A fiat currency has neither intrinsic value nor convertibility into a valuable commodity. This raises interesting questions about the nature of a currency, the role of taxation and public debt in relation to government spending, and the democratic potential of modern societies.
The chartalist view of state money
When a currency is convertible into a valuable commodity at a fixed rate (as was the case under the gold standard or as was true of the US dollar from 1945-1971 under Bretton Woods), it may seem easier to understand why people are willing to accept the currency in exchange for goods and services. A valuable commodity provides a store of value (a form of wealth or saving) in itself.
But a fiat currency is not backed by a valuable commodity, and in itself is worthless. The underlying 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 currency once everyone else has, this doesn’t explain how a fiat currency gains acceptance in the first place.
The chartalist view, adopted by Modern Monetary Theorists, is that demand for a currency ultimately 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 currency. To ensure the community accepts it, the government can impose a tax, payable only in the new currency. This ensures a demand for the currency. People now have a need to obtain the currency 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 currency. To make this possible, the government can buy some goods and services (which could include labor services) from members of the community, using the new currency. Alternatively, the government could make loans in its currency. 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, from inception, a government that issues its own currency must spend or lend before taxes can be paid.
This shows that, as a matter of first principles, a currency-issuing government’s spending or lending are logically prior to the receipt of tax revenue. To be sure, a tax obligation is first imposed to ensure a willingness in the community to accept the currency, thereby enabling the government to spend or lend its currency into the economy. But tax payments do not need to be – and from inception cannot be – received by the government before it spends or lends. Tax payments, in other words, do not finance government spending. Rather, government spending issues currency that then cycles back in the form of tax payments. Government spending “finances” tax payments.
So, for a currency-issuing government, taxes do not (and, logically, cannot) finance government spending. (A scholarly demonstration of this point is provided in Stephanie Kelton (Bell), ‘Do Taxes and Bonds Finance Government Spending?’, Journal of Economic Issues, 2000, vol. 34, pp. 603-20.)
The role of taxation
Taxation serves other important purposes. As already mentioned, viewed at the most basic level, the enforcement of a tax obligation ensures a demand for the currency. By imposing taxes, government creates a need within the community for the currency. This ensures a willingness of some individuals and organizations to transact with government, enabling resources to be transferred from the private to public sector.
Taxes are also used to moderate private spending during inflationary and deflationary episodes. When economic activity is strong and demand is testing the limits of productive capacity, prices of goods and services tend to inflate. A rise in tax payments will withdraw some private spending power from the economy, easing the inflationary pressures. When economic activity is weak, deflationary forces and mass unemployment can result. A reduction in tax payments can soften the effects.
For the most part, this moderation of private spending occurs automatically, through what are called 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.
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 to create greater space for public-sector activity.
Clearly, then, the absence of a financial constraint on government spending 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, commentators or special interest groups claim that the government “can’t afford” a popular social program, there is good reason to be skeptical. This is especially true if there happen to be high unemployment, underemployment and under-utilization of resources. The government could enable full employment and full utilization of resources by purchasing additional goods and services with its own currency.
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.
The role of public debt
Just as taxes do not finance the spending of a currency-issuing government, public debt also plays no financing role. There is no need for a government to borrow in order to finance its spending, because it creates its own currency at will. Yet, currently, governments do issue public debt, so this requires explanation. The debt must be serving other purposes, even if governments really do think the debt plays a financing role.
At present, government debt does indeed serve various functions, though none that are indispensable. One function is operational. In many countries, the central bank uses public-debt management as a means of controlling the short-term interest rate. Government deficits cause a net influx of bank reserves. This, considered in isolation, exerts downward pressure on the interbank lending rate. If the central bank is targeting a positive interest rate, it needs a way of preventing the fall of the interbank rate to zero. One way of preventing the fall is for the central bank to sell bonds to non-government. Over time, if the government runs continuous deficits, this method of interest-rate management can only work if the government continues to issue bonds sufficient for the purpose. Otherwise the central bank will eventually run out of bonds to sell. A better way to control the interest rate, and one that has been adopted in some countries since the onset of the global financial crisis, is for the central bank simply to pay the policy rate on reserves. Under this more direct method, there is no longer any need for the government to issue bonds simply for purposes of interest-rate control.
Public debt also functions as a safe vehicle for private saving. Government bonds provide a risk-free nominal return that exceeds the interest rate paid on bank reserves, and so are sought by private-sector agents. The bonds are risk free because a currency-issuing government can always meet commitments denominated in its own currency. It is precisely because a currency-issuing government faces no revenue constraint that its bonds are risk free.
So, although it is true that public debt currently serves various functions, these functions can be achieved in more direct ways. The central bank can hit its interest-rate target simply by paying its target rate on bank reserves. The government can still offer bonds to the private sector as a means of risk-free saving, if this is deemed appropriate, but there is no need to link such bond issuance to government deficits.
The overt linking of government bond issuance with fiscal deficits has a detrimental impact on public understanding of macroeconomic issues. The linkage makes it appear as if bondholders are serving public purpose, supposedly financing government deficits. It supports a fiction that a government could somehow face solvency issues with debt denominated in its own currency. It gives the false impression that there are financial limits to social provisioning, when there are only resource and political limits. And it means that politicians can falsely attribute a failure to meet reasonable social demands to “unaffordability”. In this way, community fear over the supposed perils of public debt serves a political and ideological function that results in unnecessary hardship for many.
Social implications of fiat currency
If we see through the illusion, though, it seems that the prevalence of fiat currencies is socially very significant. Under commodity-backed currency systems, external undemocratic pressures are frequently imposed on sovereign nations. So long as a government adheres to such an arrangement, it is not in a position to create and destroy currency (through spending and taxing) in whatever way best meets the needs and wishes of its constituency. This is because the government is then obliged to keep the quantity of currency in circulation in a certain relationship to its commodity 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, the Bretton Woods arrangement meant that trade-deficit economies were always under pressure to restrict domestic demand in order to preserve the foreign-exchange values 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 currencies can also be susceptible to similar pressures if a sovereign government fixes its exchange rate or pegs it to the value of another, major currency. Often the International Monetary Fund (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 a 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 able to pursue domestic policies that are responsive to the community’s needs. Some external political 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 fiscal deficits year after year since the Asian crisis of the late 1990s. The rating agencies downgraded Japan’s credit rating significantly, which many observers initially supposed would undermine confidence in the Japanese yen and cause inflation and high interest rates. But this has not occurred. Demand for Japanese public 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 that is the monopoly issuer of its own fiat currency can somehow be at risk of insolvency.
The implication of fiat currency is liberating: a popularly backed government can always purchase whatever goods and services are available for sale in its own currency. Fiat currency 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.
At the moment, the implication is not widely understood. But if the realization ever hits, we will understand that, in a fiat-currency system, the only true constraint is the availability of resources; that we are free, as a society, to utilize these resources as we see fit, and may continue to do so into the future if we can embrace environmentally sustainable ways of exercising this freedom.
But so long as we remain in the dark, the greater likelihood is austerity, wage suppression, deteriorating working conditions, decaying infrastructure, fraying social services and needless suffering in a mistaken belief that such sacrifice is necessary.