The Basics of How Modern Economies Work

What is a Modern Economy?

There are A LOT of people who do not understand how modern economies work. Most members of Congress don’t. We the people, and our elected officials are discussing the economy in terms that are not real, not accurate. Our political leaders are implementing laws that are economically harmful.

This blog is a small bit of the effort to fix this.

A modern economy has the following attributes:

  • A fiat currency, which is not backed by any commodity such as gold or silver.
  • A floating exchange rate relative to other currencies.
  • A fractional reserve banking system which banks loan out money in excess of the reserves which allows them to pay out depositors.

How Does a Modern Economy Work?

Many of the ideas below might seem foreign to you. That’s because you’ve learned it wrong up to now.

Taxes do not fund federal government spending.

The US federal government is monetarily sovereign, which means they are the monopoly supplier of US dollars.

The US federal government can purchase ANYTHING whose price is denominated in US dollars. This does NOT mean the US federal government can purchase EVERYTHING whose price is denominated in US dollars.

The US federal government literally spends money into existence.

The US federal government literally taxes money out of existence.

Why Are So Many of Us Confused About This?

Because we confuse how USERS of the currency are constrained with how the ISSUER of the currency is constrained.

You, me, every business, every non-profit, and every level of government that is not the federal government are USERS of the currency. For us, we must obtain dollars before we spend them. If we spend more than we have, we need to borrow. We incur debt.

The US federal government is the ISSUER of the currency. They literally spend money into existence and tax money out of existence. Literally.

The federal government must first spend money into the economy before that money can be taxed back.

If this seems like a weird idea for you, consider that once upon a time there were Zero US Dollars in existence. Today there are around $22T.

Have you ever stopped to wonder where they came from? How they came into existence?

If it’s necessary for the US Federal Government to collect US Dollars in taxes before they can spend any, where did the first dollar come from? How could it be taxed before it existed?

The National Debt is NOT Debt

When US federal government spends more money into existence than they tax out of existence, the difference is not debt, but rather the money we USERS of the currency use.

It is, in fact, the money supply (it’s more complicated than that because commercial banks also loan money into existence, but let’s keep the model simply for now).

The reason we are misled into thinking it is debt seems to be:

  • If we USERS of the currency spent more than we took it, it WOULD be debt.
  • After the US federal government spends money into existence, it offers people the chance to buy Treasury Bonds. When people do this, they are converting one form of money (currency) into another (treasury bills). Treasury bills are bonds on which the US federal government pays interest. If they’re paying interest, it must be debt? Right? After all, interest is what WE pay for the money we borrow.

Can the US Federal Government Spend Endlessly?

No. The US federal government is constrained in their ability to spend. They are constrained by the productive capacity of the economy.

To use a famous line from the 2016 presidential election, Hillary Clinton said the US government could give everyone a pony, but how would we pay for it?

However, the issue is not the cost of ponies, but the availability of ponies. The US government COULD provide everyone a pony if we bred enough ponies. However, since ponies are not a national priority, this is not going to happen.

WTF? Can You Backup These Claims?

I’m not an economist, so I’m going to appeal to authority (and yes, I know that appealing to authority does not make an idea right or wrong).

The first guy to see this was a bond trader, not an economist. His name is Warren Mosler. He has since been given an honorary Ph.D. in Economics because he first saw how modern economies really work.

It does seem weird that it took a bond trader to see what economists did not, but I think it helps to understand he has an engineering mind set. While he does have a BA in economics, he studied engineering for two years, then switched his major to economics.

Warren Mosler figured out how our economy works by looking at it from an engineering perspective. In order to make better trades, he studied how the US Treasury, the US Federal Reserve, and the US commercial banking system shape our economy.

Warren Mosler made a lot of money on Wall Street. And he’s offered $100 million to be proven wrong. He still has that money. He has yet to be proven wrong.

If you want to understand these concepts better, watch the YouTube video linked to below. David Graeber is an Anthropologist who teaches at The London School of Economics and he’s talking about a book he wrote titled “Debt: The First 5,000 Years”.

For the first 21 minutes, he talks about how human cultures seem to universally equate debt with morality and how various early human cultures used debt (which I found fascinating).

At 21:07 minutes, he starts to describe the origin of money, about 6,000 years ago. To save you the trouble of listening to the first part, I start the video below at 21:07. You can back up to the start if you wish, but to understand the origin of money, you don’t have to.

When you understand why and how money was created in the first place (and it WAS NOT to be more efficient than barter), you suddenly see how what I’ve said above makes sense.

I would like to get out of the way that David Graeber seems to be a weird guy. But please don’t let that cloud your listening to him describe how money first came into existence within human society.

And…. once you’ve seen it, you can’t unsee it, and you find yourself wishing that everyone else saw it too.

To be clear, what I’ve said above is descriptive, not ideological. Independent of how we feel about how the economy SHOULD work, the issuer of a currency lives by one set of rules, and the users of that currency live by another.

We all benefit by knowing how this all works. It helps us detect when our political leaders are misleading us.

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