In parts 4 and 5 of our 6 part series on understanding the modern monetary system we cover the true constraint for an autonomous currency issuer – inflation. The myth that an autonomous currency issuer is somehow equivalent to a household, business, state or European nation (all of whom are currency users) is among the most destructive economic myths in the world. In this section we try to detail why this myth persists and what the true constraint is – inflation. We also cover the topic of money and wealth and why production is the core piece of any monetary system.
Part IV - A Fiat System Where Everyone Still Thinks We Have A Solvency Constraint
The idea that the government does not have a true solvency constraint is shocking to many people. But it’s becoming increasingly well known as the Euro crisis exposes deep flaws for nations that do not issue their own currencies. As I’ve mentioned several times before, there is no such thing as the USA not being able to pay off the liabilities that are denominated in a currency that it can essentially force the banking system to produce. Warren Buffett recently made this point at an investor conference:
“The United States is not going to have a debt crisis as long as we keep issuing our debts in our own currency. The only thing we have to worry about is the printing press and inflation.”
The analogy between a household and the government is difficult to break free from. So why has this thinking never changed in the USA? Despite the dramatic changes in the monetary system after the Nixon shock neo-liberalism came to dominate economic theory in the 70’s and 80’s. After the economic successes of the Reagan and Clinton eras there was little doubt that such thinking was accurate. Of course, we all know what happened next and now many of these neo-liberal beliefs have been pointed to as causes of the recent credit crisis.
More important is the fact that investors and economists have simply ignored the fact that the USA underwent drastic changes in 1971 when Nixon closed the gold window. In essence, the system underwent this dramatic overhaul, but the thinking never changed all that much. Overnight, theories and thinking should have been rewritten, but never truly were. Whether one likes it or not, we are operating in a truly fiat world. Therefore, the thinking and theories that are derived from this era are largely defunct. Monetary Realism fills this void by describing how a fiat monetary system operates.
The fixed exchange rate misconception (such as those based on the gold standard) exists even at the highest levels of government and has been propagated by many of the world’s most prominent economists. There’s little doubt that you’ve heard US politicians discussing the financial problems of the USA as though we are “running out of money”, akin to Greece or constrained in the same ways a household or business is. These analogies are all false. I believe most people in power do not understand exactly how our monetary system works due to this fundamental flaw in understanding the difference between floating and fixed exchange rate systems. Again, the idea that the government does not have a solvency constraint is difficult to overcome since, as currency users, we always think of our lives and our businesses as being solvency constrained. The idea of an entity not having a similar constraint is often difficult to comprehend.
But people always ask: “how could these leaders not get it? How can the brightest minds and the leaders of our country not understand all of this?” Well, if we review the past actions of Alan Greenspan (who has admitted to using a “flawed” model) and the actions of Ben Bernanke leading up to and in response to the household debt crisis we can see that they have substantially misinterpreted how a modern monetary system functions. In fact, in a 2008 Congressional hearing Alan Greenspan admitted that the ideological framework he had based his entire life’s work on, was “flawed”:
REP. HENRY WAXMAN: Do you feel that your ideology pushed you to make decisions that you wish you had not made?
ALAN GREENSPAN: Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to — to exist, you need an ideology. The question is whether it is accurate or not.
And what I’m saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I’ve been very distressed by that fact.
REP. HENRY WAXMAN: You found a flaw in the reality…
ALAN GREENSPAN: Flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.
REP. HENRY WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working?
ALAN GREENSPAN: That is — precisely. No, that’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.
So you can see that the man running monetary policy in the USA for 18 years was working under a “flawed” framework. If the Fed chief has a flawed understanding of our economic system then who can we really expect to understand all of this?
Much of this confusion is also derived from the gold standard in which governments were revenue constrained. The Euro system, which is also a single currency system (like the gold standard) adds significant confusion to the current environment and is often confused as a flaw in fiat money. In reality, the Euro proves why single currency systems are inherently flawed when they do not involve truly autonomous currency issuers. The nations within the Euro are analogous to the states within the USA. In this regard, they are currency users and not currency issuers. Without floating exchange rates and/or a central treasury there is no balancing mechanism that allows this currency union to function as the USA does. The gold standard imposed similar constraints on the world and put trade deficit nations at inherent risk. We can see from the Euro crisis that this sort of currency union causes massive imbalances within such currency systems. Therefore, the ideas of the gold standard and the Euro are not applicable to the monetary system in which the USA exists.
