Money, Taxes, and Central Bank – State Mechanisms for Transferring Resources to the Public Sector
This paper examines the roles of money, taxation, and the central bank as integral components of a state mechanism for transferring resources to the public sector. Initially, it explores the origin and development of tax obligations. Subsequently, it analyzes the collaboration between the state, the central bank, and capital markets, before finally discussing the extent to which the state should endeavor to achieve a balanced budget.
The Origins of the Tax Obligation
To fulfill its responsibilities—such as building infrastructure and operating schools, hospitals, police services, and national defense—the state requires a consistent supply of goods and services. The critical question arises as to how the state should procure these resources. Resource provision cannot rely on voluntary contributions but must be mandatory. If contributions to society were voluntary, many individuals would abstain from contributing, believing their individual input to be inconsequential. If many adopt this perspective, society would inevitably face a deficit of necessary resources.
In simpler and smaller societies—such as England following the Roman withdrawal around the end of the 5th century—the need for resource provision was met through direct contributions from inhabitants. The population was required to regularly deliver goods and services in kind to the leadership, functioning as a form of collective contribution. Legal historian Christine Desan (2014) identifies this practice as a precursor to the modern tax obligation—a periodic requirement to deliver goods and services in kind to a community, whether a tribe, feudal society, or, in more modern times, a state. These obligations were to be fulfilled at predetermined dates. However, unexpected and extraordinary demands for resources occasionally arose outside the scheduled due dates, such as urgent military actions in response to sudden external threats, and thus required delivery at times other than those predetermined dates.
At a certain point in time—by Desan referred to as "the money moment"—societal leaders, such as chieftains or feudal lords, recognized that they could accept the delivery of mandatory contributions prior to the due date in exchange for issuing a form of receipt (a physical proof that the obligation was fulfilled, such as a piece of metal, stone, or wood—i.e., a token). At the subsequent due date, the community representative would accept the return of the receipt as settlement for the tax obligation, in place of the goods or services in kind that had already been delivered or rendered.
This receipt established a natural unit of account that was universally recognized within the society. It represented the mandatory contribution to the community, standardized for each societal unit, such as an individual or a family.
Why Accept Fulfilling Obligations to the Community Before the Due Date?
General Overview
Productive assets generate returns over time. Thus, theoretically, an individual should only deliver the present value of a future obligation to the community. If, however, an individual delivers the nominal value of the obligation in advance (i.e., not the discounted present value), the value of a receipt confirming that delivery has been made would only represent the present value (at the time of actual delivery) of the future obligation to deliver goods and services in kind. This present value is often referred to as the receipt's “fiscal value”.
Consequently, for the population to be willing to accept paying the nominal value of their obligation before the due date, the receipt they receive must possess additional value beyond its fiscal value — value that at least compensates for the foregone returns on the delivered contributions up until the due date (i.e., value that corresponds at least to the difference between the nominal value and the fiscal value).
The community leadership could confer such additional value on an issued receipt by accepting it as settlement from any individual with a tax obligation, not solely from the person to whom the receipt was originally issued. This practice effectively would render the receipt valuable to the entire population of the community. Consequently, receipts could be employed as means of payment in transactions between community members. The recipient of the receipt in a transaction between two private parties would recognize that the receipt could be used, either by themselves or others, as settlement for future tax obligations or in other private transactions, and would therefore be willing to accept it as payment for goods or services. In this scenario, the receipts have thus become negotiable instruments, and it is this negotiability that imparts value to the receipt beyond its fiscal value.
Consistent with the this argument, societies began to accept receipts as payment for tax obligations from individuals other than those to whom the receipts were originally issued; that is, the receipts became negotiable instruments.
Consequently, these receipts, by virtue of becoming a means of payment, acquired a liquidity value in addition to their fiscal value. It was this liquidity value—the characteristics associated with money—that motivated the population to forgo the time value (until maturity) of the in-kind contributions rendered before the due date. Since the populace was willing to provide their contributions in advance, it can be inferred that the liquidity value at least corresponded to the difference between the receipt's fiscal value and its nominal value.
