How does this work?
Since there are many different kinds of money and ways to define money (e.g. banks create a different kind of money than governments), we will use “currency” to distinguish the money that the government issues from all other money forms.
The core concepts:
- Why do we have a national currency? When nations and governments are formed, they need a way for the government to obtain the resources it needs to fulfill its role, whatever that may be. In most developed nations, this is typically done using a national currency.
- What and whose money do governments use? Governments actually create their own currency. There is a basic formula most countries use to create a national currency: (i) decide on a national money unit (e.g. Japan called theirs the “Yen”; the United States the “Dollar”, etc.); (ii) the government issues various forms of money “things” denominated in that unit (Yen or Dollar bills, coins, or electronic bank credits); (iii) impose a broad-based tax that can only be paid using the government’s newly created money. And now the government can issue and spend its own currency to obtain resources.
- Why is government currency accepted and how does it have any value? The tax obligation causes the government’s currency to become in demand and have value. Since businesses and households must obtain the government currency in order to pay their taxes, it becomes universally adopted in that economy.
- Does the government need to collect taxes before it can spend? Note above how taxes simply return to the government the money it first created. The spending has to happen first since the only way we can pay taxes in government currency is by first obtaining government currency. The government never needs our taxes in order to spend since it creates the money that it spends.
- If the government doesn't need our taxes to spend, what are taxes for? Taxes cause demand for the government’s currency so we accept it in payment for goods and services. Taxes also reduce spending power in the economy so that when the government spends to obtain necessary resources, it doesn’t create excessive inflation. Taxes are also useful as incentives and disincentives to influence behavior in the rest of the economy for public policy.
- If national governments can just create money, are there any limits to what they can spend? Yes, there are definitely limits. A big constraint on government spending is the political process. It is usually difficult to get spending approved and funded, and the public generally require their government to act responsibly and to avoid excessive inflation. The availability of the real resources that can be obtained with the state currency is a firm constraint. So governments can’t use their currency to buy what is not for sale in their currency, but they are never limited by the availability of their own currency.
- Can sovereign governments go bankrupt? A nation that issues its own currency can never go bankrupt or be unable to pay its bills, as long as those bills are due in the money they create. Governments that owe debt in a currency or commodity they don’t create can certainly become insolvent and default. So too can governments who promise to exchange their currency for another currency they don’t control. However, fully sovereign nations are the monopoly issuer of their currency, and they can always issue their money to make any payment due in their currency.
- Do governments borrow to fund their spending? Since currency-issuing governments create money when they spend, they do not need to – and in fact can’t – borrow their own self-issued currency. Government bonds can only be purchased with government currency that is already spent into the economy. This means that government bonds are serving some other role in the economy aside from funding the government. It is easiest to say that bonds simply provide a safe interest-earning way to save government-created money. A more complicated reason is that bonds help the central bank manage interest rates, but bonds are never needed to finance government spending.
- Does understanding modern money provide policy guidance? The knowledge that sovereign nations issue their own currency means that they are not constrained in the same way that currency-using governments are constrained. This has a profound impact on the range of policy options available to such governments that are not available to those with less monetary sovereignty. The debate over public policy is important and differences of opinion will remain: however, the debate should not place artificial constraints on the monetary system, but rather look at the effects of each policy on the economy and the general welfare of the people. An important example is unemployment: we now know that governments can afford to employ everyone who is willing to work for the government’s money, and that the effects of doing so can stabilize and grow the economy while enhancing the general welfare of the nation.
Credits: As usual, this post relies heavily on the work of other economists and MMT scholars. The inspiration & much of the content here came from Randy Wray's many works, including the excellent presentation Modern Money Theory: Intellectual Origins and Policy Implications.