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What is Fractional Reserve banking?

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    This is my second post on economic stuff. Just looking to start good conversation as I enjoy discussing and sharing what I know. Hope it's as well received as I intend.

    -Cheers

    ----------------------------------------------------

    Fractional
    -reserve banking is the practice whereby a bank accepts deposits, makes loans or investments, and holds reserves that are equivalent to a fraction of its deposit liabilities. Reserves are held at the bank as currency, or as deposits in the bank's accounts at the central bank. - Wikipidia

    Having said that.....The US no longer uses a Fractional Reserve System (at least as most people understand it and most writings explain it) as a way to constrain the creation of new money in the banking system. This is because banks are no longer constrained by reserves on hand (cash) in order to make new loans (the real constraint is based on the banks capital held at the Fed). Banks no longer lend customer deposits to other customers, but instead banks lend reserves to each other at the end of each day.

    So, if a bank has $10 it can make $100 in new money and meet it’s reserve requirement. But what if a customer comes in and wants to borrow $200? No problem, the bank makes the loan and than at the end of the day borrows and additional $10 from another bank (so now it has $20) who have “excess reserves”. If for some reason the money isn’t available to borrow from another bank, the Fed can lend it, though this does not happen very often as the Fed charges a higher rate.

    The system we have today appears, functionally speaking to look and act very much the same as the system in place during the gold standard, however there are subtle and importation differences.

    Banks utilize double entry accounting and create money from nothing when creating loans, but banks also create a debt that matches the money created dollar for dollar which is a liability of the bank. The borrower is responsible for repaying the bank the full amount of the loan plus interest, the bank is responsible for removing the liability from its books that was used to create the loan. The banks gross profit is the interest. If the borrower defaults on a loan, the bank must use it’s on capital to remove the liability from it’s books. If too many people default and the banks capital account drops to zero and it has no other assets to sell or borrow against, then the bank becomes insolvent.

    To understand the difference between today’s system and system in the past, here is a simple example. If you borrow $1 from a freind (who only has $1) then your friend’s “position” moves from $1——>$0. In turn your position moves from $0—→$1.

    So how is a bank different?

    When a bank creates money from nothing and lends it to you, it looks like this:

    The banks position moves from $0—→ -$1 and the borrowers position moves from $0—→$1

    Now in the first example when your freind repays the loan your position looks like this:

    $0+$1=$1 so you have $1

    The banks position looks like this:

    -$1+$1=$0

    Banks in the past operated much like borrowing from a friend in that the banks had to have the money to lend or, more precisely, a “fraction” of it, hence the term “Fractional Reserve”.

    In the first example if your friend did not pay you back, you wouldn’t owe anything to anyone, but when a bank isn’t repaid, the bank must still repay the loan or they have “negative” money on their books. When “negative” money exceeds the value of the banks capital account, the bank is insolvent.

    So, while banks are required to hold reserves, the reason for this has shifted from a constraint on lending to a part of a process by which the Fed controls interest rates.

    The Fed sets a “target rate” which it attains by adding or removing money from the banking system which in turn affects the level of reserves. If the supply of reserves is high, then banks lend to each other at low rates, but if the level of reserves in the system drops, then banks lend to each other at a higher rate because the supply of reserves has fallen. So the banks ability to lend remains the same, it is the cost of lending that changes.

  • Liberal Democrat
    Democrat
    Colorado Springs, CO
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    Uncommon Cents -- Yes, I believe what you described is right. Carlitos (our Modern Monetary Theorist expert on this website) has corrected us in the past when the question of fractional reserve banking comes up. He's not always here so maybe he won't respond. Likewise, with respect to our prior discussions of Quantitative Easing, he has steered us towards one of the MMT economist views...or rather explains it in his own words. For example this discussion by Cullen Roche:

    Pragmatic Capitalism: A QUICK QUANTITATIVE EASING PRIMER

    While I have agreed with many of the concepts of MMT, it is still difficult to carry on a discussion with someone who is "old school". And indeed my own cognitive dissonance on the subject has impaired my ability to talk persuasively with others. Usually I revert to one of the MMT discussion websites.