By rendering the receipts negotiable, societal leadership gradually found it more appropriate to view a receipt as an independent financial instrument rather than merely a "receipt" for a rendered service or delivered good. The receipts functioned as claims that society issued upon itself, corresponding to the value of the tax liability society held against each individual member. Upon the arrival of the due date, it became more logical to consider the process as a settlement, rather than proof that resources had been delivered at an earlier date: the tax liability was offset against the value of the financial instrument—the receipt—which was then returned, not necessarily by the original recipient.
Both the fiscal value and the liquidity value of the receipt were time-sensitive, but in opposite directions. The discounted value of an obligation to deliver a resource decreases the further in the future the due date of the contribution obligation lies (assuming a given interest rate) and increases as the due date approaches. Conversely, the liquidity value of the receipt is highest at the beginning of the period because the remaining usage period—the duration during which the receipt can provide liquidity services—is then the longest. Receipts with an expiration date will, in theory, be discounted towards the expiration date. However, most societies eventually extended the expiration dates and allowed any issued receipt to be used for any tax or fee. This led to a reduction in the discount rate, and the liquidity value came to remain constant.
The Connection Between Money and Real Resources (Goods and Services)
In a society as previously described, each issued receipt—that is, all means of payment produced—is linked to a specific and already fulfilled delivery of goods and services to the community (or, as we refer to it today, the public sector).
Consequently, the means of payment in such a society are by definition directly tied to a material value—a completed delivery of a certain quantity of goods and/or services to the community. There will never be more means of payment in circulation than what corresponds to the aggregate tax obligation over time. If everyone fulfills their tax obligation in advance, the state will issue receipts equivalent to the tax liability. If no one pays their taxes in advance, the state will not issue any receipts.
The means of payment produced in such a society are all directly connected to a fiscal activity—the provision of resources to society (the public sector/state).
In such a society, there will by definition always be what is referred to as a "balanced budget" in a monetized economy, where the state's "revenues" (mainly taxation) equal the state's "expenditures" (the goods and services supplied to the public sector). Since each unit of the means of payment produced corresponds to an actual delivery of goods and services to the state, in this society the public sector can never operate with a "budget deficit" in the sense that the public sector's "expenditures," or more precisely, use of resources, exceed the public sector's "revenues," that is, tax revenue.
In a society as described above, all resource transfers to the public sector are based on coercion, and the state does not engage in voluntary transactions. As a result, the usual concepts of “expenditures” and “revenues” are not applicable, making the idea of a public sector “budget” largely irrelevant.
Consider the following example:
To provide services to its populace, the leadership requires goods and services totaling 1,000 units to be provided by the population over the course of one calendar year. The obligation to supply these goods and services in kind falls due on December 31 of the relevant year.
There are 100 families in the society and each family unit must deliver goods and services worth 10 units.
10 families choose to settle their obligation ahead of time.
The society's leadership issues 10 receipts, each worth 10 units, to those families who fulfill their obligation ahead of time.
As a result, the society’s money supply now totals 100 units.
If these receipts are negotiable, they can be used in private transactions. A family wishing to avoid delivering goods and services itself can purchase a receipt from a family that has already fulfilled its obligation—perhaps by offering a quantity of grain in exchange. It is this liquidity value of the receipts that motivates some families to render their contributions before the due date.
Those who cannot present a receipt at the due date must deliver real resources to the society's leadership worth 10 units.
In this scenario, the community (represented by the society’s leadership) will always receive 1,000 units in real resources over the course of the calendar year, either before the due date or by the due date at the latest.
If the receipts expire on the due date—meaning they can only be used to fulfill the in-kind obligation due on that day—and all holders act rationally and redeem them, the money supply will drop to zero at the due date. If some holders choose not to redeem their receipts, the community will receive more than 1,000 units of real resources in the relevant tax period. Under rational assumptions, this would occur only if the receipts retain value beyond the due date—for example, if they can be used to fulfill a future tax obligation.
In such a system, each receipt is backed by a distinct and completed delivery of goods or services. Put simply, every receipt corresponds to a concrete in-kind contribution.
In this society, no more receipts are ever issued than the total tax obligation over time. All outstanding receipts represent in-kind goods and services already delivered to the state, meaning the money supply is strictly tied to the scope of the state’s fiscal activities.
In this scenario, it is reasonable to conclude that lower taxes necessarily result in fewer resources for the community. A tax of 1,000 units transfers more resources to the public sector than a tax of 100 units.
