By Iain Dooley
What the Fiat?!
What you have created is a currency with a fixed exchange rate to a commodity.
Imagine if the computer broke one day and you sent it to get repaired. If the kids came to redeem their ticks on that day they might become disillusioned with the tick system because they could not play computer games.
In order to to keep them happy you could offer them extra ticks to be used when the computer is returned.
The rate at which the ticks accrue to children in the absence of the computer would be the “interest rate”.
This is the reason why a government with a fixed exchange rate currency cannot control its own interest rate (and why a government that allows its currency to float such as Australia can).
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 1,000 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 kids; that is kids who were willing and able to do more work and earn more ticks but whom you could not pay because of the constraint of the underlying commodity.
The same would be true if, instead of ticks you issued pieces of silver stamped with your face. You would be limited in how much you could spend by how much silver you had access to.
As an interesting side note, imagine that the house next door ran the same scheme but they offered to create 2 coins with the same amount of silver you use to create one coin. Your kids might melt your coins for the silver content and have them re-minted by the folks next door, starving your mint of silver and limiting your spending capacity. This is basically what happened all the time in Europe in the middle ages and why commodity money is such a bad idea (further reading in the resources listed at the bottom of this page).
Basically fixing the exchange rate of your currency or making it out of some commodity constrains the currency and you’re going to have a Bad Time™.
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 it’s based entirely on a confidence scam: as soon as the confidence drops the value of the currency drops and we’re in an inescapable downward spiral.
That’s how mercenaries thought of money when being paid to fight a war in the olden days. 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.
In an already monetised economy, the value of the currency is defined by what is available for sale in that currency.
But how does a currency gain value initially?
The way that Christine Desan describes this (see video in resources section below) is that humans have always operated in groups, and that the leaders of those groups accept contributions from the members of the group in the interests of the group. When such a contribution is made ahead of time, a receipt is issued to the contributor as evidence (for example if I worked twice as hard this year than I normally do, I would get a ticket that said I worked an extra year’s worth of contributions).
This receipt can then be traded with other group members and becomes currency.
So outside of our family example it is the willingness of people to contribute to the good of the group and acceptance of sovereign rule (ultimately in the form of taxes) that drives value for the currency.
In other words saying that a currency will lose all value is tantamount to saying that the issuing sovereign will completely collapse and that nothing will be offered for sale in that currency.
This is also called hyper inflation and this is why you will typically see MMT proponents say that “no Australia cannot become Zimbabwe” (at least not in the near future … ) because hyper inflation or near total annihilation of the value of a currency also entails near total annihilation of the sovereign; that is to say for the US dollar to become worthless the US government would have had to collapse.
If that happens, then sure maybe you want to be like a mercenary from the middle ages and hold gold in the hopes that you can trade it for some other currency that has value.
But despite what manic street preachers and conspiracy theorists will have you believe, total collapse of the Australian and US federal governments to the extent that Zimbabwe or Venezuela or the Weimar republic in Germany collapsed is not really something we need to worry about right now.
It is not a collapse in the currency that causes a collapse of the government, but the other way around.
Around this point in the article, I’m sure some of those still reading will be yelling at the screen “BUT BANKS CREATE 97% OF THE MONEY I SAW THAT IN ZEITGEIST AND YOU’RE JUST ANOTHER ROTHSCHILD!!1”.
Firstly let me just say that I agree with you that we have far too much private credit creation at the hands of banks and that financial deregulation has been a disaster for our society and our economy.
We need to rein in banks, and make finance boring again.
However banks don’t really create “money” in the same way that government spending creates “money”.
The “money” that banks create is kind of like Disney Dollars.
This topic could be a whole article of its own so I’ll just say that when banks issue loans they are creating deposits that are valid only within that bank.
Whenever a transaction leaves the bank that originally created the deposit, it has to happen in government money (either notes and coins in the case of a cash withdrawal or exchange settlement funds in the case of electronic transactions).
When an electronic transaction takes place, banks don’t have to settle up with each other right away, they only settle up at the end of the day so they only need enough government money to cover the difference in flows between institutions.
We’re getting too far from the point of the article but I just wanted to include this note on private banking here to ensure that no-one comes into the comments and tells me how this whole article is null and void because of private banking and how could I be so stupid.
Tomorrow: Logical conclusions