The failings of fiat money

Submitted by Matthew on 1 December, 2011 - 10:56

By Martin Thomas

I think Barry Finger (Solidarity 226) exaggerates “the democratic openings made possible by fiat money”.

True, the current crisis reveals states held in hock to banks and other financial institutions permanently holding vast stocks of government IOUs (bonds). To release that stranglehold, we should call for the expropriation of the banks, insurance companies, pension funds, etc., and their replacement by a common publicly-owned service under democratic control. Coupon payments on most bonds could then be cancelled, or become only a matter of internal book-keeping within public finances.

However, Barry seems to counterpose an indefinite or almost indefinite expansion of fiat money (that is, cash in the form of bank notes, permanent and unrepayable IOUs from the government).

He sees a limit only “when demand expansion cannot induce any further capacity utilisation or increased output”.

There is a first problem here which is discussed in current debates between “Keynesians” and “monetarists”. Monetarists hold that pumping out enough cash is all that’s necessary to keep production at full tilt. They support “quantitative easing” (a way to pump out more cash), and say that public works are unnecessary. Keynesians say that the extra cash may just sit in the cash piles of wealthy people unwilling to push it into production, and call for direct state activity.

Barry, I think, calls for the government spending more cash directly on public projects, and not just for more injection of cash.

Then there is a second problem, and one which the Bolsheviks after 1917 fell foul of. There is no tidy moment when the government printing off more cash and spending it will elicit no further activity. Meanwhile, every currency note printed remains in circulation indefinitely and stokes up inflation. The inflation comes with a delay, but after a while catches up with and overwhelms the printing of new cash.

Even before October 1917, the Tsarist and then the Provisional Government, struggling with war finance, had gone beyond the limit at which printing more notes devalued the existing stock in circulation faster than it enabled the government to generate more economic activity.

The workers’ government at first saw no option but to continue the previous governments’ policy, and covered its spending by printing even more notes. As the volume of notes in circulation ballooned, their value dwindled faster. On 1 November 1917, the total currency in circulation was worth 2200 million rubles at 1914 prices; by 1 July 1921, it was worth only 29 million rubles.

For a while, illusions of “war communism” allowed some Bolsheviks to think that the result, where in the cities mostly you could only get food and other supplies by getting on the list for direct allocation by some office or factory, was a progressive move towards the withering-away of money.

By 1923-4 those illusions were thoroughly dismissed. The Bolshevik government noted that economic planning required a stable currency. It introduced a new “gold ruble” and withdrew the old notes.

It had already restarted selling bonds (on a smaller scale than under the old regime, to mobilise small savings rather than to build up a vast wall of obligations), after at first cancelling all bonds held abroad and converting bonds held within Russia into currency.


Submitted by Barry Finger on Sat, 03/12/2011 - 04:37

The western working classes are facing an international capitalist offensive. Central to that is the almost universal demand for austerity. The euro crisis and the anemic American recovery are both attributed to fiscal irresponsibility. The Greek sovereign debt crisis, in particular, is employed as the exemplar of what awaits any individual economy unless the political process accedes to the economic discipline of the bond market. This demand for austerity is a potent challenge to all political parties, including those that nominally aspire to represent the oppressed and exploited. We are offered the opportunity for an “orderly retreat” or an imposed rout. And so far the ideologically bankrupt social democrats and the business oriented Democratic Party have acted solely as a conduit from above to sell these capitalist policies to its demoralized and broken constituents. All the various national proposals are simply demands for the state to step aside and allow the organic shakeout of capital needed to restructure the economy, write off excess capital, raise the rate of exploitation, shift resources from the public to the private sphere and permit a “spontaneous” recovery of profitability somewhere down the road largely at our expense.

Keynesians and monetarists provide no ideological path beyond this business consensus. Both agree on the need for fiscal discipline over the course of the business cycle and for long-term debt reduction. Both are wary of bond markets imposing an unsupportable interest premium on government budgets in the face of continuous deficits, increasing national debt and rising debt to GDP ratios. Neither offers much support to those who wish to apply rank and file pressure on the political process to reverse course. And both schools come to these conclusions by perpetuating a vast slew of misunderstandings as to how a modern, non-commodity monetary system actually operates.

The point of the article that Martin refers to is that any entity that is sovereign with respect to the issuing of currency, that can allow its currency to float and can pay its external debts in its own currency is never revenue constrained. There is no need to tax or borrow from the private sector prior to spending. The state therefore operates on an entirely different basis than capitalist agents. The ruling class nevertheless aligns the operations of these consolidated banking authorities with accepted private banking practices. But these are legal, not functional constraints and can be reversed. In the US and Britain the treasury and central bank (fed, in the US) are government entities, but are in no sense under democratic supervision. In the euro zone, the ECB operates autonomously as a supranational capitalist entity.

Where I differ from Martin is in this. He advocates the nationalization of the private banking system. I would counterpose a true democratization of these ostensibly public institutions. I would be for placing workers’ pension funds, savings, and insurance programs on the balance sheets of the central banks, just as the fed did to the private banking systems toxic assets. But the purpose would be to preserve and expand these programs, not rescue the private banking system. I would advocate no action whatsoever with regard to the private banking sector.

