This is the first in an introductory series of discussions concerning the monetary system. The purpose of this series is two-fold: Firstly, for those students considering economics as a major, the series will give you a solid understanding of the basics from which macroeconomic reality flows. In other words, from the get go, you won’t fall for mainstream fantasy, and then one day, obtain an influential position in government where you will create recessions and high unemployment for a living and then deny responsibility. Secondly, for the general public and interested laypersons who do not wish to be economists, but rather, who do wish to obtain a firm grasp on the basics of the monetary system, federal spending, and banking and central bank operations. So, with my rather good coffee in hand, thank you so much, let’s get started. This morning, we will consider the question, “What is a US Dollar?”
Before we begin, politics has to go. It has no place here, so drop any political notions you might have. Your political feelings concerning economics and federal spending do not apply. Also, push paper dollars and coins out of your minds. Ignore the private sector, business, banks, Wall Street and China. If you’ve studied economics prior to today’s discussion, consider the time you spent studying it as wasted time. You might as well have been studying tooth fairies and the supply of and demand for used teeth. Set everything you think or have been told to believe aside. Toss it out. Let’s start from a blank chalkboard and facilitate a correct understanding, shall we? Fine.
The Origins of the US Dollar
The US Dollar is a manufactured product. An iPad is a product manufactured exclusively by Apple. No other entity besides Apple manufactures iPads. It is Apple’s monopoly product, we could say. Similarly, the US Dollar is a product manufactured exclusively by the US government. It is the US government’s monopoly product. The same applies to the British Pound and the Australian Dollar. The Pound is a product manufactured exclusively by the UK government. The Australian Dollar is a product manufactured exclusively by the Australian government, though most Australian politicians act as though they aren’t aware of it, judging from the fact that they’ve spent years stripping Australian Dollars from their domestic economy, apparently, in pursuit of creating mass unemployment. In an alternate universe, such a pursuit might be beneficial, but in this one, it is wholly unacceptable.
The US Dollar is a Unit of Account
In the world of mathematics, there are several different ways we can measure things. We can measure distance using various units such as inches, meters, feet, miles, kilometers, light years. The same is true for weight: ounces, grams, gallons, liters. Each unit of measurement can be made equivalent to another through conversion. For example, inches are one type of unit of measurement and so are feet. 12 inches is equal to 1 foot. So, we have a choice and can be satisfied to say 24 inches, or 2 feet.
In fractions, students learn that the denominator is the unit of measurement that tells us how many equal parts an item is divided into. If we change the denominator, then the way in which we are measuring an item changes. For example, 2/4 means two parts of a total of four. Changing the unit of measurement to eighths, 4/8, now means four parts of a total of eight. So, in the fractions 1/4, 1/8, 1/16, 4, 8 and 16 are the units of measurement. Similarly, a US Dollar is a unit of measurement called “the unit of account”.
Like inches, meters and fractions, we can break down the US Dollar into two parts, which, when put together, answers the questions “What are we talking about?”, and “How many are we talking about?” The first component of a US Dollar is the familiar “$” symbol. You could say that this is the bottom line, or denominator, in the US. In the United States, the “$” symbol represents what we call the “Unit of Account”, which the US government alone commands and issues. The US Dollar is how we “measure” goods and services in the US economy. If we are talking about the UK, we do not “measure” goods and services with US Dollars. In the UK, the Pound is the unit of account, so we measure in Pounds. The unit of account distinguishes one nation’s currency from another’s and so, the unit of account tells us what we are talking about:
Here, we are talking about Pounds.
Here, we are talking about Dollars.
Here, we are talking about Kilometers.
Here, we are talking about Meters
And here, we are talking about Japanese Yen.
So, if we were talking about distance, (m) would tell us that we’re talking about meters and (ft) would be feet. And if we are talking about currency, (£) would tell us that we’re talking about the UK and (¥) would tell us that we are talking about Japan.
A number added to the unit of measurement tells us “how many” of the unit that we are talking about:
How many meters? One thousand meters.
How many dollars? Ten dollars.
In mathematics, students learn that numbers are infinite. You simply cannot run out of numbers. So, for a carpenter or an engineer, that’s a good thing. When a builder starts to construct a house and discovers that his tape measure only goes to 50 meters, he does not say, “Damn. I guess that I cannot build this house, because I’ve run out of meters.” Meters go on forever:
It’s the object (wood, brick, sheet metal, land) that the builder is measuring that is finite. So, the builder can indeed run out of private property to build a house upon and material to build that house, but he cannot run out of meters to measure with. Please note this reality as it will come up again in tomorrow’s discussion.
In the real world, nobody owns or issues meters, but in the real world, national governments do own and issue units of account. So, only the US government issues the “$ US” and then, only the US government is allowed to add a number to its own unit of account, thereby creating US Dollars. Explaining the dollar this way helps people who think that US Dollars are commodities to think clearly. The US Dollar is actually no different than any unit of measurement. The number after the “$” symbol simply tells us “how many” dollars.
Modern Monetary Economy
People produce goods and services. There are different ways that people can obtain these goods and services. For instance, people could engage in barter, trading apples for trousers, sheep for corn or gold dust for a day’s work. Another method for people to produce and consume goods and services is through the use of monetary instruments.
Fundamentally, for something to be a monetary instrument, it requires an issuer of the instrument. Secondly, a monetary instrument requires that the issuer give it a face value. Third, a monetary instrument requires the issuer to promise to accept it back as payment. This is why gold itself is not a monetary instrument. Gold is a commodity and has no issuer. Gold coins, on the other hand, do have an issuer. Various governments throughout history have stamped coins that contain gold. However, the gold in the coin is not the monetary instrument: the coin and the face value of that coin is. So, today, world economies do not operate on the barter system; they operate on a monetary system. In a monetary economy, anyone could issue a monetary instrument that could cause the production and the consumption of goods and services to operate based on that particular monetary instrument. In order to achieve such a feat for an entire economy, the question becomes, how does the issuer cause its monetary instrument to become widely accepted? The most powerful method available to accomplish supreme acceptance of a monetary instrument is through taxation.
National governments are the supreme authority over their respective nations. Because they are such, they have the ability to lay a tax and then enforce those tax collections. First, the national government will declare a unit of account (US Dollars, British Pounds, Australian Dollars) then afterwards, in order to ensure the supremacy of its very own monetary instrument, the national government will lay a tax that is payable only in that monetary instrument. Because the national government is the supreme authority, when it lays a tax, it also imposes serious consequences for not paying it. The tax, and the consequences for not paying that tax, forces the citizenry to need to obtain the national government’s monetary instrument. But, if the currency is not yet in circulation, how can the citizenry obtain the currency and pay the tax, avoiding the penalties for not paying the tax?
The simple solution to the problem is for the citizenry to agree to offer goods and services for sale to the national government in exchange for the government’s new currency that it intends to issue. Because the citizenry does not know how much their goods and services are worth priced in the national government’s new currency, at this point, the citizenry simply cannot offer the goods for sale at a certain price. They could say to the government, “How about $50 for a bushel of apples”, but what does that really mean? How do apple producers know that a bushel is indeed worth $50? They simply cannot know until the price is set by the currency issuer. So, the people can only offer to sell their goods and services to the government and wait to find out what the government is willing to pay.
The government will now tell the citizenry how much it is willing to pay for the goods and services in its own currency and then it buys those goods and services. The citizenry will accept whatever price the government is willing to pay, because, as we’ve discussed, the people do not know what the price for the goods and services would be in the new currency, but also, and most importantly, because the citizenry has absolutely no choice but to accept that price. It must accept the price that the government sets in order to obtain the currency which is necessary to pay the tax. The national government manufactures some of its own currency and then exchanges it for the goods. Once the government does this, the national government becomes the price setter for the market. Now the citizenry has the national government’s currency; it can pay the tax and keep whatever is left over after taxes to use buying and selling goods and services that are priced in the national government’s currency. The reason why the domestic private sector will simply use the national government’s currency to produce, buy and sell all goods and services – in other words, to do business – is because of the national government’s tax enforcement. As long as the government can enforce its tax collections, the citizenry will demand the government’s currency. Because of this reality, the national government which issues the currency controls the market and the national economy.
History provides us with excellent examples of governments that failed to enforce their tax collections and so, they lost acceptance of their currencies. One of those nations was the Confederate States of America (CSA). In the context of issuing currency, everything started out correctly for the CSA. It declared a unit of account then laid a tax that was payable in confederate dollars. So far, so good. The CSA government was on the right track. People then needed those confederate dollars, so they offered their goods and services for sale to the CSA government. The CSA set the price of the goods and services when it agreed to purchase them with its own confederate dollars. People accepted the dollars and the CSA government was the currency-issuing and regulatory authority.
There were many problems with the CSA: War, supply shortages, etc. But, when it came to the currency itself, the problem started when the CSA government began accepting and seizing goods as payment for taxes. Rather than do the correct thing and only collect the confederate dollars as payment for taxes, it let the citizenry know that corn, wheat, cotton and various goods were also acceptable as payment. Therefore, rather than lose goods to the government that they could sell, farmers began growing only enough for themselves to eat and producers began hiding their goods from the tax collectors. Meanwhile, the CSA government continued to issue more currency to buy provisions for itself and the war effort, because collecting goods as payment for taxes was failing. With a seriously strained supply of goods and services, inflation began to rise. The CSA government discovered that it could not enforce its tax collections in its own currency by that point and eventually, the currency collapsed. Had the CSA not began its existence in a state of war, things might have turned out differently. However, even so, had the CSA lost the ability to enforce its tax collections in its own currency, the confederate dollar would have collapsed regardless. So, it is the national government’s power to tax and to enforce its tax collections payable only in the national government’s currency that drives a persistent demand for the national government’s currency.
So, to summarize this critical section: In the United States, the US Dollar forms the basis of what we call a modern monetary economy, which is operated exclusively by the US government. And when I say “US government” I’m not talking about politicians; I’m talking about the public institution that is the US federal government. In a monetary economy, there is an issuer of the “money” that everyone else uses to buy food, clothes, pay workers, invest, sell things, speculate, gamble – what have you. Everyone in the United States (you, me, Walmart, Amazon, Wall Street, Chase, Bank of America, Joe Poor and the Koch brothers) is dependent on the US government creating US Dollars and then spending them into the economy.
We will stop here for the day. Tomorrow I will discuss how the US government manufactures US Dollars, and how it spends them. We will also cover budget deficits, balanced budgets, surpluses and public debt. Please do keep in mind that everything I am discussing applies equally to the United Kingdom, Canada, Japan and Australia. If there are ever exceptions, I will note them.