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 purposes 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.
Before people can pay the tax, however, 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. This will put some money into circulation – create money – which can then be used 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 taxation in a fiat-money system (or any state-money system). Taxes are not needed to 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, there is no need for taxes to be used as a means of funding government expenditure.
The Role of Taxation
Taxation serves a different purpose. 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 economists, commentators or politicians 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 government crediting private bank accounts (spending) more than it debits them (taxing). As a result, there is an overall increase in private bank deposits and a corresponding increase in the reserves of private banks, which are held in accounts with the central bank. 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 price of the bonds would skyrocket and the interest rate, which is inversely related to the bond price, would approach zero. If 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 create and destroy its own money as it pleases. Whenever it transacts with the private sector – a ‘vertical’ transaction – money is either created or destroyed. Whenever the government runs a budget deficit or surplus, there is a net change in private-sector holdings of financial assets. In contrast, when private sector agents transact among themselves – a ‘horizontal’ transaction – there is no net change in financial assets, because such transactions always create a private asset and a matching private liability, netting to zero. The government can create or destroy net private financial assets at will; the private sector cannot. 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.