In a society where taxes are paid by supplying real resources to the leadership, the volume of resources the state receives is entirely determined—and perfectly correlated—with the tax level. Lower taxes mean fewer resources flow to the state, while higher taxes supply more resources. In this setup, the tax itself represents the real resources acquired by the public sector, and all such transfers occur under coercion rather than voluntary exchange. Consequently, the state’s “budget” is always balanced by definition; there can be no “budget surplus” or “budget deficit” because all resource transfers to the leadership are compulsory rather than transactional.
The Obligation to Deliver Goods and Services in Kind Transforms into an Obligation to Deliver Receipts
Reason for the Change
As society grows, the public sector’s need for real resources increases, both in scope and volume. The government’s demand for these resources also becomes more continuous. As a result, the state must more frequently ask whether individuals are willing to meet their tax obligations (i.e., delivering goods and services in kind) ahead of schedule.
This development results in an increasing share of the public sector’s resources being provided through individuals who choose to fulfill their tax obligations early by delivering goods and services in kind, receiving negotiable receipts in return.
Over time, it becomes evident that only a small portion of the tax obligation is actually met by delivering goods and services in kind at the due date. Instead, most obligations are settled by returning receipts that confirm these resources were previously supplied. As a result, fulfilling tax obligations through direct in-kind delivery at the due date has effectively been abandoned, becoming little more than a formality.
Nevertheless, the tax obligation still fully determines and limits the volume of resources transferred to the public sector—there remains a complete correlation between the tax obligation and the resources delivered. All transfers to the government continue to occur under compulsion (via taxes imposed by the state’s coercive power); however, the timing of when that compulsory transfer takes place has become more flexible.
Given these developments, the government finds it both impractical and unnecessarily restrictive to tie the public sector’s resource supply to a rigidly defined tax obligation—i.e., specifying in advance exactly which resources, in what quantity, must be provided at a specific time. There is a need for a system better suited to societal changes, offering greater flexibility in how resources move from the private sector to the public sector.
At the same time, the government does not wish to abandon the tax obligation as a means of compulsory resource transfer. The exercise of the state’s coercive power should remain a core feature of how resources are directed to the public sector, even as the system evolves to accommodate modern demands.
The question then becomes whether a system can be designed where the tax obligation remains part of the mechanism for transferring resources to the public sector, yet does not cap the total amount of resources transferred. In other words, in a setup where the tax obligation functions as one component in the resource-transfer process, how can we avoid letting the tax requirement itself unduly limit the public sector’s ability to receive additional resources?
The issuance of receipts in transactions with the public is restricted by the tax obligation, because each receipt is directly tied to a specific tax levy on a one-to-one basis. This direct link prevents the public sector from acquiring more real resources through private-sector transactions than the amount set by the tax.
At the same time, these transactions with the private sector involve a voluntary element (early fulfillment), making the negotiable receipts function as independent payment instruments.
Thus, the question arises: Is it necessary to maintain this strict one-to-one relationship between receipt issuance and the tax levy when a system has evolved in which receipts circulate as almost independent means of payment—both accepted by the private sector in “voluntary” transactions with the public sector (since most taxes at the due date are paid back in receipts) and used as a payment instrument within the private sector itself?
As receipts begin to function more like independent payment instruments, with a diminishing connection to their original tax obligation, the state sees a chance to make resource transfers to the public sector more flexible and efficient by eliminating the direct link between issuing receipts and levying taxes. This would allow receipts to be issued without being tied to a specific tax amount.
However, this raises a critical question: Will the private sector continue to accept receipts as payment for goods and services if they no longer formally represent fulfillment of a tax obligation (i.e., the delivery of goods and services in kind)? In other words, if these receipts no longer signify proof of satisfying a tax requirement, why would individuals and businesses still regard them as valid payment instruments?
Without a direct link to the tax obligation, the government could, in principle, issue receipts in any quantity and use them as payment in voluntary transactions with private parties at will. While this flexibility benefits the government, it assumes that private parties remain willing to accept these receipts in exchange for goods and services.
Accordingly, the government recognizes that once receipts are detached from the tax obligation, it must still ensure that the private sector has an incentive to accept them. Even after decoupling from the tax obligation, these receipts must retain value for the private sector.
