Sunday, July 11, 2010

Intro to fiat money part 1

The mysterious Bob requested a short "course" on how fiat money works. Considering that our economy runs on fiat money and probably less than 1% of Americans understand it, it's probably important to come up with a simple way to wrap one's head around it.

Imagine we all live on an island, isolated from the rest of the world. (This keeps things simple; we'll talk about international trade later.) People on the island obtain goods and services by trading with each other. Whatever merits this system has, it can be very tedious to enter into a transaction. For example, if you're a calculus tutor and you want some salmon, you have to find someone who has a bunch of salmon and wants calculus tutoring. What are the odds of finding that person in a reasonable amount of time?

So the government of the island issues green pieces of paper called "dollars" and lets people trade with dollars. There's just one problem: These pieces of paper have no intrinsic value, so there's no way I'm giving you some of my stuff in exchange for dollars.

Now let's add one more kink that will actually make these dollars valuable. At the end of each year, every island resident (government worker or otherwise) has to pay a tax of $5000. These pieces of paper will be collected and tossed into a shredder. [Alternately, the taxpayer can simply submit a YouTube video of himself shredding the money he owed.] If anyone fails to turn in $5000, he'll be put out to sea in a raft with nothing but a DVD player with Britney Spears videos and "What's Happening!!" reruns.

Now no matter what you think of the idea of having a "head tax", you have to agree that dollars now have some serious value. They're the only form of payment that the government will accept for tax liabilities.

So now dollars have value and people can use dollars for trade. I can buy fish in exchange for dollars because either the fisherman needs the dollars to pay his taxes, or he knows that somebody else needs them for taxes (and thus that guy will trade for them).

One last problem we have to address: Where do people get dollars from? They need to accumulate dollars in order to pay taxes each year, after all. Saying that they get dollars from trading with other people is a cop out, because those people need to get dollars from somewhere. Even if somehow people "started out" with a certain number of dollars floating around, they will eventually be destroyed at a rate of $5000/resident/year.

The answer is that dollars can only come from one place: the government. The government can create and destroy dollar bills and they're the only ones who can do it.

So the island government decides to hire people to do various jobs around the island such as cleaning seaweed off the beach, maintaining the roads, and running a tropical counter-terrorism unit. The employees are paid in dollars. If the government wants to, it could even supplement the supply of dollars by dropping them from a helicopter and letting people find them.

So dollars "start" in the hands of people who sell their services (or goods) to the government, the dollars are used for trade, and they eventually end up in the hands of people who need to pay taxes (government workers or private sector workers alike.)

Now here's a good question to think about: How much does the government "need" to spend each year? As a follow-up, what happens if they spend more or less than that amount?


Anonymous said...

While this lesson is for everyone, it seems clear and relatively easy so far. Given that, i would like to try to answer the some of the questions at the end of the first lesson and ask a couple as well. I will do my best to keep the scope of my questions within the example, but it will be obvious that they may be more general questions.

1) The easiest answer is if the goverment prints too few dollars: The pigeon hole principle says at least some people will be forced off the island cause they wont have enough dollars. So the lower bound of dollars is 5000*(# of residents)

2) If too many dollars are printed, the question becomes: how available are these dollars to everyone? If they are readily available, then their value decreases and in an extreme case, the dollars will become meaningless and businesses will revert to bartering again. If only a small number of people have the money, then we could actually be in a situation where people will be forced off the island. it is clear that people may be forced off the island even if more dollars are printed depending on the availablity of those printed dollars.

I wonder what the shape of the graph of the real "value" of money is as the governement starts to print more. i wonder if it is smooth, or if it flat until some breaking point in which case it sharply drops?

3) how much does the goverment "need" to print? This question is a lot harder, my guess is it is a process, not a number. For example, I would think it is more important for the goverment to have a good dollar destruction machine, and start with pumping lots of dollars into this system and then destroy them as they measure the "value" of this dollar (i do not know how they would measure this). Further, the amount they print would be dependent on the distribution of those dollars in the population.

Now a couple questions that deviate from your example.
1) i found myself asking the same question a few times when answering these questions and reading the article: what is my goal with this new money concept? In our example, i think our goal is to facilite trade as much as possible. but under what measurment do we judege success? i imagine that a guy that gets thrown off the island will wish that this favor of facilitating trade was never done. Perhaps our goal is to maximize productivity. that seems a likely outcome of this system as people will gravitate toward the businesses that will guarantee they will be able to pay their taxes.
2) say that instead of a flat 5000 tax, you pay a % of "income" you earn. i imagine this will decrease productivity.

i hope this is on the right track.

ESM said...

Just a quick answer to Coupon Clipper's questions and a comment on Bob's answer.

The issuer of the currency must issue enough to satisfy both the aggregate tax obligations imposed on the residents AND the savings desires of those residents. Savings desires is the key and the rub. There is no a priori way to determine what those savings desires are, and in fact, savings desires will change over time (and will vary with the state of the economy, the level of interest rates, and with demographics).

The desire to save some currency as a nest egg or as a cushion against lean times introduces instability into the system because the aggregate savings desire increases when the currency is scarce and appreciating and decreases when the currency is plentiful and depreciating. Therefore, we have a positive feedback system where inflation leads to more inflation and deflation leads to more deflation. The currency issuer either has to have a tax system which has negative feedback (sales or income tax) or a spending system which has negative feedback (automatic stabilizers like unemployment insurance) or it needs to be very proactive in adjusting spending and taxes in a timely fashion.

Coupon_Clipper said...

ESM, can you explain the positive feedback loop a little more? If we're in a recession, then people want to save more, so the gov't has to run a bigger deficit to accommodate that, right?

What's the problem? Is it just that politicians hate to run deficits when economic times are bad?