operations to carry out U.S. monetary
policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii)
provide the New York Fed’s trading desk with market information and analysis helpful in
the formulation and implementation of monetary policy. Primary dealers are also
required to participate in all auctions of U.S. government debt and to make
reasonable markets for the New York Fed when it transacts on behalf of its foreign
official account-holders.”

Therefore it is misleading to imply that the auctions might fail due to a lack of demand or some
sort of funding failure. The Primary Dealers are required to make a market in government bonds.
If they wanted, they could hedge their exposure to government bonds, but part of the agreement
in becoming a primary dealer is helping the government sell their bonds so demand is never
really an issue.

It's also important to understand that foreigners do not fund the spending of the USA. As a
current account deficit nation, the US government can appropriately be thought of as a net
currency exporter. This means that we send pieces of paper over to foreign nations in exchange
for goods and services. In doing so these nations get the benefit of employing millions of
domestic workers via their business partnerships with US corporations. But this doesn't mean
they "own" the USA.
When China receives dollars they can only do a handful of things with these dollars. China, for
the most part, chooses to invest these dollars in US Treasuries. They have attempted to use
their dollars to purchase other USD denominated assets, but the US government has squashed
those efforts. So, instead of leaving these pieces of paper to collect dust in vaults, they open
what is the equivalent of savings account with the US government. Most importantly though, if
you study the bond auction data from the USA you'll find that indirect foreign bidders make up a
very small portion of the auctions. This is due to the fact that the Primary Dealers are designed to
be able to take down the entire auction. As I discussed above, this is their primary role in the
agreement in being a PD. So, while China can choose to buy bonds, it is by no means necessary
that they do so. China could literally leave the market for US government bonds and the show
would go on.


This can be best seen in a recent US government 10 year bond auction. This auction occurred
just weeks after QE2 ended and just before the debt ceiling debacle occurred in July 2011 so one
would have expected this to be a very unstable auction. In fact, it was business as usual. As you
can see below, the US government was able to auction off $21B in 10 year notes with the
Primary Dealers tendering more than 2X the entire auction. Indirect bidders tendered almost half
the auction, but were not needed at all to accomplish the reserve drain. The bid to cover at 3.1
was extremely strong.

(Figure 2 - 10 Year Note Auction)

Why does any of this matter you ask? Because once you realize that foreigners and bonds in
general do not fund our spending you begin to realize that much of what your textbook taught you
about our monetary system is simply not true. A government with a monopoly supply of currency
in a floating exchange rate system has no solvency risk unlike a nation such as Greece that
exists in a single currency system with what is essentially a foreign central bank. A government
with a monopoly supply of currency in a floating exchange rate system is never revenue
constrained.

The policy implications in such a system are astronomically different – particularly for a nation
suffering a balance sheet recession (as I believe we are now). So, when you hear politicians and
pundits talking about the national debt and our imminent bankruptcy you can be certain that they
have little to no idea what they are actually talking about and instead are using fear mongering
tactics to promote a political perspective (one that usually involves separating the middle class
from its savings).

The Importance Of Understanding Sectoral Balances

The US government is never revenue constrained. They are not like a household, business or
state government. We don’t need China to buy our bonds in order to spend. China gets pieces of
paper with old dead white men on them in exchange for real goods and services. They can either
hold that money in a checking account at the Fed OR they can do what they wisely do and invest
those pieces of paper in what is actually a savings account at the Fed. We also don’t need taxes
to spend although taxes play a vital role in helping to regulate aggregate demand. It can be
helpful to understand this concept by understanding some simple accounting identities behind
government spending.

The deficit of the entire government (federal, state, and local) is always equal (by definition) to the
current account deficit plus the private sector balance (excess of private saving over investment).
To be more precise: net household financial income = current account surplus + government
deficit + Sbusiness non-financial assets. The private sector surplus represents the net saving of
the private sector (households and businesses) from income after spending, while the public
sector deficit is the government’s deficit. This is the essence of the sectoral balances approach
made famous by the late great Wynne Godley. It can be visualized with the following diagram:
(Figure 3 - Sectoral Balances)


The sectoral balances can be broken down according to GDP:
GDP = C + I + G + (X – M)
C = consumption
I = investment
G = government spending
X = exports
M = imports

