Fiat Money and its Social Significance

Fiat money has neither intrinsic value nor convertibility into a valuable commodity. This raises interesting questions about the nature of money, the role of taxation and public debt in relation to government expenditure, and the democratic potential of modern societies.
The Chartalist View of Money

When money takes the form of a valuable commodity (e.g. gold) or is convertible into a valuable commodity (e.g. the US dollar from 1945-1971 under Bretton Woods), it may seem easier to understand why people are willing to accept it in exchange for goods and services. A valuable commodity provides a store of value (a form of wealth or saving) in itself.

But fiat money is not backed by a valuable commodity, and in itself is worthless. The reason for its general acceptance in exchange is therefore not immediately obvious. Although we may be happy to accept worthless pieces of paper or metal or even mere numbers on a computer screen as money once everyone else has, this doesn’t explain how fiat money gains acceptance in the first place.

The chartalist view, adopted by modern monetary theorists, is that demand for fiat money derives from the fact that people are compelled to pay taxes in it.

A simple thought experiment, grounded in historical experience, is often used to illustrate the point. Imagine a nation that has just gained sovereignty. In the past, its people may have been using a valuable commodity or a foreign currency for the purpose of exchange, but now the government decides to introduce its own fiat money. To ensure the community accepts it, the government can impose a tax, payable only in the new fiat money. This ensures a demand for the currency. People now have a need to obtain the government’s money in order to pay taxes. The government’s first step, then, in setting up the new currency is to impose a tax obligation.

Before people can pay the tax, however, and meet their obligation, they somehow have to get hold of the new fiat money. To make this possible, the government can buy some goods and services (which could include labor services) from the non-government, using the new money. Alternatively, it could lend some newly created fiat money to the non-government. Once the currency has been issued, through government spending or lending, it can then be used by people in exchange as well as for tax payments.

So government expenditure or lending must occur before taxes can be paid.

This shows that, as a matter of first principles, government expenditure or lending are logically prior to the receipt of tax revenue in a fiat-money system (or any state-money system). To be sure, a tax obligation must first be imposed to ensure a willingness in the community to accept the currency, thereby enabling the government to spend or lend its money into the economy. But tax revenues do not need to be — and from inception could not be — received by the government before it spends or lends. Tax revenue, in other words, does not fund government expenditure. Rather, government expenditure creates money that then cycles back in the form of tax payments. Government expenditure ‘finances’ tax payments.

So, in a fiat money system, taxes do not (and, logically, cannot) fund government expenditure.

The Role of Taxation

Taxation serves other purposes. As already mentioned, viewed at the most fundamental level, the enforcement of a tax obligation ensures a demand for the government’s money. By imposing a tax, the government creates a need within the non-government for its currency. This ensures a willingness on the part of some in the non-government to transact with the government, and enables some resources to be transferred from the private to public sector.

Taxes are also used to moderate private spending during inflationary and deflationary periods. When economic activity is strong and demand is testing the limits of productive capacity, prices of goods and services tend to rise. The government can ease the inflationary pressure by raising taxes, which withdraws some private spending power. When economic activity is weak, the government can do the reverse.

Much of this moderation of private spending occurs automatically, through the ‘automatic stabilizers’. When income and employment expand, people pay more tax and receive less in welfare benefits, even if the government does nothing to alter tax rates and benefit programs. When income and employment contract, tax payments fall and welfare receipts rise.

Taking these considerations together, taxation enables the transference of real resources from the private to public sector in a non-inflationary manner. By removing some private spending power, the government is able to purchase goods and services without unduly bidding up prices. So, although taxes do not fund public education, health care and other services, they do create space for them. They provide scope for the government to develop its socioeconomic program. However, in real terms, it is actually the government spending that taxes away private resources. When the government purchases goods or services, these are removed from the private sector and transferred to the public domain.

Ultimately, the size of the public sector relative to the private sector is a political choice. The right tend to prefer lower taxes and a smaller role for government; the left tend to support higher taxes, which create greater space for public-sector activity.

Clearly, then, the absence of a financial constraint on government expenditure does not mean that there are no limits. It just means that the limits are resource or political constraints, not financial constraints. The government might want to expand health care but confront a shortage of doctors and nurses – a resource constraint. Alternatively, there might be enough doctors and nurses but strong opposition to the government’s plan – a political constraint.

Nevertheless, the absence of a financial constraint is very significant. When politicians or commentators claim that the government “can’t afford” a popular social program, there is good reason to be skeptical. This is especially true if, like now, there happens to be high unemployment, underemployment and under-utilization of resources. The government could enable full employment and full utilization of resources by purchasing the necessary goods and services with its own, freely created fiat money.

For instance, modern monetary theorists point out that full employment could be achieved by the government introducing a job guarantee at minimum wage to anyone who wishes to work. Once economic activity picked up in the rest of the economy, enterprises that paid above minimum wage would attract workers out of the job-guarantee program.

In fact, something pretty similar to this was done on an informal basis in numerous countries in the post-war period up until the 1970s. Policies that succeeded in keeping unemployment below 2 per cent for much of the post-war period were not atypical, but met with stiff resistance from capitalists and central bankers who preferred high unemployment to put downward pressure on real wages. This was the story, for example, in New Zealand. An excellent film, In a Land of Plenty, documents capital’s opposition to full employment in that country, and the subsequent abandonment of an implicit employment guarantee.

Certainly there are powerful sections of society opposed to full-employment policies, but if sufficient democratic pressure were exerted, a job guarantee could be introduced. The resources are clearly available. The very existence of the unemployed workers makes the hiring of them affordable. The only thing missing is the political will.

The Role of Public Debt

Just as tax revenue is not required to fund government spending, public debt is in no way needed to fund budget deficits. There is no need for the government to borrow in order to fund its net spending, because it can create its own money at will. Yet, currently, the government does issue public debt, so this requires explanation. The debt must be serving other purposes, even if the government really does think the debt funds its net spending.

At present, government debt does indeed serve various functions, though none are indispensable. One function is operational. The central bank uses government-debt management as a means of controlling the short-term interest rate. Whenever there is a net flow of funds out of the banking system or a net flow into it, the central bank buys or sells short-term government bonds to put the system back in balance and maintain its target interest rate.

The effect of a budget deficit is to cause a net inflow of funds, because it involves the crediting of private bank accounts (spending) more than debiting of them (taxing). In short, the central bank coordinates an overall increase in the reserve balances of private banks, which are held in special accounts with the central bank, and a corresponding increase in private bank deposits. Banks will be keen to exchange their excess reserves for short-term bonds, to earn higher interest, but because the system is in surplus, there will be excess demand for available bonds.

If the central bank stood aside and left private banks to compete for existing bonds, the interest rate would drop to zero. Whenever the central bank’s official interest-rate target is above zero, it has to step in and mop up the excess liquidity by selling government bonds (issuing public debt) in exchange for the excess reserves. In other words, debt is issued to control the interest rate, not to fund the net expenditure.

Government debt also provides the private sector with a vehicle for saving. Bonds provide a risk-free return that exceeds the interest rate paid on bank reserves, and so are sought by private-sector agents.

Australian Modern Monetary Theorist Bill Mitchell has explained in an eye-opening post how the private-sector desire for bonds was made very evident in his country in the early 2000s during the period of a conservative government that oversaw ten budget surpluses in eleven years. Since the budget was in surplus, it was initially supposed that there was less need to issue government debt – the assumption being that the purpose of debt is to fund budget deficits. The assumption was quickly revealed to be unfounded. The drying up of government debt caused disquiet in the financial community, which suddenly had less access to risk-free government bonds.

The government’s response was for the central bank to sell bonds (issue debt) even though there was no budget deficit. This should have demonstrated once and for all that the issuance of public debt has nothing to do with funding government net spending.

In short, the government has no need of funding. It is in a position to spend or lend as it sees fit. Private-sector agents are financially constrained; the government is not.

Although it is true that government debt currently serves various functions, these functions could be achieved in a different – and more direct – way. The central bank could simply pay its target cash rate on all bank reserves. This would ensure that its short-term interest-rate target was achieved without any need to issue public debt. It would also provide a saving vehicle to the private sector that is equivalent to short-term bonds.

The simplicity of this solution suggests that other factors must be at play in prolonging the unnecessary issuance of government debt. Most likely there is a political motivation. The existence of public debt makes it appear as if it is possible for the government to run into debt problems. It gives the false impression that there are financial limits to the expansion of public-sector activity, when there are only resource and political limits. And it means the government can claim it is not meeting social demands because they are “unaffordable”. In this way, community fear over the supposed perils of public debt serves a political and ideological function for sections of capital and capitalist governments.

In Britain, the fear of public debt appears to have aided financial capital in its demands for a return to fiscal austerity, despite the economy struggling to recover from its worst recession since the 1930s. In the United States, Obama has claimed repeatedly that “the government is running out of money”. Such claims have the effect of legitimizing inaction on unemployment, cuts to social security, insufficient reform of the US healthcare system, underfunding of education, inadequate provision of childcare and so on. The notion of a government running out of its own fiat currency is nonsensical. In spite of this, the illusion that public debt can be a problem persists.

Social Implications of Fiat Money

If we see through the illusion, though, it seems that the introduction of fiat money is socially very significant. In commodity-money and commodity-backed money systems, external undemocratic pressures were frequently imposed on sovereign nations. Governments were not completely free to create and destroy money in whatever way best met the needs and wishes of the community. This is because they were obliged to keep the quantity of money in circulation in a certain relationship to their gold reserves or, under Bretton Woods, their foreign currency reserves.

Under Bretton Woods, for instance, the US government was obliged to stand ready to convert the US dollar to gold on demand at $35 an ounce. If the US government acted in ways that reduced the real value of the US dollar, or other governments or private-sector agents acted in ways that increased the market value of gold, the US government would be forced to pay an ounce of gold for $35 when in reality the value of an ounce of gold might have risen to $45 or $50. This requirement hampered the US government in its domestic operations. Eventually, due to the costs of the Vietnam War, the US government under Nixon refused to continue convertibility and the system broke down.

More generally, commodity-backed money meant that trade-deficit economies were always under pressure to restrict domestic demand in order to preserve the foreign-exchange value of their currencies. In effect, the system created external, undemocratic pressures that hindered a sovereign government’s pursuit of the will of its citizens.

Fiat money can also give rise to similar pressures if a sovereign government fixes its exchange rate or pegs it to the value of another, major currency. Often the IMF applies pressure on the governments of poor countries to fix or peg their currencies when it extends loans. The elites in these countries will sometimes be happy to go along with the IMF’s demands, because fixing or pegging the currency value at an artificially high rate cheapens imported luxury items for the wealthy minority. However, the policy harms these countries’ trade performance and also prevents governments from pursuing full-employment policies.

So fiat currency in itself is not enough to ensure policy freedom and an absence of external, undemocratic pressures. But if a fiat currency operates under a flexible exchange-rate regime, the undemocratic pressures are largely absent. The government is then at liberty to pursue domestic policies that are responsive to the community’s needs. Some external pressures do remain, but a government is perfectly at liberty to resist them. For instance, rating agencies can and do attempt to influence government policy, but any government of a developed country that bends to these pressures does so entirely voluntarily.

Japan is a case in point. In that country, the government has implemented very large budget deficits year after year since the Asian crisis. The rating agencies downgraded Japan’s credit rating significantly, which many observers initially feared would undermine confidence in the Japanese yen, and cause inflation and high interest rates. But this has not occurred. Demand for government debt has remained strong with interest rates at or near zero, and inflation is not at all in prospect.

The global financial crisis has made very clear that the rating agencies do not deserve to be taken seriously, and the Japanese government is right to ignore them. The agencies hand out AAA ratings for toxic junk while supposing that a sovereign government who is the monopoly issuer of its own fiat currency can somehow be at risk of insolvency.

The implication of fiat money is liberating: a popularly backed government can always purchase whatever goods and services are available for sale in its own currency. Fiat money enables a system in which, in principle, the government is constrained only by real resources and the political desires of the community. For this principle to be put fully into practice, there needs to be democratic accountability. The community’s desire may be for small or big government. Fiat money makes either feasible.

It is not clear, however, that the implication is widely understood. It is in the interests of a small minority to try to conceal the implication, because fiscal austerity suits elite interests. It results in high unemployment, which suppresses real-wage growth. It also creates an impression that desirable social policies are “unaffordable”, legitimizing inequality and government inaction.

It would be a powerful thing for us to wake up to the fact that, in a fiat-money system, we need not be constrained by the disciplines of capital and the profit motive to the extent we choose; that the only constraint is the availability of resources; that we are free, as a society, to utilize these resources as we see fit. With such a clear realization, no amount of mystification and propaganda could hide the obvious.

If the realization ever hit, the elites might struggle to quell our demands for full-employment, fulfilling work, improved working conditions, more and higher quality leisure time, better services, public-goods production and environmentally sustainable living that would be likely to follow.

But as long as we remain in the dark, the greater likelihood is for savage attacks on wages, social services and general living conditions, as capitalists and capitalist governments take advantage of high unemployment and an irrational fear of public debt to continue a massive upward transfer of wealth to a small but powerful financial elite.


