Introduction.

Most currencies today are what is called "fiat", that is they are not backed by gold or any other valuable commodity. This raises the interesting question as to why this form of money has value. The most widely accepted set of reasons are set out in the economics text books, while there is a less widely accepted reason, namely that money derives its value from the fact that citizens need money in order to pay taxes. This latter idea is part of Chartalism.

It is argued below that the extreme Charalist view, namely that almost every currency since civilisation began derives its value from tax is a gross exaggeration of the role played by tax. That is there are an infinite number of shades of grey between government having complete control of money and in contrast, the private sector having complete control.


The text book explanantion.

The text book explanantion as to why fiat money has value is approximately as follows.

There is an inherent desire by households, businesses etc for some form of currency (other than in very simple economies, e.g. desert islands inhabited by less than about three families). This is because money provides a more efficient method of buying, selling and generally doing business than barter. This sometimes results in some form of currency arising automatically, and the currency normally consists of some valuable commodity. For example in some prisoner of war camps in Germany in WWII, inmates effectively used cigarettes as a form of money. And there are (or used to be) African tribes which use/d cattle as money (not a very conventient form of money!).

But fairly early on in the history of most countries or societies, government normally takes a keen interest in the currency and tries to dominate the administration of the currency. I.e. governments can so to speak "build on" the desire by citizens to have a currency. And governments normally declare that the money which it, the government, administers or issues is "legal tender". Legal tender is a means of payment that creditors cannot legally refuse when it is offered in settlement of a debt. This declaration is normally accepted by citizens as long as government does not administer the currency in a totally incompetent manner. Zimbabwe is an example of a country which has failed here, and its citizens are turning to other currencies in order to do business at the time of writing. (For more on "commodity monies" see under the "commodity money" heading in the adjacent column.)


Chartalism.

Chartalism is a theory with a long history. Keynes and other’s of his generation were sympathetic. A part of the Chartalist view of the world is that fiat currencies do not derive their value so much from the above text book reasons, but from the fact that citizens need the money with which to pay tax. Probably the main current advocate of this idea is Prof L. Randall Wray. Abba Lerner subscribed to chartalism: see "Lesson No 3" here.

Another advocate is Warren Mosler (WM) and an article by him advocating Chartalism is criticised below. He has a very good site which explains some economic topics with greater clarity than is usual. However he seems to adhere to the idea that "taxes give money its value" (TGMV). I’ll deal with some general weaknesses in TGMV first, then with the article in which Mosler advocates TGMV: “Soft Currency Economics”.


Flaws in TGMV: 1. Dictatorial regimes.

Advocates of TGMV often illustrate their ideas by reference to relatively dictatorial regimes where the government issues a currency and forces citizens to do various things they would not otherwise do, including paying tax. Probably the extreme case is a slave and slave owner economy where the latter gives the former “tokens” in exchange for their work. The slaves in turn spend the tokens on food, housing etc, provided by the slave owner doubtless at a healthy mark up. Nice for the slave owner.

In dictatorial regimes the currency (or "token") certainly derives its value partially or wholly from the fact that citizens must obtain it to pay tax. And certainly there have been societies where the currency was established essentially by government with a view to collecting tax, and in such societies the currency derives its value primarily from the fact that the currency is the only way of discharging tax obligations. But this "derivation" is derived from dictatorial powers.

In contrast, in democracies, governments just don’t wield significant dictatorial economic powers. Democratic governments certainly control the police and the armed services which in principle gives them big potential dictatorial powers. But if they misuse such powers, such governments get the boot at the next election. In other words democratic governments are essentially glorified conglomerates which provide a variety of goods and services, and payment for these services happens to be called "tax". But the name "tax" is irrelevant: one could equally well call the payments that citizens make to other large conglomerates a "tax" (e.g. payment for food at large supermarket chain).

As an illustration of the lack of monopoly powers that democratic governments have, consider education and health, two very large chunks of governments spending, certainly in European countries. Schools and hospitals are effectively in competition with private sector schools and hospitals. If government doesn’t do a good job of running schools, hospitals or anything else it is liable to be booted out at the next election, or citizens campaign for the removal of offending bureaucrats or politicians. Another alternative is that citizens campaign for the privatisation of various parts of the government machine: a movement which reached a peak in the UK during Margaret Thatcher's reign. Thus the “dictatorial regime” illustration is irrelevant.


