A modern economy is incredibly complicated, and there is a lot that we do not fully understand. That is one of the reasons why making predictions is so difficult, and why there will always be plenty to argue about.
However, there are some complex things that we can understand because they were engineered by humans. There are no big controversies about how cars or smartphones work.
One example of a human-engineered system that we should understand is our monetary system. So why is there so much confusion and debate about it? I argue in this post that it is because the conventional description of how money works is intentionally misleading.
It is possible for anyone with an internet connection and sufficient time and determination to figure out the truth. But most people don't have the time and are not sufficiently interested in the topic. Others have found that, when they do manage to understand, it is very difficult to convince others. Why? Partly because it requires a counterintuitive conceptual leap, and partly because it requires people to ignore what they read in and hear from other trusted sources.
The key conceptual leap is to appreciate that money has to come from somewhere, and in modern fiat currency systems that somewhere is the government, which has monopoly power to create the sovereign currency*. Most governments have handed some of the authority for money creation to a central bank. However, for all practical purposes the central bank can be considered to be part of the government.
[*the Eurozone is different]
So how does this money get to us? In almost all cases by government spending. The action of spending introduces money into the economy for the first time. In practical terms when a government Department wants to pay, for example, a company for providing it with something, someone sits at a computer and types numbers to mark up the value in accounts that all banks have at the central bank. You could call it printing money but 'typing money' is more accurate.
If governments were very small relative to the size of the economy they could do this without any problem. However, when they get as large as they are now, they would be introducing a huge amount of new money into the economy each year, and this would cause inflation because the added demand for goods and services would exceed the capacity of the economy to supply them.
It is for this reason that taxation is necessary. It removes spending power from the non-government sector to ensure that overall demand does not exceed supply and cause inflation.
The sequence of events is important. First the government spends, introducing new money. Then it taxes to remove money. Creating the money is necessary before it can be removed. Removing it is not needed until it has been created. Governments must spend the money into the economy before it can be removed by taxation.
This simple reality of how money is created by spending and removed by taxation has two very important implications.
First, since the government does not need tax revenues to fund its own spending, or any other current or future obligations, it can never be forced to default on any of these obligations. It may choose to do this because of self-imposed rules, but this will be a choice made, ultimately, by the electorate. An analogy is a cricket scorer. They can never run out of points because they create them.
Second, there is no need to remove through taxation all the money introduced through government spending. In fact there are good reasons for wanting taxation to remove less money than introduced through spending. The main one is that it enables the non-government (private) sector to accumulate savings (net financial assets). If taxation always removed all the money the government spent then it would be impossible for the private sector to accumulate savings in the form of government money. When the government removes by taxes more than it spends, it is confiscating savings from the private sector.
Now you can see why the way that we talk about government taxation providing revenue to fund spending is misleading, and potentially dangerous. By implying that tax revenues need to be raised to fund government spending, and calling the annual shortfall a deficit, and the cumulative shortfall government debt, we give the impression that it is imprudent and unsustainable for government spending to exceed tax revenues. And we wrongly imply that it would be a good thing for the government to confiscate private sector savings, and that it is a bad thing for the private sector to accumulate savings. Surely this is wrong?
To repeat, a government deficit represents a private sector surplus, and government debt represents cumulative private sector saving. When understood this way it should be clear why it is potentially dangerous for the government to run a fiscal surplus and eliminate its debts, as this prevents private sector saving. It is only justified when the economy is operating at full capacity or there is demand-driven inflation. In fact whenever the US government has tried hard to run surpluses to reduce its debt this has ALWAYS followed by financial collapse and depressions. Coincidence?
So why we stick to an incorrect description of government spending and taxation?
Many people just accept the views of experts as it makes intuitive sense. We know from personal experience that we need to earn money before we spend it. So why do the experts not correct this misunderstanding. Some have admitted that the conventional (taxes fund spending) explanation is necessary to provide the 'discipline' needed to prevent excessive government spending. They reason that, if politicians and voters believe that increased government spending has to be funded by taxes, this provides a built in constraint on excessive public spending, since taxes are deeply unpopular. If they realised that this was not the case it might be difficult, in a democracy, to control government spending.
So the fundamental reason for maintaining the fiction is that the public cannot be trusted with this knowledge. Is this ethical?
Leaving aside the ethics, another problem is that when people make decisions based on a misunderstanding, the consequences can be devastating. In fact one could make the case that the global financial crisis, and the six depressions that preceded this in US history were the direct result of operating our monetary system based on this misunderstanding.
