Sunday, May 25, 2014

Where's our economic recovery coming from?

We have previously discussed how the private sector's surplus/deficit (i.e. what most of us think of as "the economy") MUST EQUAL net government deficits/surplus (spending less taxes) + net foreign trade (exports minus imports). This is a simple double-entry accounting truism -- all transactions with money must balance out.

Understanding this simple ECON 101 principle is critical to understanding the essential role of Government money in the economy. 
Net Domestic Financial Savings = Net Government Spending + Net Foreign Trade (economists use the terms Current Account and Capital Account for the Foreign Trade component)
From this formula, it should be quite obvious that if we change financial assets in one sector, it has to affect at least one of the others

  • Example 1: if exports fall by $1 billion, that means there is $1 billion less in the Private Sector, unless that difference is made up by an increase in Private Sector debt or Government deficits.
  • Example 2: if imports exceed exports ($ flow out of the domestic economy) and the Government runs a surplus (removes more $ from the economy via taxation than it adds via spending), then the Private Sector must significantly increase debt levels in order to run a sufficient deficit to overcome these monetary drains. (This is exactly what occurred during the Clinton years as shown in the chart below).
  • Example 3: if the Private Sector lowers debt and increases savings (i.e. has a surplus), and if imports exceed exports (i.e. net $ flow out as goods flow in), then by definition, the Government MUST be running a deficit equal to the net import outflows + Private Sector savings.
For a net importing nation, in order for the Private Sector to have a surplus,
the Government must run deficits.
Example 3 above happens to reflect the recent US economy after the Great Financial Crisis (GFC). We can rearrange our accounting equation to solve for the Government Sector as follows:
Government Deficits = Domestic Savings minus (Exports less Imports)
Like it or not (and we really should like it), Government money is a partner in the economy. We generally want the Private Sector to be in surplus. Note that you can't have ALL countries net exporting - there has to be a 50-50 split, so for all the nations that net import, deficit spending is NORMAL, and trade partners also support it by holding currency reserves and bonds of the nations they seek to export goods to.

Government deficits ALWAYS rise and fall in response to what is going on in the economy. Recessions cause a drop in tax receipts and increase in government spending on unemployment and welfare. Naturally, this results in a rise in deficits which help push the Private Sector into surplus. Such counter-cyclical balance to the economy is GOOD

A Fiscal Trap Occurs When Fiscal Policy Aims to 
Balance the Budget—And Private-sector Financial 
Fragility Can Worsen the Problem
Unfortunately, politics and misguided economic thinking (such as debt & deficit hysteria) cause many to see the rising deficits as bad and thus seek to reign in government spending and raise taxes. Of course this just leads back to Private Sector hardship which lowers tax receipts and increases government spending again - a "fiscal trap".

This way of thinking cuts off one leg from our three-legged stool: we rely only on increased private debt or increased exports to get out of trouble, cutting our most powerful ally, the nation's monetary system, out of the game. 

So now that we have established the importance of the sector balance equation, how do we apply this logic to the current economic malaise in the US economy? If we look at our sectors, we can see the following:
  1. We are a net importer, so $ are flowing out of our economy in exchange for goods from abroad. We are starting our equation negative.
  2. Private sector debt levels are still very high and there's still evidence of strong savings desires and de-leveraging (Private Sector reducing debt). We are unlikely to see the Private Sector significantly spending above its income for a while.
So where else can our economic recovery come from? Here are our choices, and it should be quite obvious that Government money can play a key role:
  1. Export more to increase domestic income. As stated above, the US is unlikely to become a net exporter in the near term due to our Reserve Currency status and mutual trade interests.
  2. Private sector borrows more. Again, with record debt levels and falling real wages, there is little room for productive credit expansion (of course the financial industry will always try for more Ponzi credit until defaults rise and it all collapses again, but I'll save that for another day).
  3. Lower taxes to increase spendable incomes. The payroll tax holiday was exactly the right kind of fiscal response needed, but it ended too quickly (see the fiscal cliff comments above). Tax cuts for businesses or capital gains will have little effect since there is no increase in demand.
  4. Write off/down debt to increase spendable income. In addition to reducing the tax burden, reducing debt burdens will free up income which increases demand for goods & services. We could use more debts write-downs than bank bailouts.
  5. Increase government spending. We seem to have no trouble doing this during wartime (WWII deficit spending is arguably what ended the Great Depression), but refuse to take the same approach to help our citizens during times of peace. We can certainly debate what are the most beneficial uses of Government money, but a functioning government & legal system, education, national defense, world-class infrastructure, sustainable low cost energy, care for the elderly, a social safety net and affordable medical care, and full employment should all be high on most lists.
  6. Reduce Private Sector savings. The current tax structures provide strong incentives to save, funneling trillions into real estate, mutual funds, 401k/IRA/529 plans, and bonds. These savngs are dollars that are NOT being spent on goods and services, and is a big reason for the size of our national deficits. Remember, the so-called national "debt" is exactly the non-government sector financial savings. Without tax reform and re-regulation of the financial industry, it is unlikely we will see much change here. 

