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: