Introductory Series: The Monetary System – US Currency Part 2

Morning everyone.

We will continue where we left off with a look at how US Dollars are created, and how they enter and leave the US economy. In part three of our introductory discussions on US currency, we will examine what budget deficits, surpluses and the national debt really are. Following part three, we will then take a look at other aspects of the monetary system, including banking operation and central bank operations. Let’s get started.

In the United States, the currency manufacturing process begins when Congress authorizes spending for various federal initiatives, which the mainstream refers to as “the federal budget”. Once the President has signed the “budget”, the currency manufacturing process is complete. If the total authorized is $4 trillion, then $4 trillion has been manufactured and is now awaiting disbursement. Disbursement is the act of paying out or disbursing money, which in the case of the federal government, is the paying out of “money” that the government created, through the process known as federal spending.

The US Dollar manufacturing process does not involve printing machines at the Bureau of Engraving and Printing, nor does it involve coin stamping by the US Mint. There is no storage facility for the $4 trillion manufactured by Congress. The manufacturing of US Dollars means, quite simply, that Congress has authorized the US Treasury to enter various bank accounts and credit those bank accounts with no more than $4 trillion within that particular fiscal year, unless otherwise instructed to increase that amount. To understand the simplicity of the concept, let us use a more familiar, but imperfect, example.

Apple manufactures and then sells iPads. Let us assume that Apple decides that this year it will manufacture 10 million iPads. It then authorizes its production facilities to begin manufacturing 10 million iPads, which they do, and Apple then disburses (ships) those iPads to retailers.

In a similar way, the US government manufactures and then issues US Dollars every year. It is the constitutional duty of Congress to ensure that the US government will supply the US domestic economy with US Dollars and also determine the appropriate level of taxation for that particular fiscal year. Each year, Congress must, therefore, decide how many dollars the federal government will manufacture and how many it will reclaim through taxation and destroy. (We will discuss taxation momentarily. For now, let us concentrate on how the manufacturing and disbursement process) Then, when approved by the President, the US Treasury is authorized to begin disbursements of those newly manufactured US Dollars. In the case of US Dollars, manufacturing is not the physical creation of a product, but rather, it is the decision to set the level of US Dollar injections into the private sector to a fixed amount for that particular fiscal year. Congress has the authority to manufacture and then disburse an infinite number of US Dollars. So, when Congress sets the US Dollar manufacturing output to a certain level in any given fiscal year, Congress is actually setting a limit on the number of US Dollars it will allow to be created and then disbursed by the US Treasury. Treasury will then obey this restriction for two major reasons:

1.) Authority: Congress is the supreme authority to which treasury must submit.

2.) Operational: Every bank account that treasury credits will result in those US Dollars entering the economy. Thus, if the US Treasury did not obey Congress and simply credited bank accounts to whatever level it saw fit, the act could either lead to an economic collapse or inflation.

Item number two leads us to a brief, but necessary, discussion of the Federal Reserve. The Federal Reserve is a creation of Congress, designed to operate the nation’s banking system as the central bank. The Federal Reserve system is a part of the US government. Congress has empowered the Federal Reserve with the authority to manufacture US Dollars on the fly, without congressional approval in order to meet the nation’s monetary policy goals and to ensure that the payments system operates properly. The reason why Congress does not need to instruct the Federal Reserve on how many US Dollars to manufacture like it does with the US Treasury, is because monetary policy does not result in US Dollars entering the economy.

The US Dollars created on the fly by the Federal Reserve are to meet the needs of the payments system and monetary policy goals, and so, those US Dollars always remain with the Federal Reserve. We will discuss central bank operations later on in the series. For now, it is only important that you understand the distinction between fiscal policy and monetary policy. Fiscal policy directly impacts the economy through injections of US Dollars and monetary policy does not. Fiscal is the actual purchasing of goods and services or the crediting of bank accounts which enable consumers to spend, in order to manage the US economy. Monetary policy is indirect, involving no injections of currency into the economy.

Monetary policy affects the economy indirectly through two methods: Typical and atypical operations. Typical monetary policy is the adjustment of interest rates, and an example of atypical monetary policy is Quantitative Easing (QE). QE requires the Federal Reserve to emit US Dollars on the fly in order to build up reserves, but those dollars that the Federal Reserve manufactured through QE never enter the economy. QE is a mere asset swap for reserves. QE is not an injection of additional US dollars into the economy that would result in consumer spending and increased production. Bank customers have no direct access to reserve accounts. In order to access reserve accounts, an individual’s personal checking or savings account would have to be credited along with the QE reserve build up or banks would have to lend out those reserves. Banks cannot and do not lend out reserves whatsoever. Bank lending involves the creation of bank IOUs which are denominated in US Dollars, making them acceptable to settle tax liabilities owed to the US government. As such, the bank IOUs can then act as “money” in the private sector when spent. (We will discuss bank lending later in the introductory series) So, since banks cannot lend out reserves and no individual bank accounts are credited through QE operations, QE is the mere building up of excess reserves in reserve accounts with no available outlet for those reserves to leak into the economy.

