Creation of money by the government

I hope that it is clear by now that private banks cannot create inflationary money. The problem for a political system with a banking system as described is that the government cannot create money either. And governments have only 3 ways to finance their deficits. The first one is taxation, the second one is domestic and foreign borrowing, and the third one is by printing new inflationary money. As I explain extensively in my other document, printing money is taxation through inflation. Inflation is a way of taxation that most governments very often prefer to use. Taxation is very unpopular, borrowing requires confidence on behalf of the lender that you will honor your obligations and carries the cost of interest, while printing money does not require a third party’s confidence in the government’s policies, it does not carry interest, and it is not as unpopular as taxation. Of course increasing the money supply increases inflation, but most people do not realize that inflation is taxation. Therefore taxation is more unpopular than inflation. If a government goes too far with the printing press though, it can cause very high levels of inflation, or even hyperinflation, with catastrophic consequences for the economy. But in the short run political parties tend to overlook the long run consequences.

I now want to describe the difficulties that a government faces under the gold standard, in its effort to finance deficits by printing money. To make things simpler, let’s start from day 0. Citizens have no savings in gold or oranges yet. They now start producing oranges and gold. Some of them produce oranges and some produce gold, and it is gold that serves as a medium of exchange and a store of value. Producers of oranges, exchange their surpluses with gold, and deposit gold at the bank. Similarly, gold miners exchange their gold for oranges, and deposit whatever quantity of gold is left at the bank. Note that the deposited gold does not represent only the past surpluses-savings of gold in the economy. It represents the surpluses-savings of all goods and services in an economy. When I exchange my extra orange for 1 gram of gold, and I deposit that gold at the bank, that gold represents a surplus of 1 orange that was stored in gold. I mean that the deposited gold at the banks represents all surpluses, all savings in the economy. Surpluses in oranges, surpluses in haircuts, surpluses in gold, surpluses in cleaning services etc, that are all converted and stored in the common store of value, which in my example happens to be gold. In my example gold is the only way to store value, but in reality this is not the case.

The private banks now deposit the citizens’ gold at the central bank, and the central bank issues new “1 gram of gold” bank notes. These notes could be called something else. They could be called dollar notes, or euro notes or whatever. I prefer to use the name “1 gram of gold” notes to emphasize that these notes are “made” of gold, they are backed by gold. Let’s assume now that there is 1.000.000 grams of gold deposited at the state’s box of gold in the central bank, and 1.000.000 “1 gram of gold” notes circulating in the economy.

Even though it makes no difference for my analysis, in order to be a bit more accurate, I have to add that the price of orange and gold would not be fixed in reality. The banknotes are indeed backed and redeemable for 1 gram of gold, but that does not mean that they will always buy 1 orange. The relative price of gold and oranges will vary according to weather, demand and supply, changes in tastes etc. In other words bank notes will always be redeemed for 1 gram of gold, but that gold might buy 1 orange, or 2 oranges, or half orange, depending on the prices prevailing at the market. But this should not be confused with a general increase of the price level that arises as a result of inflationary money creation. Relative prices must change when market conditions change.

So, we have 1.000.000 grams of gold in the state’s box at the central bank, and 1.000.000 “1 gram of gold” notes circulating in the economy. Let’s suppose that the government wants to issue some more “1 gram of gold” notes, to finance its deficits and avoid taxing its citizens. Can the government do that? Well for a while it can. I assumed that the total gold of the economy is 1.000.000 grams, and let’s say that 100.000 of these grams belong to the state. But the government decides to host the Olympic Games that cost 200.000 grams of gold. The treasury issues a check of 200.000 grams of gold, and gives it to the contractor. The contractor deposits the check at X Bank, in order for the latter to clear it. X Bank in turn sends the check to the central bank for the latter to clear it. The thing is that in reality, the gold is not kept in separate boxes with a bank name written on each box. It is placed all together at the central bank’s vault, and the central bank holds electronic information about the owners of that gold.

