MMP Blog #9: What If the Population Refuses to Accept the Domestic Currency?


In the last two weeks we asked, and answered, the question: why would anyone accept a “fiat currency” that has no intrinsic value without precious metal backing? We have argued that legal tender laws, alone, are not sufficient because it is generally too difficult for government to enforce them. Further, we know that “fiat currencies” are often accepted even where their use is not required (ie: where there are no legal tender laws, or at least none that are applicable).

We concluded that “taxes drive money”: if a sovereign has the power to impose and enforce a tax liability, it can ensure a demand for its currency. This is the one transaction that government can ensure its “fiat currency” is used: in payments made to itself.

We also concluded that other kinds of obligations will work: if you need the currency to pay fees, fines, or tithes, you will demand at least enough currency to make those payments. And, finally, we argued that an authority that monopolizes a needed resource (land, energy) can “name the price”, i.e., dictate what must be delivered to obtain it. So that, too, could drive a currency—and, again, it is because the authority can choose the form in which the payment is made.

The best kind of payment is an obligatory one—one that must be made to stay out of prison, or to avoid death by thirst. An obligatory payment that must be made in the sovereign’s own currency will guarantee a demand for that currency.

And we argued that even if one does not owe taxes (or fees, etc.) to the sovereign, one might still accept the currency knowing that others do have tax liabilities and thus will accept the currency. But how much currency will be accepted? Can the sovereign issue more than the tax liability? How much more?

Imposing and enforcing a tax liability ensures that at least those subject to taxes will want the domestic currency, in an amount at least equal to the tax liability that will be enforced. In the developed nations, the population is willing to accept more domestic currency than what is needed for tax payments—typically government does not find sellers unwilling to sell for its currency.

The normal case—let us say, in the US or the UK or Japan—is that anything for sale is for sale in the domestic currency. These sovereign governments never find that they cannot buy something by issuing their own currency.

To be clear: if there is something for sale with a US Dollar price, it can be bought by delivering US currency. (We will just note a caveat here, to be explained more fully later: sometimes, especially for payments made by mail, paper currency and coins are not accepted. But when a payment is made by check, there is a transfer of bank reserves—a kissing cousin to sovereign currency.)

However, the situation can be different in developing nations in which foreign currencies might be preferred for “private” transactions (payments that do not involve the sovereign). To be sure, the population will want sufficient domestic currency to meet its tax liability, but the tax liability can be limited by tax avoidance and evasion. This will limit the government’s ability to purchase output by making payments in its own currency.

We can get a rough idea of the limit imposed on a government whose population prefers foreign currency. Let us say that the government imposes a tax liability equal to one-third of measured GDP. However, because the informal sector escapes accounting, let us assume that GDP only represents half of the true level of output.

Further assume that government is only able to collect half of imposed taxes due to evasion. This means that collected taxes equal only one-sixth of measured GDP and only one-twelfth of true output and income. (Hello, Greece! Just kidding, but that is one of the claims frequently made.)

At a minimum, in such a situation government will be able to move one-twelfth of national output to the public sector through its spending of the domestic currency (since those who really do have to pay taxes need the domestic currency to meet their obligations).

In practice, the government will probably be able to capture more than one-twelfth of national output because some “private” entities (domestic and perhaps foreign) will want to accumulate domestic currency as well as other claims on government (such as government bonds)—recall from previous discussion that government deficits allow accumulation of net financial wealth in the form of government IOUs. Hence it is likely that government will be able to purchase somewhat more than a twelfth of GDP, while collecting taxes equal to a twelfth of national income, with some households or firms (or foreigners) accumulating the rest of the currency spent as net financial wealth.

(These calculations are necessarily approximate because we are ignoring possible effects of taxing and spending on the behaviour of the population. For example, imposing a tax can drive more production into the “grey market”, leaving measured GDP and taxable income lower.)

To capture a larger per cent of national output, government needs to pursue policies that will a) reduce tax evasion and b) formalize more of the informal sector. Both of those actions would increase taxes on the population and would allow government to obtain more output.

If taxes are at just one-twelfth of national output, it might not be effective for government to simply increase its spending to try to move more resources to the public sector—this could just result in inflation, as sellers would accept more domestic currency only at higher prices (as they already have all the currency they need to meet the tax obligation they think will be enforced). And beyond some point, government might not find any sellers for additional currency.