Or stated differently;
GDP = C + S + T
C = consumption
S = savings
T = taxes

From there we can conclude:
C + S + T = GDP = C+ I + G + (X – M)
If rearranged we can see that these sectors must net to zero:
(I – S) + (G – T) + (X – M) = 0
(I – S) = private sector balance
(G - T) = public sector balance
(X – M) = foreign sector balance
20
You can see this different version of the above chart in visual form by viewing the sectoral
balances in the USA going back to 1952:
(Figure 4 - Sectoral Balances part 2)
What you can essentially see here is that the USA has run budget deficits for the majority of the
last 60 years (in fact well over 200 years). More importantly, however, the domestic private sector
balance has remained in surplus until the late 90's. This was in large part due to the government's
desire to run budget surpluses as we believed the government sector needed to "save" in order to
spend. As voters cheered the "fiscal prudence" of Bill Clinton they had no idea that he was
helping to contribute to the bankruptcy of the private sector and ultimately lead us towards one of
the greatest economic calamities of the last 75 years. In essence, the surplus years of the
Clinton Presidency removed net financial assets from the private sector and forced the private
sector to sustain their standard of living by acquiring money in the only other way possible - by
going into debt. What would ensue over the course of the next 10 years would be the largest
debt bubbles in the history of modern economies.
Another important conclusion from the above analysis is that you'll see that all three sectors
cannot be in deficit or surplus at the same time. This is impossible as one sector's deficit is
another's surplus. You will often hear politicians say "we all need to tighten our belts". When it
comes to political rhetoric that sounds great, but when it comes to reality it is simply not rational. If
the private sector desires to net save then the public sector must spend. Both cannot save
without causing adverse effects to the economy. If, as we saw in 1999, the private sector and
public sector both attempt to save then there is an increasing likelihood that the private sector will
attempt to sustain its standard of living by taking on excessive levels of indebtedness. In a world
with global trade we are certain to have trade deficit and trade surplus nations. This means that
once you input the foreign sector into the above equation you are, by definition, going to have
countries that MUST run government budget deficits or ultimately suffer shrinking economies.

"Money" Is Not "Wealth"
This accounting identity does not merely mean the government can spend money and make the
population wealthy. Money is not wealth. Money is simply the medium of exchange that allows
citizens to exchange and transact in the underlying goods and services. If a government spends
money in excess of a nation’s underlying productivity it will devalue this "money" and generate
inflation. This would result in too much money chasing too few goods. So, the key for government
is to balance the amount of money in the system in order to keep the temperature just right - not
too hot and not too cold.
So, MMT does not claim that the government can just recklessly spend. But it’s imperative that
the government spend SOME money otherwise they are simply debiting the system each year via
taxation without ever crediting accounts. If Americans are to transact in the currency of the US
government then the government must first issue the currency before it can be used to transact.
For instance, just ask yourself what would happen if the government imposed a one time 100%
asset tax? The private sector would instantaneously be without money. How would they spend?
How would they invest? How would they pay taxes? The economy would collapse and the
government would be “rich”. The government balance sheet would be clean, but the private
sector balance sheet would be destroyed. Not a plan for economic prosperity. After all, we do not
run our government for the benefit of government, but for the benefit of the private sector.
Government is merely a tool that can be utilized to further private sector prosperity.
Many financial theorists actually believe the Great Recession (and the Great Depression) was
caused in part by account SURPLUS. You’ll notice that both events were preceded by great
periods of “fiscal competence”, ie, budget surpluses. If you review the history of the United States
you can garner a greater appreciation for this idea that government is not a household and that
surpluses are not the ideal goal for the government balance sheet. Professor Randall Wray
elaborates on this fact:

