At one time or another many of us have probably pondered questions such as: Where does a national currency come from? How does a currency system basically work? Why might people agree to accept a national currency in the first place? How can we be confident that a national currency won’t collapse and that people will continue to accept it in economic transactions? Can a government ever go broke and leave citizens footing the bill? Can financial affordability even be an issue for government?
The answers to these questions depend, above all, on whether the government in question is a currency issuer or a mere currency user. The simple tale traced below illustrates some basic aspects of a society in which government issues its own currency. It is important to understand that the illustration does not apply to governments that use a currency issued by some other entity. For example, it does not apply to a state or local government that is required to transact in a currency issued by its national government. Such governments are mere currency users, much like households and private businesses. They do not issue their own currencies. Equally, the illustration does not apply to a national government that has given up its prerogative to issue a currency and has instead agreed to use what is essentially a foreign currency. This is currently the predicament of those European governments who have committed to using the euro. At least for now, such governments have reduced themselves to the status of mere currency users. If, at some point in the future, these European governments decide to go off the euro and reintroduce their own currencies, the following illustration will then become applicable to them, but not until then.
Most national governments, however, do issue their own currencies. This is true of the national governments of countries such as China, the US, Russia, the UK, Japan, Brazil, India and too many others to mention.
To illustrate in very simple terms the position of such governments and the nature of their currencies, consider Buckwell Island. It is an imaginary island. Its people have just voted to form a nation. Elected representatives from each region of the island have gathered to discuss some basic needs of the new nation.
After much discussion and consultation it is agreed that there need to be some common rules governing access to natural resources, ownership or stewardship of property, and the conduct of business activities. It is decided that the newly formed government will need to see to the effective defense of the island and develop key public services in education, child and aged care, health care and civil administration as well as build or oversee the building of roads, a public transport system and a modern communications network. All this will take time and much effort.
The island government realizes that it will need to hire some people to perform roles in the public sector. It also needs a way for private sector activity to be integrated into the economy. To this end, it decides to introduce a national currency called the ‘buck’.
The currency is established in two basic steps:
First, the government officials return to their local electorates and announce that all citizens of at least working age will be required to pay taxes. A tax authority will be established to monitor and enforce payment. Significantly, it is specified that all taxes and other government charges will have to be paid in bucks. No other currency or item will be accepted. In addition, all income and wealth generated on the island will be evaluated in bucks, with taxes imposed accordingly. Court settlements will also be specified in bucks.
Since people require an income, and since income and wealth will be evaluated in bucks and subject to tax, this first step in establishing a national currency creates a need within the community for its members to earn or otherwise obtain bucks.
The effect of this first step is to ensure at least some demand for the currency. Since people need bucks to pay taxes and other government charges, they will accept the currency in payment for goods and services that they are able and willing to supply either to government or to fellow Buckwellians.
With a basic demand for the currency now created, the second step in establishing the currency is for the government to open up various channels through which members of the community can actually get hold of the currency. In partial fulfillment of this objective, nominated government representatives release a list of public sector job positions. It is announced that there will be jobs for teachers, health practitioners, administrators, police officers, defense and peacekeeping forces and other important roles. Suitable applicants are free to apply for these jobs. If successful, they will be paid in bucks.
The officials also announce a list of goods and services that the government would like to purchase from private businesses. This opens up opportunities for prospective businesses to sell output to a large customer (the government). To obtain finance, competing businesses will be able to approach a newly established public bank for loans. These loans will be issued in bucks. In time, private banks may also be permitted to operate. For now it is left as a future question for the voters to decide.
The effect of these measures is to ensure that citizens can get hold of the currency. Some people will accept a job offer from the government to work in the public sector. Business operators, financed at least initially by public loans, will be able to start production and sell their products or services to customers, generating revenues in bucks. The rest of the working-age population will be able to seek employment in the private sector in exchange for bucks.
The government also announces a Job Guarantee program. Anyone who cannot find a job elsewhere can accept a job-guarantee position financed by government and administered by local government or perhaps community organizations. Those who are unable to work due to age or sickness will receive a pension paid by government.
With these policies in place, everyone can get hold of bucks. They will be obtained either as newly issued currency when the government spends, pays pensions or lends, or as circulating currency when households or businesses make payments with bucks yet to be extinguished by taxation.
To facilitate economic activity as well as saving, citizens are granted the right to hold accounts at the public bank. Payments for goods and services can be made through the direct debiting and crediting of bank accounts or the exchange of hard currency.