15 thoughts on “Fiat Money and its Social Significance

  1. So what is the solution to becoming one of the elite??.
    Why work for a living?.
    Why do businesses go Bankrupt?

  2. Chris: Welcome. As explained in the post, households and businesses are financially constrained. They need to earn or borrow income before they can spend. A currency sovereign, in contrast, is not revenue constrained. Its constraints are real (resource availability) and political (most notably, the democratic process).

    Enterprises that fail to make a profit or service their debt will go out of business unless it is determined through the political process that they should be kept alive. I would argue that the “too big to fail” type policies would have had less — not more — chance of being implemented if the broader community’s preferences on the matter were taken into account and weighted appropriately. This sort of corruption, especially in relation to the big banks, is also occurring under other monetary systems.

    The method for becoming part of the elite is to rid yourself of any principles and cheat, lie, steal and murder your way to the top. Even then, you will need a lot of luck. A better solution would be for the 99 percent to take back control of the direction in which society is heading.

  3. Interesting reading…. I assume though that this is what was implemented by latter day Nazi Germany and also Zimbabwe…. Both cases lead to rocket inflation and extreme poverty. You talk of being constrained only be resources, but maybe these cases show that we *are* constrained by resources, which the present system (in Britain) helps to manage. ?

  4. I’ve been following MMT for a while thanks to Stephanie Kelton’s activity on Twitter. This is one of the better, and more concise descriptions of the theory I’ve read.

    What I don’t understand is why the theory has failed to gain more traction among economists, particularly Keynesian economists like Krugman. Krugman, Stiglitz, and a lot of others argue correctly that austerity at this time is bad policy and that the Government should be spending more, not less, deficits notwithstanding – yet they seem to be in agreement that the debt is a problem that needs to be addressed down the road. That position would seem to be just as illusory as the notion that it must be addressed now.

    If they don’t buy into it, how will politicians ever embrace it? What has to happen?

  5. @ Bob Fishell

    Several factors are operative. One is “the not invented here” syndrome that affects all levels of vested interests. Closely associated is the “I hate admitting I was wrong” syndrome, as well as “I am among the Very Serious People” syndrome. These are strong cognitive biases that stand in the way of change pretty universally, not only in economics.

    In mainstream economics model-worship is also a strong cultural force. Krugman’s major objection professionally to MMT is “no model.” He is hardly alone in this. No matter that his ISLM assumes a monetary system that is no longer operative, it’s a model. Mainstream economics is all about model-building, regardless of whether the model is representation of the economy. Facts that disconfirm favorite models are either denied or spun. A fundamental assumption of the mainstream is that factual evidence provided by data is secondary to the mathematical elegance of the model. So data is always suspect. Economists are not alone in this. Former GM chairman and CEO Jack Welch has been ranting lately how the official US employment figures are cooked.

    As far as I can tell those the really big hurdles, although there are some others, like failure to take the trouble to actually understand a position before criticizing a straw man instead. Of course, when someone like Krugman does this, it creates disinformation about the position.

  6. Yes of course, unemployed people are one resource. But print money, give it to them presumably for services, and they are eventually going to want to buy *stuff* with that money. That’s where I question the lack of a resource limit. If there’s not a surplus of *stuff* then prices rise and you have essentially stealth taxed savers to provide for these 2.5m.

    I’m not arguing against you per se, just trying to improve my understanding.

  7. Yes, it is all about real resources and their distribution. If goods are rationed through a market system in which price is denominated in the govt’s unit of account, then distribution of real resources takes place through economic policy and the balance of public-private and within the private sector is a matter of political decision for voters to make. The right says to let “market efficiencies” dominate regardless of social outcomes, and the left says to take social outcome into consideration in economic policy making.

    In capitalistic economies increasing demand doesn’t “crowd out” real resources. Rationing is price-based, so prices increase if the market cannot expand to meet increasing demand, rationing available supply, or else substitutes are restored to if available, or else developed. Very seldom is there a supply shortage that is not addressed by investment when there is effective demand present.

  8. It’s good to see a post that ties MMT together with the need for government accountability. I would suggest that the MMT community thusly utilize their collective economic acumen to make a further connection, to the economics of election theory. The implications are massive, as we shall see below.