One way to maintain the private sector’s acceptance of receipts and prevent them from losing value is to make receipts the sole means of settling taxes. In other words, providing real resources directly to the government would no longer be an option. Under this system, the only way to pay taxes would be to return the government’s receipts at specified due dates. As a result, the private sector would be both formally and practically compelled to acquire receipts for tax payments, ensuring at least the level of demand matching the overall tax obligation.
In such a system, the receipts would no longer serve as formal proof of fulfilling a tax obligation in advance; instead, they would function solely as a means of payment. Once decoupled, they effectively become claims on the government, which the government agrees to accept as settlement for future tax liabilities. Paying taxes would therefore amount to offsetting two claims against one another. Consequently, these instruments transform into a pure means of payment, and referring to them as “receipts” in the traditional sense would no longer be accurate.
The Change: Termination of the Obligation to Deliver Goods and services in Kind
The government terminates the arrangement in which tax obligations could be met by delivering a specified amount of goods or services in kind at a predetermined due date. It decides that henceforth, tax obligations can only be settled by delivering receipts (with limited exceptions, such as military service). As a result, these receipts no longer serve as proof of in-kind deliveries; instead, they function purely as payment instruments or claims against the government.
Thus, the formal coercive element associated with the tax obligation shifts:
From an obligation to deliver goods and services in kind;
To an obligation to deliver the government's own negotiable receipts.
By transferring the coercive element of the tax obligation to the delivery of the government's receipts, the government ensures a demand for these receipts that at a minimum corresponds to the tax obligation.
Consequently, the formal coercive element in the tax obligation shifts:
From something the government does not initially possess but seeks to acquire (real resources),
To something the government can create without limit (claims upon itself), which it then uses to procure the real resources ithe public sector lacks.
As outlined earlier, the government initially introduces these new means of payment into circulation by using them to purchase goods and services from the private sector. In doing so, the government establishes a closed loop for its own currency.
This arrangement offers two main advantages for the public sector:
First, the government gains full flexibility to acquire whatever real resources it needs, in any quantity, at any time.
Second, the issuance of these means of payment (formerly "receipts") is no longer directly linked to, and thus not limited by, the taxes levied. The amount of means of payment the state issues when purchasing goods and services does not need to correspond to the amount it ultimately requires in taxes or fees.
As a result, the government’s ability to acquire resources is no longer bound by a predetermined tax obligation. The direct link between taxation and the transfer of resources to the public sector has been broken, allowing the government, in principle, to issue as many claims on itself as it deems necessary.
At this point, only two factors limit the amount of resources the public sector can acquire:
the availability of goods and services, and
the demand for the government's money.
By shifting the coercive element of the tax obligation to the delivery of the government's receipts, the government ensures a demand for these receipts that at a minimum corresponds to the tax obligation.
In this system, it becomes meaningful to talk about the state running a “budget deficit” or “budget surplus,” as well as the public sector having “revenues” and “expenditures.” This shift occurs because the public sector now acquires resources by purchasing goods and services from the private sector in voluntary transactions—instead of through coercion. Consequently, the government can choose to run a “budget deficit” by spending more money (i.e., issuing more means of payment) than it withdraws through taxes
The challenge for the government in this system is to maintain a stable value (for the private sector) of its means of payment. A key question is whether this stability depends solely on the tax burden (i.e., the demand for government-issued currency created by taxes), or whether other factors also help determine its value.
The amount of means of payment in circulation - the Money Supply
With the system restructured so that tax obligations must be settled in the government’s own means of payment, the amount of money in circulation is no longer constrained by the amount of taxes levied. Instead, it is primarily determined by:
Public Purchases: The volume of goods and services the public sector (the society’s leadership) chooses to acquire.
Private Sector Demand: The private sector’s demand for money beyond what the public sector needs. For instance, the private sector can obtain currency by selling metal to the government (e.g., at the mint), which effectively counts as the government purchasing that metal.
Tax Withdrawals: The amount the government removes from circulation via taxes and fees.
A society structured in this manner is often referred to as a “monetized” society.
In monetized societies, the general principle is that anything offered for sale domestically can be bought with the national currency—even if there is no legal requirement to do so in private transactions. As a result, people typically accept more of the national currency than what is needed solely to cover total tax obligations. In other words, the private sector requires liquidity beyond its aggregate tax liability.