How Could It Be Possible That Our Leaders Don’t Understand This?
I believe these misconceptions persist due to three primary reasons:
- First of all, this is all highly complex. Understanding the functions of a monetary system is high finance. We cannot expect everyone to understand it and we should expect most theories and outlines of the modern monetary system to be somewhat incomplete due to the dynamic existence of modern economies.
- Second, this system in its current format is not very old and most of the people in power currently were educated by a generation in which this system was not largely applicable. Despite the fact that the world changed dramatically in 1971 when Nixon closed the gold window, we continue to work under theories and textbooks that don’t fully account for this change. Therefore, the theories of old run rampant in modern economic circles.
- Thirdly, politicians and ideologues have a vested interest in keeping the American public from understanding that the government is fundamentally different from a household, state or business.
The True Constraint for a Currency Issuer
Now that we understand that an autonomous currency cannot “run out of money” it’s important to also understand that there are real constraints on a government’s ability to create money. Aside from the obvious constraint of real resources, the autonomous government’s true constraint is never solvency, but inflation. Inflation becomes problematic when a nation’s spending outstrips productive capacity. This is a real reduction in our standard of living. But it’s important not to confuse some inflation with a reduction in living standards. You might have read that the US Dollar has fallen 90% since the inception of the Fed in 1913. This is true actually. The purchasing power of the dollar has fallen substantially. But this does not necessarily mean the standard of living of Americans has declined 90% since 1913. In fact, living standards have soared since then. How is this possible? Ultimately, the real benefit of our labor is the time it provides us. Adam Smith once said:
“The real price of everything, what everything really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.”
There’s No Free Lunch
It’s very important to remember that just because the government does not have a solvency constraint, it does not mean it has no constraint. The bogey here is inflation that is constantly based on the tax rate, spending, borrowing, production, consumption, the money supply, etc. So spending and taxation must always be done in accordance with a nation’s productive capacity so as to avoid imposing undue hardship on the private sector via a reduction in real living standards. Thus, government cannot just spend and spend or the extra dollars in the system will chase too few goods, drive up prices and reduce living standards. It’s important to understand that government cannot just spend recklessly. This is important so I’ll say it again. This does not give the government the ability to spend and spend. If they spend in excess of productive capacity and tax too little they can create mal-investment and inflation resulting in lower living standards. Likewise, if the government taxes too much and spends too little they create a government surplus and private sector deficit (by accounting identity). This can result in deflation and/or excess private sector debt levels as the private sector literally suffers a dollar shortage.
Some people claim that Monetary Realism says budget deficits don’t matter. That is a vast misrepresentation of our position. Deficits most certainly do matter. Maintaining the correct level of deficit spending is, in many ways, a balancing act performed by the government based on an understanding of the sectors of the economy. It is best to think of the government’s maintenance of the deficit like a thermostat for the economy. When the economy is running cold the deficit can afford to be higher. When it is hot the deficit should be lower. Because there is no solvency concern in the USA (as there is in the revenue constrained European nations) the only concern is inflation or possible hyperinflation.
It’s also important to note that spending by the government must be focused on its efficiency. If spending is misdirected or misguided there is a very real possibility that this spending will simply result in higher inflation that is not offset by increased productivity. If you pay people to sit on their couches all day long there is no reason to believe why this sort of government policy will not result in long-term economic decline in the citizenry’s standard of living. Living standards, ultimately, come down to the private sector’s ability to produce and innovate. The USA is extremely wealthy not because our government issues a lot of money, but because we are an extremely productive and innovative nation. The power in capitalism is the ability to offer its users more time. Therefore, government has an incentive to promote productive output and maintain sound stewardship of its currency.
Part V – Understanding Modern Money
“Money” is a vague term. Technically, anything can serve as money. And historically, many things have served as “money”. As a social construct “money” is really nothing more than a tool that helps us interact in our everyday lives. The history of “money” is lost in time, but scientists have discovered forms of monetary systems in primitive monkeys in which sexual favors are traded in exchange for protection, grooming and other “bonds”. These primitive societies use forms of money in exchanges as a form of social bond that interlinks the species in the attainment of survival. Obviously, modern forms of “money” have evolved to become more complex and institutionalized.
