Sunday, July 18, 2010

Intro to Fiat Money Part 2

To review the ideas from part 1:

1. All the island dollars that people have came from government spending at one time or another.

2. When the government spends, it increases the net dollar wealth of the world. You can think of government spending as the government printing green pieces of paper and exchanging them for good and services.

3. When the government taxes, it decreases net dollar wealth. You might think of taxation as the government collecting money and dumping it into a shredder.

4. Fiat money has value because it’s the only form of payment accepted for island taxes.

A lot of this probably sounds odd if you're used to thinking about gold backed currency. The goal here isn't to attack or defend fiat currency; rather I just want to explain how it works and how these ideas might affect policy decisions.

As Bob and ESM pointed out in the comments to part 1, in year 1 the government has to spend (or give away) at least as much money as it wants to collect in taxes each year; otherwise people won't have money with which to pay their taxes. ESM went further and said that the government has to spend enough for people to pay their taxes and satisfy their demand for dollar savings.

If the government spends or gives away $6000 per person per year and collects $5000, then people will be able to save $1000/person on average. Some people might save more or less (and some could end up in debt), but $1000 has to be the average.

You should also note that in this example, the government ran a deficit of $1000/person. So each year, the government deficit matches the change in private dollar savings. If the government runs a deficit, then total dollar savings must rise, and if the government runs a surplus, total dollar savings must fall. (This might be the opposite of what you thought previously.)

For this reason, some people (though admittedly, not many) refer to the national debt as "the national savings account". People's total accumulated dollar savings must match the government's accumulated dollar debt. It's a closed system after all.

A few other interesting points about this system:

  • The purpose of taxation is not to raise revenue, at least not on the federal level. The island government prints and destroys its own currency, so it can spend however much it wants.

  • Of course, printing a lot of money and not destroying very much money can cause the dollar to lose value and trigger inflation. So the real reason for taxation is to reduce the number of dollars floating around to "make room" for the dollars that the government wants to deploy. Another way to say it is that the government taxes in order to reduce aggregate demand and keep prices under control. A second purpose of taxation is to give dollars value in the first place!

  • Not everyone has to pay taxes for this set-up to work. Even if only people whose last names began with "A" had to pay taxes, dollars would still have value to Mr. Aaronson. But Mr. Bozo would still value dollars since he knows that Mr. Aaronson values them. In other words, Mr. Bozo is happy to accept dollars as payment for calculus tutoring, since Bozo can then use those dollars to buy stuff from Aaronson. So they'll both value dollars. To pick a more realistic example, U.S. dollars have value to Canadians even though they (typically) don't have to pay U.S. taxes.

Next time: How does government borrowing work? Is printing money the same as borrowing?

2 comments:

Bob said...

So i have a few questions if you dont mind.

in point 2, you say "when the goverment spends, it increases net dollar wealth of the world". By that, i believe you are making the (obvious) statement that when the goverment spends its created dollars, there are more dollars out there for people. Is that a correct reading of your statement?


In your example with Mr Aaronson and Mr Bozo - it seems true that while the dollars are of value to Mr Bozo, they are of less value than they are to Mr Aaronson. So in this fiat money system, it can be that a dollar does not have equal value to each participant.

My last question: (i realize that this question is not in the scope of the class. your goal is to explain the fiat system, no more, no less.) but is there a particular goal in mind in creating this type of system? Understanding the goal might help me anticipate what comes next or put the lesson in some type of context.

Coupon_Clipper said...

in point 2, you say "when the goverment spends, it increases net dollar wealth of the world". By that, i believe you are making the (obvious) statement that when the goverment spends its created dollars, there are more dollars out there for people. Is that a correct reading of your statement?


Yup, that's what I mean. You raise a good point in that the gov't could increase dollar wealth without creating any real wealth in the process.

Here's the opposite case: I might take a bunch of raw materials and build a car (or take some ideas and build a business). Total dollar wealth hasn't increased but real wealth has. I've created something of value.

In your example with Mr Aaronson and Mr Bozo - it seems true that while the dollars are of value to Mr Bozo, they are of less value than they are to Mr Aaronson. So in this fiat money system, it can be that a dollar does not have equal value to each participant.


Well, you can always say that dollars have different values to different people (think of a dollar's value to Warren Buffet vs. it's value to you or me). But, ignoring transaction costs, the value in terms of what it can buy should be the same. Just like you might not have a use for IBM options of a block of copper, but you know its market value and therefore know what it's worth to someone else. You would expect to receive that amount of money in e xchange for the options or the copper.

My last question: (i realize that this question is not in the scope of the class. your goal is to explain the fiat system, no more, no less.) but is there a particular goal in mind in creating this type of system? Understanding the goal might help me anticipate what comes next or put the lesson in some type of context.

Money is great for a lot of stuff. The main benefit that comes to mind is making trade work in a low-friction way. But fiat money has the additional (perhaps dubious) advantage that the gov't has a natural way to tweak the value of the dollar. This is obviously susceptible to abuse. ESM probably has a lot more to say about this.