The money supply can be increased in response to the population's demand for liquidity in several ways:
Historically (the Middle Ages):
Money was produced in exchange for metal delivered to the mint. People would effectively “buy” currency from the state by giving, for example, 100 grams of silver to the king’s mint and receiving 90 grams in coin form. Because the minting added the king’s stamp, those 90 grams of coined silver were considered as valuable as the 100 grams of raw silverModern Capitalist Systems:
Today, the private sector’s demand for liquidity is met through state-licensed financial institutions—banks and other credit providers—authorized to lend money. Banks base their lending decisions on commercial considerations (a form of credit rationing). When a bank grants a loan, new money is created, and the money supply increases accordingly. Producing deposit money requires no physical resources—only keystrokes on a computer. By extending a loan, the bank acquires a claim on the borrower, while the borrower obtains a corresponding claim on the bank in the form of commercial bank money. In effect, the state has outsourced money creation to licensed financial institutions.
Fulfillment of the Tax Obligation Does Not Transfer Resources to the Public Sector
In a monetized system—where the government can issue its own currency and spend more or less than it collects in taxes—the resources flowing to the public sector no longer hinge on the level of tax revenue. The traditional one-to-one connection between taxes and the issuance of receipts (now money) has been severed. Because the government can purchase goods and services by issuing currency, it does not need to balance its budget in each period; it can spend more than it withdraws in taxes and fees, or it can spend less.
In a monetized society, the government can operate with either budget deficits or surpluses because it acquires resources through voluntary purchases from the private sector rather than through coercive means. Tax collection no longer directly transfers resources to the government; it simply involves returning the government’s own currency—money—to the state. As a result, public resources are supplied not by compulsory in-kind deliveries from every citizen, but through voluntary transactions in which the government buys goods and services from private individuals and businesses.
In a monetized society, the government does not impose taxes to fund its purchases of goods and services. Instead, taxation serves to generate demand for the medium of exchange (claims on the government) that the state offers in return for those goods and services. By issuing its own currency, the government already has access to the means needed to acquire resources; collecting taxes merely reclaims the money (claims) it has already put into circulation.
Consequently, paying taxes in a monetized society does not itself transfer resources from taxpayers to the government. Rather, taxation functions as one element in the method the state uses to obtain resources from the private sector..
In a monetized society, money is not merely a “thing” but a crucial component of the state’s method for securing resources (goods and services) for the public sector. Taxation remains the coercive element in this setup, but instead of requiring in-kind contributions of real resources, it mandates payment in the government’s own currency.
The Purpose of Tax Obligations
In a monetized society, where the compulsory element (coercive aspect) of taxation has shifted from the delivery of real resources to the payment of the government's own means of payment, the tax obligation can also be utilized as a tool to achieve objectives beyond merely creating demand for the government's currency:
Influencing Behavior: Taxes can penalize activities deemed undesirable or encourage more socially beneficial behaviors through tax breaks and incentives.
Promoting Equity: Taxes on wealth, inheritance, and high incomes can address issues of inequality and help redistribute resources.
Combating Inflation: When economic demand exceeds supply, raising taxes withdraws purchasing power from the private sector, reducing inflationary pressure. (Steering towards a stable value of the government's means of payment.)
The Relationship Between Money and Real Resources in a Monetized Economy
A key question in a monetized economy is why a government-issued claim on itself—namely, its own currency—has value when:
The direct connection to the delivery of goods and services has been severed.
Money is not a commodity like gold, which exists in finite quantities. Modern money (fiat money) cannot be redeemed for a commodity such as a precious metal.
Modern “fiat money” is essentially a government-issued, interest-free obligation with no fixed maturity.
Why does the private sector accept this fiat money as a means of payment in transactions among themselves? What underpins the value relationship between the government’s currency and the real goods and services produced by society in a monetized economy? Is the value of money still anchored in material assets—as it was when tax obligations were tied to the delivery of a specific quantity of goods and services in kind—and if so, in what manner?
Some argue that the value of money is no longer tied to physical assets in the way it once was when tax obligations entailed delivering specific quantities of goods and services. Even calling fiat money “debt” may be misleading, because a standard debt claim requires the debtor to pay back something of equal value. In contrast, a holder of a banknote cannot demand from the government anything more than another banknote of the same denomination. Nonetheless, these notes can be used to settle debts to the government, and they function as a medium of exchange in private transactions.