While it would be incorrect—for reasons explored later—to argue that taxes “pay for” government spending, it is true that inability to impose and enforce tax liabilities will limit the amount of resources government can command.

The problem is not really one of government “affordability” but rather of limited government ability to mobilize resources because it cannot impose and enforce taxes at a sufficient level to achieve the desired result.

Government can always “afford” to spend more (in the sense that it can issue more currency), but if it cannot enforce and collect taxes it will not find sufficient willingness to accept its domestic currency in sales to government.

Put simply, the population will find it does not need additional domestic currency if it has already met the tax liability the government is able to enforce (plus some accumulation of currency for contingency purposes). In that case, raising taxes would increase demand for government’s currency (to pay the taxes), which would create more sellers to government for its currency.

Until government can impose and collect more taxes, its spending will be constrained by the population’s willingness to sell for domestic currency. And that, in turn, is caused by a preference for use of foreign currency for domestic purposes other than paying taxes. While this is not a big problem in developed countries, it can be a serious problem in developing nations.

In this blog, we have presumed government spends and taxes using currency (notes and coins). In practice, governments use checks and increasingly use electronic entries on bank accounts. Indeed, government uses private banks to accomplish many or most transactions related to spending and taxing.

In coming weeks we will provide a more “realistic” account of taxing and spending using bank accounts rather than actual currency. This does not change anything of substance—but it does require some understanding of banking, central banking, and treasury operations, discussed in the following blogs.

19 Responses to MMP Blog #9: What If the Population Refuses to Accept the Domestic Currency?

  1. It occurs to me that no one ever asks the question "Why would anyone accept gold?" But really, why would I want gold? I have no use for it.The only reason anybody ever accepts any money is that someone else will accept it in turn. But most people never examine their very most basic assumptions.

  2. "While it would be incorrect—for reasons explored later—to argue that taxes “pay for” government spending, it is true that inability to impose and enforce tax liabilities will limit the amount of resources government can command.The problem is not really one of government “affordability” but rather of limited government ability to mobilize resources because it cannot impose and enforce taxes at a sufficient level to achieve the desired result."Man, you are going to make my head implode. You cannot sell this to the rest of America. Believe me, I'm from the middle of it. I may as well join the Communist Party…

  3. Why would anyone buy gold? Why would anyone buy a Van Gogh? Or race horse, dumpy house, diamond,etc?Gold is an ancient commodity that holds some value throughout history. It's advantage is that it can be converted into any sovereign currency. Unlike most anything else, except, perhaps, precious gems.Unfortunately for many, gold is a long term investment as there are sales commissions involved in the conversion upon sale. And the caveat about using commodities as a money for our system is that it is difficult to make a short term profit on it.Which is to say, unlike a currency which can be lent out literally overnight at a profit and receiving the return of your principal, we have no way maintaining a lender of last resort to protect the system during crashes and panics….And best of all, when the gold miners go on strike or run out of reserves, everybody starves or murders the "rich who have all that gold" as the economy collapses.So the next time Ron Paul, a great guy, by the way, ask if gold is money, thank your favorite deity it isn't because during panics and crashes the government pushes a few key strokes and we have our money back maintaining a minimum stability until the crisis subsides. And besides, can you see all these "corporate jet owners" and "union bosses" lugging all of that gold to bribe the gang in Washington. Wait, that might not be a bad idea!

  4. "The problem is not really one of government “affordability” but rather of limited government ability to mobilize resources because it cannot impose and enforce taxes at a sufficient level to achieve the desired result."If the government is benevolent and has the good of the people in mind, this sounds great. But what if its not?I like to think of MMT from a progressive point of view and when I do it sounds good… but reading those same words above from the viewpoint of a reactionary or totalitarian government gives me the shivers.MMT appears to vest a lot of power in the sovereign by eliminating the need to finance government debt and thus curtail the economic power of the government. Are there any safeguards that would prevent the abuse of this power in the absence of the financial restraint?–Bolo, rjmeyers(at) hotmail.com

  5. Q:"Why would anyone accept gold?"A: Because it's very easy to detect a counterfeit with very old technology. A "touchstone" scratches a gold coin, and an acid applied shows what's real and what's not…

  6. The link to this page from the Modern Money Primer tab is broken. You can only get to it through the recent posts column on the left.