In summary, with the Private Sector still seeking to increase savings and reduce debt, and net imports from the Foreign Sector, our solution lies in fiscal policy - reduce taxes and increase Government spending. 

A strong economy and real prosperity for our children is not just feasible - it is the fiscally responsible thing to do!

Thursday, May 22, 2014

What is a Federal budget for?

Excerpts from an excellent article just published - read the full article here - it's concise and right to the point.

For a currency-issuing nation, what is more important? Whether our real resources are fully utilized and society has its real needs met, or how many bank reserves and bonds we have? If you care about your country and your children & grandchildren, seek to understand this incredibly important concept as it's not what you learn in school, from the media, or from your political party. We have become so hung up over false notions of debt and inflation - vestiges of our gold standard days - that we can't see our way forward anymore. Let's solve our real needs and the money stuff will take care of itself. Our nation's best days can still lie ahead. 

Both political parties are dominated by the false view that the federal budget must be balanced. The only difference is that conservatives think the government has a spending problem and liberals think it is a revenue problem. Both are wrong and it is hurting America’s competitive global advantages.
In the modern world of fiat currency the federal government must focus on real resources (available materials, factories, infrastructure, labor, knowledge) instead of financial resources (money and bonds) in managing the economy. Money is the vehicle that allows the smooth movement of goods and services from sellers to buyers in the economy. The federal government as the sole issuer of the U.S. dollar can issue all the money it needs to move any resources of the nation.
The Congressional budget exercise should not be about achieving a balanced federal budget. The budget should be developed to assure that all available resources of the nation are put to good use. There is plenty of work to be done, and we can avoid high unemployment. The federal government can employ all the resources not employed by private industry. If unemployment is high, as it is now, federal deficits are too small.
Many will denounce deficits as causing inflation or adding to a gigantic national debt. They forget to mention that inflation is the result of demand greater than our productive capacity. But, government purchases of either goods or services from labor, which are readily available because of high unemployment, increase total production along with demand, and that benefits businesses. Such purchases are not inflationary.
They also fail to mention that the huge national debt is in reality a huge private asset. The national debt is nothing more than government bonds that individuals, banks, and pension funds hold in their accounts as secure savings instruments.

Friday, May 16, 2014

Where does money come from?

Money can usually be separated into two kinds: national or state money, and bank money. Bank money can be said to be inferior to state money and is discussed in a separate blog post here. This post is about a sovereign state's money - what we now usually think of as our national currency. 

Money can be described as a lot of things, but at the root of it all is an IOU, and what gives that IOU validity is taxation. 

Here’s how State money comes from and how it works:
  1. Let's start at the beginning: a new nation is formed.
  2. The new State creates its monetary unit (dollar, yen, franc, etc.)
  3. The State is granted (or forcefully assumes) the exclusive right to impose taxes on the population and the power to enforce collection of those taxes.
  4. The State promises to accept its monetary unit in payment for taxes (i.e. redeem its IOU at face value). The monetary units now have value to everyone who owes taxes.
  5. The population needs to obtain the monetary units in order to pay their taxes. Now everyone is “unemployed” until they obtain the units!
  6. The State provisions needed resources or spends by issuing new monetary units into the economy (mostly via computer entries crediting bank accounts). Of course, the private sector accepts them as payment for wages, goods, etc. since they need the units.
  7. Over time, the State money replaces most other forms of money since everyone uses the State money for accounting, pricing, wages, taxes, and exchange of goods & services.
  8. Much of the private sector will try to save some money units, requiring the government to issue more than it taxes away just to keep up with demand for its money.
  9. A national currency has been created.