Historically, the physical tokens representing money (often called “a token of money”) were tangible commodities—such as gold coins—that had their own intrinsic value in addition to their function as currency. By contrast, when the physical manifestation of money is just an electronic record (e.g., a bank deposit) or a paper banknote, its worth derives solely from its function as money.
In modern economies, government-issued fiat money is not something the state itself lacks; rather, the state can create as much of it as it wishes—without using external resources—to obtain what it does need: real goods and services.This means the state must ensure that the money it produces holds value for the private sector, encouraging people to accept it in exchange for their goods and services.
Since government-issued fiat money is essentially an interest-free claim on the state with no set maturity date—and cannot be redeemed for anything else—the question arises: Why do people still value it?
Tax Obligations:
Fiat money retains value primarily because taxes and fees can only be paid in the state’s currency. Those who owe obligations to the state must acquire that money, which in turn motivates them to produce goods and services in exchange for it.Acceptance in Exchange:
Once people need the currency to settle obligations to the government, it naturally becomes accepted as a medium of payment in private transactions as well.
In short, the core reason government-issued money holds value in a monetized economy is that it is the only means by which citizens can settle their mandatory obligations (taxes and fees) to the state.
Thus, even in a monetized economy, there is still a link between the monetary unit and the real goods and services produced by society. However, several key differences arise compared to a non-monetized system:
No Fixed Exchange Ratio:
In non-monetized systems, the state directly sets an exchange ratio by requiring payment in a specific quantity of goods and services. In a monetized economy, there is no predetermined ratio between real resources and the monetary unit.Market-Driven Value:
Because the state acquires goods and services through voluntary transactions, supply and demand in the marketplace determine the exchange ratio between money and those goods and services. This establishes the value of the monetary unit through market forces rather than direct government decree.Variable Purchasing Power:
The amount of money needed to buy a given set of goods and services fluctuates according to production costs, availability, and other market dynamics.
In this way, the economic value of the monetary unit remains tied to material resources, but it is primarily the market—rather than the state—that sets the actual exchange ratio.
A stable monetary value gives society the predictability needed for making informed decisions about allocating limited resources. Consequently, in a monetized market economy, the state takes an active role in regulating the value of money rather than leaving it entirely to market forces. Government policies aim to keep money’s value—reflected in general price levels—relatively constant over time, often through inflation targeting.
Historically, until the Bretton Woods system was dissolved in 1971, a key strategy for preserving the currency’s stability involved anchoring it to a specific commodity. Governments tied their currencies to a fixed weight of a precious metal like gold, promising to redeem money for gold at the stated exchange ratio (a less comprehensive version of the system in pre-monetized economies; receipts in exchange for the delivery of goods and services in kind).The idea was that this specific exchange ratio, set by the state, would form a basis for general price formation in society. Under the Bretton Woods agreement established after World War II, several currencies were pegged to the U.S. dollar, which was then linked to gold; however, direct redemption of dollars for gold was not available to everyone, and the system’s exchange rates were upheld largely through capital controls.
Today, most countries no longer set a fixed exchange ratio between money and goods—neither generally, as in pre-monetized societies, nor through precious metals, as was common until 1971. Instead, modern economies rely on pure fiat money, and governments work to maintain its value primarily through monetary policy. This responsibility is typically assigned to independent central banks, which use interest rate adjustments as their principal tool to influence inflation and stabilize the currency.
The Collaboration Between the State, the Central Bank and the Capital Market
Bank of England - the First Modern Central Bank
The first modern central bank, the Bank of England, was established in 1694 through a compromise between the English monarch and the business community.
This compromise was driven by two primary factors:
Insufficient Money Supply:
During the 16th and 17th centuries, the English economy faced a persistent shortage of coins. The limited circulation of coins was inadequate to satisfy the business community's growing demand for money. This issue is explored in greater detail under point A below.Rise of Credit Networks:
The chronic money shortage led to the development of various credit networks over the same period. These networks began to challenge the King's exclusive control over coin production. The implications of this challenge are discussed further under point B below.