To summarize, there is a basic two-step logic involved in Buckwell Island’s introduction of a currency. First, by requiring taxes and similar charges to be paid in bucks, the government ensures that people are willing to accept the currency. This step ensures at least some demand for bucks since people need them, at minimum, to pay taxes. Second, the currency is issued. The government issues bucks by hiring workers, providing pensions, extending loans to businesses and purchasing some of their output.
It may be noticed that it would be impossible for anyone actually to acquire bucks before the currency had been issued. Until government spent on goods and services, or paid pensions, or the public bank lent, there would be no way for anyone to obtain bucks. An implication is that government spending and public lending are logically prior to the occurrence of economic activity denominated in bucks. Households and businesses could not make any payment in bucks before the currency had been issued.
A system of accounting and basic bookkeeping is put in place with the aid of spreadsheets maintained by the public bank. Whenever the government decides to spend or lend bucks, the public bank types in the appropriate new numbers in its spreadsheets. If the government pays 100 bucks for office stationary, the public bank marks up the account of the stationary supplier by that amount. The new deposit will be an asset of the stationary supplier and a liability of government.
The stationary supplier is one entity in what can be called the non-government sector. This sector includes all households and private businesses on the island as well as any foreigners making transactions in bucks.
When the government spends 100 bucks on office supplies, the financial assets of the non-government sector, taken as a whole, increase by the same amount. This increase in non-government financial assets is offset exactly by an increase in government liabilities of the same amount. In this way, bucks (which are government liabilities and non-government assets) are created out of nothing.
Conversely, when the stationary supplier pays perhaps 30 bucks in tax, this amount is subtracted from its bank account. This action destroys 30 bucks. They no longer exist. The stationary supplier’s assets go down by 30 bucks as do government liabilities. As a whole, the financial assets of the non-government sector decrease by this amount, as do outstanding government liabilities.
In short, government spending and lending create bucks. Taxation eliminates bucks. Loan repayments to the public bank also function as tax payments, and so eliminate bucks. The discharge of any other government charges, such as through the payment of licensing fees or fines, also eliminates bucks.
It is important to note, however, that of the two means of currency issuance – government spending and public lending – only government spending enables non-government, viewed as a whole, to extinguish its financial obligation to government. Government spending adds to the net financial assets of non-government. This is not true of public lending. When the public bank makes a loan, say, to a construction firm, it is true that the newly issued bucks are an asset of non-government (specifically, the construction firm) and a liability of government (specifically, of the public bank). But this is offset by the fact that the loan is an asset of government (the public bank) and a liability of non-government (the construction firm). Overall, there is no net impact on financial assets held by non-government. Therefore, public lending has no impact on the level of non-government’s financial liability to government.
An implication is that government spending is logically prior to the paying down of non-government financial liabilities to government. This liability cannot be extinsguished with funds borrowed from the public bank, since this will simply shift the form of the liability from a tax liability to a loan liability. In contrast, when the government spends, non-government receives an asset that is not matched by an offsetting liability within the non-government sector. Rather, the newly created liability is held by government. For instance, when the government pays 100 bucks to the stationary supplier, it credits the public bank account of the stationary supply. This new deposit is an asset of the stationary supplier and liability of the public bank. Net financial assets held by non-government increase. Or, equivalently, the financial liability of non-government to government shrinks.
The government’s spending is not constrained by the amount of taxes paid in the past. To the contrary, the capacity of citizens to pay taxes originates from government spending. A currency-issuing government, such as Buckwell Island’s government, can always afford to purchase whatever is available for sale in its own currency. In other words, if something has a sale price in bucks, the island government can always afford to purchase it, since it is the sole issuer of bucks.
As a matter of logic, something cannot be destroyed before it exists. Bucks must be created through government spending or lending before they can be eliminated through taxes, the repayment of public loans or the discharge of other financial obligations to government. Or, to put it another way, the government must issue its financial liabilities before they can be extinguished.
Clearly, there is no limit to how many financial liabilities the government can issue in its own currency. For Buckwell Island’s government, there is never a question of financial affordability when it comes to anything that is available for sale in bucks. To issue its liabilities, the government simply makes a decision to spend. With the decision made, the bucks are keystroked into existence when the public bank types them into the accounts of spending recipients.
However, the absence of a financial limit does not mean that there are no limits to what can be achieved in real terms. It would be pointless for Buckwell Island’s government to keep increasing its spending if there were no actual goods and services that could be produced to meet the extra demand. Acting in this way would merely bid up the prices of various goods and services. And since the prices of these goods and services might also enter into the costs of producing other goods and services, there could potentially be a bout of excessive inflation in which prices, on average, rose rapidly and continued to rise for some time. Inflation causes the currency to lose some of its purchasing power. A unit of the currency – one buck for the islanders – would purchase less than before.