“With one brief exception, the federal government has been in debt every year since
1776. In January 1835, for the first and only time in U.S. history, the public debt was
retired, and a budget surplus was maintained for the next two years in order to
accumulate what Treasury Secretary Levi Woodbury called “a fund to meet future
deficits.” In 1837 the economy collapsed into a deep depression that drove the budget
into deficit, and the federal government has been in debt ever since. Since 1776 there
have been exactly seven periods of substantial budget surpluses and significant
reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823
to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from
1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920
to 1930 by about a third. Of course, the last time we ran a budget surplus was during the
Clinton years. I do not know any household that has been able to run budget deficits for
approximately 190 out of the past 230-odd years, and to accumulate debt virtually
nonstop since 1837.
The United States has also experienced six periods of depression. The depressions
began in 1819, 1837, 1857, 1873, 1893, and 1929. (Do you see any pattern? Take a look
at the dates listed above.) With the exception of the Clinton surpluses, every significant
reduction of the outstanding debt has been followed by a depression, and every
depression has been preceded by significant debt reduction. The Clinton surplus was
followed by the Bush recession, a speculative euphoria, and then the collapse in which
we now find ourselves. The jury is still out on whether we might manage to work this up
to yet another great depression. While we cannot rule out coincidences, seven surpluses
followed by six and a half depressions (with some possibility for making it the perfect
seven) should raise some eyebrows. And, by the way, our less serious downturns have
22
almost always been preceded by reductions of federal budget deficits. I don’t know of any
case of a national depression caused by a household budget surplus.”14
So you can see what occurs when the government runs a surplus or fails to sufficiently spend in
the currency in which the private sector must transact. It effectively bankrupts the private sector.
In 1929 and 1999, the government had debited too many accounts and forced the private sector
into deficit. This results in the private sector borrowing what it can’t actually get its hands on as
citizens attempt to sustain their standard of living. The risk is full-blown debt deflation due to
excessive debt levels (because you borrow to make up for the income shortfall). This
phenomenon was even more pronounced during the 1800's when we suffered SIX depressions.
Conclusion
In sum, most of what we have been taught in school is based on a now defunct monetary system
(the gold standard). MMT is not a theory, but merely a description of a modern fiat currency
system. While its description of the modern monetary system is accurate, it is by no means a
holy grail. And those who apply policy prescriptions are merely utilizing the realities of the system
to apply what they believe are sound uses of the system. It does not mean the government can
just credit accounts and create real wealth. No, real wealth is only created through real
productivity. And while government can't create this wealth it can be used as a tool to help the
private sector to achieve prosperity. I think it’s important to understand that government is not
always bad or that government spending is always evil. In fact, government serves a vital
purpose within our society. How involved that government is in the day to day lives of its citizens
is to be decided by the citizens themselves.
I believe MMT and Functional Finance provide a more accurate portrayal of the monetary system
in which we reside in the USA and in many other autonomous states throughout the world. It is
my hope that a greater understanding of our monetary system will result in a less dogmatic, more
pragmatic and more rational perspective of our economy so as to help us all in achieving the
prosperity we desire.
23
References:
1 - Mosler, W. (1995), Soft Currency Economics
2 - Wray, R. (2007), Endogenous Money: Structural and Horizontalist
3 - Roche, C. (2010), MMT & The Concept of Vertical and Horizontal Money Creation
4 - Carpenter, S & Demiralp S. (2010), Money, Reserves, and the Transmission of Monetary
Policy
5 - Edesess, M. (2011), Beyond the Efficient Market Hypothesis
6 – Wikipedia (2011), Legal Tender Cases
7 – Keynes, JM. (1914), The Royal Economic Journal, vol. XXIV
8 – United States Secret Service, Know Your Money
9 – Roche, C. (2011), Hyperinflation – It’s More Than Just a Monetary Phenomenon
10 – Roche, C. (2011), Buffett’s Silly Talk About the US Debt
11 – FRBNY, Open Market Operations
12 - FOMC, Minutes, September 12, 1961, p. 49
13 – FRBNY – Administration of Relationships with Primary Dealers
14 – Wray, R. (2010), The Federal Budget Is Not Like a Household Budget
Miscellaneous Works Cited:
Understanding Modern Money, By L. Randall Wray
Soft Currency Economics, by Warren Mosler
7 Deadly Innocent Frauds, by Warren Mosler
Interest Rates and Fiscal Sustainability, By Scott Fullwiler
It's Time to Rein in the Fed, By Scott Fullwiler and L. Randall Wray
9 Myths We Can't Afford, by L. Randall Wray and Marshall Auerback
MMT and the Operational Realities of Our Monetary System, By Scott Fullwiler
Modern Central Bank Operations - The General Principles, Scott Fullwiler
Sector Financial Balances Model of Aggregate Demand, by Scott Fullwiler
24
Helicopter Drops Are Fiscal Operations, By Scott Fullwiler
A collection of Essays by Wynne Godley, Wynne Godley
The Financial Instability Hypothesis, Hyman Minsky
The Natural Rate of Interest is Zero, Warren Mosler & Mathew Forstater
The Neo-Chartalist Approach To Money, By Randall Wray
Protecting the Budget From Intergenerational Warriors, By Galbraith, Mosler, Wray
The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus, James
Galbraith
* This paper will be updated and improved periodically, if not frequently.
** A Special thanks to Warren Mosler, Scott Fullwiler and Marshall Auerback who have helped
me enormously with this work.

here is the original PDF from their website

now that we understand MMT why is the fiscal Cliff important

!







a bit more on the condition of the goverment liabilities

Here are some really cool videos and I want to give all credit to the "Khan Academy" for all the videos I posted and how clearly he comes across with the concepts that I want to convey to newbies and pros alike.

here is a little series on the situation that Greece finds themselves in at the moment.

