Continue from the first article titled “1 – Metallic Theory of Money”, it’s said that people accept the one-dollar gold coin as a payment for the goods and services they offered for other reason, but certainly not because of the intrinsic value of the gold coin (i.e not because the gold used to mint the one-dollar gold coin worth 1 dollar).
If people accept a one-dollar gold coin as a payment for one bag of rice because of the intrinsic value of the gold within the coin is worth one-dollar, what will happen when the one-dollar gold coin is minted half-gold and half-alloy? This would have reduced the intrinsic value of the one-dollar “gold coin” by half to 0.5 dollar.
If that’s the case, then people would have demanded TWO one-dollar gold coins as a payment for one bag of rice.
The history of the Greek have shown that. For example: In fact, the unit of account of the ancient Greek is Denarius. People accept one-Denarius gold coin that’s minted with 100% pure gold is accepted as a payment for one bag of rice.
As time passes, the new one-Denarius gold coin is now minted with only 10% pure gold while 90% alloy (i.e. the coin get degraded) and people knows that very well. However, they still accept the new one-Denarius “gold coin” for THE SAME one bag of rice!
In other words, no matter how much the intrinsic value of the one-Denarius “gold coin” has evaporated, people still could get THE SAME one bag of rice for one Denarius.
The purchasing power (value) of one Denarius “gold coin” has nothing to do with what material the coin is made of (i.e. has nothing to do with intrinsic value of the “gold coin”).
“Metallic theory of money” which proclaims the idea that the purchasing power of one Denarius “gold coin” depends on the intrinsic value the “gold coin” is therefore not applicable to answer the question of “How money is created”!
So far, here’s what we have seen: The proponent of “Metallic Theory of Money” mistakes that money is created to facilitate exchange in system barter as a medium of exchange, so the purchasing power (value) of the money must come from the intrinsic value of the money (i.e. the value of precious metal used to coin it).
So, if money is not created out of system barter as a medium of exchange, how is it created? Here comes a more intuitive theory – “State Theory of Money”.
In this theory, money is created out of the government’s operation instead of the system barter. Here’s an example narrative:
- It starts with the State (i.e. the government), for example: The State wanted to employ citizens to build a team of army for the State.
- As a wage for the citizens who came to join the army, the government did 2 things:
- Select a unit of account; Let’s say the government select “dollar” as unit of account.
- Issue token of liabilities in the selected unit of account to the citizens who came to join the army as wage.
- For example, if the government decided to hire the citizens for army for 50 dollar a month, at the end of every month, the government will issue token of liabilities, on the token, it said something like this: “The State owe you 50 dollar”, verified and stamped by the government to show that it’s really issued by the government.
- The token can be made by precious metal or alloys or just paper as long as it can record how much the state owe you.
- OK! Let’s say the first month after the citizen joined the army, they receive the token of liabilities (in paper) issued by the government saying: “The State owe you 50 dollar”, they’re puzzled and confused: “What can I do with this paper? Can I buy something with this paper? Will people accept this paper as a payment for the goods and services I want?”
- The key question asked by them is this: “Will people accept this paper as a payment? Why people want this piece of paper? What can this paper do? It’s just a paper issued by the government!”
- Yes, indeed, so far, the paper is just a liability of the government to the citizen who joined the army and those citizens cannot buy goods and services because the seller doesn’t accept it for payment because the paper can’t do anything.
- What is the point of paying the soldiers (who worked hard to protect the State) something they can’t use to buy goods and services to survive?
- This would be a SCAM!
- So, the State came out with an idea: A taxation system! The State started to levy tax onto its citizens such as head tax and property tax.
- They State make a hard rule that the citizen can only use the token of liabilities issued by the State to pay for the tax they owe to the State.
- For example, the citizens have to pay for the tax annually and if they fail to do so, it’s considered a serious offence with penalty imposed.
- By making the citizen owe them the taxes from the start, enforcing that the tax can only be paid using the liabilities issued by the government and the penalty imposed if fail to do so, the State has garnered enough incentive for people to start accepting the token of liabilities of the State as a payment for the goods and services they offered.
- This creates demand for the token of liabilities from the State.
- The story becomes: In order to earn the token of liabilities of the State to pay for the taxes, the citizens started to join the army as the State will pay the army using the token. The citizen who doesn’t want to join the army started offering goods and services to the citizens (who joined the army and received the token issued by government) and accept the token of liabilities by the government as a payment so they could get enough to pay for the tax they owe to the government.
- For example, if a citizen owes 10 dollars in tax to the State, he/she has to either join the army to earn enough token of liabilities saying: “The State owe you 10 dollar” to pay the tax or alternatively, he/she can offer goods and services for the citizens who joined the army in exchange for the excess token of liabilities issued saying: “The State owe you 10 dollar” that they possess.
- When the citizen paid the 10 dollars tax he owes to the State at the State office, the citizen hand over the token of liabilities saying “The State owe you 10 dollar” to the officer. The officer then told the citizen: “Now, you’re free. See you next year.”
- The rationale is: The citizen owes the State 10 dollar, the State also owe the citizen 10 dollar (as recorded on the token of liabilities), so the effect is nobody owes anything. The debt is said to be settled.
- The token of liabilities issued by the State is also commonly known as “money” today.
Following this “State Theory of Money”, we can conclude that:
- Money is the token of liabilities from the government who wanted the goods and services from the citizen such as the State want the citizens to serve as the army troop or build buildings for the government etc.
- The State enforce taxation to make its token of liabilities valuable and therefore accepted by the citizen as a payment for goods and services.
- The citizens have to work for the State or produce goods and services to obtain the token of liabilities (money) to pay for tax or to redeem the tax liabilities they owe to the government or else they will face serious penalty.
- Will the State ever run out of money to pay the goods and services the State want to buy? No way! Because the government can issue token of liabilities out of thin air and give it as a payment to the citizen for offering goods and services.
- What happen when the State collapse due to foreign invasion? Foreign troops (The new State) might want the citizen to work for them as well. They pay the citizen who worked for them using their own token of liabilities and enforce tax that must be paid in their token of liabilities.
- Everyone starts to accept the new token of liabilities issued by the new State and reject the ones issued by the collapsed State. The citizen started to ditch the “money” issued by the collapsed State as if it’s a trash (because it can no longer be used to redeem tax liabilities owe to the new State).
- Thus, the value of money depends on the ability of the State to enforce taxation, not its intrinsic value.
- A money is worth 10 dollar not because it’s made up of precious material worth 10 dollar, but because the money can be used to redeem 10 dollar of tax liabilities from the State.
- Comparison of “State Theory of Money” to “Metallic Theory of Money”:
- “Metallic Theory of Money”: Market -> Money -> Government
- Market exists first as system barter, to facilitate exchange, Money is created as a medium of exchange.
- Government stepped in to synchronize economic activity by issuing “standard” money.
- “State Theory of Money”: Government -> Money -> Market
- The government chooses a unit of account and issue token of liabilities (i.e. money) in that unit of account as a payment for goods and services produced by the citizen.
- Government enforce taxation to make people to accept the token of liabilities as payment for goods and services.
- As the citizen starts to offer various goods and services denominated in the unit of account (chosen by the State) to get the token of liabilities they need to pay tax, a market is created.
- “Metallic Theory of Money”: Market -> Money -> Government