Thus, in the context of US Dollar creation, Congress need not concern itself with the level of US Dollars created by the Federal Reserve as it would the US Treasury, because monetary policy is not government spending.

Federal Taxation

As discussed, when Congress decides to authorize the manufacturing of a certain number of US Dollars in any given fiscal year, it also decides how many US Dollars it will withdraw from the US economy and destroy. The withdrawal and destruction of US Dollars by Congress is called taxation, which like US Dollar creation, is authorized by the US Constitution, Article 1, Section 8. Federal taxation is not theft, because US Dollars are not a privately created product. They are not commodities.

While it is true that private entities can possess US Dollars and it is illegal to steal US Dollars from those private entities, it must be understood that the only reason why private entities possess any US Dollars in the first place, is because the US government manufactured the dollars and then spent them into the economy. In simple terms, this means that all US Dollars are the property of the US government. The US government authorizes you to use them for any legal purposes you wish. Whatever goods and/or services that you manage to obtain using the US government’s currency are yours to keep. However, the US Dollars are not yours. Again, you are only authorized to use them for any legal purposes. All US Dollars are public funds that belong to the US government, and at any time, the US government has the authority to demand back from you any or all of its currency in your possession, which by law, you must surrender upon demand. The US government makes this demand through taxation. Just like you can demand the return of your property from someone whom you allowed the use of your property, and resort to the force of law to ensure the return of your property, the US government can also demand its property back from you through the force of law.

Federal taxation is the demand by the US government of the return of its US Dollars. The US government is not interested in your house, car, boat or other goods you’ve obtained using the federal government’s currency. The federal government wants its currency back. The reasons for this were explained in part one of yesterday’s discussion. In order to ensure a perpetual demand for US Dollars, the US government demands payment of taxes only in US Dollars. Goods and services are not accepted as payment for taxes for this very reason. The government is only interested in maintaining a demand for US Dollars and accepting goods as payment for taxes would eventually result in the collapse of the US Dollar and the US economy. Now, it is certainly true that the federal government could seize your house, car and boat if you do not pay your taxes. But that is a method of punishment; a penalty for not obeying the law. It is not the object of taxation. So, under penalty of possible imprisonment or seizure of property, the US government guarantees the enforcement of its tax collections, which, in turn, guarantees that the demand for US Dollars will continue unabated.

Federal taxation today, does not fund any federal spending of any kind whatsoever. There is no such thing as federal “taxpayer-funded” corporate subsidies, welfare, military or anything else. The tax dollars that you pay to the federal government are not given to people on welfare or to “ham and eggers” in charge of large corporations. All federal tax dollars are destroyed. However, at one time in US history, federal tax dollars did fund federal spending. That time in US history was during the fixed exchange regime called the Gold Standard.

The gold standard was a regime where the US government agreed to peg its infinite US Dollar to a finite commodity (gold) in order to needlessly give the US Dollar “intrinsic value”. The government accomplished this by fixing the value of a dollar to a certain amount of gold. In order for the gold standard to work, it required that the US government agree to exchange gold for US Dollars upon demand. In order to do that, the US government had to maintain gold reserves, so it could actually exchange gold for US Dollars. While the US government could never run out of US Dollars, the gold standard meant that the US government could run out of gold. So, to ensure that it couldn’t run out of gold, it had to limit the number of US Dollars in circulation to the gold supply. The way the federal government did that was through taxation.

By taxing some US Dollars and then spending them, the amount of currency in circulation remained consistent with the gold supply. Thus, by spending tax dollars, no extra currency was added. Now, if the federal government wanted to spend more than it collected in taxes, it had to offer treasury bonds. The US government would offer these bonds and investors voluntarily purchased them. In doing so, the US government could spend these voluntary contributions as well as the tax dollars, so, again, the amount of currency remained consistent with the gold supply. In the free-floating, non-convertible fiat regime that we have today, the US government has no gold reserves to defend through taxation and borrowing, and so, it does not tax or borrow to fund its spending. To repeat, you must understand that during the gold standard, the federal government had to ensure that the amount of currency in circulation was in keeping with the amount of gold it had in reserves. If it did not do this (tax and borrow to fund spending) and persistently increased the number of US Dollars in circulation, then there would be more dollars than gold available (in other words, “printing money” to fund spending), and when people demanded gold for their dollars at the fixed exchange rate, the federal government could run out of gold. This is one reason why the term “printing money” today makes no sense. The second reason is because the US government does not print cash to fund its spending. Dropping the gold peg and moving to free-float fiat entirely changes how federal spending works.

