An alternative to popular faith
Most of the states are deeply in debt. Some of them even have stopped paying their bills. I live in Illinois. It is a deadbeat state. Our newspapers run editorials suggesting solutions to Illinois’ huge budget problems. These solutions detail tax increases and spending cuts. Sound familiar?
Neither solution will work. All states, counties and cities should understand why even the most well considered tax increases and spending cuts cannot solve their financial problems.
Yes, Illinois has among the most dishonest groups of political leaders. And yes, Illinois ranks in the upper 10% of the most distressed states. But it’s not entirely the fault of our crooked politicians.
No political entity, whether it be country, state, county or city can prosper and grow, unless it either can create money or obtain money from outside. Spending reductions reduce services and negatively impact the economy, which reduces tax collections in a never-ending downward spiral.
Tax increases merely circulate money within the political entity.Additional money is needed, because even nominal inflation reduces the real value of money. Imagine that together, the state of Illinois, its counties, cities and citizens, owned a total of $100 billion. To balance its budget, Illinois decides to raise taxes, which takes $10 billion from taxpayers and sends it to the state, which then sends the $10 billion back to the taxpayers when it pays its bills.
What has happened? Essentially nothing. There still is a total of $100 billion in the state, except after a year, even with a modest annual inflation of 2%, this money now is worth only $98 billion in purchasing power. After ten years of 2% annual inflation, that same money now is worth less than $82 billion.
Another reason the states, counties and cities cannot survive on taxes alone: Federal taxes remove money from the state every year, and as the money supply declines the state’s economy declines.
Unlike the federal government, Illinois cannot create money at will. It must obtain money from outside its borders. There are but two sources of outside money. One is exporting. We can send goods and services to other locations, which will send us money. But it is quite difficult for any state’s exports to exceed its imports by enough to grow its economy and stay ahead of inflation. An oil-rich state like Alaska and a tourism state like Nevada, both have money coming in from outside. But even these states eventually need a source of additional income.
And that source is the federal government, which in 1971 ended the gold standard, giving itself the unlimited ability to create money, not supported by taxes. By comparison, Greece is not so fortunate. It is limited by the “euro standard.” Illinois is limited by the “dollar standard.” All three standards limit money creation.
Despite fears of “big government,” the federal government must assume more financial obligations. As states, counties and cities continually raise taxes, they find they are in a never-ending, futile cycle, not just because of inefficient management, but also because it is long-term impossible for any political entity to survive, much less grow, without the ability either to create its own money or to receive money from outside its borders.
Rather than pundits calling for ever higher taxes and/or reduced spending, neither of which add to the money supply, they should demand more federal support. Mathematically, that is the only lasting solution.
In summary: The anti-big-federal-government crowd fails to take into consideration the fact that unlike the federal government, the states, counties and cities are unable to create money. When any political entity is unable to create money, its economy will stagnate, unless it receives funds from outside. Worse than stagnate, its economy will decline because inflation makes its own money lose value.
Ongoing economic growth demands ongoing money growth by the federal government.
Rodger Malcolm Mitchell
http://www.rodgermitchell.com
#Monetary Sovereignty - Mitchell 
Hi Rodger,
Isn’t your analysis somewhat tautological? That is, fiat money leads to inflation (even if nominal). Consequently, we need to create more money to keep pace with inflation as money has lost some of its value. That seems to be somewhat akin to a dog chasing its tail. Is there no viable system that doesn’t include an eternal inflation component?
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Hi, Rodger!
What do you think of this idea? Charter a state bank and borrow money for essentially nothing from the Fed? Like Goldman Sachs. 😉 Then let the state bank lend that money to the state for peanuts, as well as lend money to its citizens on better terms than the big banks are doing? After all, the state bank would have no toxic assets on its books. 🙂
Would that work?
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Re. charter bank, states generally have legal limits on what they can borrow and always have limits on what they can service. Those are the problems.
Re. inflation. We have inflation, because the Fed and all the politicians want a low level of inflation. It is felt to be a better option than deflation. There is nothing special about fiat money that makes it lead to inflation.
By definition, all money is fiat money. Even gold becomes fiat money when a nation decides (by fiat) that it will serve as money.
Money serves as a proxy for goods and services in a barter transaction. For instance, here are three barter transactions:
A bushel of corn for a bushel of wheat
A gram of gold for a bushel of wheat
A dollar for a bushel of wheat.
All are barter transactions, with the dollar and the gold being proxies for the corn. If the U.S. declares that gold is money, that is fiat money.
And yes, we need continuously to create money, not only to keep pace with inflation, but also to keep pace with population growth, current account deficits and to stimulate economic growth. (See the February 15, 2008 post at http://www.rodgermitchell.com
If you want the economy to grow forever, the money supply must grow forever.