So our national money is really the government’s IOU; it has the monopoly on issuance of money. It is pointless to debate economic ideas, monetary policy, and government spending approaches 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?
  • Government has no real limits on its ability to spend and cannot run out of its own money. However, it can be 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 budget limits and deficit ceilings are self-imposed and often are hindrances to the proper functioning of the monetary system and the health of society and the economy.
  • The government can create IOUs endlessly by spending them into existence. As long as people still need them for taxes, they will have value (of course if they create too relative to the capacity of the economy, inflation may occur and/or the value of the currency may fall).
  • Taxes remove money from the economy. Taxes "redeem" the government "IOU". When the government’s money is returned to the government, the tax obligation is met and the IOU is now "paid off".
  • If the government needs to spend again, it simply issues new IOUs. It CANNOT save its own IOUs collected via tax payments in order to spend them. That would be like Starbucks waiting to collect Rewards card points from customers before it can issue new Rewards points to new customers. Issuing new units always comes first; redemption follows, and has nothing to do with new issuance. Taxes DO NOT and CANNOT pay for government spending.
  • Taxes are essential to make money function. Without taxation, money has no value or wide circulation. But taxes do not pay for a single penny of government spending.
  • Unless governments first spend their money units into the economy, no one will have them in order to pay their taxes!

So-called “deficits” are 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. (In fact in the US we have tried to do this seven times in our history and each time, predictably, we crashed the economy). Why? Because people want to save some of the national currency, and removing all the government money from the economy means we all end up with less (i.e. a recession) or we have to "save" by collectively going into debt (borrowing to spend, which of course always ends badly!)

State money's purpose is to direct resources (labor and goods) to public causes. It could be to fight a war, build a highway system, educate our children, care for our elderly. All we need to do is tax enough of it back to create continual demand for the money that is being spent. 

There is NO evidence that such use of government spending causes hyperinflation, and if we ever did get to that point, we can simply tax more money back out of the economy to cool things down (that's actually how our tax system should be used in this system).

That is how money came to be, and that is how it should be managed. 

More reading

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


Randy Wray has written much on the subject. Here is an excellent piece explaining how money arises in the real economy through finance.


YouTube Video:

Monday, May 12, 2014

Why are we dumping excess labor?

Benjamin Graham wrote that the State may deal with actual or threatened surplus in one of four ways: 
(a) by preventing it;
(b) by destroying it;
(c) by “dumping” it; or
(d) by conserving it.

Since the 1970s, economic theory and monetary practice has dictated that economies must maintain a certain level of unemployed in order to prevent inflation. 

In other words, the perceived threat of surplus labor requires that we dump it. Like excess food that will affect prices, we throw people out of the workforce to spoil and rot. 

It doesn't make as much sense when we put it in those terms, does it?

Actually, there is little evidence that such policies can even manage inflation (remember stagflation anyone?) and the costs to society are immense, both socially (in family breakdowns, rising crime, mental and health problems, etc.) and economically (in lost production).

Why not conserve labor instead? A job guarantee would allow the people's money to be used to pay for employment for anyone who is willing and able to work.

Here's one economists' take on how it could work (and what's a false solution): When is a job guarantee a Job Guarantee? There are plenty others out there. 

Sunday, May 11, 2014

It’s the Engine, Stupid, not the Oil!

Money is the lubricant of the "real" economy. It is the thing that facilitates frictionless transactions, is created to enable investment in productive capacity, and that ensures our national resources are fully utilized. The real economy is the engine that produces everything we need and want. At least, that's how it should be. 

But we’ve made oil the object and our engine has been relegated to a role of giving us more oil, and so of course it’s running inefficiently and blowing smoke! We have cylinders that aren’t running at all, sitting idly unemployed. We think that by saving enough oil we can have anything, while neglecting the engine that actually produces what we need. 

