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The US currency is no longer based on a gold standard. That has huge implications for all financial policy decisions made by the US government. That change in our monetary system completely changes the way we should think about all monetary and fiscal operations. There is no longer any equivalence in financial management between households and the federal government. Unfortunately, the wrong belief that our monetary system is constrained as if our currency were still on the gold standard continues to cripple our nation’s sustainable economic growth in the name of “fiscal responsibility.”
Nixon Did It
In 1933 President Roosevelt took us off the gold standard domestically to implement his successful New Deal program. But, the value of our money was still tied to the value of gold through foreign trade. Gold was the means of payment for all imports.
In 1971, President Nixon officially defaulted on international gold payments. That action had the effect by 1973 of changing our money to a nonconvertible, fiat currency with a floating foreign exchange rate.
Federal officials in Washington struggled for years to come to grips with the relationship between gold and currency. In the mid-70s they gave up any pretense of a dollar to gold monetary relationship. It is little wonder that to this day our currency is not widely understood. This lack of understanding has had a devastating impact on our fiscal and monetary operations.
Federal policy decisions based on gold standard beliefs are largely responsible for the massive wealth inequality in America today.
The Monetary Base and Inflation
Under a gold standard, a nation’s monetary base (Currency in circulation + Bank vault cash + Bank deposits) depends on the amount of its gold supply and the value assigned to it. The only ways to expand the monetary base to promote economic growth are to arbitrarily inflate the value of gold or obtain more gold through mining or exports.
Simply stated, a nation must create money to buy gold from either gold miners in the private sector or foreign trade surpluses. Then the gold rests in government vaults and the private sector holds the money.
Having spent its money to buy gold, government must tax or borrow it back for its own expenditures. This familiar way of thinking about our currency persists to this day despite Nixon’s decision in 1971.
Under our current nonconvertible fiat system all that gold-centric thinking is wrong. We must rethink everything about how we manage our monetary base, where our money comes from and where it goes, how we manage inflation, and what we gain or lose in foreign trade. Our correct understanding of these issues impacts our ability to recognize whether policies help or hurt the economic and social issues that concern us every day.
The Federal Reserve Bank (Fed), or private banks acting as Fed agents, issue all US dollars. There is no other source. The detailed double-entry bookkeeping that records fiscal transactions is beyond the scope of this note. But, the entries reveal that:
- The federal government creates money when it spends and destroys money when it taxes.
- Banks, accredited by the Fed, create money upon issuing loans and loan repayments destroy money.
So, the monetary base is flexible and varies according to the needs of government and the private sector to buy goods and services.
There is no limit to the amount of money the federal government can create. But, there is a limit to the nation’s productive capability, which includes labor, natural resources, and equipment. Interestingly, the New Deal initiated in 1935 demonstrated that we can manage our productive capacity to employ all who want to work.
Inflation will rear its ugly head if the federal government tries to buy more than the country can produce. When the country turned its productive capacity to win World War II, measures were taken through price controls and rationing to contain inflation.
For decades since WWII, the productive potential of the nation has been underutilized. That is, federal government spending has been below that necessary to use all the nation’s available resources including labor. In fact, government practice has been to enforce involuntary unemployment on the labor force to maintain a buffer stock of unemployed labor.
Think about it. The Fed, through its management of the federal funds rate (the interest rate at which banks borrow in the federal funds market) tries to control inflation by assuring that 3% to 5% of the labor force remains unemployed. This buffer stock of unused labor keeps wages low to prevent dollar devaluation, which is inflation.
Buffer stocks are nothing new; they have been used to control the price of grain with the government guaranteeing the price of a commodity. To assure a minimum price farmers would receive for their crops, government would buy excess grain and store it in times of plenty. Then it would sell grain at the same price in bad growing seasons.
A buffer stock of some sort is always needed to preserve the value of a sovereign currency. In the past we used gold. Now we use the price of unemployed labor. Wouldn’t it be much better if we used the price of employed labor by implementing a federal jobs guarantee (JG)? The JG would establish the minimum wage and other conditions of employment. Business firms would then have to meet or beat these minimum terms when hiring.
We must control inflation. We can do that by abolishing involuntary unemployment and implementing the JG. That will ensure that everyone who wants a job can have one at a livable wage and provide useful public service.
Deficits Matter; We Need Them
If government taxes less than it spends, those dollars, pejoratively called a deficit, remain in the private sector to grow the economy. When government decides to spend more than it taxes, it borrows by selling US Treasury securities that soak up the dollars not destroyed by taxes. Then, the “deficits,” as US Treasuries, remain as assets in the private sector.
So, the total sum of US Treasuries outstanding is a record of the dollars not taxed out of existence since the beginning of the republic. That sum, trumpeted with alarm, is called the national debt, an economically meaningless historical record that causes much political consternation and misunderstanding.
Under a gold standard, as stated above, government must tax or borrow from the private sector to obtain funds to spend.
Under our fiat system, a system that people have used for most of human financial history, it is obvious that taxation and borrowing can not take place unless there is already money in private hands. So, like the gold standard, the federal government must first spend funds into private hands before it can collect taxes or sell treasuries.
Think about it. When one earns a dollar, one can only consume, pay tax, or save. Nothing else is possible. When one uses money to consume, the recipient of that money has the same three options. Any money saved is money not taxed away. We see that savings are possible only when the government spends more than it taxes. That is, the federal government must run a “deficit” and increase the national “debt” to make private savings possible.
