Money–the Big Picture

While we all know how money works (or doesn’t) for us personally. Here is how it works in the Macro Economy and will have you questioning claims by politicians and US news media. Not short, but simple and easy to understand….guest post by Ken Simpson:

OK, in summary I think we have established that modern money in the U.S. is:

1.       Credit

2.       This credit is denominated in the currency issued by the Federal Government in the accounting unit the Federal Government uses called the “dollar”.

3.       The currency/money issued by the Federal Government therefor represents the government’s credit.

4.       This credit, in units of dollars, printed on notes (or in electronic digits) is not backed by and thereby given its value by a commodity, like gold or silver, nor is it backed by and given value by another country’s currency. We call this a “fiat” or “sovereign” currency because the government is in no way restrained from creating or spending its currency when the currency’s value floats on international markets. The government may create restraints on its own spending or taxing in its own currency but these are self-created political restraints, and as all things political, they can be changed or eliminated or created at any time the government chooses.

5.       The Federal Government purchases goods and services from the private sector in the currency it issues. But, why would people, households and businesses in the private sector accept notes of credit in dollars for services and goods that they provide to the government if the government’s currency is not pegged to the value of a commodity like silver or gold? The answer is: The private sector exchanges good and services for dollar credits because they need the government’s credits to extinguish their tax obligation to the government. [Cynthia and I have a standing joke about this. J.M. Keynes wrote that “the government establishes the thing necessary to pay taxes”. We joke; what if the government wanted rats asses in payment of taxes? The answer is that people would be out collecting them and exchanging them for goods and services because the governments tax imposition had given rats asses value.]

6.       The combination of government spending and taxing is called “fiscal policy”. When the government taxes more money out of the private sector than it spends into the private sector, we call this a Federal Surplus. A Federal Surplus is a flow of net dollars out of the private sector. When the government spends more money into the private sector than it taxes out, we call this (the “dreaded”) Federal Deficit. However, the Federal Deficit is the mechanism by which fiat currency enters the private sector. It is a net flow of dollars from the government to people, households and businesses in the private sector. Every dollar that is in the private sector (that is not being created by bank credit when a loan is made and thereby eventually extinguished when a bank loan is paid off or default on) is there because the government spent it into the private sector and did not tax it back out. The accumulated fiat currency in the system is there because the Federal Government has run deficits year after year for the most part. Most importantly, the system needs dollars to create an effective number of transactions to create a growing economy with full employment and thereby the maximum creation of real wealth right now and for future generations.

Now, let’s consider the macro economy and money. Money, that is not saved, is spent. Someone’s spending equals someone’s else’s income. Spending equals income. Money spent is called effective demand. There is almost unlimited demand for goods and services, but only demand backed by money (i.e. spent money) creates effective demand. Increasing effective demand reduces inventories. Businesses, under most conditions, react to dwindling inventories by purchasing more goods and materials, hiring and investing in new equipment, etc. In doing so, they may take out loans and this credit creation allows banks to create money that is called endogenous (inside) money as in inside the private sector economy. This money in turn creates more effective demand and so on and the whole thing will cascade into a growing economy if there is enough money being spent and borrowed. Money that goes into savings (and debt payment) does not create demand. [Economists make the screwy assumption in their models that debt payment is part of savings but it doesn’t act that way.] However, if there is enough spending, private and government spending combined, effective demand can get to appoint where there is more demand for goods and services than the economy can produce or expand to produce. The capacity of the economy to produce may be reached and yet, there is more money chasing goods and services than there are goods and services. At this point prices begin to rise as the value of money goes down and we get inflation or what we would properly call demand side inflation. At this point the easy and proper thing to do, if inflation is higher than we wanted it to be, would be to use fiscal policy and raise taxes to destroy money and thereby reduce demand and cool off the economy. Taking these steps would not be a surprise to us because we would have been warned to look for inflation, after we reached full employment.

In addition to demand side inflation, we also have what is called supply side inflation. Supply side inflation is sort of the flip side of demand side inflation. The difference is that the economy can be perking along or stagnating or contracting and a supply side shock can cause inflation. Supply side shocks are usual small and effect a single commodity that for some reason becomes suddenly scares and thereby it does not have a huge macro effect. There is usually supply side inflation but for only one or a few commodities.  A good example of a serious supply side shock was the OPEC oil embargo in the 1970’s. This supply side shock raised the price of a critical commodity that was needed for transportation and the manufacture of many other critical commodities. This shock rocked the entire economy and raised prices on almost everything. At the time, the unions were strong and they had contracts that automatically raised workers’ wages as inflation rose. None of the economists at the time knew what to do and Paul Volcker, Chairman of the Federal Reserve, raised interest rates to try and check inflation by making money more expensive to borrow and the result was the  economy had inflation and high interest created stagnation at the same time. No one group in the private sector wanted to take the hit of income loss and the Congress and the Executive Branch did nothing. It was time for rationing and price controls to cushion the shock and spread the pain and help the needy but nothing was done. The Keynesian’s, who were the leading economists at the time, did not have answer for what was happening and the “free market” laissez faire neoliberals took over.