  7. Bolo: MMT appears to vest a lot of power in the sovereign by eliminating the need to finance government debt and thus curtail the economic power of the government. Are there any safeguards that would prevent the abuse of this power in the absence of the financial restraint? Bolo, MMT is a descriptive, scientific theory, not a policy proposal. All governments "use MMT" in wartime, when it really counts. Governments have never needed to "finance" their debt, and that is not what is really happening. To the extent they have the power to tax, they have always had the power to destroy, to abuse. The "financing" of government debt is just a stupid shell game whose main point is to disguise what is going on. The point is whether this knowledge, this power should be reserved to a few financiers manipulating for their selfish, moronic and frequently destructive ends, or for the many, who could and have put this knowledge of the social technology of money to good use.MMT-guided policy proposals are applied common sense, are about seizing what you already have, not about endowing a sovereign with new powers.

  8. Calgacus: Yes, governments have had to finance their debt when they do not issue fiat currency. This has been quite common throughout history. Actually, non-government issued currency has been relatively common in history as well.It is only fiat currency issued as a monopoly by the sovereign that does not require debt to be issued and thus does not require the financing of debt. This is the insight that MMT has brought to the fore.I don't believe that financing the debt is a shell game with the current regime(s) in power. I think that many of them do truly believe that the government must pay down its debt. Giving them the power to spend without hindering them with debt obligations would be a bad thing. Think about what the US government would do if it didn't have the debt cloud hanging over it. Not what it "could" do, but what it would do.The mechanism identified by MMT is great, but it must go hand-in-hand with serious governmental reform and (in my opinion) de-escalation of centralized powers.

  9. Let me see if I got this right. When tax money is getting less due to recession, government has a problem expanding its spending. If it does spend much more than his tax revenues will be, it will cause inflation. On the other hand if it tries to rise tax too high, it might force some of its economy towards the shadow economy. People have to make a living somehow. I could already notice this in some areas where you cannot find qualified workers if you don't pay some of their wage in black money. I assume that the attempt to kill cash has to do with controlling payments and tax payments. In Europe we are moving to cash limit of 1.000 € that will not have to be reported in Germany by 2012. Regards, Dietmar

  10. Not quite- the rate matters, not the specific revenue. In a recession revenue drops due to a lack of money circulating, not due to lowered tax rates, so if the money does get pushed in, tax obligations will increase right along with it; in fact, it becomes important to introduce enough money into the system to pay people for things exactly so that people don't jump to a shadow economy instead where not enough money is on hand to meet their needs.

  11. Bolo: It is only fiat currency issued as a monopoly by the sovereign that does not require debt to be issued and thus does not require the financing of debt. This is confused. See response to blog #8 & comments Money is intrinsically fiat money, and always has been. All forms of money are forms of debt. Issuing money = issuing debt. That is why I said calling only currency and reserves "money" & calling bonds "debt" and insisting that money (=debt) issuance must be "financed" by bond (=another kind of debt) issuance is a stupid shell game. It is like saying the issuance of one dollar bills is "financed" by issuing 100s.Yes, bond issuance has real effects on interest rates. Maybe it can be a good idea. But the main function is to sow confusion, and the preposterous illusion that modern governments need to finance their spending other than by, well, spending, which is backed up by taxation. Convertibility (of currency only) and real world constraints like wars and the lack of taxing power may have made governments need to "finance" their spending, particularly in often chaotic medieval Europe, which saw the birth of modern banking, as a marriage between the state's money and the private sector's "non-government issued currency". So I was too sweeping when I said governments never needed finance. But modern governments, with modern taxing powers, like the ancient Middle Eastern states that invented money, simply do not need anyone else's financing. When push comes to shove, with financial crises like now, and war, they DO finance themselves by effectively printing money – but always hidden behind a curtain of verbiage, to confuse the marks.Giving them the power to spend without hindering them with debt obligations would be a bad thing. No, it would be an impossible thing. Spending money IS hindering the government with debt obligations, the debt obligations called "money" (currency, cash, reserves, bonds) held by the private sector. Government bonds, debt obligations are money. Money is a bond, a debt obligation. The main thing is to spend enough to have real full employment, not how we pretend to "finance" it. Whether there is a zero interest rate policy = no bonds="spend without hindering them with debt obligations" (an incorrect usage) or lots of bonds and "debt" pretend-hindrances is secondary. "Take care of full employment and the budget will take care of itself." (Keynes). Everything else would take care of itself with a rational full employment policy.Think about what the US government would do if it didn't have the debt cloud hanging over it. Not what it "could" do, but what it would do. The imaginary debt-cloud has not constrained the evil the US government does, its endless, insane, murderous wars, the endless handouts to wealthy criminals in the least. The debt cloud is only used as a constraint on the poor, the working people, the real economy. The question is whether the US is so depraved that the only way to destroy and stop the parasites is to destroy their host – which is what the debt cloud constraint is doing. I think understanding how things really work might lead to the best of both worlds – destruction of the parasites, and health of the host.

