The Origin of Currencies (or: the deficit-savings equality)

This is the first of a series of introductory posts I would like to make to avoid cluttering future commentary with superfluous explanation.

It is well known but poorly understood that our currency (and the currencies of many other nations) has no intrinsic value; it is not officially convertible to gold or any other commodity. This is not a bug, it’s a feature. Productivity and unemployment suffer badly during periods of price instability, which are prone to happen when prices are tied to the fluctuating value of a commodity like gold. Depressions were more common when currencies were backed by gold. Recessions were deeper and lasted longer. Removing the commodity backing from currencies has generally been successful in enabling monetary policy to stabilise prices. In countries like ours where prices are strongly affected by lending the central bank can buy and sell unlimited amounts of debt in its own currency to control interest rates. In countries like Singapore where most necessities are imported the central bank can stabilise prices by buying and selling unlimited amounts of its currency internationally to maintain the exchange rate. This kind of flexibility is only feasible when the currency issuer has no obligations of convertibility to any commodity, and we are better off for having it. This system of currency is called fiat money, meaning that it is money by order of the government.

The simple difference to older commodity currencies has far reaching consequences, many of which remain unrecognised by policy-makers today. The old economic models treat money as a commodity like any other, a simple abstraction from a direct barter economy, or ignore it completely. To the general public a dollar still does represent a simple unit of exchange – a store of value. To the treasury it represents a means of adjusting the distribution of private wealth. To the central bank it represents a cancellation of part of the debt assets it holds which it paid for by printing that dollar. Usually I will speak of the federal government and the central bank together as “the government”, and use “the treasury” when there is a need to distinguish the federal government from this wider definition. We’ll come back to those interpretations of a dollar later. To understand them we need to first consider how money is created.

Imagine a newly formed nation with a government and a private sector who wish to set up a fiat currency system. The government creates money by spending it in the private sector and destroys it through taxation. By being the sole issuer of the currency the government controls the money supply, and by making it the only way of paying taxes it creates demand. Since it is the origin of money the old mantra of “tax and spend” must be reversed. The government must spend in order to tax. After money enters the private sector by government spending the money supply expands by being lent and re-lent through the fractional reserve banking system, but every positive balance created by this process is balanced by a negative one held somewhere else (actually this is true of all fiat money, since it represents a liability to the central bank, more on this in a future post). Thus the government acts not only the sole issuer of currency, but the sole provider of net savings. If the government were truly to be debt-free and in surplus – to have taxed more of its own currency it has spent – there would be no net savings in the private sector. If all private debts were also settled then there would still be an outstanding debt to the government and not a single note or coin left to pay it.

This relationship between deficits and net savings can readily be shown symbolically with the function for Gross Domestic Product (GDP). GDP is the dollar value of everything produced within a country (not counting things like components of a machine for which the value has already been included in the value of another product) minus all the money that left the country from imports. It is written as:
GDP = C + I + (G - T) + NX
This function is known as a macroeconomic accounting identity, meaning it is true by definition. C represents spending on private consumption, I represents investment spending on capital, G represents government spending, T represents taxation and NX represents Net Exports, or exports minus imports. Since every dollar spent must also be earned, GDP is sometimes used synonymously with income. There is another way of calculating GDP using incomes directly, but for now it will be sufficient to understand that they are equivalent. Income is written as Y, so we can also write the GDP function like this:
Y = C + I + (G - T) + NX
Since every dollar of income earned must either be spent or saved, we can represent net private savings using symbols from this formula as Y – C – I or income minus consumption minus investment. In more elaborate models savings is better defined as Y-C and I includes items ranging from mortgage payments to cash reinvested in the business that earned it. The government budget deficit (or surplus) is government spending minus taxes, or G – T. Rewriting the formula in terms of the deficit gives us:
G - T = (Y - C - I) - NX
Meaning that aside from the balance of trade, the change in private net savings is determined entirely by the size of the deficit. When the government runs a surplus the private sector is forced to dis-save. The government hasn’t reduced its¬†liability¬†in any way since it has no obligation to convert the cash to any real commodity. It has simply removed savings from the bank accounts of its citizens.

Update: Someone asked me if the government borrowing from individuals causes this kind of analysis to break down. It’s a good question – the government borrows from the private sector all the time since its debt is the sole type of asset traded in the open market operations system by which monetary policy is enacted. The answer is no. Since the government only borrows to spend, if it borrows directly from the private sector two things happen:

  1. Savings change hands between lender and the recipient of subsequent spending.
  2. A debt asset is created in the private sector.

There are a couple of ways of thinking about this: either that debt asset cancels out a debt liability somewhere else in the private sector thus increasing net savings (the net present value method) or the interest payments on that loan will be a steady flow of new savings into the private sector. Either way, net savings have increased. It does not matter who the government borrows from, it creates money when it spends.

Note that “creating money” in this sense is not the same as printing it and indeed usually happens without a corresponding issue of new notes and coins. These two processes are operated separately by the treasury and the central bank respectively. The treasury is ultimately managed by our elected officials and its decisions are referred to as fiscal policy. The central bank (Australia’s central bank is called the Reserve Bank of Australia) is an operationally independent organisation which has been granted the legislative power to manage the nation’s money supply by making decisions called monetary policy. When the treasury creates money (by spending it) it borrows from the central bank at interest. The central bank may choose to issue new notes and coins or may simply debit the treasury’s account electronically and use its existing reserves of cash from the commercial banks that hold accounts there. The central bank chooses when to print new money and at what interest rate to lend it in order to achieve its goal of price stability. The treasury chooses where to spend money and who to tax it from in order to achieve its goal of increasing the well-being of the citizens.

The most important result to note from this is that the government as currency issuer is not like an individual or business in that it does not need to “balance the books” to remain solvent. The notion of a monetarily sovereign government becoming insolvent in its own currency is absurd. The role of the government in spending and taxation should only be to the benefit of its citizens, which is most cases involves two things: ensuring access to essentials and creating a fairer distribution of wealth and income. Pursuing a balanced budget for its own sake is more likely to do harm than good, removing scarce savings from an already over-leveraged, debt-laden society.

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