We have created huge incentives to save extra oil rather than invest in our engine, so our engine suffers from inadequate lubrication. Saving oil won’t help the next generation have the real production needed to eat, gain skills, work and live well. It’s the engine that produces, and it can produce whatever the next generation needs if we run it with enough oil and keep investing in it, replacing old parts and upgrading with the latest technology. The next generation needs a healthy engine, not a broken engine and a stockpile of this generation's oil.

How often have we heard it said lately, “this is the first generation in US history not to live as well as their parents”? It is tragic, and completely unnecessary. I'm not willing to resign to such a pathetic outcome for our children and grand children! Are you? 
  • Do we not have food or housing? In fact housing is nicer than ever, and the move toward organic sustainable agriculture is restoring our food supply. 
  • Do we lack the ability to educate and train? No!
  • Do we lack energy or natural resources? Hardly!
  • Do we not have the means to build state-of-the-art production systems? Of course not!
  • Has innovation died? Are we no longer a nation of entrepreneurs? I am as excited today as I have ever been with the inventiveness, creativity and innovation happening throughout the country.

So why are so many unable to work? Why are businesses not growing and investing? Why is our engine spluttering and smoking, barely able to keep running? We’ve become afraid to put more oil in to compensate for all the oil being saved (and yes, we should address the excessive “saving” (extraction) part too, but I won't go there now).

This generation can and should be the most remarkable of all. They will transform every part of our economy to be more efficient and less destructive to our natural resources, dramatically improve our food supply, invest life-saving devices and science, lead us to improved health, and so much more!

Don’t believe the lie that we’re doomed to live in austerity. There’s no shortage of this kind of oil – we have the monopoly on its production! Let’s focus on what really matters, and stop fearing the use of money to benefit the real economy and society. 

Saturday, May 10, 2014

The Myth of the Great Moderation, by Haiku Charlatan

An eye opening comparison of the shift in economic policy from the post-WWII period to the debt-driven economy of the past 40 years.

For my conservative friends, don't get hung up with the Keynes references; and yes, there was plenty to complain about in society and the economy during the post WWII era also. 

Look rather at the big picture shift into a debt-based economy and the inequality that resulted as we rejected appropriate regulation, trusted in greed to be self-regulating, and shifted to debt as the path to wealth. 

You'll need to pause the video at times to read the quotes and look at the data as it moves a bit fast.

For those unconvinced, please share your comments on which of the following principles you disagree with and why.

Thursday, May 8, 2014

What about bank money? Can't the Private sector save by itself?

In the previous post we discussed the three financial sectors that affect money in an economy. We now look within the Private sector to the banking system. 

It is very helpful to separate money into two categories:
  • Government money (note: the terms Government and State are used in this blog interchangeably when referring to a currency-issuing sovereign)
  • Bank money, which is "created" whenever banks issue loans (mostly via simply crediting your bank account with numbers representing the amount of the loan). 

Bank money used to be quite separate from government money. In the past banks would issue their own IOUs or bank notes and often their value would differ from one bank to another. These bank notes would not be accepted by the government in payment for taxes but would circulate as money locally because people needed the bank money to retire their bank debt. Think of the national currency as the US Dollar and the local money could be First Bank $1 Note. It gets confusing because we use the same term for both - the dollar - and so we think of bank money and government money as the same thing. 

The distinction has become further blurred because our government has agreed to insure (FDIC) bank money so that if a bank goes out of business we don't lose our savings. This is a good thing. Furthermore, the central bank now provides a system for all banks to move money between themselves to clear transactions, so that all bank money and government money are now exchangeable at par. It all looks the same to the average person.

But there are differences in how the two types of money function.
  • Net inflows of Government money (spending less taxes) into the Private sector have no corresponding financial offset in the private sector. They result in net financial savings mostly in the form of bank reserves, Treasury bonds, bank account balances, and cash. [Note the logical and very real implication: our so-called "national debt" is actually our nation's financial savings.] 
  • However, all bank-issued money has a corresponding private sector liability. For every bank dollar saved there is a bank dollar owed. While some individuals or a businesses might be net saving, others are net in debt. When viewed in the aggregate, the Private sector cannot save financial assets from bank money (bearing in mind that they may be accumulating non-financial real assets such as houses or machinery). 