  12. Fascinating posts all round … got me reading about the mechanics of the Fed. So govt creates money by selling treasury bonds via primary Fed dealers (FOMO) but Fed buys bonds from those dealers again. Net effect is that Fed fiat money (base money) ends up in primary dealer accounts and multiplies through the banking system from there. Mmm … so if we were to start this all over again today, where would the primary dealers get their first money to buy the first treasury bonds?

  13. On the issue of why fiat money is acepted at all, I posed the question to reddit/economics and didn't get much of a response. However, there were two answers given:1. "Because it has a record of storing value, is widely accepted, and is actually backed by the production in our economy." 2. "It's backed by oil. Because countries buy oil with it, they save their money in dollars. Because they save their money in dollars, we don't have to tax as much as we spend. That's our credit card."Could you address these views?

  14. Lets see if I have this straight..In theory the FICA tax could be eliminated without a drop in the delivery of services through government spending. As long as the public exclusively uses the dollar as the exchange mechanism tax rates don't matter. The public acceptance of currency drives the ability for Sovereign states to create wealth and redistribute. Tax laws only matter to the extent it serves to legitimate the currency.

  15. ^They also help to regulate aggregate demand and can be used to incentivize/disincentivize certain activities, amongst other things.I'm sure Prof Wray will get into some of these issues in future entries.

  16. Annon at 8:57;Correct up to a point – yes, we absolutely can and absolutely should eliminate payroll taxes, and we could do so without having to cut SS and Medicare etc. (I assume these are the principal 'services' you have in mind.) Social Security is a transfer payment. It transfers real goods and services from working-age people to retirees, disabled people and survivors of personal tragedies. The money needed to accomplish this is created by fiat and does not need to be pre-funded or 'saved up' in a desk drawer in West Virginia. This charade was originally a harmless but politically necessary exercise to get the bill through a Congress that wasn't a lot brighter than the one we have now. Then, in 1983, Alan Greenspan, Ronald Reagan and Tip O'Neil hatched a grand bargain to make the payroll tax much, much heavier – in the name of making it 'solvent'. Since then, the U.S. government has 'saved' several trillion dollars' worth of its own debt for no reason at all – greatly diminishing the real wealth of the American people.But tax rates do still matter. (Speaking now of all taxes, not just payroll taxes.) If taxes are too high, too much purchasing power will be withdrawn from the economy, private spending will decline (because people can't afford to buy what they produce), production will slow, wages will decline and we will end up in a recession. Other kinds of events can start these cycles, but running big government budget surpluses is a sure-fire way.If taxes are too low for a given level of government, the government can end up spending more money than the real economy can respond to via increased production. Then we get inflation. For lots more wonderfully-clear examples, head over to moslereconomics.com. For a more doctoral-thesis treatment, Google 'billy blog'.Cheers

  17. “Put simply, the population will find it does not need additional domestic currency if it has already met the tax liability the government is able to enforce (plus some accumulation of currency for contingency purposes).”

    And yet, the population of the US, for example, does accept more currency than it needs to pay taxes. That leaves us back at the bigger fool theory.

    I think it makes more sense to say that the population wants there to be one currency, and the ability to pay taxes with it is a necessary condition to its selection vs. other contenders, all else being equal. Thus, a currency has the other attributes of money, including general acceptability beyond the needs for taxes, and it has the added benefit of being acceptable to the King, then it becomes the currency, but that does not mean that it is “backed” by the ability to pay taxes. Indeed, the whole point of fiat money is that it is “backed” by fiat, i.e., it’s fiat all the way down.

  18. the population wants there to be one currency

    I think there is plenty of evidence that the public will accept more than one currency… Coupons, trading stamps, frequent flyer miles, Ithaca dollars etc. etc.

  19. “And, finally, we argued that an authority that monopolizes a needed resource (land, energy) can “name the price”, i.e., dictate what must be delivered to obtain it”.. So this explains why the U.S military has intervened in the middle east & around the globe. As long as oil/natural resources are traded in dollars= New York as the finacial capital of the world.