!








further on the European Debt crisis
an article by wikipedia

http://en.wikipedia.org/wiki/Europea...gn-debt_crisis

and Again through my own research I found it to be reliable I encourage you to check their sources for yourself

here is another article
http://www.npr.org/blogs/money/2012/...rope-explained

looking at purchasing power parity using the big mac index.

http://en.wikipedia.org/wiki/Big_Mac_Index

http://www.economist.com/node/21542808


an article written by Forexstrategist
http://www.theforexstrategist.com/th...rency-markets/

I don't think I have to stress how important macroeconomics is for the Foreign exchange markets, again Thanks to khan academy here are some videos on macro Economics that can help understand how to tie economic factors with current exchange fluctuations.

due to the fact that the videos I am posting here are slowing down the server I will delete them but will give you the source you can go to to watch them for yourself.

This website is incredibly informative and If you are an aspiring trader YOU HAVE TO DO YOUR JOB, watch the videos understand them.
take what you can knowledge can never hurt you in this game. Especially when the calendar is full of macro econ releases.

http://www.khanacademy.org/finance-e...d-expenditures here is where you can see the full list of videos.

this playlist contains
Financial Markets by Professor Schiller

http://www.youtube.com/playlist?list=PL7BCC1476DBC62903
Financial theory by Yale university


http://www.youtube.com/playlist?list=PLD1F8A840ADDBB06B

quantitative finance
http://www.youtube.com/playlist?list=PL8DC1113ADB63358E

I will stop for now.......discussion questions, clarifications are now open......
in my next post I will talk to you about Neuroscience, psychology and how it is a horrible Idea to rely on patterns....as our minds are wired to seek patterns and use predictions through sensory inputs.

once we establish a grounding in the fundamental forces of what moves price, we can explore the extrapolations and ..the statistics as well as simple mathematics used in finance.

Successful long term trading is a lot more than patterns, and lines on a chart to even being to use a chart one hast to know what is a chart?

When you manage to throw all that stuff you posted in a pot and boil it down into a trading method please let me know.

sci·ence (shttp://img.tfd.com/hm/GIF/imacr.gifhttp://img.tfd.com/hm/GIF/prime.gifhttp://img.tfd.com/hm/GIF/schwa.gifns)

2. Methodological activity, discipline, or study:

scientific [ˌsaɪənˈtɪfɪk]
3. conforming with the principles or methods used in science

Think deeply.

Cheers

Yes, a million times yes! So much to read and watch in this thread. (And a lot of the khan videos, too.)

And the specific trading method is......... (opening the envelope)

TADA !!!!! (envelope is empty)

What? (is it exactly) ?

?
?
No winner! The jackpot will increase with Gnarly taking it all ??

Jesus christ...

i was interested after reading the first paragraph, then after scrolling down i realize this thread's IQ is too high for me..

i'm gonna go read about threads about how to turn $100 to $1M - that i can i understand.

Knowing what you know about capital markets. Being December the last month of the year. Looking at the potential market moving events this month what bias do you think the market will have? Has it all been priced in? Taking historical volatility of the instruments you're trading what are the likely targets? How is price reacting to them?.what is your VaR? Only you are responsible for your trades. I merely want to help you make better decisions.

I'm not sure if any of the above qualifies as scientific in the way that you describe:


It sounds more like conjecture, best estimate or a judgement based on incomplete drivers and best guesses. I'm interested in a scientific look at exchange rates but I'm doubtful that it can be arrived at through economics (a soft science at best). But I will follow along and add any thoughts where I feel I have something to add.

yes....I see what you are saying..... economics is the "Dismal science" and with so many variables, factors, forces, and human emotions the water gets muddy quickly.

Perhaps I should have worded my thread differently....many a mathematician has tried to derive purely mathematical and predictable, testable, falsifiable formulas one of the most promising was the Black-Scholes-Merton option pricing model which dynamically hedged a position but when Russia defaulted we know what happened to the elegant equation along with the entire market due to leveraged positions they held (thankfully the Fed stepped in).

I digress .....I see how trading cannot be exactly like physics or Healthcare for that matter but at least I want to continue this thread to start intelligent discussions grounded on real drivers, not hocus pocus superstitions that the user of these said techniques have no idea if they actually work or not..