In this regard, it is best to think of “money” as being the social tool with which we primarily exchange goods and services. Money is more than merely a medium of exchange, but its primary purpose for existence and most prominent use is in exchanges for goods and services. Specific forms of “money” are generally viewed as having a high level of utility if they meet certain criteria:
- A widely accepted medium of exchange
- A store of value
- A widely accepted unit of account
In the modern monetary system fiat “money” (or paper money) is the form of “money” we utilize on a daily basis. In a strict sense, this paper money is largely a creature of law. In the society of the USA this paper money takes the form of US Dollars. In the next few sections we will dive deeper into the value of “money” and the importance of “money” to our society.
What Gives Fiat Money Its “Value”?
Monetary Realism views money as being driven by many different factors. What backs the notes a government creates? What gives these pieces of paper value? It’s helpful to break the demand for fiat money down into two components. The first is acceptance value and the second is quantity value. Acceptance value represents the public’s willingness to accept something as the nation’s unit of account and medium of exchange. This is achieved mainly through the legal process and democratic vote. That is, the government and the people deem a specific thing (such as the US Dollar) as the accepted unit of account and medium of exchange. But the government cannot force currency acceptance upon its users merely by stating the thing that is usable as the nation’s medium of exchange. Quantity value describes the medium of exchange’s value in terms of purchasing power, inflation, exchange rates, production value, etc. This is the utility of the “money” as a store of value. While acceptance value is generally stable and enforceable by law, quantity value can be quite unstable and result in currency collapse in a worst case scenario.
Ultimately, these pieces of paper represent some amount of output and production that can be purchased. The notes in and of themselves have no intrinsic value, but serve as a medium of exchange that allows the citizenry to exchange various goods and services. The willingness of the consumers in the economy to use these notes is largely dependent on the underlying value of the output and/or productivity, the government’s ability to be a good steward of the currency and the ability to enforce its usage. I like to think of this as an interconnected bond between these various forces. If any link in the bond is broken the nation’s currency is at risk of collapse. Importantly, production sits at the top of this bond. After all, if a nation has nothing to produce then the formation of a monetary system serves little purpose. Further, a system that does not evolve via production can expect to become increasingly unstable over time as living standards stagnate.
(Figure 2 – The fiat currency linkages)
The value of these notes is ultimately determined by three key linkages:
2. Currency management
3. Taxes, laws & regulation
Production is vital in giving any currency its value. The goods and services that are produced by the citizens and the value that other citizens are willing to pay for these goods and services is what ultimately makes any fiat currency viable. Therefore, government has an incentive to promote productive output and maintain sound stewardship of its currency. Otherwise, they risk devaluing the currency and possibly threaten the stability of their currency system. Paying its citizens to sit at home doing nothing, buy cars they don’t need or purchase homes they can’t afford are unproductive forms of spending that are likely to turn a nation of producers AND consumers into a nation of consumers. If government is corrupt in its spending and becomes an institution that is mismanaged and detracts from the private sector’s potential prosperity then it is only right that the citizens revolt, denounce the nation’s currency and demand change.
The autonomous nation’s government, which is the organized body formed through representation of the private sector, deems what is acceptable as currency. In the USA our representatives have deemed that the currency is the US dollar14. The government has deemed the dollar as the USA’s unit of account and medium of exchange. In this regard, the dollar is a creature of law.
While the state plays an important role in setting the acceptance value of money, money is not necessarily valuable only because the state says it is valuable. The “value” of the currency involves other linkages. Keynes once compared money to a theatre ticket:
“money is the measure of value, but to regard it as having value itself is a relic of the view that the value of money is regulated by the value of the substance of which it is made, and is like confusing a theatre ticket with the performance”.
This is an accurate portrayal of currency in a modern fiat monetary system. Government issued fiat money, in and of itself, has no intrinsic value. The theatre ticket has no value aside from the paper it is printed on, however, given the value of the performance citizens will be eager to attribute a certain value to these tickets because they are deemed by the theatre as being the tool of entry into the show. If the theatre mismanages the number of tickets in circulation they will devalue the tickets. In much the same way, the US government deems the US Dollar to be the ticket with which we can see (and interact in) the US economy. If the show is good (productivity is high), the number of outstanding tickets are not mismanaged (government doesn’t spend in excess of productive capacity) and the tickets are sustained as the only form of entry into the show (the tax and legal system sustains itself) then the currency remains a viable medium of exchange. So we can see how the linkages shown above work in tandem to give a fiat currency a particular value.