In a fiat regime, the capabilities of federal spending expand to the limit of the production ability of the economy. The gold standard forced the federal government to target the gold supply instead, which, depending upon the nation’s trading position, could be less than the limit of the production ability of the economy or equal to it. Nations with weak trading positions had to ship their gold overseas to settle payments, thus, as their supply of gold dropped, these nations also had to reduce the amount of their own currency in circulation. As a result, these nations couldn’t address domestic unemployment and so, they were forced to endure persistent recessions. The point here, then, is that unlike a fiat currency regime, during the gold standard the gold reserves were the target and not the economy’s actual maximum ability to produce goods and services.

Pegging the dollar to gold did absolutely nothing that was beneficial for the US Dollar or the US economy. The entire point of the gold standard was to assign a particular value to a monetary instrument that did not require that value in order to act as “money” in the first place. It’s not important that the US Dollar have “intrinsic value”. What’s important here is that things you can buy with the US Dollar have value. For instance, if nobody in the US wanted apples, then nobody in the US would use the US Dollars in their possession to buy apples. Apples, in effect, would have zero market value in the United States. In the same way, labor that is unemployed has zero market value, because nobody in the market is willing to use the US Dollars in their possession to buy that unemployed labor. Just like the apples that nobody wants are left unsold, so are the involuntarily unemployed left unemployed.

So, in today’s fiat currency regime, the target of federal spending operations has to be reaching the real ability of the economy to produce goods and services, and to maintain that level, otherwise unemployment and recessions will be inevitable. Fiat changes things completely. Since there are no gold reserves to defend, there is nothing for the federal government to limit the amount of currency in circulation to, except for the limit of the economy to produce. Thus, the federal government no longer taxes or borrows to fund spending since they serve no real financial purpose in a fiat system. While it is true that the federal government does tax and does issue bonds, it is also true that the tax dollars collected exit the economy and the dollars collected from bond sales are not spent. Today, US Dollars used to purchase US Treasury bonds are moved to securities accounts that are held at the Federal Reserve, and remain there earning interest. So then, why tax at all is usually the question from many people at this point.

First, as we’ve discussed, federal taxation drives the demand for US Dollars. Second, in a fiat regime, federal taxation reduces the spending power of the private sector. Let us assume that the US has reached the limit of the economy’s production capacity and further federal spending has pushed past this limit and is creating inflationary pressures. By increasing taxes, the federal government removes US Dollars from circulation, thus, decreasing the number of dollars available that consumers can spend. As the currency in circulation drops, consumers slow their spending and inflationary pressures drop.

Third, in a fiat regime, federal taxation is used to alter behavior. Smoking is a good example. The cigarette tax raises the price of cigarettes to the point that, hopefully, some people either cannot afford them anymore or simply refuse to pay the high price. As a result, the number of smokers drops in the US. The goal of the tax, then, is to reduce smoking. Consider also small nations with congested roadways. The nation might consider placing a very high tax on car purchases, in order to discourage people from buying cars and to encourage them to seek alternate forms of transportation. Denmark did exactly this, levying a 180% tax on car registration. As a result, people ride bicycles or use public transportation and congestion is reduced. The purpose of the tax isn’t to fund healthcare and welfare spending, but to modify the population’s behavior.

Fourth, federal taxation unemploys labor. When the federal government raises taxes, this reduces consumer spending power. When consumers contract their spending, business loses income and, as a result, business lays off workers. The federal government can now buy the unemployed labor and use it for public projects. In other words, federal taxation allows the federal government to provision itself with workers.

Fifth, federal taxation creates better equity. By targeting large tax increases at the opulent (the extremely rich), while reducing taxes on working and middle class citizens, the government destroys the wealth built up by the rich in terms of US Dollars while leaving more US Dollars in the hands of everyone else, and the result is better equity among the populace.

So, that is the answer to “why tax at all”. When it comes to federal spending, taxation doesn’t mean revenue; it means what it’s supposed to mean: “a burden”. When the populace complies, the federal government achieves its economic and social goals. The question, then, for federal tax policy within a fiat currency regime is, “What kind of society do the people want?” and then once the voters speak, the federal government aims its spending and tax policies towards creating and maintaining that kind of society. If the economic and social agenda is persistent involuntary unemployment, underemployment, low wages, poverty, recession, high crime rates, vast income inequality, costly university education, expensive private healthcare and crumbling infrastructure, then the federal government will continue to maintain its current economic policies. If the economic and social agenda is persistent full employment, price stability, decent wages, low crime, better equity, tuition-free university education, universal healthcare and a modernized, functional infrastructure, then the federal government will alter its fiscal stance and expand its deficit towards those goals.

We will stop here for today. In part three of US currency, we will examine budget deficits, surpluses and the national debt. After that, the introductory series moves on to banking operations, where we will discuss how banks lend, and then finish up with central bank operations.