A. Insufficient Money Supply in the English Economy
During the 16th and 17th centuries, the prevailing belief in England was that money served as a means of payment primarily because it possessed intrinsic value—substantive worth inherent to the material itself. In transactions, money was perceived to hold the same intrinsic value as the goods being purchased. This perspective, often referred to as the "Aristotelian" view of money, treated money as a liquid commodity exchanged for other goods of equal value. Precious metals naturally fit this role due to their inherent value, ease of transport, and durability, making them the dominant standard for monetary transactions.
However, the availability of precious metals was severely limited both within England and globally. The inflexible assumption that money must consist of or contain precious metals resulted in a chronic shortage of money in England’s rapidly expanding economy. In the latter half of the 16th century, for example, the demand for money in England rose by nearly 500%, whereas the supply increased by only about 60% (Wennerlind, 2011).
Private credit networks emerged as one way to address this shortfall, relying on personal agreements to extend credit. Yet these instruments were not widely circulated and could not serve as a complete replacement for physical currency. Moreover, England’s legal system at the time was not sufficiently equipped to handle greater negotiability of debt instruments, limiting the overall effectiveness of these private credit solutions.
Overall, this persistent shortage of money constrained economic growth in England throughout the 16th century and significant portions of the 17th century. The limited supply of currency made it difficult for businesses and individuals to engage in smooth transactions, constraining both economic expansion and overall efficiency.
As the 17th century progressed, the problem became so severe that the English government established various commissions to investigate the causes of the shortage and propose solutions. Most of these committees concluded that, under the assumption money had to consist of or include precious metals, the most straightforward way to increase the national money supply was to bring more gold and silver into England. They advocated maximizing exports while minimizing imports to achieve a positive trade balance, which would result in a net inflow of metallic coins. Some more unconventional proposals even suggested exploring alchemy as a way to boost precious metal supplies.
Surprisingly, England’s chronic money shortage was not resolved by an increased supply of gold and silver but rather by a shift in how people understood the nature of money.
Over the latter half of the 17th century, the perception of money gradually changed. Instead of viewing money as a commodity with intrinsic value, people began to see it primarily as credit—an immaterial concept—with coins functioning merely as physical symbols of this credit. In other words, coins were seen as “tokens” representing a claim, rather than possessing inherent worth themselves. It remains unclear whether the growth of credit networks during this period caused this new understanding of money or was simply a result of it.
Under this new perspective, metallic coins no longer constituted money in and of themselves. Rather, they were viewed as tangible representations of money—a means of transferring claims, or credit, between legal entities. In this way, England effectively returned to an older notion of money, reminiscent of primitive societies where receipts documented a community member’s claims on its leadership, as described earlier.
This new understanding of money cleared the path for non-metallic forms of currency. Although gold and silver had long served as its physical embodiments, the idea that money is essentially credit indicated that other tangible items could also function as means of payment, provided they were backed by solid collateral. Under this interpretation, coinage was explained by the fact that gold and silver acted as collateral for the credit represented by coins. The gap between a coin’s monetary value and the value of its metal content underscored that money’s worth extended beyond the metal itself.
This raised the question of what could serve as suitable collateral for credit money—a topic that became the subject of intense debate. Some argued that it had to be property-based, while others believed collateral need not be explicitly or formally documented. Certain theorists stressed the significance of the borrower’s (issuer’s) character and ethics in securing credit money, whereas others contended that a strong, well-organized state with an efficient tax system could provide the legitimacy and security needed to back its own credit money.
During the latter half of the 17th century, multiple proposals emerged regarding how credit money could be used in general circulation. One of these proposals directly led to the founding of the Bank of England in 1694.