It’s important to note that the government does not maintain a coercive monopoly over the people. That is, currency viability is not merely based on the government’s ability to enforce its usage. As mentioned above, there are other components that play an equal or greater role in currency viability. But that does not mean that taxation and the legal framework are not crucial in helping to sustain the viability of the system. Without rules and regulations that help sustain the fabric of the monetary system, the government that Americans have built long and hard to create would become increasingly fragile. The United States Secret Service was in fact created specifically for this purpose – to protect the US Dollar.16 There is arguably, nothing more important to government and societal stability than maintaining the value and faith in the nation’s currency.
“Money” Is Not “Wealth”
It’s important to understand that “money” is not “wealth”. Money is simply the tool that allows citizens to exchange and transact in the underlying goods and services. If a government spends “money” in excess of a nation’s underlying productive capacity it will devalue this “money” and generate destructive inflation. This would result in too much money chasing too few goods and a potential decline in real living standards. So, the key for government is to balance the amount of money in the system in order to keep the temperature just right – not too hot and not too cold. So, Monetary Realism does not claim that the government can just recklessly spend.
Like excessive taxation, a lack of spending can be debilitating for the economy (at times). We know from the sectoral balances (discussed in detail below) that a tax cut has the same impact on the federal budget deficit as a spending increase (both add to the size of the Federal budget deficit). So it can be useful at times to use this understanding to help the private sector achieve higher living standards through the changes in budget deficits and the private sector’s accumulation of net financial assets. For instance, if the government were to tax us all 100% of our incomes the economy would collapse and the government would be “rich”. In essence, the currency issuer would be suffocating the currency users of the medium of exchange that is legally deemed the nation’s “money thing”. The government balance sheet would be “healthy”, but the private sector balance sheet would be destroyed. Not a plan for economic prosperity. After all, we do not run our government for the benefit of government, but for the benefit of the private sector. Government is merely a tool that can be utilized to further private sector prosperity.
Another example that readers might find helpful is the idea of private sector saving being government dissaving. We often hear pundits and economists say that the US government should pay off the national debt. But paying off the national debt would involve eliminating all of the savings bonds in the US economy. This is why you never hear your grandmother say “I wish Uncle Sam would pay off the national debt so I could get rid of these savings bonds!”. The entire concept of paying off the national debt is nonsensical. Government debt merely represents a private sector savings account. Moving money from a savings account to a checking account (the logical equivalent of paying off the national debt) only eliminates a form of savings account that the private sector relies upon heavily.
Is Time The Ultimate Form of Wealth?
The reason why any society forms in the first place is because we have a collective understanding that we can achieve a better overall living standard if we leverage one another’s strengths and abilities. I have argued that human beings are the ultimate pack animals even though we like to think of ourselves as rugged individualists. This basic innate understanding is what drives us to need one another and understand that we are better off in groups than we are alone.
Our monetary system is simply an evolution of this understanding from spoken bonds (and even unspoken bonds) to written bonds. But the goal of a society has not changed despite the fact that the tools we use have changed. The end game has always been the same. It is the desire to generate improving living standards through the efficient use of resources resulting in the optimization of time. The element of time, in my opinion, is the key piece of this puzzle. The true holy grail of modern macro is not price stability or full employment. It is time. Time is the ultimate form of wealth in a modern society. It is through time that we are able to live fuller and more meaningful lives. What you do with your time is up to you. But the key is that having more time means being able to do more of what you want to do. In theory, we can consume and produce an infinite amount given the time. But time, as we all know, is not infinite for finite creatures. Here, I introduce the “MR Law”:
“We generate improving living standards through the efficient use of resources resulting in the optimization of time”
This is a powerful concept and one that can change the way modern societies approach economics, public policy and every day life. When one understands that time is the ultimate form of wealth their perspective is dramatically altered and the playing field is changed. And while full employment and price stability are admirable goals, they become secondary to this understanding that sits above them in the hierarchy of societal goals.
