Most people, and that includes economists, are under the belief that they have a firm grasp on the origins, functions, and limitations of money. But what if we’re wrong, what if the concept of “money” has evolved over the decades so that we in fact are short-changing society by adhering to our outdated thinking.
This idea, that society is ill served by mainstream thinking on money, is the basic premise of Modern Monetary Theory, as explained by Stephanie Kelton an economist at Stony Brook University in her book the Deficit Myth. For starters Kelton explains that the standard explanation of the origins of money is basically “urban legend.” We tell students that money came into being because it was an improvement over the barter system. But historians find no evidence that any society ever functioned on a barter basis.
In fact, the origins of money can be traced to the state’s need acquire goods or services. To fulfill their needs, governments impose taxes, which must be paid in the currency issued by the state. Since everyone is subject to taxation, the monetary unit quickly becomes the medium of exchange, and the standard of value (price of any good or service). It’s easy to overlook the importance of this point. Before the government can tax us, they must provide us with the currency we need to pay taxes.
This fact, once accepted, will reverse our economic thinking when it comes to government spending and taxation. Today it is universally believed that governments must tax or borrow before they can spend. The only money available to them is what they acquire by taxing your income or borrowing your savings. The reality is that governments spend their currencies into existence, and only later do they tax or borrow, for reasons mostly unrelated to the need to finance government expenditures.
The easiest way to see this is to think about stimulus checks, unemployment compensation or SNAP (food stamps). In each case, families eligible find their accounts credited for the amounts they quality for, they have money. So if the government can spend money into existence, why does the government resort to borrowing or taxation? In terms of borrowing, the government doesn’t need to borrow, it simply chooses to. It’s a way of allowing the public to convert dollars into an interest earning asset that has a zero default risk.
As for taxes, there are four reasons to tax. The first is to siphon enough spending from the private sector insure that the nation’s demand does not exceed its capacity to supply which would increase the inflation rate. The second reason is to divert resources from private use to the government’s use. The last two reasons for taxes have to due with redistributing income and wealth, and encouraging or discouraging certain behaviors.
To further highlight the power of money creation, the Federal Reserve which is technically not a part of the government, is responsible for the quantity of Federal Reserve Notes (paper dollars) in circulation, the Federal Reserve also controls the size of digital dollars, also known as bank reserves. When the Fed bailed out Wall Street, they did not use tax dollars as were commonly assumed. They simply credited the commercial bank’s reserve account at the Fed, in other words they simply added “money” to their accounts with a few simple key strokes on a Fed computer.
Once we understand how money works, and its limitations, what becomes important in government finance is full employment, not the size of the budget deficit. We’ve mistakenly made assumptions, at various times, that full employment is synonymous with 4, 5, or even 6 percent unemployment, and that if we ever dropped below that level the nation would be racked with hyperinflation. In past months we saw that the official unemployment rate drop to 3.5 percent with still no inflation in sight.
Given what we now know about money, the question we ask should not be, “How is this going to impact the deficit?” Rather we should be asking, “How much can we spend, what can we accomplish?” If we don’t extend the $600 per week unemployment compensation the economy will tank and unemployment will skyrocket. We need to adequately fund schools, day care centers, the postal system, state governments, and health care to workers who have lost their health insurance.
Traditional methods of financing the government still have a place in macroeconomics, but only when we’ve reached our true full employment/maximum production point as evidenced by a sustained spike in inflation. Until then we should not deny society the welfare benefits it deserves simply because we’ve mistakenly focused on budget deficits and not how money creation and government finance really works.