    The political discourse in this country is such that even those who understand correctly debt and deficit spending, are more than likely pandering to the lowest common denominator amongst us who believe that the federal budget is no different than one's household budget.

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    Hey, thanks for the reply.....I think Carlitos posted on another thread. I too have spent years learning economics.

    It's actually in interesting story. In my 30's (early 90's) in the early days of Massive Multiplayer Online Roll-playing Games (for those that aren't familiar MMORPG's are games that once they begin, they don't stop. They are persistent existing 24/7), being the nerd that I was I became interested in game design. Not from a graphics or world setting or story perspective, but to help create the underlying design. How to motivate people to play the game in a way that was best for the community, to keep the game healthy and people having fun.

    I quickly learned that players got ahead of other players by unbalancing the systems that designers create. Soon after that, I realize that the big mistake that most companies were making in the genre is that, like the rest of the real world, economics is the foundation upon which everything rests. People are motivated, especially in games, to achieve. They measure their achievements in money, wealth and possessions. Most game companies would start with an idea, a story and charachters to fill them. Then they would try to figure out the economy.

    So I started looking at the economics of the game world and I realized that soooooo few people really understood human behavior. I spent about 10 years working on ideas, usually alone. Now this whole time I had absolutely no real understanding of modern economies. I thought money was backed by gold, I though banks lent customer funds. I thought taxes paid for spending and that government operated like a household and so on.....

    Once I had designed what I thought was an excellent game economy, I decided to spend some time learning real world economic theory. The first theory that I remember coming across was the quantity theory of money. From there I studied ideas from the Chicago and Austrian schools....But something just didn't sit right. Then I found Keynes and eventually MMT via Kelton, Mitchell, Mosler, Wray and others.

    The deep unbelievable irony is that I thought the game world and the real world were entirely different, once I learned MMT I realized that the game world and the real world are so very much alike in many ways. One thing that differs in the game world, something that makes understanding a littler easier, is that, everyone is trying to win, but politics, racism, sexism, favoritism, nepotism....At the core these things do not exist. It is truly a world of equal opportunity in that, whatever constrains are placed upon you, anent there because of game, they are self imposed.
  • Strongly Liberal Democrat
    Democrat
    Pensacola, FL
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    Something different between the game world and the real world is that lack of motivation exists in the real world. The game world is a special set because a common denominator is motivation and by joining to compete a motivated set of competitors. Reading your posting about banking brings up somEthing I think about but don't know if it recognized. A natural law is a constant never changing influence without consequence. I consider profit a natural law of economics. No matter what the conditions are profit is always influential. Economics can be art in application but profit is always there. That can be the problem with all finances. The theories and principles can be honest and sincere but the players in life accept the rules with appreciation and then immediately using the rules as validation immediately begin to distort them for profit. Profit not being limited quantitatively then it spins out of control. Not limiting profit is a destructive fallacy because it creates an end game. Economists should not create end games.

  • Strongly Liberal Democrat
    Democrat
    Dallas, TX
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    Uncommon Cents Wrote: Hey, thanks for the reply.....I think Carlitos posted on another thread. I too have spent years learning economics.

    It's actually in interesting story. In my 30's (early 90's) in the early days of Massive Multiplayer Online Roll-playing Games (for those that aren't familiar MMORPG's are games that once they begin, they don't stop. They are persistent existing 24/7), being the nerd that I was I became interested in game design. Not from a graphics or world setting or story perspective, but to help create the underlying design. How to motivate people to play the game in a way that was best for the community, to keep the game healthy and people having fun.

    I quickly learned that players got ahead of other players by unbalancing the systems that designers create. Soon after that, I realize that the big mistake that most companies were making in the genre is that, like the rest of the real world, economics is the foundation upon which everything rests. People are motivated, especially in games, to achieve. They measure their achievements in money, wealth and possessions. Most game companies would start with an idea, a story and charachters to fill them. Then they would try to figure out the economy.

    So I started looking at the economics of the game world and I realized that soooooo few people really understood human behavior. I spent about 10 years working on ideas, usually alone. Now this whole time I had absolutely no real understanding of modern economies. I thought money was backed by gold, I though banks lent customer funds. I thought taxes paid for spending and that government operated like a household and so on.....