How does the entrepreneurial process work to create real wealth?
To understand the relationship between innovation, consumption, production and living standards we will use an example. Alexander Graham Bell is one of the greatest innovators in American history. So what did Mr. Bell do exactly? He created a more efficient way to communicate by inventing the telephone. Clearly, communication is a vital part of human life. And in theory, there is infinite demand over the long-term to communicate.
At some point in his life, Mr. Bell sat down and probably said something to the extent of – “it would be far more efficient if I could talk to Mr. Smith immediately as opposed to sending him a telegram”. Clearly, this desire was not unique to him. And all Mr. Bell did was fill a demand by inventing a product that helped consumers meet this demand. But the important role that Mr. Bell played in the job creation process is not that he necessarily created jobs independent of his consumers (as we showed above, they are interdependent). After all, there were plenty of messengers already employed and working before the telephone came into being (Mr. Bell actually destroyed their jobs).
What Mr. Bell did is give his consumers more time to consume other goods and services. He reduced the toil and trouble of having to acquire things by providing them with a product that made their lives more efficient and productive. Just imagine all the ways that the telephone improves our quality of life and makes us more efficient. The businessman in NYC no longer had to wait for the telegram from his business partner in Chicago to discuss their new business decisions. Instead, he picked up a telephone and a decision was made in a matter of minutes. There are innumerable (better) examples of the way that a simple innovation such as Mr. Bell’s helps us to improve productivity, efficiency and ultimately our standard of living.
The MR Law: “We generate improving living standards through the efficient use of resources resulting in the optimization of time”
As previously mentioned, it’s not uncommon to hear that the US dollar has fallen 90%+ since the Federal Reserve was created. This is technically true, but despite its decline in purchasing power, our real standard of living has increased dramatically because we have become so much more productive. An American in 2011 lives a much fuller life than an American in 1913. This is because we have been afforded (through productivity) the luxury to use more time as we please.
The key point here is that improvements in our standards of living provide us with the ultimate form of wealth – they give us more time to do the things we think will help us achieve happiness (whatever that might be to any particular person). This is the ultimate form of wealth. The entrepreneur gives us more time to consume more goods and services and do the things we want in our lives. If we look at the modern economy we can see how streamlined this process has become. For instance, last night at 7 PM I put my laundry in the wash, I put the dishes in the dishwasher, ordered dinner from a local restaurant and went upstairs into my office where I did an hour of work. At 8 PM my dinner arrived, my laundry was done, I ate dinner on a fresh clean plate and I had done an hour of work in this period. Imagine trying to do all that 100 years ago? How long would it take you? Days? Perhaps even weeks? That is a remarkable increase in living standards. And why are we able to do all these things in such a condensed period of time? Why am I able to consume so much more than I could have 100 years ago? Because entrepreneurs created a machine that cleans my clothing for me, they created a machine that cleans my dishes for me, they created an oven that cooks my dinner, a car that allows the deliveryman to deliver my dinner, and invented a computer which allows me to efficiently and effectively accomplish work. We live in a remarkable world. If, as a people, we are not productive and our government is a poor steward of our currency then it’s not unimaginable that our real living standards will stagnate or even decline.
Importantly, we must understand that consumption and production are two sides of the same coin. We often hear economists arguing about supply side policies and demand side policies. The reality is, BOTH are important. Mr. Bell needs customers to sell his phones just like Mr. Bell’s customers needed Mr. Bell to communicate more efficiently. Too often the world of economics devolves into a black and white story when the truth generally lies somewhere in between.
Lastly, it’s important to understand in these discussions of inflation and living standards that hyperinflation is a very different phenomenon from inflation (which is quite normal in a fiat currency system). In recent years we have heard many hyperinflation predictions based on misunderstandings of banking and the monetary system. Hyperinflation is a disorderly economic progression that leads to complete rejection of the nation’s currency. It is not merely a monetary phenomenon, but primarily a political phenomenon. Throughout history, hyperinflations have tended to occur not because the state prints money, but because of exogenous factors. The primary causes have been decline in production, corruption, regime changes, ceding of monetary sovereignty and loss of a war. These rare events have tended to lead to a decline in tax receipts or an increase in the money supply ultimately resulting in decline of the currency.