At the same time, the spending power of the state (or euro zone), unencumbered by the prior need to divert a revenue stream from the private sector, should be used to purchase goods from the private sector for public use. This additional demand would put idle capacity into play, and begin to absorb the mass ranks of the unemployed. And if this did not mop up the excessed population, socialists should also advocate a program of government as employer of the last resort. There is no doubt that the additional business activity so engendered would recapitalize the failing private banking system. But if this recapitalization did not extend all the way up the ladder to the hedge fund and shadow banking rungs, swaths of social parasitism would simply be wiped out at no cost to society.

Is this sufficient? For now it provides a program of fight back that addresses the immediate needs of workers. But impressing idle private capacity for public purpose means that such use values would loose their commodity status and drop out of the circuit of capital formation. This presents a set of problems that goes beyond what can be discussed here. And a massive counter cyclical program that does not, at the same time, fail to purge excess capital values while consciously restructuring the production structure, leaves the underlying causes of the present crisis in tact, even if it defuses the triggers.

Is this necessarily inflationary? If it were, so much the worse for the banking system. The working class would be able to emerge from its debt peonage at the bankers’ expense. But I cannot follow Martin’s argument that the expansion of cash needed to accommodate additional economic activity must lead to inflation. If that were the case, any form of expanded reproduction would be inflationary. It is true that an injection of demand beyond the capacity of the system to accommodate that demand with additional output would build inflationary pressures. But there is no reason why a state cannot respond to such signals as they arise with increased taxes heavily tilted towards the rich that neutralize excess demand and put a halt to inflation.

The examples of Tsarist and revolutionary Russia are hardly supportive of Martin’s contention. Tsarist Russia was not suffering in wartime from idle capacity and mass unemployment due to a business crisis. It had a production structure that, when fully utilized, was nevertheless insufficient to meet the mounting demands of war. And Revolutionary Russia, after Brest-Litovsk, surrendered regions resulting in the loss of 40% of its industrial proletariat and 70% of its raw materials, pig iron and steel. This meant a shortage of economic products due to an actual shrinkage of physical and human capacity that no method of state financing could reverse.


Submitted by martin on Tue, 13/12/2011 - 08:33

As the first measure in the economic crisis, Barry recommends that "the spending power of the state (or euro zone), unencumbered by the prior need to divert a revenue stream from the private sector [i.e., I guess, to tax it, or sell bonds to it], should be used to purchase goods from the private sector for public use".

He thus advocates a change in the workings of the central bank, but "would advocate no action whatsoever with regard to the private banking sector".

He "cannot follow Martin’s argument that the expansion of cash needed to accommodate additional economic activity must lead to inflation", and reckons that the inflation in wartime Tsarist Russia, and early Bolshevik Russia, was due to the fact that production capacity, in its war-damaged state, was already strained to the maximum.

I doubt it's true that production was running at maximum capacity, even war-damaged maximum capacity. In any case, history has many examples where just printing more currency results in runaway inflation when there is obviously slack capacity: Hungary 1945-6, Israel 1980-5, Russia 1992-4, Zimbabwe 2004-9.

If the central bank prints more pounds (or dollars, or whatever) and the government uses them to buy bricks, or schoolbooks, or medicines, then, with the buying power of the currency unchanged, the total buying power of all the cash in circulation increases far more than in proportion to the extra notes printed.

Each note serves not only for the first purchase it makes (bricks, books, etc. bought by the government), but for hundreds of other purchases.

The effect is redoubled where there is a developed banking system. Most money in modern economies is created by private, not central, banks, and exists in the form of account balances rather than notes and coin.

In Britain at present, for example, there are about £61 billion of notes and coins in circulation, but £2,124 billion in circulation in "broad money" (M4, in Bank of England statistics).

In general (although erratically, and sometimes with reverses), a large increase in the base of notes and coins is multiplied up into a much larger increase in "broad money".

Another process of multiplying-up has happened when the government's purchases of bricks, books, etc. stimulated further demand (for consumer goods for brickworkers, new printing machines, etc.) which mobilised previously-idle capacity.

But even in a depressed economy, with much idle capacity, that multiplier is likely to be smaller than the multiplier by which increased buying power exceeds the amount of new notes printed.

At some point, in some way, the clash between spiralling notional buying power and more modestly-rising production is resolved by the buying power of each note decreasing.

At a further point, there is a breakdown. The buying power of each note decreases faster than the notes can be printed. The total buying power of the notes in circulation diminishes while capacity remains idle.

Having said that inflation can't be a problem, Barry concedes that it may be, and recommends "increased taxes heavily tilted towards the rich that neutralise excess demand and put a halt to inflation".

Good! But effective taxation of the rich has to be introduced before inflation explodes. With high inflation, by the time the taxes have been gathered in, the inflation has reduced them to trivial amounts. (This was a problem in Germany in the early 1920s: hence the debate then about "taxation of real values", or "Erfassung der Sachwerte").

Taxing the rich is not just an optional extra in a crisis policy, to be invoked only in exceptional emergencies. The same about "action in regard to the private banking sector": it is an essential even for a mild reform policy.

Martin Thomas

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