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Iain Dooley discusses the "State Theory of Money" and why governments can deficit spend forever and still sustain full employment.

THERE ARE TWO competing “creation stories” of money and which one you subscribe to has a big impact on your economic understanding.

That currency:

  • arose spontaneously out of barter and markets are created spontaneously; or
  • is a constitutional and social project created by a sovereign to provision itself and markets are a by-product of this.

The former is the dominant, orthodox, money creation story, but the latter is historically accurate and more logical. This theory is called the State Theory of Money and it has some very interesting policy outcomes.

I'll first present an explanation of this theory of money and then some logical conclusions from it. At the end of the article, I'll include some resources you can read in case you think I'm just making this up.

The economy as a chore chart

Imagine you are a parent and you have some children. You want your kids to do some chores around the house, so you put a chart up on the fridge for each kid.

When they do a chore, they get a tick and ten ticks equals 15 minutes of time playing computer games.

Some things should be immediately obvious:

  • the amount of chores you can get done is limited by the number of children you have, not the number of ticks you can write down;
  • the children cannot redeem ticks unless you have issued ticks; issuing must precede redemption;
  • when you issue ticks, you create a claim on a resource and when the children redeem ticks the claim is destroyed.

What you have created here is basically a currency and the same three statements apply to every modern currency.

For the sake of brevity, I'm going to ignore private markets (such as trade between siblings) and banking (private credit), although if you would like to see how they fit in please say so in the comments and I'll do a follow up.

What the Fiat?!

What you have created is a currency with a fixed exchange rate to a commodity.

Now imagine your kids wander into a duplicating machine and, all of a sudden, there are more of them. Great! You can get more chores done right?

Only to the extent that there is enough computer time for them to redeem their ticks. If you had 50 children you would get to the point where the constraint would be computer time and you couldn’t get more work done, even though you had plenty of kids willing and able to work.

Fixed exchange rates have the same basic constraints, whether they are a currency peg (where, for example we agree to convert AUD to USD at a fixed rate), or fixed to a commodity (such as a gold standard).

They work fine under certain conditions but, ultimately, they limit your domestic fiscal policy space to the extent where you might end up with unemployed labour — people who were willing and able to work but you were unable to pay because of the constraint of the underlying commodity.

So how do we make a currency that has value without tying it to some commodity?

People complain a lot about “fiat” currency and how it has no value, because it’s made of paper and based entirely on a confidence scam.

That’s how mercenaries thought of money when being paid to fight wars in days gone by. They wanted currency they could melt and take to a competing mint of the sovereign who won the war. But they would always go and get the gold or silver minted into coin so they could spend it.

That is, the coin had a value that exceeded its commodity content because it was accepted in payment of taxes and therefore, readily accepted by people under that sovereign rule as a medium of exchange.

All successful currencies (those that lasted more than a few decades) have been “fiat”. They obtained their value by official decree — and that value exceeded the commodity content of the coin. (This must have been true otherwise all coins would be immediately melted.)

So, you might wonder, if even money made out of gold has a value higher than its commodity content, why have the commodity at all? You could have a coin with no commodity value and rely only on the “fiat” value.

Well, it turns out that is true. Outside of our family example, it is the purchasing power of a currency that determines its value and the willingness of a sovereign to accept it in payment of taxes that drives its demand.

Logical conclusions

So currencies are a constitutional project and their value is driven by the willingness of a sovereign to accept the currency in payment of taxes.

There are some interesting logical conclusions of this.

The government should always spend to maintain full employment

Governments create money to move resources to the public purpose.

When we have people who are willing and able to work but cannot obtain employment in the private sector, it is insane for the government not to hire those people.

Think about a football game. Would they ever stop the game and leave the players idle because they had awarded too many points?

The government cannot borrow its own currency

A unit of currency is nothing more than a tax credit. A voucher issued by the government.

If I were to borrow a voucher that I issued, I would have to provide a receipt which would be equivalent to the original voucher.

In other words, since all government money is already a liability of the government, it cannot borrow it back.

I created this video demonstrating how this works:

The government can never run out of money but it can run out of resources

If we only have two kids we can’t just write down a million ticks and get more chores done. The limit of our spending is the capacity of the kids to do chores.

Thus the government could sustainably deficit spend forever, so long as total spending doesn’t exceed the capacity of the society to produce goods and services (which would be inflationary).

Further resources

Iain Dooley is the co-founder of the Australian Employment Party. You can follow him on Twitter @iaindooley.

Creative Commons Licence
This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Australia License

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