We saw in part 2 that to establish a currency, government needs to do three things:
1. Define a unit of account (e.g. dollar).
2. Impose taxes that can only be paid in that unit of account.
3. Spend or lend the currency into existence.
The most basic purpose of taxation (introduced in step 2 of the sequence) is to create a demand for the currency. Provided taxes are effectively enforced, we in the non-government will have a need to obtain the currency, because it is the only means of paying taxes.
Economists sometimes summarize this as “taxes drive money”. This is shorthand for the idea that taxes create a demand for the currency. Or, put slightly differently, taxes ensure acceptance of the currency. They ensure that we will be willing to accept the currency in payment for goods and services (including labor services).
The government’s commitment to accept its own currency back in payment of taxes is in keeping with the interpretation of money as an IOU discussed in part 11. We saw that, as a general rule, an IOU is made acceptable by its issuer promising to accept it back again in payment for services rendered.
A currency-issuing government’s IOU is the currency. Like any issuer of an IOU, government promises to accept its IOU back again in fulfillment of obligations to it.
Government is well positioned when it comes to getting its IOU accepted because it has the authority to impose and enforce financial obligations payable only in its own IOU.
For example, taxes in the United States must be paid in dollars. To be more specific, final settlement of taxes only occurs in government money of a particular form known as reserves. (The other form of government money is cash.) Reserves are special funds that commercial banks need for settling transactions. The government’s monetary agent, the Federal Reserve, is the sole issuer of reserves, and the commercial banks have special accounts with the Fed for holding these reserves.
In other countries with their own currencies, the situation is similar. People in the United Kingdom must pay taxes in pounds. The Chinese are required to pay taxes in yuan, the Japanese in yen, Russians in the ruble, and so on.
Unlike other monies lower down the ‘money hierarchy’, acceptance of the currency is essentially compelled rather than voluntary. Since we have little choice but to pay our taxes, we must obtain the currency.
In principle, of course, government is imposing taxes on our behalf. Any legitimacy it has is bestowed on it by us. The purpose of government (considered in part 1) is to perform functions that are best handled collectively. A national currency is the central tool for doing this. It enables government to move some resources to the public sector.
The government achieves this through spending. When the government spends its currency into existence by purchasing goods and services from non-government, these goods and services are shifted to the public sector and non-government obtains currency with which it can pay taxes.