3 modern money facts at work

First, under a fiat monetary system, “state money” has no intrinsic value. It is non-convertible which means that you can take a $AUD (Australian Dollar) coin to the government and in return you will get a $AUD coin back. There is no responsibility to do more than this. So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced. That motivation emerges because the sovereign government has the capacity to require its use to relinquish private tax obligations to the state. Under the gold standard and its derivatives, money was always welcome as a means of exchange because it was convertible to gold which had a known and fixed value by agreement. This is a fundamental change.

Second, given the relationship between the commodity backing (gold) and the ability to spend is abandoned and that the Government is the monopoly issuer of the fiat currency in use (defined by the tax obligation) then the spending by this government is revenue independent. It can spend however much it likes subject to there being real goods and services available for sale. This is a dramatic change.

Irrespective of whether the government has been spending more than revenue (taxation and bond sales) or less, on any particular day the government has the same capacity to spend as it did yesterday. While a government could theoretically run out of gold or foreign currency, when it comes to its own currency, there is no such concept of the government being “out of money” or not being able to afford to fund a program. How much the national government spends is entirely of its own choosing. There are no financial restrictions on this capacity.

This is not to say there are no restrictions on government spending. There clearly are – the quantity of real goods and services available for sale including all the unemployed labour. Further, it is important to understand that while the national government issuing a fiat currency is not financially constrained, its spending decisions (and taxation and borrowing decisions) impact on interest rates, economic growth, private investment, and price level movements.

We should never fall prey to the argument that the government has to get revenue from taxation or borrowing to “finance” its spending under a fiat currency system. It had to do this under a gold standard (or derivative system) but not under a fiat currency system. Most commentators fail to understand this difference and still apply the economics they learned at university which is fundamentally based on the gold standard/fixed exchange rate system.

Third, in a fiat currency system the government does not need to finance spending in which case the issuing of debt by the monetary authority or the treasury has to serve other purposes.

This is a fundamental departure from the gold standard mechanisms where borrowing was necessary to fund government spending given the fixed money supply (fixed by gold stocks). Taxation and borrowing were intrinsically tied to the government’s management of its gold reserves.

So in a fiat currency system, government borrowing doesn’t fund its spending. It merely stops interbank competition which allows the central bank to defend its target interest rate.

The flexible exchange rate system means that monetary policy is freed from defending some fixed parity and thus fiscal policy can solely target the spending gap to maintain high levels of employment. The foreign adjustment is then accomplished by the daily variations in the exchange rate.

Conclusion

You cannot apply the economics of the gold standard (or USD convertibility) to the modern monetary system. All the fear mongering about the size of the deficit and the size of the borrowings (and the logic of borrowing in the first place) are all based on the old paradigm. They are totally inapplicable to the fiat monetary system.

Bill Mitchell

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