    Imagine the following set of voter preferences for 3 candidates. The candidates MMT1 and MMT2 are well versed in MMT, and understand the fallacies around the fiscal cliff hysteria. The candidate FC is a fiscal cliffer (for lack of a better word), who either doesn’t understand MMT or pretends not to, in order to carry out the ambitions of Wall Street.

    35% FC > others
    33% MMT1 > MMT2 > FC
    32% MMT2 > MMT1 > FC

    In an ordinary Plurality Voting election, FC wins with 35% of the vote (providing everyone votes honestly for their favorite candidate). This in spite of the fact that a massive 65% majority would prefer *either* of the MMT candidates.

    This is the vote splitting or “spoiler” effect, and it also explains why Maine has a Republican governor who is one of the least popular governors in the country. A Democrat and a moderate independent split the majority vote.

    There are simple alternative ways of voting which almost completely solve this kind of problem. The simplest, called Approval Voting, allows voters to vote for as many candidates as they wish. The candidate with the most votes still wins. A slightly more sophisticated system is Score Voting, where the candidates are scored on a scale such as 0-5, and the candidate with the most points wins. There are several other systems which are based on rankings, but tend to be much more complicated and lead to worse outcomes.

    Here’s where the economics come into play. This is big.

    In the year 2000, a Princeton math PhD named Warren D. Smith conducted an extensive series of computerized election simulations, meant to measure the efficacy of various voting systems based on a metric called “Bayesian regret”. Bayesian regret simply measures the net voter welfare (“utility”) lost by inefficiency in the voting system.

    Smith’s results were surprising in their magnitude. It turns out that an upgrade to Score Voting increases the public welfare as much compared to ordinary vote-for-one Plurality Voting as Plurality Voting improves vs. random non-democratic selection. I.e. Score Voting “doubles democracy”.

    Stop and think about that for a moment. Think about the welfare increase we get by at least having the amount of democracy we do, compared to rule by random chance: say accident of royal birth, or successful coup. (Various large studies of GDP as correlated to democratic-ness are impressive.) Now imagine doubling that, simply by changing how people vote. In the case of Approval Voting, you merely change the rule from “vote for one” to “vote for one, or more”.

    If you think using your big economically savvy brains to spread the MMT gospel is important, I implore you to also learn about Bayesian regret. Here’s a starting point:

    Clay Shentrup
    The Center for Election Science

  9. Excellent Article..and agreed…commodity monetary system is for the Elites…which want to submerge us into an unneeded austerity only because of their lack of knowledge on our Monetary System….

    By the way Fiat Money is backed by the US Treasury…if there is any metal involved it is the metal of our weapons…

    Fiat Money and our Central FED are the greatest inventions of modern times

    For more on Chartalist theory

  10. If it were true that funding isn’t the limitation on government spending, it seems to me that government could simply provide all citizens with all their wants and needs. No tax required, just spend, spend, spend.

    Do you really think that running out of real resources is the only limit? The *allocation* of real resources is the main determinant of their supply. In other words, it is the ingenuity of individuals, driven to acquire goods and services *they* want, that create the resources (and the goods and services that other people want).

    Come a properly socialist government, social programs will provide all citizens with housing, education, healthcare, pensions etc, and there will be jobs for all! Hang on a minute, why would we *need* jobs???

  11. Hi Michael G: It does not follow that “if the funding isn’t the limitation” that the “government could simply provide all citizens with all their wants and needs”, because there are limitations. The limitations are real resources (inflation) and political obstacles.

    None of this implies taxation can be done away with. It is through the tax obligation that the government can ensure a demand for its currency. An enforced tax obligation is a sufficient (not necessary) condition for a currency’s viability. In addition to driving a demand for the currency, taxes can be used to moderate demand if inflationary pressures emerge. They help to maintain the value of the currency:

    Value of the Currency
    A Short Note on the Currency Value

    In the post it was also noted that there are political constraints, so no, I do not think that resources are the only constraint. This doesn’t change the fact that there is an absence of financial constraint for currency-issuing governments.

    Nor is there a denial of the importance of innovative individuals and the initiative and creativity of the population. Some of this creativity and productiveness is expressed in the domestic private sector. Some of it is organized in the public sector through a transfer of real resources and productive activity from the private to public domain. The tax obligation is what enables this real transfer to occur.

    Fiat Money as a Means of Shifting Some Resources to the Public Sector
    Cranks at the Financial Times

    The notion that taxes can underpin demand for a currency has a long history in economic thought. The view was endorsed by Adam Smith, Say, John Stuart Mill and Keynes among others.

    More on Cranks at the Financial Times

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