    Once I had designed what I thought was an excellent game economy, I decided to spend some time learning real world economic theory. The first theory that I remember coming across was the quantity theory of money. From there I studied ideas from the Chicago and Austrian schools....But something just didn't sit right. Then I found Keynes and eventually MMT via Kelton, Mitchell, Mosler, Wray and others.

    The deep unbelievable irony is that I thought the game world and the real world were entirely different, once I learned MMT I realized that the game world and the real world are so very much alike in many ways. One thing that differs in the game world, something that makes understanding a littler easier, is that, everyone is trying to win, but politics, racism, sexism, favoritism, nepotism....At the core these things do not exist. It is truly a world of equal opportunity in that, whatever constrains are placed upon you, anent there because of game, they are self imposed.
    Uncommon Cents, are you on facebook?
  • Strongly Liberal Democrat
    Democrat
    Pensacola, FL
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    Why is the vital importance money facilitates and plays in the circulatory system of our economy ignored compared to other aspects?

  • Independent
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    Recommend Yves Smith's book "Econned: how unenlightened self-interest undermined democracy and corrupted capitalism."

    imo, ALL banks that utilized fractional reserves are by definition insolvent. The moment that a bank is forced to sell assets to cover a potential run the prices for those assets will drop like a rock as the bank's competitors and the so-called market (read: other parties, friendly and/or unfriendly) will smell blood in the water and force the asset prices lower.

    Smith's book focuses on the failure of neoclassical economics which almost completely ignores the impact of a financial system and money on economics.

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    lonely bird Wrote:

    Recommend Yves Smith's book "Econned: how unenlightened self-interest undermined democracy and corrupted capitalism."

    imo, ALL banks that utilized fractional reserves are by definition insolvent. The moment that a bank is forced to sell assets to cover a potential run the prices for those assets will drop like a rock as the bank's competitors and the so-called market (read: other parties, friendly and/or unfriendly) will smell blood in the water and force the asset prices lower.

    Smith's book focuses on the failure of neoclassical economics which almost completely ignores the impact of a financial system and money on economics.


    Not sure if I'm fully understanding the point your making. With that I'll respond and if I've misunderstood, you an correct me.
    ---------------------
    But that's just it. Fractional reserve banking as it existed in the age of the gold standard, no longer exists. The idea that banks are constrained in lending by the reserves they can acquire is over. A bank can make all the loans it wants retaliative to the amount of investor capital it wishes to risk. A bank does not need to sell assets in order to cover it's reserve requirements or to cover bank "runs". A bank simply looks to the inter-bank market when it needs funds to cover loans. This is because loans create deposits.

    This is where the old system (pre '71) looks the same as the new system (post 1971). When a loan is made the lendee or whoever the lendee gives the money borrowed to ends up depositing the money back into the banking system. So a $1000 loan that makes it's way back into the system creates enough reserves to lend out $100,000 more. In this sense, the old system and the new system appear the same and is often the source of confusion.

    The distinction to be made is that banks are not in any way constrained by the reservesthey hold when they make loans. In other words, banks don't take an inventory of reserves to decide if they can make loans on any given day.

    Banks manage risk. The cost of failure to manage risk comes out of the banks investor capital (the money that was deposited at the Fed to start the bank). If they poorly manage risk the losses come out of the investors capital. When that capital is gone, that is when the bank becomes insolvent.
  • Are you sure you want to delete this post?
        
    Chet Ruminski Wrote:

    Why is the vital importance money facilitates and plays in the circulatory system of our economy ignored compared to other aspects?

    Chet can you be more specific?
  • Independent
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    Uncommon Cents Wrote:
    lonely bird Wrote:

    Recommend Yves Smith's book "Econned: how unenlightened self-interest undermined democracy and corrupted capitalism."

    imo, ALL banks that utilized fractional reserves are by definition insolvent. The moment that a bank is forced to sell assets to cover a potential run the prices for those assets will drop like a rock as the bank's competitors and the so-called market (read: other parties, friendly and/or unfriendly) will smell blood in the water and force the asset prices lower.

    Smith's book focuses on the failure of neoclassical economics which almost completely ignores the impact of a financial system and money on economics.


