Thursday, April 3, 2014

Money Myth 5: Fiat money isn't backed by anything - it's all based solely on trust.

FACT: The money of sovereign currency-issuing nations derives its value from the imposition of taxes, not blind trust. Taxes "drive" modern money (but never fund government spending), and that's a good thing!  

The blogosphere is rampant with fear-filled predictions of the collapse of the US Dollar. These authors tend to decry the concept of "unbacked" fiat currency and pine for the days of "sound" money backed by gold. Their dire warnings about government "money printing" leading to a calamitous economic collapse are usually accompanied with exhortations to buy gold (presumably they make money from the gold and silver exchanges that advertise on their sites). It's easy to sell doom & gloom. It's surprisingly difficult to convince people that there is hope and prosperity within our grasp. Yet there really is when we understand modern money!

So this is how modern State money really works:
  1. Let's start at the beginning: a new nation is formed or reconstituted.
  2. The new State creates its monetary unit (dollar, yen, franc, etc.)
  3. At the same time the State is granted the right to impose taxes on the population and the power to enforce collection of those taxes.
  4. The State decrees (i.e. by "fiat") that its new money is the only thing it will accept in payment for the taxes owed. 
  5. The money now has value to everyone who owes taxes - in fact everyone needs to find a way to earn them - we have just created the concept of unemployment!
  6. The population now needs to obtain the government money in order to pay their taxes and so it is willing to work or sell goods to the government in exchange for this new currency.
  7. The State can now issue new money into the economy (today this is done mostly via computer entries crediting bank accounts) to provision whatever labor or products or services it it authorized to do for the people. 
  8. The private sector happily accepts this money in payment for wages, goods, etc. since they need the units for their taxes, or because they know others will need them.
  9. In a very short time, the State money replaces other forms of money in that domestic economy since it is more practical for everyone to use the State money for accounting, issuing loans, determining prices, paying wages, taxes, and the exchange of goods & services.
  10. The private sector will also try to save some of this money for future needs which means the government usually must issue more than it taxes away just to keep up with demand for its money.
  11. A national currency has been created. It is not based on "trust" but upon the establishment of a government that has power to tax.

We gave our government a monopoly on the issuance of money for a very important reason - so that it can issue that money as needed for public purpose. Why did we leave the gold standard? Because it put shackles on our nation's ability to issue money as needed for public purpose! 

It is pointless to debate economic ideas and approaches to government spending that are not based around this understanding. There's no such thing as a private sector economy without State money and a functioning government sector. Much folly has resulted from economic theories and political policies that ignore or diminish this reality.

What does this mean practically?
  • Our government has no real limits on its ability to spend and cannot run out of its own money (but of course this doesn't mean it should spend without accountability). However, it definitely IS limited by the availability of the real resources that it wants to procure and the willingness of labor to perform its work.
  • Government can now “afford” to buy/build/fund anything for sale in its own currency. Of course, consideration is still given to the impact of its spending on the economy, prices, output, foreign trade, etc., but there is never a shortage of money unless it is self-imposed
  • Any constraints such as balanced budget requirements and deficit ceilings are self-imposed and usually counterproductive to the proper functioning of the monetary system and the health of society and the economy.
  • The amount the government taxes has nothing to do with its ability to issue money or spend. The level of taxation ideally should be used as a means of keeping the economy at full employment.

So-called budget “deficits” are completely normal, indeed essential, in such a system: they are exactly what we made the system to do

If every dollar that has been spent into existence is subsequently taxed out of existence, we would be quite foolish. Why would we hurt the economy this way? (In fact in the US we have tried to do this seven times in our history and each time, predictably, we sent the economy into depression). 

Why do we need constant deficits? 

Firstly, many nations import more than they export and so we have a net outflow of money from the domestic economy. This functions much the same way as savings and taxes; both of which remove spending from the private sector. Secondly, people always want to save some of the national currency. By removing all the government money from the economy we are also removing all our savings, and also causing the amount of spending to fall precipitously. When spending falls, businesses can't pay their bills and so they downsize the workforce, and loans can't be repaid and so default rates rise and banks fail.

State money's purpose is to direct resources (labor and goods) to public needs and desires. It could be to establish a national park, build a highway system, fight a war, educate our children, provision medical services for those that need them, or care for our elderly. 100% of this is accomplished by issuing new money. The government simply must tax enough of it back to create continual demand for the money that is being spent and to maintain balance in the economy (too little tax and we get inflation; too much and we get unemployment). 

State money (fiat money) is sound money. It is far more powerful and provides much more policy space than linking a nation's currency to gold or fixing exchange rates between nations ("Exhibit A" - see the Euro!) The question is whether we will fully use this invention for the purpose for which it was created - to ensure the safety, prosperity, and happiness of all citizens.

Hope is completely within our hands. Let's grasp it! 

More reading

Monopoly Money: The State as a Price Setter,
Taxes Drive Money,
Tax-Driven Money: The evidence from history

J.D. Alt has produced an excellent visual explanation of how money functions, called Diagrams & Dollars. See links and video below.



YouTube Video: