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 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 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 non-government, using the new currency. Alternatively, the government could lend some of its currency to 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, 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), ‘Can Taxes and Bonds Finance Government Spending’, Journal of Economic Issues, 2000, vol. 34, pp. 603-20. A working paper version can be found here.)
The Role of Taxation
Taxation serves other important purposes. As already mentioned, viewed at the most fundamental level, the enforcement of a tax obligation ensures a demand for the currency. By imposing a tax, the government creates a need within non-government for the currency. This ensures a willingness on the part of some in the non-government sector to transact with 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 episodes. 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 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. So, although taxes do not finance 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 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 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 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 the necessary goods and services with its own, freely created 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.
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 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 can create 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 these functions could be carried out in a simpler way. One function is operational. The central bank uses public-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 government deficit, considered in isolation, is to cause a net inflow of funds, because it involves the crediting of private bank accounts (spending) more than the debiting of them (taxing). In particular, a government deficit, viewed in isolation, will require the central bank to coordinate an overall increase in the reserve balances of private banks, which are held in special accounts with the central bank, along with a corresponding increase in private bank deposits. Banks will be keen to exchange any excess reserves for short-term bonds, to earn higher interest. But if the banking system as a whole has a surplus of reserves, there will be excess demand for available bonds.
If, amid a system-wide surplus of reserves, the government simply left commercial banks to compete for available bonds, the interest rate on the bonds would drop to zero (or to the interest rate paid on reserves). Whenever the central bank’s official interest-rate target is above zero (or above the rate it pays on reserves), it has to step in and mop up excess liquidity by selling government bonds (public debt) in exchange for surplus reserves.
To offset the impact of a government deficit on the level of reserves in the banking system, the fiscal authority (e.g. the Treasury) issues public debt to match any government deficit (any excess of government spending over tax payments). The sale of newly issued government bonds results in a debiting of non-government bank accounts and banks’ reserve accounts as members of the non-government sector pay for the bonds. This nullifies the impact of the government deficit on the level of reserves in the banking system, thereby assisting the central bank in its conduct of monetary policy. In other words, public debt is issued to help the central bank maintain control of the interest rate, not to finance government spending.
Public debt also provides the private sector with a vehicle for saving. Government bonds provide a risk-free return that exceeds the interest rate paid on bank reserves, and so are sought by private-sector agents.
Australian economist Bill Mitchell has explained in an eye-opening post how the private-sector desire for bonds was made very evident in Australia in the early 2000s during a period in which government ran ten fiscal surpluses in eleven years. Since the government was in surplus, it was initially supposed that there was less need to issue public debt – the assumption being that the purpose of public debt is to finance government deficits. The assumption was quickly revealed to be unfounded. The drying up of public debt caused disquiet in the financial community, which suddenly had less access to risk-free government bonds.
The government’s response was to issue more debt even though there was no fiscal deficit. This should have made clear that the issuance of public debt is not for the purpose of financing government spending.
In short, a currency-issuing government has no need of financing. It is in a position to spend or lend as it sees fit. Private-sector agents are financially constrained; a currency-issuing government is not.
Although it is true that public debt currently serves various functions, these functions could be achieved in a different – and more direct – way. The central bank could hit its interest-rate target simply by paying its target rate on all bank reserves. Under this method, the short-term interest-rate could be set without any need to issue public debt.
The government could still offer bonds to the private sector as a means of risk-free saving, if this was deemed to be appropriate, but there would be no need to link such bond issuance to government deficits.
The simplicity of this solution suggests that other factors must be behind the unnecessary linking of government bond issuance with fiscal deficits. Most likely there is a political motivation. The linkage makes it appear as if bondholders are serving a useful function, supposedly financing government deficits. It also creates a misleading impression 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 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 reasonable 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.
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 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 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 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 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.
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-currency 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.