We also have what is known as hyper-inflation. A lot of alarmist politicians and economist say, we are about to have hyper-inflation any minute and they make this call endlessly to scare people for their own personal political gain. Hyper-inflation took place around 1930 in Germany and lately in Zimbabwe. Both were the result of extreme supply side shocks. After World War I the victors tried to make Germany pay the victor’s war debts. The German economy was in ruins and its government was also suffering under extreme war debt. The victors demanded to be paid in gold or their own currencies. To make a long complicated story shot. Germany couldn’t pay up so France occupied Germany’s industrial heartland along the Rhine. The German worker’s went out on strike to prevent the French from seizing the products of their labor. The strike turned into a general strike and the German government kept paying the German workers and people while the strike continued. Financial markets punished the Germans by short selling the Mark in combination with the of the mother of all supply side shocks. Enter hyper-inflation and wheelbarrows full of money. Zimbabwe was the same story on a small scale. Land seizures completely disrupted a rural economy and nothing was produced, while the government paid its political supporters.

There is also a special kind of hyper-inflation that can effect countries with fiat currencies. As we have mentioned, the government’s tax imposition is required to create a demand for fiat currencies and thereby give the currency value. The U.S. Confederacy during the Civil War faced a tax revolt on the home front. The war required the Confederacy to spend like a drunken sailor, but imposing a tax imposition was beyond the capability of the government and hyper-inflation took over.

I will close with fantastic, shape shifting phantom of the “U.S. debt”. For the sake of discussion, I will ignore the more than four trillion dollars’ worth of Treasury Notes that represent the Federal interagency debt like the Social Security Trust Fund of two and one half trillion dollar. How a currency issuing government can owe money to itself is beyond comprehension, but our idiot politicians think this shit is mashed potatoes. We shall ignore the ignorant.

Let’s begin with a question: “How can a currency issuing government go into debt?” Well it cannot go into debt for real, but it can pretend. First, we have a relic, there are a lot of them in Washington, of the Gold Standard Era. When the U.S. was trying to keep the U.S. dollar equal to a certain amount of gold after WWII in order to help international trade go smoothly with everyone in the “Free World” pegging their own currency’s value to a certain amount of a dollar, Congress passed a law that said for every deficit dollar spent the Treasury had to “borrow” a dollar from someone by selling a Treasury Note, in the hope that this would keep the value of the dollar stable in relation to gold. This helped but it didn’t work. There wasn’t enough gold in the World to represent all the dollars that were needed to make the Post War Boom a boom and finance a couple of wars at the same time. Something had to give and Nixon made it happen. Nixon took the U.S. off the Gold Standard and the dollar became the unit of account for our newly sovereign, once again, fiat currency. However oopsie, no one noticed. We ended up with a gold standard ideology and continuing gold standard operations by the Treasury and the Federal Reserve. Since then, we have had a fiat currency but no one in Washington knows what to do with it. No one seem to realize that when the Treasury borrows a dollar from the private sector, it was simply borrowing a dollar back that it had already spent into the private sector. It was a wash. There is now no operational reason for the Treasury to borrow dollars or sell Treasury notes. None. (There is also no operational link between taxing and spending.) However, the private sector loves Treasuries. It can’t get enough of them. Banks love them, investors love them, savers love them and who wouldn’t. They take their dollar denominated notes and turn them into dollar denominated notes that pay interest. Not only that, they are backed by the “full faith and credit” of the U.S. government. The U.S. government is the currency issuer and it can always pay the interest and/or balance on its Treasury notes, unless the Congress goes completely insane and orders the Treasury not to. Furthermore, Treasury notes are in fact part of the money supply and at the same time they are the private sector’s savings. There is absolutely nothing wrong or scary or immoral or evil about the private sector’s savings. Repeat after me please: “In a modern monetary economy the state’s debt is fictitious”. I know it is hard to say or believe but facts are stubborn things. The U.S. government, Treasury and Federal Reserve, can turn dollar notes into dollar Treasury Notes and back again ad infinitum. There can be no operational thing like a “debt limit”. There may be one in the minds of traitorous Congress critters, who would sabotage their own laws and programs that they voted for, but that is nothing more than inane, political shenanigans that the Obama likes to pretend are lawfully binding for his own shenanigans.

There are no operational limits on government spending or “debt”. However, there are real limits on resources, labor and established capacity. Everything else is smoke and mirrors politics of an ongoing swindle of the American people. ~

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