Rodger Malcolm Mitchell
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Rodger, someone on another blog pointed out that North Dakota has a state bank, and that that state is doing OK. Do you know anything about that? Thanks. 🙂
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No. If you find out let me know. I don’t see how borrowing from a state bank solves the fundamental problems of state borrowing limits and annual increases in money needs.
Rodger Malcolm Mitchell
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I believe by definition, “fiat” currency is that which is mandated by the government. I don’t know if you can argue that historically gold was a fiat currency as it arose before governments as a medium that was valued and trusted
If the government allowed (and enforced) contracts written with gold as a currency between consenting parties, gold would be a currency, but not a fiat currency. Competing currencies (i.e. silver, paper etc would also be legal again between consenting parties). This is precisely what some people support.
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“If the government allowed (and enforced) contracts written with gold as a currency between consenting parties, gold would be a currency, but not a fiat currency.”
A fiat is a legally binding decree. By definition, money exists only because of government fiat. The term “fiat money” is a redundancy.
If the government declared gold an official currency, that declaration would be a fiat, and gold would be a fiat currency. It would have a fixed value, rather than a market value.
If gold merely is the subject of a barter transaction, as in “How much money will you give me for an ounce of gold?”, then gold would not be a currency, although a subsequent contract would be enforceable.
Ten dollar gold pieces were fiat currency. They were declared money, by government fiat, and they were worth exactly $10, neither less nor more. You could exchange them for exactly two $5 silver coins or 1000 copper pennies, which also were “fiat” money.
That is one of the signs of money. It has a definite worth rather than a market value. Today, because by fiat, neither gold nor silver nor copper nor nickle is money, their relative value is negotiated.
This is important, because lay people tend to disparage paper as “fiat” money, while gold was thought of as “real” money. “Real money” is an oxymoron, because by its very definition money is a substitute for real goods and services in a barter transaction.
Rodger Malcolm Mitchell
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Rodger: “I don’t see how borrowing from a state bank solves the fundamental problems of state borrowing limits and annual increases in money needs.”
Here is what I had in mind. A state bank, being a part of the Federal Reserve system, can, under circumstances like today, can lend money to the state and, if necessary, get reserves cheap from the Fed, just like Goldman Sachs. So, even though a state cannot create its own currency, a state bank can create money just like any other bank. Under conditions like today, when regular banks are not lending, a state bank could. 🙂
North Dakota, like almost every other state, has some form of balanced budget legislation. It would be interesting to find out how its state bank is set up and operates.
Now, my idea may be completely wacko, but hey! it’s a thought. 😉
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Min, you are correct that banks can get unlimited reserves from the Fed, but banks’ real ability to lend is limited by their capital requirements.
Rodger Malcolm Mitchell
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Rodger,
I believe you are distorting my comment somewhat. I did not state that the government would “declare gold an official currency” The role of the government might only be to enforce contracts between consenting parties whether those parties agree in advance to exchange goods or services for grams of gold, ounces of silver or paper dollars. That is, the parties to a contract (or purchase and sale) would in essence decide what money is, not the government.
I suspect you may reply that whatever the government decides that taxes must be paid with automatically becomes money, but I see no reason why there could not be multiple currencies as long as the government enforces the terms of specific contracts (e.g. I’ll rent you an apartment for a monthly cost of one ounce of gold).
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Jack, contract law already enforces the barter transactions you suggest.
Rodger Malcolm Mitchell
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The government will not enforce a contract ‘written in gold’ to the best of my knowledge.
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That’s true for most people, except for dentists, artists, electronics manufacturers, jewelry manufacturers and others who use gold for its functional properties. So?
I don’t understand the preoccupation with gold. Gold is just a mineral, neither more nor less. It is no closer to being money than are silver, copper, nickel or paper.
Actually, paper is closer to being money than is gold and also is more useful.
Rodger Malcolm Mitchell
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Rodger,
I’m not sure if you’re being disingenuous or not. I have never heard anyone argue for a nickle or aluminum standard, but there are many that do support a return to the gold standard (I know your thoughts on that). In addition, witness the recent purchase of 200 tons of gold by India. India purchased the gold not because it is a strategic or useful metal. They purchased it (I assume) because it is a paper currency alternative that over time has kept pace with inflation.
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“I have never heard anyone argue for a nickle or aluminum standard. . . “
That’s exactly the point. Why not a nickel standard? Gold is no closer to being money than are nickel, copper, platinum, silver, oil or even water.
They are better hedges against inflation than gold. They are more useful. And, in any event, being a hedge against inflation or being useful have absolutely nothing to do with being money.
So again, what is the preoccupation with gold? It simply makes no sense.
Rodger Malcolm Mitchell
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https://en.wikipedia.org/wiki/ANCAP_(commodity_standard)#Details_of_ANCAP
39 years out maybe Ammonium Nitrate, Copper, Aluminum, and Plywood would have been a better hedge for inflation.
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Using a commodity as money, or as a backing for money, is a doomed proposition.
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