2. Tax is not necessarily paid in fiat money.

In the UK (and perhaps other countries) citizens do not absolutely have to pay taxes in the local fiat money. They can pay, if they want, by giving the tax authorities a house, plot of land, or lump of gold. This is very unusual because of the sheer inconvenience, but it happens from time to time. (The UK tax authorities, out of the kindness of their hearts, always bend over backwards to be flexible if it helps them relieve UK citizens of the latter’s worldly wealth. I know from experience.)

A possible answer the above is that the tax authorities are almost bound to convert the lump of gold (say) into the local fiat money, thus the tax has effectively been paid in this money. This argument is invalid for the following reason: the tax obligation has been extinguished by the lump of gold. Period. End of story. Of course the tax authority converts the gold into money, but it would almost certainly do this even if the prevailing currency were not a fiat one. Thus the “conversion” has nothing to do with fiat currencies as such.

Another possible answer to the above criticism of Chartalism is that the proportion of tax that people pay with lumps of gold etc is ridiculously small, thus the criticisms is almost irrelevant: i.e. in practice, people pay the vast majority of tax using the fiat currency. The answer to this is that people also pay the vast majority of their tax in the prevailing currency where the prevailing currency is not a fiat one. I.e. the reason people pay the large majority of their tax using a fiat currency in a fiat currency regime results from the fact that the fiat currency is the prevailing currency, not from the fact that it is fiat.


3. Private banks can issue fiat money.

The UK was off the gold stand (i.e. had a fiat currency) for longish periods between the two world wars, plus the Bank of England was not nationalised till 1946. Doubtless there was close cooperation between the UK government and the B of E during this period, but strictly speaking the currency was not issued by government.

Moreover, private banks creating fiat money is not just a technicality last seen before the Bank of England was privatised. In the lead up to the credit crunch, the commercial banking sector created money on a scale that rendered central banks almost irrelevant. Or in the words of a former chief economist at the IMF, the finance industry "captured government" in the lead up to the credit crunch (1). Another well researched article making the same point is here.

The more irrelevant central banks become, the more it becomes a nonsense to say that it is central banks or governments that give the money its value. (Also, the further this process goes, the less the relevant currency is a “fiat”, and the more it falls into some other category: “commercial bank created”, “debt based”, call it what you will.)

Having belittled government, it should be said that a fiat currency cannot operate without effective government. In a relatively lawless regime where anyone can set up a printing press and print money, or anyone can set up a bank and run it on a blatantly fraudulent basis, a fiat currency would not work. Gold or silver would be a better currency.

Also it has to be wrong for the profits from "seigneurage" (the right to print money) to accrue to a private institution. That is, the natural issuer and administrator of a fiat currency is government, as Charalists rightly point out. But this does not necessarily make TGMV valid.

Finally a number of leading economists are calling for the abolition of the US central bank, the Federal Reserve. E.g. see third para here. When the government's central bank does not exist, government's role in money creation becomes very indirect.


4. Which comes first: food and shelter or taxes?

Another weakness in TGMV is that for the very poorest people in any society, the main purpose of money is obtaining food and shelter. If their income is only just sufficient for the two latter, and government then demands taxes from such individuals, government will get short shrift. Government can if it likes imprison those on the breadline for not paying taxes, but government will still not get the taxes it wants. Indeed, government far from gaining any income, will have to spend large sums of money keeping such individuals in prison.

The above point can be put another way, as follows. The most fundamental purpose of money is to obtain food and shelter. AFTER those needs are met, people will then spend money on other items including luxuries and taxes.


5. TGMV: this is news to various presidents and prime ministers.

The idea that governments have compete control of the money supply and/or can control its value is news to various presidents and prime ministers.

William Lyon Mackenzie King (prime minister of Canada in 1920s) said: "Until the control of the issue of currency and credit is restored to government and recognized as its most conspicuous and sacred responsibility, all talk of sovereignty of Parliament and of democracy is idle and futile... Once a nation parts with control of its credit, it matters not who makes the nation's laws... Usury once in control will wreck any nation."

Thomas Jefferson, US President 1801-9 said, "I believe that banking institutions are more dangerous to our liberties than standing armies."

Abraham Lincoln, US President 1861-5. "The government should create, issue and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers. By adoption of these principles, the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity."


Soft Currency Economics.

Soft Currency Economics is the title of an article by Warren Mosler (WM) advocating Chartalism. Obviously readers will be better off reading WM’s article first, but this is not essential.