    Not sure if I'm fully understanding the point your making. With that I'll respond and if I've misunderstood, you an correct me.
    ---------------------
    But that's just it. Fractional reserve banking as it existed in the age of the gold standard, no longer exists. The idea that banks are constrained in lending by the reserves they can acquire is over. A bank can make all the loans it wants retaliative to the amount of investor capital it wishes to risk. A bank does not need to sell assets in order to cover it's reserve requirements or to cover bank "runs". A bank simply looks to the inter-bank market when it needs funds to cover loans. This is because loans create deposits.

    This is where the old system (pre '71) looks the same as the new system (post 1971). When a loan is made the lendee or whoever the lendee gives the money borrowed to ends up depositing the money back into the banking system. So a $1000 loan that makes it's way back into the system creates enough reserves to lend out $100,000 more. In this sense, the old system and the new system appear the same and is often the source of confusion.

    The distinction to be made is that banks are not in any way constrained by the reservesthey hold when they make loans. In other words, banks don't take an inventory of reserves to decide if they can make loans on any given day.

    Banks manage risk. The cost of failure to manage risk comes out of the banks investor capital (the money that was deposited at the Fed to start the bank). If they poorly manage risk the losses come out of the investors capital. When that capital is gone, that is when the bank becomes insolvent.

    Ok. Let us start with risk. Banks do not manage risk. Or rather did not. This includes the shadow banking system. Their models dealt with risk or so they thought. But the models were flawed and in addition they weren't dealing with risk which is something acceptable when you can cover it. They were dealing instead with uncertainty. Assumptions were made that were not valid and the instruments they were dealing with were basically fraudulent. When their models failed and their assumptions such as housing prices rising forever failed they were forced to sell assets. To their detriment the assets included the very instruments that were fraudulent. Thus they experienced runs. This hit the shadow banking sector as well as the regular banking sector. And we know it hit both because indymac and wamu no longer exist for example.

    the reserve requirements simply do not cover the uncertainty. They didn't then and don't now. Yes, the fed can open the window for them but the problems lies with the system itself. Looking at credit unions they cannot lend out in the same manner. The regular bank system due to financial "innovation" (read: deregulation and exotic instruments) collapsed and will collapse again unless it is deconstructed. Yves Smith's book discusses this. There actually a lot of writers who discuss the financial system and its impact and the impact of issues such as regulatory capture. James K. Galbraith is another good author but he can get super technical.

  • Are you sure you want to delete this post?
        
    lonely bird Wrote:
    Uncommon Cents Wrote:
    lonely bird Wrote:

    Recommend Yves Smith's book "Econned: how unenlightened self-interest undermined democracy and corrupted capitalism."

    imo, ALL banks that utilized fractional reserves are by definition insolvent. The moment that a bank is forced to sell assets to cover a potential run the prices for those assets will drop like a rock as the bank's competitors and the so-called market (read: other parties, friendly and/or unfriendly) will smell blood in the water and force the asset prices lower.

    Smith's book focuses on the failure of neoclassical economics which almost completely ignores the impact of a financial system and money on economics.


    Not sure if I'm fully understanding the point your making. With that I'll respond and if I've misunderstood, you an correct me.
    ---------------------
    But that's just it. Fractional reserve banking as it existed in the age of the gold standard, no longer exists. The idea that banks are constrained in lending by the reserves they can acquire is over. A bank can make all the loans it wants retaliative to the amount of investor capital it wishes to risk. A bank does not need to sell assets in order to cover it's reserve requirements or to cover bank "runs". A bank simply looks to the inter-bank market when it needs funds to cover loans. This is because loans create deposits.

    This is where the old system (pre '71) looks the same as the new system (post 1971). When a loan is made the lendee or whoever the lendee gives the money borrowed to ends up depositing the money back into the banking system. So a $1000 loan that makes it's way back into the system creates enough reserves to lend out $100,000 more. In this sense, the old system and the new system appear the same and is often the source of confusion.

    The distinction to be made is that banks are not in any way constrained by the reservesthey hold when they make loans. In other words, banks don't take an inventory of reserves to decide if they can make loans on any given day.

