How Money Works: The Overview

© by Mark Dempsey


Since before the Renaissance, businesses have used double-entry bookkeeping to track their finances. This means financial items have two names: asset and liability (debt).

If you have a note and deed of trust—the California equivalent of a mortgage—that is your liability. The note is the IOU, and the deed of trust specifies the security for the loan. People buying a house with a note and deed of trust pay the note holder, that is their liability. But the note holder collects their payments, so to the note holder, the same thing is an asset, not a liability. Similarly, if you have a bank account, that is your asset, but to the bank, it's the money they owe you. It's the bank's liability.

You can march down to the bank and demand it reduce its debt because you hate the word "debt," but it's not a very sensible thing to do. The bank would just make your account—your asset—smaller. Most people don't connect this to national accounting, but the same double-entry naming system applies there, too.

To understand the connection, we need to understand a little federal fiscal policy. First of all, the federal government is the monopoly issuer of currency. Dollars don't grow on billionaires. The Federal Reserve ("the Fed"—the US central bank) and Treasury issue dollars at the direction of Congress.

Incidentally, most of those dollars are electronic entries in Fed bank accounts. A Fed technician types "1" in a special computer terminal to make a dollar. If the technician adds three zeroes, it's a thousand dollars. Three more zeroes and it's a million; three more zeroes and it's a billion...et cetera. We will run out of dollars when the Bureau of Weights and Measures runs out of inches. Never.

The usual description of federal fiscal policy is "tax & spend." That's deceptive but plausible since it's the fiscal sequence for a household. But households don't issue currency. The question the tax & spend crowd needs to answer is this: Where would taxpayers get the dollars with which they pay taxes if the monopoly provider of dollars didn't spend them first? Dollars don't grow on billionaires; the federal government issues them.

So, unlike a household, federal fiscal policy must be "spend first, then retrieve some dollars in taxes." Notice that, unlike a household, the spending is completely independent of tax revenue. This is not a new observation, the chair of the New York Fed, Beardsley Ruml, wrote a paper in 1945 entitled "Taxes for Revenue Are Obsolete."

Taxes are important because they create the demand for the currency, among other things. Taxes do not, and cannot provision federal spending. If you went to the local IRS office to pay your taxes in paper dollars, they would mark your bill paid, and then shred the dollars.

And what are the dollars spent by the government, but not yet retrieved in taxes—you know, the dollars in your wallet? Answer #1: the dollar financial assets of the population. In other words, part of peoples' savings. Answer #2: part of the national debt. Both answers describe the same thing.

You might notice that your dollars are notes—the phrase "Federal Reserve Note" appears on one side. The notes—IOUs—are from the Fed to the note holder. What does the Fed owe you for your dollar? Answer: a dollar's worth of relief from an inevitable liability: your taxes.

Confusing currency creators like the federal government with currency users like households is the source of some mischief, too. And the "Fiscal Responsibility™" illusion has persuaded governments to reduce national debt significantly seven times since 1776. The last of these reductions was the Clinton surplus. Perhaps the most dramatic occurred in 1835 when Andrew Jackson paid the national debt off entirely and refused to renew the charter of the US Central Bank.

That debt payoff meant there was no public currency. People did their business with monetized gold ("specie") and over 7,000 varieties of private bank notes of varying reliability. Jackson effectively sucked all the dollar savings out of the economy. It was an economic nightmare, too, culminating in the "Panic of 1837," a large depression. Speaking of depressions, the Coolidge and Hoover administrations also sought to significantly reduce the national debt which led to a wave of asset forfeitures and foreclosures now known as the Great Depression. Significant economic downturns follow all the substantial reductions in national debt.

So...why are Wall Street financiers who should know better still lobbying for a smaller national debt? Remember, that a government that issues fiat currency, like the US, is fiscally unconstrained. It can pay any debt owed in that currency, and would never be involuntarily insolvent. Why would otherwise financially sophisticated people try to trigger a wave of asset forfeitures or foreclosures?

Unfortunately, we have a plague of vulture capitalists who are eager to take advantage of a population impoverished by national debt reductions. Some want to dominate labor by reducing social safety nets for the sake of "labor discipline"—the message that you had better take whatever crappy job is on offer or suffer the indignities of poverty, even homelessness, and starvation....and if you're rebellious, we'll put you in a cage.

Currently, the US is the world's leading incarcerator. With five percent of the world's population, the US has 25 percent of its prisoners. Labor discipline and vulture capitalism (AKA "disaster capitalism") are currently ascendant. Until people know how money works, this will likely continue, too.

The object is to get cheap labor and pick up distressed assets for cheap. Labor discipline and fiscal austerity serve the wealthy and keep their wealth intact, inflating stock and real estate prices while draining the pocketbooks of the poor.

One frequently heard objection to this overview is this: "If the government just prints lots of money, then we'll get [gasp!][hyper]inflation." This is a theoretical possibility, but history does not support this concern.

The (right-wing, libertarian) Cato Institute published a study of 56 historical hyperinflations. How many originated with a central bank printing too much money? Answer: zero. The typical inflationary episode began with a shortage of goods accompanied by a balance of payments problem.

The classic examples of Zimbabwe and Weimar Germany support that observation, too. In the former Rhodesia (Zimbabwe), the colonial farmers left and the natives were unable to produce the same amount of food. For one thing, raising European livestock requires a tsetse fly eradication program—otherwise the herds die of sleeping sickness. So a country that had previously fed itself was forced to rely on imported food. Hyperinflation followed after the food shortage and balance of payments problems.

In Weimar Germany, the French were impatient that the Germans didn't provide their WWI reparations (in this case, some telephone poles) so they marched their army into Germany's industrial heartland, the Ruhr, and shut it down. A shortage of goods ensued. The reparations were already a balance of payments problem.

The most devastating episode of US inflation in recent years occurred in the '70s when the OPEC used the "oil weapon" to protest the Yom Kippur war fought by the Israelis. US pre-fracking peak oil was in 1971 when the price of oil was $1.75 per barrel, so the US couldn't produce its way out of the OPEC shortfall. The price quadrupled virtually overnight, peaking at $42 per barrel in 1982. The shortage of this critical commodity produced a wave of inflation throughout the country, and not incidentally, a balance of payments to OPEC problem.

Finally, here's a statement no one said, ever: "Hey, the Japanese just attacked Pearl Harbor, but we're a little low on dollars, so we won't respond." On the contrary, the government took over roughly half of the US economy in World War II. Federal taxes increased, not to pay for the war, but to suppress the demand for resources needed to fight the war. Supply shortages might cause inflation, but not if people don't have the money to spend.

The Green New Deal would only consume 5% of the economy, and we would not need to raise taxes to implement it.

That's how the money works.

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The author teaches "Heterodox Economics" for the CSUS Renaissance (senior education) program.

Update #1: One person reminds me that we could balance the budget with a trillion-dollar coin. Congress has authorized Treasury to issue coins of any denomination for coin collectors, but the Obama administration turned down the suggestion of the trillion-dollar coin. It's admittedly a gimmick, and Treasury doesn't count coins as "notes" (debt). The inflationistas could be placated by simply depositing the coin--or several of them--in the Treasury's account at the Fed without spending it. It would make the Treasury's Fed account "balance," but it's too gimmicky to really amount to anything, at least in this writer's opinion.