In Part 1, I explained how paper came to be substituted for gold, but I didn't explain why gold was used in the first place. Gold has the advantage of being generally impervious to the elements. It is also scarce enough and hard enough to come by that it took a lot of work to acquire it. People came to see that they could trade their work for gold and in turn trade the gold for something they wanted - the product of another persons work. This eliminated one of the big problems of bartering, the need to find someone who had what you wanted and who wanted what you had in order to make a trade. Gold as a medium of exchange came to be what we now call money. It was the invention of money that allowed civilization to develop, for without money, the division of labor is not possible.
The division of labor means that people can specialize in whatever they do best, thus producing more. Their surplus can be traded with others who do something else best. In order for a system like this to work the money must have a known, predictable value. It needs to be stable to facilitate exchange and to serve as a store of value. When the value of money is not stable, it does not serve its purpose very well. We read of situations in South America where money looses value so fast that people demand to be paid twice a day. They spend their morning's earnings during lunchtime, and their afternoon's wages in the evening. Productivity is seriously hampered in situations like this.
These consequences of an unstable currency are fairly well known. However, the alternative to admitting that we could not have both Guns and Butter was unthinkable to politicians who liked their plush jobs and wanted to be reelected. They had to find another way; a way to keep up with the spending without raising taxes, for that might cost them reelection. A way to spend money without raising taxes was needed. The solution was quite ingenious.
The explanation for how the government creates money is rather complex. While the government could simply print more bills, that would be a clear sign that the currency was being devalued. To avoid this, the government borrows money. Having a Federal Reserve Bank, with the ability to issue notes, allows it to borrow from itself. It does this by having the Treasury borrow from the Federal Reserve.* The Treasury gives the Federal Reserve a Treasury bond and the Federal Reserve gives the Treasury some Federal Reserve Notes, known to us as dollar bills.
The reason this works for the government, but not you and me, is the Legal Tender law mentioned in Part 1. The government's IOU's are legal tender, meaning you must accept them or lose the right to collect what is owed to you. I can print all the IOU's I want, but I don't have a way to force you to accept them in payment for your goods or services.
The Treasury conducts regular auctions of its bonds to the public, and the Federal Reserve will also sometimes sell some of its Treasury bonds. Both foreign investors and U.S. citizens buy them. If U.S. citizens buy the bonds, the money they would have used for other purchases is taken out of the money supply and shifted to the government. If all government bonds were bought by us citizens, the government could have a stable currency, since citizens would be foregoing their spending and letting the government spend in their place. Unfortunately, the fact is that there are so many bonds that there's no way we can buy them all. The problem with this procedure, no matter who implements it, is that it adds to the amount of money available to buy things, but does not add goods or services to be bought. Generally speaking, those bonds that are not purchased by us cause inflation because the dollars they represent are added to the money supply.
Sometimes, in attempting to hold down inflation, the government will raise interest rates. This does a couple of things: it causes people to slow down their spending, especially on items that require financing, and some people save more money than they would have otherwise. Saving money is not bad, in the context of a free market, because the money saved would be available to others for starting a business, buying a house, etc. When the money saved is gobbled up by the government for its spending programs it causes distortions in the market place. This happens because the government runs programs that the free market will not support. When there is a demand for a good or service, someone will move to fill that demand. That demand is known as an "opportunity" to business people who are always looking for opportunities. Logically then, it is only when there is insufficient demand to warrant a business person's interest, that demands go unfilled.
*Actually it is a little more complex. The Treasury auctions its bills, notes, and bonds to the public at large. The Fed then uses what is termed "Open Market Operations" and buys the Treasury securities from the public in the open market, meaning it goes through security dealers rather then buying them directly. The effect is that the Fed has bought Treasury securities (bills, notes, and bonds) with its Federal Reserve Notes, a process known as monetizing the debt. Most of the transactions are handled with bookkeeping entries and electronic funds transfers. Nobody bothers to actually print all of the bills involved.
Copyright 2006 by T. D. Blackburn Permission hereby granted to reproduce with this copyright notice included.