Fortunately, Buckwell Island’s government and citizens understand that the level of total spending – which includes the spending of government, the island’s households and businesses, and foreigners – needs to be kept in sensible proportion to the capacity of the society as a whole to produce real goods and services. This does not necessarily mean that taxes must be as high as government spending. To the extent that households, businesses and foreigners wish to spend less than their incomes, this subtracts from the overall level of demand and makes it possible for government to spend somewhat more than it taxes without causing excess demand.
Although our tale is very simple compared with the complexities of modern economies, it does highlight some basic points that will help address the questions posed at the outset. Introducing more real-world factors, such as a private banking sector, would greatly complicate the details of the story but not change the basic issues presently under consideration. Returning to the questions:
Question 1. Where does a national currency come from?
Answer. In a society with a currency-issuing government, the currency originates from governmental decisions to spend. Whenever Buckwell Island’s government follows through with its decision to spend, bucks are created. As has been discussed, the bucks so created are a financial liability of government – a form of liability that the government can issue without limit – and a financial asset of non-government.
Question 2. How does a currency system basically work?
Answer. The currency originally comes from government. When the Buckwell Islanders sell goods or services (including labor services) to government, they receive bucks in exchange as income. When businesses borrow from the public bank to invest in production or hire workers, these expenditures likewise go to somebody as income. In this way, bucks enter the economy and can be used for various purposes within the economy. Some of the bucks received as income will be used by households and businesses to pay taxes. Some will be saved in accounts at the public bank or in hard currency. Some will be used to buy goods and services from foreigners. And some will be used to buy goods and services from others in the island community, creating additional income in the process. In this way, bucks circulate from one household or business to another until at some point they are eliminated through taxation.
Question 3. Why might people agree to accept a national currency in the first place?
Answer. An important reason is that people must obtain the currency in order to pay taxes or meet other financial obligations imposed by government. This ensures that the Buckwell Islanders will accept bucks in particular, in preference to some other currency. The imposition of taxes and other government charges is not necessarily the only reason people might accept the currency. But this factor is sufficient to ensure at least a base level demand for the currency.
Question 4. How can we be confident that a national currency won’t collapse and that people will continue to accept it in economic transactions?
Answer. A complete collapse of the currency would mean that it was no longer possible to buy goods and services with the currency. It would mean that nobody was willing any longer to accept the currency in payment for anything. A complete breakdown of the currency will not happen so long as the government effectively enforces taxes and other obligations denominated in its currency. It is the successful enforcement of these obligations that guarantees the currency remains acceptable in exchange at least to some extent.
Even so, we have also recognized that the currency can lose some of its purchasing power when the tax burden becomes too light relative to the level of government spending. If taxes were kept very low but the government chose to spend a great deal in comparison, this could cause (in combination with other spending) more demand than the economy could cope with in a timely fashion and result in a bidding up of prices for many goods and services. A unit of the currency – one buck for the islanders – would then buy less than before. The purchasing power of the currency would decline.
What matters, in this respect, is the strength of spending in general, whether by government or non-government. All spending carries some risk of inflation if it causes demand to outstrip the capacity of the economy to supply additional output. The more households, businesses and foreigners wish to save bucks (rather than spend them), the more it is possible for government spending to exceed tax payments without causing undue inflation.
On Buckwell Island, an outbreak of inflation would be met by a narrowing of the government’s deficit (or widening of its surplus) primarily through the operation of automatic stabilizers. In boom times, stronger private-sector activity would cause both a reduction in government spending on the job-guarantee program and an increase in tax payments. These countercyclical variations in government spending and taxing would moderate demand and help to keep inflationary pressures in check.
Question 5. Can a government ever go broke and leave citizens footing the bill?
Answer. A currency-issuing government can never go broke so long as it sticks to operating in its own currency and refrains from borrowing in foreign currencies. (To the extent that a government becomes indebted in a foreign currency, it reduces itself to the status of a currency user and can run into financial difficulties.) A government that sticks to its own currency faces no financial constraint. It can always create more currency if and when this is deemed appropriate.
Question 6. Can financial affordability even be an issue for government?
Answer. A currency-issuing government can always purchase whatever is available for sale in its own currency. By the same token – and at the risk of stating the obvious – the government cannot purchase what is unavailable for sale. Put simply, there can be a shortage of natural resources. There can be a shortage of workers. There can be a shortage of knowledge and technical know-how that prevents certain goods or services from being supplied within a particular time frame. These constraints place limits on what can be done in real terms. But, importantly, anything that can be done within these real limits is affordable for a currency-issuing government.