Ok good points regarding Black Scholes and LTCM and good start, let's see where this goes! I think though in spite of what I said, the market microstructure field is becoming more scientific by using tools from science (time series analysis) and different disciplines more than the macro economics field. Microstructure seems to be focusing on the empirical reality of the market and then attempting to explain why things are the way they are, rather than going around the back way: theory first and then attempting to justify theory with evidence or proofs. I think working from the empirical to the theoretical is the right way, but that's just my opinion.

By the way while on the topic of LTCM, I just read in Hedge Fund Wizards the interview with Edward Thorp that he came up with the Black-Scholes formula independently and was using it to trade his fund (without publishing it) because he felt it was too big an advantage to share.

HUH?! I don't mean to be rude but "thankfully the fed stepped in"? Are you joking? The LTCM bailout opened the door for too big to fail and subsequent 4 TRILLION in WS bailouts.....And look where we are now.

WOW Red Lion, you posted a lot of good stuff already! Gosh, in my case I will need some time to digest this huge amount of data.

Thanks for the effort in compiling and posting it.

Now that said, let me point that every video and article you posted is essentially a "theory", meaning that it may make sense but
it can be wrong.

Experts, or should I say "experts", can come up with explanations that will seem to explain things but will indeed (Internationale or not)
sending you away from the truth.

Intentional, when they want people to believe in something so they can profit from it, and unintentionally when they just got it wrong.

A good example of intentional misleading can be seeing in the big institutions like the FED, BIS, IMF etc. If you analyse it, they have no
gain in keeping people well informed so I would take all their publications with a grain of salt.

Unintentional examples would be people like Marc Faber, Peter Schiff etc. Marc Faber changes his opinions as CNBC changes their headlines. Peter Schiff is calling for a massive hyperinflation Armageddon for the last 7 or 8 years, so you get the picture.

They are all occasionally right and in time their predictions can become right due to the fact that they threw so much poop in the air that something end up sticking.

So my point is that in order to get to a true empirical/scientifically proven understanding of the foreign exchange market one has to be extra careful about the data's source.

4.6 billion dollar loss and represented a risk to various counter parties that in turn would have potentially caused contagion should have been allowed to get out of hand by the Fed? I fail to see where the joke is.

I'm all for bashing the FED and the government as a good American I distrust Washington, however, I dare claim that the actions taken by the fed have absorbed and contained to a certain extent what would have been massive TRILLIONS of dollars in toxic assets.

I remind you that we have GDP growth (slow but growth non the less), we avoided a deflationary spiral, and inflation is so far subdued. I can imagine a scenario where things could have been much much worse had the fed not acted as lender of last resort.

Interesting excerpt from : paper by Carol L. Olser "Brandeis University"