    Banks manage risk. The cost of failure to manage risk comes out of the banks investor capital (the money that was deposited at the Fed to start the bank). If they poorly manage risk the losses come out of the investors capital. When that capital is gone, that is when the bank becomes insolvent.

    Ok. Let us start with risk. Banks do not manage risk. Or rather did not. This includes the shadow banking system. Their models dealt with risk or so they thought. But the models were flawed and in addition they weren't dealing with risk which is something acceptable when you can cover it. They were dealing instead with uncertainty. Assumptions were made that were not valid and the instruments they were dealing with were basically fraudulent. When their models failed and their assumptions such as housing prices rising forever failed they were forced to sell assets. To their detriment the assets included the very instruments that were fraudulent. Thus they experienced runs. This hit the shadow banking sector as well as the regular banking sector. And we know it hit both because indymac and wamu no longer exist for example.

    the reserve requirements simply do not cover the uncertainty. They didn't then and don't now. Yes, the fed can open the window for them but the problems lies with the system itself. Looking at credit unions they cannot lend out in the same manner. The regular bank system due to financial "innovation" (read: deregulation and exotic instruments) collapsed and will collapse again unless it is deconstructed. Yves Smith's book discusses this. There actually a lot of writers who discuss the financial system and its impact and the impact of issues such as regulatory capture. James K. Galbraith is another good author but he can get super technical.

    Ok, so I think we're talking about two different things. I am aware of the things that you speak, but you're talking about managing risk weighted asset classes like derivatives. While I agree with most of your assessment, I will say that banks are responsible to manage risk. We could write reams on how they failed. I'd argue the failure begins as a cultural one. Embracing ideas like "free markets" and letting the "invisible hand" guide markets are destructive notions. The first, free market, is just a euphemism for "lawless market" and trying to capture the brilliance of Adam Smith by referring to the "invisible hand", something he mentions only three times in his works, none of which have anything to do with how the term as it is understood by those that use it, are the root of the problem. Economics is a system for allocating resources. The public will try to unbalance that system in order to make larger profits from less and less productive work. The government on the other hand, is responsible for maintaining that balance and I'm sure we could agree that the money created though non-productive work magnified by a system of massive inequity has exacerbated the problem. The problem being the influence money has on government.

    Having said that, to be clear, when I talk about "Fractional Reserve Banking", I'm really just talking about how banks make loans to the public. If you believe that FRB works as it did pre-1971 then you might belive in the Quantity Theory of Money, in that money is a commodity and as you increase that "commodity" (money) you encourage more borrowing and that borrowing usually causes demand driven inflation.

    I'm arguing that the QToM is wrong (though I didn't say it until now) and by extension FBR is also wrong in light of how government and the Fed manage money today.

    Hope that clears things up.

  • Strongly Liberal Democrat
    Democrat
    Pensacola, FL
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    Uncommon Cents Wrote:
    Chet Ruminski Wrote:

    Why is the vital importance money facilitates and plays in the circulatory system of our economy ignored compared to other aspects?

    Chet can you be more specific?

    Money is passively aggressively weighted toward increasing wealth instead of sustaining an economy. There are no controls to maintain an economy as well as there are no controls to prevent the abuse of money. Contemporarily there is no conceivable abuse posed by money. All the economists, theories and schools support money in the short term without regard to the purpose of money. This is a short answer due to using my phone but when I get back to my desktop I will answer in detail. But consider the value of going public. An operating business of value x without a single improvement can go public and increase its capitalization signigicantly. This is made possible by the instantaneous convertibility of money and is supported not by the benefit of the product of the company but by the value of the symbol of the company for trading. The stock market is licensed, regulated and legally authorized to do business but that begs the question "what for".

    The end result is less money in circulation and therefore a shrinking economy and increasing number of people with a worth less than zero.

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    I think I'm catching what your saying, though I'll wait for your full explanation.

    I will add this much, I don't believe that most theories of economics "support" money or policy prescription. The idea behind a descriptive theory is simply to describe, be it Neoconservative, Austrian or MMT.

    If the description is flawed, then resulting policy prescription supported by it's adherents will, in most cases, be flawed.

