Saturday, February 19, 2011

Gold is Gone

We old timers had our economic education when currency had value, because it was backed by gold.  We were happy to know that every dollar we possessed represented a little bit of gold at Fort Knox.  Nixon took us off the gold standard in the early 70's, because our foreign creditors, who helped finance the Viet Nam War, wanted to be paid in gold.  That was decimating our supply.

Now the rules have changed, our dollar bills have no intrinsic value.  Rather, we have "fiat" money instead of "commodity" money.  Fiat money has value only because the government says it is legal tender and requires that we pay taxes with it.  It is counterintuitive, but once we get our heads around it, we have a better understanding than most Congressmen and any newscaster.

Even someone with no tax liability has to use the fiat money, because others need it to pay taxes.  Taxation creates demand for fiat money.

Government creates money by spending it into the private sector to buy goods and services to provision itself for tasks laid upon it by the Constitution and the US Congress.  Government retrieves the spent money by taxation and balances a shortfall by the sale of bonds.  A balanced budget would not require the bond sales.  A budget surplus would, through taxes, withdraw money from the private sector.  Money retrieved by taxation is effectively destroyed.  Let’s follow simply what happens.

When the government spends its annual $3.5 trillion budget, it injects the money into the economy.  When Bill takes out a loan from the bank or uses his credit card, money is created and injected into the economy.  But, as Bill pays off the loan the money is removed from the economy, so there is no net creation of money.  If Bill loans money to Joe, and Joe pays it back with interest, Bill is richer, but it has involved no creation or destruction of money.  It's just a private transaction.  The net money in the economy is the difference between money spent into existence by the Government and that extracted by taxes.

If the Government runs a deficit, the difference between the $3.5 trillion spent and that retrieved by taxes remains in the private sector as savings in the form of Treasury securities.  If Government were to take back in taxes the whole $3.5 trillion that it had spent, there would be nothing left for us to save that year.  So, as the Government runs a deficit the economy is able to grow.  By consistently running a deficit the Government accumulates debt, which is now wealth in the private sector.  A debt in the public sector is an asset in the private sector.  To reduce the debt, Government takes wealth out of the private sector.

There is no need for us to pay off the debt.  But, we have to maintain our ability to pay the interest on that debt if only as a measure to keep it from growing faster than GDP.

Loans and private business transactions move money around the economy.  We all work, innovate, and scheme to get more of it, but there is no net input of money without Government spending.

This is not a liberal scheme for irresponsible spending.  It's just the way things work.  Too much deficit leads to inflation; too little stunts economic growth and may lead to deflation.  Of the two, should one occur, inflation is easier to cure.

We should also note that too much private surplus is a bad sign.  In fact, the signature of a recession is high private saving as people avoid spending and high public deficit as tax revenues decrease.  Currently the public deficit and private surplus are both running at historic highs of about 10% of GDP.

Our national debt represents the cumulative savings of many in the world including you and me.  We might be proud that so many seek the safety of our currency, and that it functions as the world’s primary reserve currency even though there are some drawbacks.

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