Monetary Theory
Many many misconceptions exist about money and how it works. On this page I address some of the major components such as how fiat currency works and how government actually spends money. I then go on to some of the theoretical implications of those details.
Monetary Theory is an area with a lot of unsettled debates that are hotly contested by experts the world over. So I will be clear where I am simply explaining how a thing works mechanically (strictly factual), and where I am exploring an implied outcome (debated theory).
So, beginning with the Facts…
Fiat Currency - Not Backed By Anything?
The first and most common thing you’ll find when searching for how fiat money works, is that fiat money is a type of government issued currency that is not backed by a precious metal, such as gold or silver, nor by any other tangible asset or commodity.
> This is technically correct (the best kind of correct), but not the whole story.
The next thing you’re likely to find in a search is that fiat money is based on the creditworthiness of the issuing government.
> This too is technically correct, but again, is not the whole story.
In particular what these two explanations lack, is a clear explanation for the common person as to what fiat currency actually is. After all, how is government creditworthiness measured? And how does this fit into the international exchange markets? Why are two currencies from governments with equivalent credit ratings not worth the same amount?
These questions are not answered by these definitions.
Backed by the Economy
A simpler and still accurate way of thinking about how fiat currency gains its value is to think about the total productivity of the economy. All the goods produced and services purchased combined amount to the GDP of a nation. Divide the GDP of the nation by the number of $’s in circulation, and that’s the value of your fiat currency.
In essence, the fiat currency is backed by the productivity of the economy.
This means that the exchange rate between currencies can be guesstimated between 2 countries (C1 and C2):
> (GDP C1 / Total Currency C1) / (GDP C2 / Total Currency C2) = $C1 to $C2 Conversion Rate
Now real-world conversion rates are also affected by human factors like investor confidence, which is why this is a guesstimate, but you can do this calculation yourself (for countries that have a good estimate on how much currency they have) and see that it produces results that approximate exchange rates pretty consistently.
So, in essence, Fiat Currency is backed by something - it’s backed by the productivity of the economy that we live in.
(Factual Explanation)
Goverment Spending - Taxation as Revenue?
The purpose of taxation in a fiat currency system (like ours) is to maintain the demand for the currency. Since taxes are collected in the national Fiat Currency, people need to either operate in that currency or convert to it to pay taxes. The inconvenience of conversion in any healthy economy ensures that the official currency remains the medium of exchange.
While it is often called "revenue" in the sense that it's collection, it's not "revenue" like a company has revenue though.
A company can only spend what it has or can loan on terms decided by another party. A government can spend whatever it wants either directly (printing) or indirectly (debt) but it determines this on terms that it largely decides for itself.
Since most currency in existence is digital, if you look under the hood of a fiat currency issuer, the government doesn't actually take the tax monies collected and spend them on things, it creates money through the mechanisms of its choice and spends it, and then collects tax monies which are effectively destroyed.
But We Balance the Budget?
Yes, we balance the budget by mostly destroying as much money as we create. See, we know that too much money in circulation degrades the currency, resulting in inflation. If you print enough money, this will always be true. As such the amount of taxation "revenue" the government collects does significantly affect what a government should spend.
However, it is important to understand that it has no impact whatsoever on what a government can spend. There is no fixed mechanical limitation. The government can double or triple the budget tomorrow, nothing is stopping them. They shouldn't do this (for a whole range of reasons), but they can - they're not actually limited by tax “revenue”.
This means that if you're having a high level conversation about economics and government spending, it's inappropriate to characterise taxation as “revenue”, due to the many incorrect implications associated with that word.
Destruction and Creation
The government has money it destroys and money it creates.
Some of the money destroyed is lost through loss of value as a result of inflation, and the rest is destroyed through taxation. The money that is created is either balanced with taxation (money spent “from” taxes), “printed” (created free in excess of taxation), or “borrowed” (created as debt through bonds sold to the private sector). Notably, the government can spend the money created through debt even if those bonds have not actually been purchased yet - since they are effectively just a promise that the government will pay a level of return to an investory based on them offsetting an amount of money that the government has already created.
Economic theories deal with how the government should choose what money to destroy or create, and they influence the language that is used to describe how the national budget works - but no matter the language used, this is what is actually happening.
(Factual Explanation)
Inflation - Result of Printing Money?
(Factual Explanation)
Moving onto the Theory…
The Fisher Equation
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Modern Monetary Theory
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