Economic Reform Australia Blog

Where does money come from?

In this electronic age, money virtually comes from nowhere. If you happen to be a currency-issuing central government – that is, a central government that owns and issues the nation’s currency – you can always find the money required to make purchases. You and I can get hold of money, but we have to produce something of value and exchange it with someone or some entity already in possession of money. You and I can’t create money out of nothing. That’s counterfeiting, and it’s illegal. Banks can create money out of nothing, but they always create a financial liability of the same value. Hence, banks don’t create ‘net’ financial assets (i.e., financial assets over and above financial liabilities). They just create new financial assets that are always matched by new financial liabilities. A currency-issuing consolidated central government (incorporating Treasury and Central Bank) is in a league of its own. It can create ‘net’ financial assets because when it creates money for itself in order to spend, it doesn’t create a financial liability against itself in the sense that the ability of the consolidated central government to create and spend more money into existence is not reduced. If the Federal Government creates $100 million for its own spending purposes (i.e., to acquire $100 million of real stuff), it doesn’t owe $100 million to anyone or anything. It may have to use some real resources to create the $100 million. If the value of the resources is $1 million, it will have acquired $99 million of real stuff. The $99 million of real stuff acquired is called ‘seigniorage’. It’s an old term. It’s not a term used to mislead or trick people. Yet it’s a term that even economists don’t know about, let alone our Federal Treasurer and his advisors.

Remember the eastern states floods of 2009 and 2010? The Federal Government had to acquire around $9 billion worth of real stuff to undertake flood reconstruction projects. People then said, including our Prime Minister, that the cost to the Federal Government of flood reconstruction was $9 billion. They were all wrong. The true cost to the Federal Government was the market value of the real stuff that the Federal Government had to expend to: (i) acquire $9 billion of spending power (negligible in an electronic age); (ii) determine how best to spend it (bureaucratic planning); and (iii) then spend it (i.e., put the $9 billion worth of real stuff to appropriate use). Even if the value of the real stuff expended was $1 billion (it would have been much less), the cost to the Federal Government would only have been $1 billion. The $8 billion difference would have been the Federal Government’s seigniorage.

You can now see the extremely privileged position enjoyed by a currency-issuing central government that is not enjoyed by you, me, or other entities (including state and local governments). Everybody but the Federal Government uses the nation’s currency and are therefore subject to a budget constraint. The only constraint faced by the Federal Government is the real stuff available for sale, which is always limited by the fact that we live in a world of scarce resources and a limited technical capacity to convert some of these resources into real goods and services (which means every national economy has a limited productive capacity). So when I say that the Federal Government has no budget constraint, what I’m saying is that they can spend as much as they like, but they can’t purchase as much as they like. The Federal Government might have access to a bottomless pit of Australian dollars, but it does not operate in a Garden of Eden. There’s only so much stuff available for sale no matter how much money the Federal Government can create for itself.

What happens if the Federal Government spends too much – i.e., it pushes total spending within the economy beyond the economy’s productive capacity? It’s spending becomes inflationary. In this situation, it can reduce its own spending or, if it is determined to maintain high spending levels (e.g., in order to ensure an adequate provision of health and education services), it can reduce the private sector’s spending. It does the latter by taxing the private sector. Indeed, from a macroeconomic perspective, taxation by a currency-issuing central government does nothing but enable it to spend in a manner that is not unduly inflationary. It’s not done to finance its own spending because a currency-issuing central government has unlimited access to the nation’s currency. It has absolutely no need to impose taxes to finance its spending.

What if the electorate doesn’t like having some its spending power reduced in order to allow the Federal Government to provide critical infrastructure in a non-inflationary manner (i.e., doesn’t like being less able to afford more and more useless gadgets in order to ensure adequate health and education services)? It can always vote it out of office. But that’s a political issue, not an economic issue. It has also become an ideological issue for some small-minded people who believe that the economic role of government should be as small as possible (whatever that means). Thanks to them, we have more consumer junk in our houses than ever while at the same time governments close hospital wards, run-down the nation’s education infrastructure (Gonski Review), and leave 648,000 Australians on the unemployment scrapheap (as at November 2012). Sadly, a lot of these small-minded people happen to be economists, despite the fact that economics is supposedly “the study of how to efficiently allocate society’s scarce resources”. It is plain to see that much of the economics profession wouldn’t know ‘allocative efficiency’ if it fell over it, let alone ‘ecological sustainability’ and ‘distributional equity’. It is also plain to see that mainstream economics is driven by ideology – indeed, by people who have no interest in studying the world as it is, but the world as they would like it to be.

Philip Lawn