Near the start of the article there is an illustration of a simple fiat money economy. The "economy" consists initially of a household where parents provide children with board, lodging and housekeeping services for free. Then the parents decide they've had enough (so like the real world!) and decide the children must do household chores in exchange for board and lodging. In WM's words:

“One day the parent announces that the children may earn business cards by completing various household chores. At this point the children won’t care a bit about accumulating their parent’s business cards because the cards are virtually worthless. But when the parent also announces that any child who wants to eat and live in the house must pay the parent, say, 200 business cards each month, the cards are instantly given value and chores begin to get done. Value has been given to the business cards by requiring them to be used to fulfill a tax obligation”.

Note that WM introduces money and tax to the economy at the same time. This is misleading, because the basic quesion under discussion is whether tax and money are separable or inseparable. But never mind.

As pointed out above under the "Dictatorial regime" heading, the whole TGMV argument is in a bind, as follows. If the prices charged by government for its services are fair, then government is little more than a conglomerate much like any other conglomerate. Alternatively if government is being dictatorial, then such a government is not relevant to a democracy. So are the payments that parents and children make to each other are “fair” or “free market price”. In this particular economy it is virtually impossible to say what the fair or market price for anything is because there is little effective competition.

But this doesnt matter because there only two are two possibilities: either the prices are fair, or there is an element of exploitation. If the prices are fair, it is inaccurate to describe any of the payments as a “tax”. Alternatively, if there is exploitation, then the payment can be said to include an element of tax. But as was shown under the “Dictatorial Regime” heading above, the illustration then becomes a bit of a nonsense. The TGMV argument is in check mate here, is it not?

WM continues: “The children will likely desire to earn a few more cards than they need for the immediate tax bill, so the parent can expect to run a deficit as a matter of course.”

The first half of the above sentence is correct, the second is not. That is, the children will probably want a few cards in reserve. This is the equivalent of the well known “precautionary” motive for holding money, set out in the text books, (i.e. everyone likes setting something aside for a rainy day). But why would the children want to hold an ever increasing number of cards as is implied by the second half of the sentence? This makes no sense for the children. Indeed, as MW himself points out in his article entitled "Full Employment and Price Stability", people have a desired level of net financial assets. That is, people will dissave if their actual accumulation of net financial assets exceeds their desired accumulation of net financial assets.

WM then moves on to the possibility of parents and children borrowing cards from each other and paying interest. WM claims “The reason for the borrowing is to support a minimum overnight lending rate by giving the holders of the business cards a place to earn interest.” Why on earth would the parents want to offer to pay interest simply to support an overnight interest rate? What’s in it for them? WM doesn’t tell us. I suggest that what is in it for them is as follows.

There is a limit (as pointed out above) to the number of cards the children will want to hold for precautionary reasons. The parents (like all of us) are interested in “consuming now and paying later”, and they will pay for the privilege of doing so: the payment is called “interest”. Indeed, it is quite possible that the children’s desire to “consume now and pay later” exceeds that of the parents, in which case the children rather than the parents would run into debt and pay interest to the parents.

WM then claims: “Notice that the parent is not borrowing to fund expenditures” My answer: yes they are, as good as. This is for the following reasons. Assuming the children have as many “precautionary” cards as they want, the parents cannot print more cards to fund their consumption: the children just wont want the cards (or if the cards get into circulation they become devalued: inflation). But what the parents CAN do is bribe the children to part with some cards by paying interest on them, which reduces the “precautionary” number of cards in the hands of the children to below their desired level, which in turn will induce the children to take more cards.

Alternatively, parents could bypass the “bribe the children to part with some cards” bit and just issue interest bearing cards to the children. (This is pretty well the equivalent of WM’s $100bn illustration at the beginning of “Deficit Spending for Dummies” (one of the articles on his site). Here he rightly points out that the net effect of government borrowing and spending $100bn is to increase government debt in the hands of the private sector to the tune of about $100bn).

In addition to there being a limit to the number of cards the children will hold for precautionary reasons, there has to be some limit to what they will hold in the form of “interest bearing cards” (US Treasuries in the case of the US).

There is also a limit to how much US national debt that China and others will be willing to hold. Exactly where this limit is, is anyone’s guess. As regards the US national debt, the “debtphobes” who WM criticises (Ross Perot, etc) have a good point, though their points are not well expressed because they have not studied economics in depth. These debtphobes are uneasy, and they are right to be uneasy: it is not wise to borrow right up the limit of what one’s creditors are prepared to offer. Ask US house owners who are “under water” (to use US parlance) or who have “negative equity” (to use UK parlance). Ask the many corporations who became grossly overleveraged and are now near bankruptcy. Ask Iceland, Ireland, or half of Eastern Europe, which went bankrupt or near bankrupt in 2009.

Footnote:

1. Thanks to Winterspeak for this link.