Therefore when the central bank receives the check issued by the treasury, it sees that the state’s gold of 100.000 grams is not enough to cover the expenses. However, contrary to what it would do for a private bank, it credits X Bank’s account with 200.000 grams of gold and says that everything is OK. X Bank then credits the contractor’s account, and the contractor starts preparations for the Olympics. The country now owes 100.000 grams of gold. In accounting terms this appears as a debt of the government to the central bank, but in reality it is a debt of the government to its citizens. Except that the citizens do not know that the just lent their government 100.000 grams of gold. Alternatively, instead of a check by the treasury, the government could have ordered the central bank to create 100.000 new notes. The central bank would create these notes pass them to the treasury, and write in the central bank’s books a government debt of 100.000 “1 gram of gold” notes. The treasury would pay the contractor, who would deposit these notes at X bank. X bank would open a deposit in his name and send the bank notes to the central bank in order for the latter to transfer 100.000 grams of gold in its box. The central bank would credit X bank’s gold account which would match the debt created by the government. I think the case with the check is better for illustration purposes. So you better think of this transaction in terms of the treasury check. But both cases are exactly the same. In both cases what happened is that the central bank owes a private bank 100.000 grams of gold, and the government owes the central bank 100.000 grams of gold. In reality, it is of course the government owing to its citizens 100.000 grams of gold, since the central bank is only a governmental institution.

The government just created money. But it did not created new wealth. It simply used its citizens’ accumulated wealth to finance the Olympics. This will of course appear as a debt of 100.000 grams of gold when the government prepares its financial statements at year end, but who notices? Everybody is happy. Everybody got their money. And the government did not have to tax anybody, and did not have to borrow any money. Only inflation was affected. But who cares when inflation is low? The problem for the government under the gold standard is that this artificial money expansion increases demand, it increases the price level, the country becomes more expensive and starts losing its competitiveness, imports start rising and exports start declining. The economic agents abroad that receive the country’s bank notes as a payment for their sales send these bank notes through their central banks, to the domestic central bank, in order for the latter to redeem it for gold.

Therefore if the government is very active in creating inflationary money, the country’s gold reserves will start declining. People will start doubting that the government will be able to redeem its bank notes for gold, and there will be a confidence crisis. Even domestic citizens might start redeeming their bank notes for gold. But there is not enough gold to pay for all bank notes in circulation, since the government used much of it for its expenditures. At some point the government will have to either abandon the gold standard all together i.e. stop redeeming the bank notes for gold, or change the exchange rate between bank notes and gold i.e. say that it will exchange each bank note for half instead of 1 gram of gold. Thus the gold standard imposes much more discipline on a government’s fiscal policies. On the contrary if the government passes a law, as is the case in all countries, imposing its paper money as the legal means of payment without promising to redeem it in gold, there is no limitation on the creation of inflationary money.

Now the bank notes do not derive their value from gold but from the law, and the government can create as much money as it wants. Well, almost as much, because excessive use of inflationary money as a means of taxation can lead to catastrophic hyperinflation. The point is that the gold standard imposes much more discipline on a government, and it is no surprise that governments do not like such regimes. It is no surprise either, that socialists hate the gold standard and libertarians love it. Because it is socialists that like excessive taxation, and since direct taxation is unpopular, they prefer to use the indirect taxation of monetary expansion. Libertarians do not favor big public sector and excessive taxes and they therefore love the gold standard as a barrier to socialist policies.

To make things simpler, think about it in the following. If society’s savings are a pile of gold, and the government takes some of this gold without taxing, it will have to pay back with gold. But the government does not have gold. But if, as it happens in all countries, the government passes a law that imposes paper money as the legal and only means of payment it is in effect forcing its citizens to save their surpluses in paper money. Now if the government can take some of the savings without taxing the citizens. If the citizens ever ask for their money back, the government can always print new money and pay them. But this paper will buy much less than it used to. Of course it is possible to save in gold but it is not as convenient. And therefore most people will hold their savings in the form of paper money. The honest thing for a government would be to back paper money with gold.

The gold standard and budget surpluses

As I already said, the gold standard is a regime favored by libertarians and of proponents of small public sectors in general. This rule prevents politicians, or at least makes it much harder for them, to follow policies based on budget deficits. There is another way however to prevent governments from creating deficits, and this is by passing a law requiring governments to have on average budget surpluses. Some political systems in developed countries do so, as a means of self discipline. In Sweden for instance, there is a law imposing budget surpluses of +1% on average. That means that deficits are allowed, but they will soon have to be reversed. But such laws are not welcome at all by socialists, since they are even stricter than the gold standard. Under the gold regime as I described above, at least temporarily, a government could finance a deficit by monetary expansion. The law of budget surpluses makes life for socialists even tougher since they can only use taxation to finance their projects. There is also a softer version of this rule that allows deficits but only if they relate to public investment i.e. road networks, harbors etc, with the hope that such investments will increase the country’s GDP.

Central banks and conspiracy theories

The main idea of this document is that there are no fat greedy bankers, but rather fat greedy governments and politicians. However there is one last issue which is the conspiracy theories about central banks. Such theories claim that central banks print money for themselves and this is the cause of the crises. In other words they claim that it is not that central banks are directly or indirectly at the mercy of their political systems but the other way round. The following link has a lot of information about conspiracy theories concerning the Federal Reserve Bank, which is the central bank of the U.S.A.

Such conspiracy theories are everywhere and always supported by populists, or by people that are not very educated or intelligent, and they have a tendency to believe populists. Political systems in developed countries try to make their central banks as independent as possible, in order to protect their monetary policy from political cycles. They do so in order to put a barrier between politicians and the money machines. And they do so with laws that they pass in their own parliaments. For instance the board of the Fed, is appointed by the president of the United States of America and approved by the congress, but the president cannot terminate the chairman’s tenure once he is appointed. They do so because they do not want the chairman of the central bank to be at the mercy of the president and the congress. They want the chairman to have some degree of independence in order to be able to resist pressures on behalf of the congress, to follow more expansionary policies. Because the truth is that politicians tend to focus on short rather than long term consequences.

The problem is that political systems do not provide enough independence to their central banks. For instance by law the Fed’s goals are price stability and low unemployment. The same applied for the central banks of the socialist southern European countries. However this was not the case for Germany. Bundesbank’s goal was set by law to be only price stability, and this partly explains the superiority of the German economy, since the political system had to be much more disciplined. Because when you include low unemployment as a goal of the central bank, the central banker is at the mercy of politicians. Politicians know that if their irresponsible fiscal policies lead to high unemployment, the central bank will have to step in and give them a hand in the form of monetary expansion, since it is required by law to do so. But an increase in paper money can only have short run positive effects and will definitely has very strong long term negative effects. Therefore this commitment of the central bank to intervene in case of rising unemployment gives negative incentives to the political system. If on the other hand the goals of central banks were only price stability and the stability of the financial system, politicians would be much more cautious and disciplined.

But even when low unemployment is one of the central bank’s goals, the economists from the academia that that run them, are a significant obstacle to the political system since they do not have to worry about political cycles. And this is the reason that socialists and statists want central banks to be at the absolute control of the political system. And they circulate conspiracy theories about central banks, in order to convince ignorant people that central banks should be stripped from any form of independence. They want the money machine under their complete control. When politicians have the money machine under their control, they can do the following. Suppose there is a 3 people economy, the president and two citizens. The president wants to take a dollar from John and give it to Nick. He can print 3 dollars give 2 dollars to John, and 1 dollar to Nick. If you take into account inflation, the net effect was to give 1 dollar to Nick. But John is happy too. He got a dollar. He did not realize that 1 dollar was taken from him. He thinks 1 dollar was given to him. He only notices inflation. This is the reason that politicians do not want economists running central banks. In less developed countries the money machines are indeed at the mercy of the political system, in the way that statists and conspiracy theorists want them to be. Only in the developed word central banks enjoy some degree of independence.

The Fed has indeed shares which are held by all the private banks operating in the U.S.A. But banks are required by law to hold the Fed’s shares. And by the same law they have to keep a part of their funds with the Fed. But private banks do not have a saying on the conduct of monetary policy which is determined by a board appointed by the president and approved by the congress. Moreover all the interest earned by the Fed is returned to the treasury at the end of each year (for more details see the link I provided above).

I will therefore conclude by saying that contrary to what conspiracy theorists suggest, the problem with central banks is that they do not have enough independence and they have to accommodate irresponsible fiscal policies. The most famous case is of the northern and southern European countries. The northern European countries provided much more independence to their central banks and they always outperformed the southern countries in economic terms.