Bank money is formed by private sector borrowing. Many of our economic "boom" periods have been characterized by a large expansion of private borrowing (very often in excessive amounts and followed by inevitable "busts"). Banks create new money with every loan they issue. Bank money does impact the real economy: in a very positive way when it is used to build productive assets, and in a very negative way when it is used to speculate on existing assets or over-leverage businesses or households. But from a strictly financial sense, it is only Government money or a Foreign sector surplus that adds to Private sector net financial wealth. 

In the aggregate, we can't save money without an outside source injecting it into our economy. 

Think of it this way: if everyone saved and kept saving, then by definition there would be less and less money circulating to buy the output of all the producers, which means less money to pay wages (and make loan payments). Without some injection of additional money from either net exports or government deficits, unemployment would rise and wages would fall. This is, in fact, part of what is going on in the US today.

Some countries can get away with no deficits from the government sector (i.e. no injections of money into the economy) because they have a large enough trade surplus to make up for the amount of money the private sector desires to save. However, simple math tells us that all nations cannot be net exporters, and even those that do often can't keep up with the national savings level and still require some form of government money source (e.g. less taxes or more spending).

More private sector debt can give an appearance of financial gain, but eventually it will reach Ponzi-type levels where new debt is required just to pay the interest on the old debt, and as defaults rise, the overextended banking system busts as it did most recently in 2007-2008.

Once again, we reach our same conclusion that the monetary system can and should be used as a tool to benefit the nation. This tool can be used in many ways, from providing for full employment, lowering tax burdens, investing in education or infrastructure, and much more. We don't have to be afraid of using it!

Let me emphasize that this discussion is about the monetary system, not the real things money buys. Real wealth can be accumulated through ownership of land, capital goods, etc. We are strictly addressing how to use the monetary system properly to ensure enough dollars are always present to provide for full employment and a prosperous nation.

Deficits create financial savings

Money in a nation is not limited. False notions of fixed money supplies or limited gold reserves need to be put aside in order to properly understand how money works in an economy. When the government spends it does NOT use up money that would otherwise have existed in the economy. It is in fact injecting newly created money that we collectively save.  

It is helpful when talking about a nation’s money to separate the economy into three sectors:
  1. Government sector
  2. Private sector
  3. Foreign sector

When we want to assess how "the economy" is doing, we are usually talking about the Private sector. Viewing sectors independently helps us understand what is influencing the economy, and guides our understanding of how the monetary system can be used to benefit the economy (or more specifically, the nation's citizens).  

These three sectors ALWAYS balance. If the Private sector has a deficit with one sector, at least one other sector has to make up the difference. So how does each one influence money flows and the other sectors? 
  1. Government sector adds money through spending and removes money via taxation. Whatever is spent and not taxed remains in the Private (or Foreign) sector as savings (e.g. cash, deposits, bonds, bank reserves).
  2. Private sector's money is affected by the flows from the two other sectors. In addition, banks create bank money through loans to households & businesses but this is offset by an equal liability (debt) and so there is no "net savings" from bank money (see here for more on this).
  3. Foreign sector removes money when the Private sector imports (we buy goods; they get money), and adds money when the Private sector exports (they get goods; we get money).

We can see from this picture that the money left in the economy from net Government financial activity is actually a financial asset of the Private sector. Our nation's so-called "debt" is actually our savings.

If a country imports more than it exports as is the case with the US there is a drain of money from the economy that has to be made up somewhere. This can be via Private sector debt (borrowing to spend more than we earn), Private sector recession, and/or the Government spending more than it taxes (i.e. deficit spending). Recessions are evidence that some part of this equation has changed and the Private sector is contracting. 

Unfortunately, we have been led to believe that there is no alternative but to suffer unemployment and "real economy" contraction during such times. Appropriate use of government money can be used to offset another sector loss during such times, along with debt write-offs that free up incomes.

[Scott Fullwiler and Stephanie Kelton provide more detailed explanations of this equation, demonstrating how Domestic Private Sector Net Saving = Government Sector Deficit + Current Account Balance. See here, here and here

The chart below from Stephanie Kelton illustrates the net balance over time, highlighting the Clinton era surpluses which logically resulted in a recession once private debt creation reached a peak and could no longer compensate for the government removing money from the economy.]

Friday, May 2, 2014

News keeps spreading... QE is a tax!