Many politicians advocate reducing the national debt. Some promote a balanced budget amendment to the Constitution. Doing that would prevent any possibility of creating private savings. Economic stagnation, recessions, or depressions would become more common. The chart below illustrates the situation. Federal deficits correspond to private savings.
To retire the national debt would mean retiring all US Treasuries, which would eliminate all private savings. The chart clearly shows that the reduced deficits during the decade leading up to 2008 resulted in reduced private savings that lead to the Great Recession. Let’s hope that future presidents understand what deficits mean, learn from the consequences of Bill Clinton’s deficits, and don’t repeat his mistake.
Taxes Matter; We Need Them
We have seen that federal spending is a separate federal government financial operation and must precede taxation. Still, taxes are necessary for the following reasons.
Taxes
- legitimize our currency. They create demand to acquire the tax credits (dollars) that government accepts in payment of taxes.
- are a means of averting inflation by reducing demand for consumption.
- inspire commerce to earn tax credits.
- can penalize lawbreakers.
- can reduce wealth inequality.
Borrowing; We Don’t Need to do It
Under the gold standard, government sold interest-bearing assets, US Treasuries, to preserve its gold supply. Treasuries were an attractive alternative to potential buyers of gold, and they served as convenient collateral in financial transactions.
Under a fiat system, government has no need to borrow, because government can create as much money as needed to achieve its objectives within the constraints of its available resources. But there remains a market demand for US Treasuries in private sector financial transactions and for risk-free income. So, the selling of Treasuries to match deficit spending has continued as a financial practice as a matter of superfluous law.
Also, the Fed buys and sells treasuries to adjust the quantity of reserves in the banking system to defend its funds rate target. However, the Fed could defend its rate target as well without Treasuries by simply paying interest on bank reserves just as it has done since 2008.
Banks Are Important
Bank lending creates most of our money. As private loans must be repaid with interest they add no net financial assets to the private sector. However, in the absence of federal deficits, the monetary base will grow as long as lending outpaces repayments and will decrease whenever payments outpace lending.
Indeed, acting for the government, the Fed issues money on a monopoly basis as needed by the economy. The Fed sets the price, the federal funds rate, at which banks can borrow money. Then the Fed supplies all that is needed in the overnight federal funds market at that price.
Many otherwise knowledgeable people still wrongly think that the money supply is limited as if it were based on gold and that any increase in the monetary base causes inflation. Further, common thought holds that competition between private and federal borrowing will “crowd out” private borrowing by driving up interest rates. The common belief that there is a fixed money supply, as with a gold standard currency, causes government and private companies to compete for money. Thus, if the government uses too much money, the interest rates go up and crowds out borrowing for private businesses.
In fact, contrary to common thought, federal government deficit spending increases the monetary base and will “crowd in” private investing if government spending is appropriately targeted into the domestic economy.
Because the Fed manages it, the federal funds rate is a policy variable not controlled by market influences. Bond vigilantes are artifacts of the gold system and do not exist in a fiat monetary system. Let us be glad the gold system is gone.
Trust Funds Are Misunderstood
Unlike a gold based monetary system, federal government saving has no meaning in a fiat system where needed money is always available.
So, there is no need for Medicare and Social Security Trust Funds, which are government savings accounts. Therefore, projected budget shortfalls are no real threat to Medicare and Social Security. The threat is embodied only in current laws that need to be changed.
Congress can always make the necessary funds available. But, with funds alone it can not make the necessary personnel and facilities readily available. That takes proper federal government management, foresight, planning, and funding necessary to ensure that care facilities and care givers are available as needed.
Foreign Trade Is Misunderstood
Under a gold system, imports would draw down a nation’s gold bullion reserves. So, countries would try to balance trade to maintain their monetary base. US trade was well balanced until the early 1970’s when the gold standard no longer applied. President Trump’s trade policies, which make use of tariffs to decrease imports, models the Gold standard. In that case exporters are winners of gold and importers are losers.
Under the fiat system, a nation trades its own plentiful currency for imports of products or services from foreign workers using foreign resources. Thus, exports are costs to us, as the products of American workers result in benefits for another nation. In what is called the “real terms of trade” the importer is the winner as its residents enjoy an improved standard of living.
It is true that imports tend to increase involuntary unemployment in the US. However, as stated above, under a fiat system the nation can eliminate involuntary unemployment and stabilize the value of the currency with a JG.
Conclusion
In the early 1990’s a heterodox school of economics rediscovered these insights into a fiat monetary system. Since then the school has codified its work in many publications, lectures, symposia, and college text books under the moniker of Modern Monetary Theory. Its work establishes that the fiat monetary system reveals fiscal policy space not available under gold standard constraints.
The school encourages any country with a sovereign, nonconvertible, fiat currency with a floating foreign exchange rate to maximize its productive capabilities to the benefit of all its residents.
Programs like universal healthcare for all, free college education at public institutions of higher learning, superior public education system, modernization of our transportation, water & sanitation infrastructure, and addressing the climate crisis with the urgency it demands are not radical. They are achievable within the constraints of our available resources.
Unemployment indicates that federal deficits are too small and fiscal stimulus should be implemented. Inflation indicates that the limits of productivity are being tested. Then remedies such as taxes, spending cuts, or regulations are in order.