"Technical trading is widespread in foreign exchange markets. Taylor and Allen (1992) show that 90 percent of chief dealers in London rely on technical signals. Cheung and Chinn (2001) find that technical trading best characterizes thirty percent of trading behavior among U.S. dealers and the fraction had been rising. Similar evidence has emerged for Germany (Menkhoff 1997) and Hong Kong (Lui and Mole 1998).
Trend-following technical strategies generate positive-feedback trading. Froot and Ramadorai (2005) present evidence for positive-feedback trading among institutional investors: their results indicate that, for major currencies vs. the dollar, a one standard deviation shock to current returns is associated with an 0.29-standard-deviation rise in institutional-investor order flow over the next thirty days.
Contrarian technical strategies generate negative feedback. For example, technical analysts claim that “support and resistance” levels are points at which trends are likely to stop or reverse, so one should sell (buy) after rates rise (fall) to a resistance (support) level. Support and resistance levels are a day-to-day topic of conversation among market participants, and most major dealing banks provide active customers with daily lists of support and resistance levels.
Option hedging also generates both positive- and negative-feedback trading. To illustrate, consider an agent who buys a call option on euros. If the intent is to speculate on volatility the agent will minimize first-order price risk (“delta-hedge”) by opening a short euro position. Due to convexity in the relationship between option prices and exchange rates, the short hedge position must be modestly expanded (contracted) when the euro appreciates (depreciates). The dynamic adjustments therefore bring negative-feedback trading for the option holder and, by symmetry, positive-feedback trading for the option writer.
Barrier options – which either come into existence or disappear when exchange rates cross pre-specified levels – can trigger either positive- or negative-feedback trading and the trades can be huge. Consider an “up-and-out call,” a call that disappears if the exchange rate rises above a certain level. If the option is delta-hedged it can trigger substantial positive-feedback trading when the barrier is crossed: since the short hedge position must be eliminated, the rising exchange rate brings purchases of the underlying asset. The entire hedge is eliminated all at once, however, so the hedge-elimination trade is far larger than the modest hedge adjustments associated with plain-vanilla options. Many market participants pay close attention to the levels
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at which barrier options have been written, and make efforts to find out what those levels are. Related option types, such as TRNs, also trigger substantial feedback trading but tend to spread it out somewhat.
Price-contingent customer orders are the third important source of feedback trading in foreign exchange. These are conditional market orders, in which the dealer is instructed to transact a specified amount at market prices once a trade takes place at a pre-specified exchange-rate level. There are two types: stop-loss orders and take-profit orders. Stop-loss orders instruct the dealer to sell (buy) if the rate falls (rises) to the trigger rate, thereby generating positive-feedback trading. By contrast, take-profit orders instruct the dealer to sell (buy) if the price rises (falls) to the trigger rate, thereby generating negative-feedback trading. (Though the titles imply that anyone placing an order has an open position, this need not be – and often is not – the case.) The standard trigger for execution is a traded rate on an auditable source that matches the rate specified in the order, though other triggers can be specified (where auditable sources include EBS, Reuters, and voice brokers). Orders remain on the books until executed or cancelled, unless specified otherwise. Many orders are specified as “good ‘til close in X,” where X would be a major trading city.
Take-profit orders are often used by non-financial firms that need to purchase or sell currency within a given period of time. Their option to wait is valuable due to the volatility of exchange rates. They can avoid costly monitoring of the market and still exploit their option by placing a take-profit order with a dealer. Financial firms also use take-profit orders in this way. Stop-loss orders, as their name implies, are sometimes used to ensure that losses on a given position do not exceed a certain limit. The limits are frequently set by traders’ employers but can also be self-imposed to provide “discipline.” Stop-loss orders can also be used to ensure that a position is opened in a timely manner if a trend develops quickly. Savaser (2008) finds that stop-loss order placement intensifies prior to major macro news releases in the U.S.
One might imagine that these orders would tend to offset each other, since rising rates trigger stop-loss buys and take-profit sales and vice versa. However, as discussed in Osler (2003, 2005), differences between the clustering patterns of stop-loss and take-profit orders reduce the frequency of such offsets. Take-profit orders tend to cluster just on big round numbers: roughly 10 percent are placed at exchange rates ending in “00” (such as 1.2300 or 120.00) and another four percent are placed at rates ending in “50.” If orders were distributed randomly these fractions would all be about 1 percent. Stop-loss orders are less concentrated on the round numbers and more concentrated just beyond them (meaning above (below) the round number for stop-loss buy (sell) orders). Over 18 percent of stop-loss buy orders have trigger rates ending in two-digit combinations from 51 to 60, while only eight percent of stop-loss sell orders have such trigger rates. Similarly, over 16 percent of stop-loss sell orders have trigger rates ending in 40-49, while only six percent of stop-loss buy orders have such trigger rates.
Since stop-loss and take-profit orders cluster at different points, offsets are limited and these orders create noticeable nonlinearities in exchange-rate dynamics (Osler 2003, 2005). The presence of stop-loss orders, for example, substantially intensifies the exchange-rate’s reaction to macro news releases (Savaser 2008). Likewise, the tendency of take-profit orders to cluster at the round numbers increases the likelihood that trends reverse at such levels. This is consistent with the technical prediction, introduced earlier, that rates tend to reverse course at “support” and “resistance” levels. Finally, the tendency of stop-loss orders to cluster just beyond the round numbers brings a tendency for exchange rates to trend rapidly once they cross round numbers.
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This is consistent with another technical prediction, that rates trend rapidly after a trading-range break out.
Market participants often report that stop-loss orders are responsible for fast intraday exchange-rate trends called “price cascades.” In a downward cascade, for example, an initial price decline triggers stop-loss sell orders that in turn trigger further declines, which in turn trigger further stop-loss sell orders, etc. Upward cascades are equally possible: since every sale of one currency is the purchase of another, there are no short-sale constraints and market dynamics tend to be fairly symmetric in terms of direction (most notably, there is no equivalent to the leverage effect). Dealers report that price cascades happen relatively frequently – anywhere from once per week to many times per week. Osler (2005) provides evidence consistent with the existence of such cascades."