Chris Mayer of the Daily Reckoning is picking up on the modern monetary understanding.

QE is not printing money - it is more like a tax for the simple reason that it reduces the flow of interest payments from the government (which creates them as new money via computer keystrokes to bank accounts).

What The Fed Is Really Doing To Your Money

Thursday, May 1, 2014

Once Upon A Time… Money Fairytales

Sit down, and let me tell you a tale of intrigue and tragedy. Long, long, ago humankind emerged from the dark primordial swamp of hunter-gatherer subsistence living and began the first primitive marketplace. Attempting to barter and exchange goods with one another, they soon discovered there was not a complete “coincidence of wants” – i.e. the leatherworker desired bread, but the bread maker desired bricks from the stonemason for a new oven not a sling from the leatherworker.

And so, as the story goes, money was born. Perhaps money may have started as the baker’s IOUs (since everyone wanted bread and would accept his “credit”), but eventually pure gold & silver became the best store of value and means of exchange and everyone lived happily ever after… at least until banks came along.

Those with extra money after meeting their needs wanted safekeeping for their gold and silver hoards and so banks were created to safely store their wealth. To make more money, the banks started lending out the gold (or receipts to gold) with interest to others who needed it. Not satisfied, the greedy bankers then began lending out more than they held in deposits, and so fractional reserve banking took over, inflating the money supply, causing inflation, and triggering economic crises.

Meanwhile, governments joined in by progressively devaluing the pure gold coins by debasement (reducing the gold content-to-price ratio) and seigniorage (dictating that the face value of their coins exceed the underlying precious metal value). Eventually, governments ditched the firm anchor of gold altogether and launched the world down the perilous path of un-backed “fiat” money, printing our way to hyperinflation and economic disaster. 

And so we await the knight in shining gold and silver armor to rescue our doomed civilization from the clutch of fiat-printing central bank dragons.

It’s a great story … for a novel. It is also largely fictional. Unfortunately, when fairy tales become economic history textbooks, much trouble enters the land.

Historians will tell you a much different story: one of circulating credit based initially around agrarian calendars; of sophisticated banking systems and credit clearinghouses enabling trade across continents; and of State-based monetary systems dating back into the early Mesopotamian valley civilizations over two thousand years BC. Throughout history, money has been credit, and for a very long time, most money has been State money enabled by some form of taxation. Whether inscribed and encased in clay or etched into wooden tally sticks, records of creditors and debtors have been recorded for thousands of years, and have functioned as the backbone of commerce and as a means of States to provision resources to themselves.

For those raised on the view that gold-backed money and 100% reserve banking equals “happily ever after”, it is important to know that such a system has rarely if ever actually existed in the real world. There is much evidence to the contrary. And even if one isn’t persuaded from history, we can at least agree that our present monetary systems are definitively State-based, backed by taxation, and have no link to gold. They require no borrowing from the population or from abroad, and so we cannot understand their function through the prism of gold-based or gold-convertible currencies. 

Before we pine for a golden "ever after", let’s first understand first how our current system works so we can operate it correctly, and cast off the confused policies that make nations pretend they live under imaginary constraints of a bygone and somewhat fictional era. Then we can deal with the real constraints head on.

State Money & Not State Money

So money as we know it is sovereign State money. A national currency is exactly that – the nation has a monopoly on the ability to issue its own currency. Our money is the thing we use to measure wealth, value goods and services, and account for transactions between buyers & sellers. Examples include the US dollar, the British Pound, Swiss Franc, the Canadian, New Zealand and Australian Dollars, the Japanese Yen and the Chinese Yuan Renminbi. Countries that operate this way have more flexibility than those who don’t.

Note that some countries have given up their sovereign currency. In Europe, the Deutsche Mark, French Franc, Italian Lira, Spanish Peseta, Dutch Gulden, etc. were surrendered (what were they thinking!) in order to share a currency that each country no longer issued (the Euro). Other countries use another nation’s currency or they issue their own currency but promise to keep its value in line with another currency that is viewed as stronger than theirs. A number of Central American countries do this with the US Dollar and some Pacific islands use the New Zealand Dollar. These countries all limit the range of policy options available to their citizens by removing or limiting the freedom they would otherwise possess as a currency-issuing sovereign State.

More reading on the history of State money