    We need to understand how money works before we can prescribe a fix. I think it's obvious that I see MMT as describing how money works, I'd like to think that my personal prescriptions are sound based on my understanding, but at the end of the day, my prescriptions are based on my biased policy agendas mixed with my understanding of how money and human behavior work.

    Examples,

    I think government spending should act counter-cyclically, I think everyone should have a reasonable minimum of opportunity, I think taxes (or lack thereof) can be used to decrease income disparity I would support very, very large personal exemptions with aggressive taxes after that. I think laws that hold powerful people criminally responsible for knowingly harming the economy and more specifically the lives of those in it, are important part of society that understand that individuals are better off when the whole meets it's potential and so on. I'd like to think that my ideas, informed by my understanding of money and the prescriptions I recommend would in fact meet your description of a purpose of money.

    I'll leave it there for now.

  • Strongly Liberal Democrat
    Democrat
    Pensacola, FL
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    Uncommon Cents Wrote:

    I think I'm catching what your saying, though I'll wait for your full explanation.

    I will add this much, I don't believe that most theories of economics "support" money or policy prescription. The idea behind a descriptive theory is simply to describe, be it Neoconservative, Austrian or MMT.

    If the description is flawed, then resulting policy prescription supported by it's adherents will, in most cases, be flawed.

    We need to understand how money works before we can prescribe a fix. I think it's obvious that I see MMT as describing how money works, I'd like to think that my personal prescriptions are sound based on my understanding, but at the end of the day, my prescriptions are based on my biased policy agendas mixed with my understanding of how money and human behavior work.

    Examples,

    I think government spending should act counter-cyclically, I think everyone should have a reasonable minimum of opportunity, I think taxes (or lack thereof) can be used to decrease income disparity I would support very, very large personal exemptions with aggressive taxes after that. I think laws that hold powerful people criminally responsible for knowingly harming the economy and more specifically the lives of those in it, are important part of society that understand that individuals are better off when the whole meets it's potential and so on. I'd like to think that my ideas, informed by my understanding of money and the prescriptions I recommend would in fact meet your description of a purpose of money.

    I'll leave it there for now.

    I understand the descriptive vs prescriptive. I am thinking if tasked to describe how brushes and colors are used to make a painting the description would have to be influenced by the purpose of the painting. This forum and then Sanders sparked my interest in MMT.

  • Are you sure you want to delete this post?
        
    Chet Ruminski Wrote:
    Uncommon Cents Wrote:

    I think I'm catching what your saying, though I'll wait for your full explanation.

    I will add this much, I don't believe that most theories of economics "support" money or policy prescription. The idea behind a descriptive theory is simply to describe, be it Neoconservative, Austrian or MMT.

    If the description is flawed, then resulting policy prescription supported by it's adherents will, in most cases, be flawed.

    We need to understand how money works before we can prescribe a fix. I think it's obvious that I see MMT as describing how money works, I'd like to think that my personal prescriptions are sound based on my understanding, but at the end of the day, my prescriptions are based on my biased policy agendas mixed with my understanding of how money and human behavior work.

    Examples,

    I think government spending should act counter-cyclically, I think everyone should have a reasonable minimum of opportunity, I think taxes (or lack thereof) can be used to decrease income disparity I would support very, very large personal exemptions with aggressive taxes after that. I think laws that hold powerful people criminally responsible for knowingly harming the economy and more specifically the lives of those in it, are important part of society that understand that individuals are better off when the whole meets it's potential and so on. I'd like to think that my ideas, informed by my understanding of money and the prescriptions I recommend would in fact meet your description of a purpose of money.

    I'll leave it there for now.

    I understand the descriptive vs prescriptive. I am thinking if tasked to describe how brushes and colors are used to make a painting the description would have to be influenced by the purpose of the painting. This forum and then Sanders sparked my interest in MMT.

    The best way for me to learn MMT is to help others understand it.

    With respect to our early conversation. It's interesting because I watched a documentary on Netflix called "Poverty Inc". It's amazing how good intentions can lead to such terrible outcomes.

    Given all that I know about MMT, there is nothing that MMT can do to solve problems of government corruption and corporate greed combined in the worst possible way with caring hearts and an industry created to "care" for the poor.

    Those who need change the most are powerless to affect it, those that need it the least have the power to keep things the way they are.