Isn't it time for the truth?
However, there are some complex things that we can understand because they were engineered by humans. There are no big controversies about how cars or smartphones work.
One example of a human-engineered system that we should understand is our monetary system. So why is there so much confusion and debate about it? I argue in this post that it is because the conventional description of how money works is intentionally misleading.
It is possible for anyone with an internet connection and sufficient time and determination to figure out the truth. But most people don't have the time and are not sufficiently interested in the topic. Others have found that, when they do manage to understand, it is very difficult to convince others. Why? Partly because it requires a counterintuitive conceptual leap, and partly because it requires people to ignore what they read in and hear from other trusted sources.
The key conceptual leap is to appreciate that money has to come from somewhere, and in modern fiat currency systems that somewhere is the government, which has monopoly power to create the sovereign currency*. Most governments have handed some of the authority for money creation to a central bank. However, for all practical purposes the central bank can be considered to be part of the government.
[*the Eurozone is different]
So how does this money get to us? In almost all cases by government spending. The action of spending introduces money into the economy for the first time. In practical terms when a government Department wants to pay, for example, a company for providing it with something, someone sits at a computer and types numbers to mark up the value in accounts that all banks have at the central bank. You could call it printing money but 'typing money' is more accurate.
If governments were very small relative to the size of the economy they could do this without any problem. However, when they get as large as they are now, they would be introducing a huge amount of new money into the economy each year, and this would cause inflation because the added demand for goods and services would exceed the capacity of the economy to supply them.
It is for this reason that taxation is necessary. It removes spending power from the non-government sector to ensure that overall demand does not exceed supply and cause inflation.
The sequence of events is important. First the government spends, introducing new money. Then it taxes to remove money. Creating the money is necessary before it can be removed. Removing it is not needed until it has been created. Governments must spend the money into the economy before it can be removed by taxation.
This simple reality of how money is created by spending and removed by taxation has two very important implications.
First, since the government does not need tax revenues to fund its own spending, or any other current or future obligations, it can never be forced to default on any of these obligations. It may choose to do this because of self-imposed rules, but this will be a choice made, ultimately, by the electorate. An analogy is a cricket scorer. They can never run out of points because they create them.
Second, there is no need to remove through taxation all the money introduced through government spending. In fact there are good reasons for wanting taxation to remove less money than introduced through spending. The main one is that it enables the non-government (private) sector to accumulate savings (net financial assets). If taxation always removed all the money the government spent then it would be impossible for the private sector to accumulate savings in the form of government money. When the government removes by taxes more than it spends, it is confiscating savings from the private sector.
Now you can see why the way that we talk about government taxation providing revenue to fund spending is misleading, and potentially dangerous. By implying that tax revenues need to be raised to fund government spending, and calling the annual shortfall a deficit, and the cumulative shortfall government debt, we give the impression that it is imprudent and unsustainable for government spending to exceed tax revenues. And we wrongly imply that it would be a good thing for the government to confiscate private sector savings, and that it is a bad thing for the private sector to accumulate savings. Surely this is wrong?
To repeat, a government deficit represents a private sector surplus, and government debt represents cumulative private sector saving. When understood this way it should be clear why it is potentially dangerous for the government to run a fiscal surplus and eliminate its debts, as this prevents private sector saving. It is only justified when the economy is operating at full capacity or there is demand-driven inflation. In fact whenever the US government has tried hard to run surpluses to reduce its debt this has ALWAYS followed by financial collapse and depressions. Coincidence?
So why we stick to an incorrect description of government spending and taxation?
Many people just accept the views of experts as it makes intuitive sense. We know from personal experience that we need to earn money before we spend it. So why do the experts not correct this misunderstanding. Some have admitted that the conventional (taxes fund spending) explanation is necessary to provide the 'discipline' needed to prevent excessive government spending. They reason that, if politicians and voters believe that increased government spending has to be funded by taxes, this provides a built in constraint on excessive public spending, since taxes are deeply unpopular. If they realised that this was not the case it might be difficult, in a democracy, to control government spending.
So the fundamental reason for maintaining the fiction is that the public cannot be trusted with this knowledge. Is this ethical?
Leaving aside the ethics, another problem is that when people make decisions based on a misunderstanding, the consequences can be devastating. In fact one could make the case that the global financial crisis, and the six depressions that preceded this in US history were the direct result of operating our monetary system based on this misunderstanding.
Isn't it time for the truth?
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