Monday, November 7, 2011

Understanding Fiat Money

There seems to be a lot of confusion concerning just what gives money its value or even what money really is. I think that evidence has shown that this is a somewhat elusive issue, because the nature and role of money has varied throughout history (See David Graeber's book "Debt: The first 5000 years").

But almost invariably, money has represented a credit-debt relation. Money is one person's asset and another's liability. It has taken many forms throughout history: gold, tokens, coins, tallies, people, cigarettes, and even numbers in bank accounts. There really are too many to name in a reasonable amount of time. But the important point is that the object represented a relation or social obligation. The gold or whatever was the asset of one individual but the liability of another.

Money in recent history has evolved from precious metals and the gold standard to paper money and eventually to pure credit represented by numbers in bank accounts or so the tale goes. But if gold was what gave money its value (supposedly) and our paper currency or even our pure credit currency isn't backed by gold then what gives it its value?

That is, if money is a credit-debt relation and not merely an object, then what gives it value? Some contend that the goods it can buy is what gives it value, i.e. that it is backed by real goods. This seems to make sense, because after all, paper money is pretty worthless in and of itself. It doesn't do anything but get you other things that do have some use-value. I suppose you could use it as kleenex (as in one of my favorite movies), but clearly its physical properties are not what give it value. Pure credit money would have no value at all then.

Instead, we give it value by accepting it. Just like the key to obtaining a loan (a debt) is getting it accepted by a creditor, the key to any money is getting it accepted. I can create my own money, essentially IOUs, but the only way that it would have value is if someone was willing to accept it usually in exchange for something. They might do this if they trust me to make good on my promise to pay them back whatever it is that I said I'd pay them back.

Acceptance, then, is the key to any money having value. All monies fall into a sort of hierarchy of acceptance. Not many people would be willing to accept my IOUs, but perhaps they would accept them from a higher more powerful institution, say a bank. In fact, that's what bank loans are, bank money. They aren't US Dollars. They are convertible into US Dollars, but they aren't initially US dollars.

So why do we use US dollars as currency? Because our government requires us to pay our taxes and fines to them in US dollars. To pay taxes we need to obtain US dollars. We do this by working for the state, offering goods and services to the state in exchange for US dollars. We then use those dollars to pay our taxes. Logically, the gov’t must pay out at least as many dollars as it requires in taxes, otherwise some of us wouldn’t be able to pay our taxes and would face the punishment of not paying our taxes. But even more likely, it will have to pay out more dollars than it requires us to pay in because we will want to save and prepare for future tax liabilities. This means that the govt MUST spend at a deficit (gov’t spending>taxes).

Because we need US dollars to pay taxes, we will also use them to exchange for other goods and services outside of the government sector because others will also need US dollars to pay their taxes. So long as the tax liability is sufficiently high and on a sufficient amount of the people in the nation, US dollars will be the most accepted form of money. If taxes aren’t high enough, then inflation can become an issue. Spending should be high enough to provide the public with enough dollars to pay back in taxes and to satisfy their desire for net financial saving. With this understanding, you can see that a balanced budget would be disastrous! Deficits do matter; the right sized deficit is what we need, not a balanced budget.

To sum up, acceptance is what gives money its value, not real goods and services (note however that real goods and services are what matter in an economy because we create money in order to obtain or lay claim to those goods and services, but that the value of money still depends on acceptance). Taxes are what make state money the most accepted form of money in a nation, and it is therefore the state’s ability to issue a tax on its people that gives it its power over the monetary system.

Moving to a gold standard would not remove this power from the state. It would only restrict their ability to respond to economic or financial crises much like in the early 20th century.

For more on this topic I recommend this post from L. Randall Wray.


  1. This reminds me of something I've wanted to ask you Alex. If the US economy is run on a print money-tax system then why does everyone treat it as a tax-budget system? For instance in the debt ceiling debate, the president made a comment that he might not get the social security checks out. His treasury secretary said that we would run out of money on a certain date. Now from what I understand from your posts this is impossible. That we can in effect "print money," and then tax it to keep down inflation. That we never have to worry about running out of money only inflation. If this is all true then how come nobody in government even the treasury secretary acts like it? Are they misinformed? Are they being deceptive? Are they afraid that if people find out that they don't need their taxes for next year's budget there would be a revolt? Economists seem to have a different vocab then the government. It seems to me that this cannot continue forever. That soon the government needs to explain that America is not a business with a budget, or people might get fed up with a system they can't understand and create one they can, even if it hurts.

  2. Yes, great questions! Still searching for the answers myself. There are many economists who use this same language, not just politicians, and I'm left wondering are they ignorant or are they purposefully deceiving us? Neither answer is very comforting.

    The actual operations are somewhat complex and are highly coordinated between the Fed and the Treasury so that it appears that the government can't spend without either taxes or loans (bonds). But in reality it doesn't need to do this, the reason it does is so that the Fed can control overnight lending rates to meet its targeted rate.

    If people did find out the truth there very well might be mass revolt. It also might mean a huge increase in government spending which wouldn't necessarily be good either (and might explain why Republicans are a little more heavy-handed on the balance the budget talk, though both sides are very guilty), because there is an optimal amount of deficit to be achieved. I hope neither occurs, but I don't see much leadership in government enlightening us on the truth. My professors have been trying to spread this truth to the public for the better part of their careers and are really just now making some headway.

    I'm not sure about a lot of things in economics, but what I wrote about in this post is one area I am quite certain of.