B. The King's Monopoly on Coin Production, the State's Means of Payment, Was Challenged
A key factor driving the establishment of the Bank of England was the challenge to the King’s exclusive right to produce coins, which had long served as a core aspect of state authority. Severe shortages of metallic coins compelled European merchants, including the English, to seek alternative payment methods based on credit, such as bills of exchange. Over time, some trading houses evolved into proto-banks, issuing loans through these new instruments—often called “credit money.” Initially, these loans were extended primarily among merchants, but eventually states also tapped into these credit networks. Within these networks, credit money proved far more efficient than the King’s coins:
Resource Constraints on Coin Production
Producing coins required precious metals, which were in limited supply. Consequently, the number of coins in circulation could not keep up with the growing needs of the English economy. It was therefore difficult for the state to mint enough coins to meet its resource demands, including financing wars.Risk of Crowding Out
The state’s demand for coins could drive up their price (i.e., raise interest rates) and limit credit for the private sector. In a system where only metal-backed coins served as legal payment, the finite supply meant the state’s demand could “crowd out” private borrowing, hindering economic growth and financial flexibility.Inefficiency of Coins
Coins were heavy to transport and costly to store, making transactions cumbersome—especially for large or frequent exchanges.Advantages of Credit Money
In contrast, the credit money created by the business community was intangible and relied on social relationships, where creditors held claims on debtors. Because it could be “created out of thin air” through credit issuance, it wasn’t constrained by limited physical resources. This flexibility made credit money more practical and scalable for transactions both within and beyond established trading networks
Consequently, the modern payment technologies developed by the business community posed a threat to the authority of the state, which still relied on the more cumbersome system of coinage. At the same time, these new payment methods likely contributed to shifting perceptions of what money truly is, as discussed in point A (or they may have arisen in response to that changing perception).
However, credit money within the business community had limited reach. It was not accepted outside their networks, its negotiability was uncertain, and it could not be used to settle obligations such as taxes and fees owed to the state. An alliance with the King or the state—by having the King “put his stamp” on credit money—could reinforce and extend its circulation, making it generally acceptable within the state’s borders and usable for paying taxes and fees.
The agreement between the King and the business community allowed a privately owned bank—run by members of the business sector—to issue banknotes (credit money) in the King’s name. In return, the bank pledged to finance the King and, by extension, the English state. This arrangement transformed the bank into a “bank of issue,” granting it the authority to circulate notes representing claims on itself, all denominated in the King’s currency and functioning as promissory notes.
This new system marked a sharp break from the centuries-old practice in which the state minted coins by having the public provide precious metals to the royal mint in exchange for officially stamped coins. The state profited from “seigniorage,” the difference between the face value of the coins and the actual value of the metals they contained. Essentially, once stamped with state authority, the coins were worth more than their raw metal content.
Under this new system, the roles were reversed: the state began paying for money rather than producing it. Instead of minting more coins to fund its activities, the English king borrowed money and paid interest on these loans. The central bank served as the lender, issuing banknotes as the money lent. These loans, along with accrued interest, were repaid through tax revenues. This change enabled the state to utilize a more flexible and scalable form of money, making it easier to finance its activities and reducing its reliance on limited precious metal supplies.
The king no longer produced money; the central bank now held that exclusive authority. Its decision to extend credit to the state depended on the state’s ability to service and repay the debt with future tax revenues—effectively letting the state use the future value of taxes in the present.
Initially, the central bank provided these loans in the form of short-term claims on itself—specifically, “notes” and “bills” (banknotes). These banknotes entitled their holders to redeem them in specie (coins), which formed the central bank’s reserves supplied by its investors. The state then used these banknotes to cover public expenses.
The private sector accepted these banknotes because the state, in turn, accepted the same banknotes to settle tax obligations. This mutual acceptance created a circulation system where the central bank’s banknotes held a central role. Additionally, there was a legal limit on the number of banknotes that could be issued, ensuring controlled expansion of the money supply.
This arrangement laid the groundwork for modern national debt. The state could use the banknotes either to pay interest and principal on its loans from the central bank or to cover public expenses. Consequently, the central bank’s banknotes gained a pivotal role in the financial system, setting the stage for how national debt mechanisms would evolve.
The value of these new banknotes depended on a functioning framework of public monetary expenditure (the issuance of banknotes) and taxation (the withdrawal of banknotes). This structure provided the legitimacy and public confidence needed for the banknotes to be trusted and considered valuable—reflecting the very trust underpinning today’s central bank money. However, unlike then, modern central banks are owned by the state and are not subject to a legal limit on how much money they can create. Instead, they regulate the money supply according to legal mandates (e.g., inflation targets).
The first loan extended by the English central bank to the state amounted to £1,200,000 and has never been fully repaid. Whenever the principal on a central bank loan remains outstanding, it effectively increases the money supply; conversely, repaying the principal decreases the money supply—a principle that still applies in modern monetary systems.
This 1694 compromise is widely regarded as the origin of the current relationship among the state, the central bank, and the capital market in most Western democracies. It established the foundation for the value of modern money.
Today's Collaboration Between the Central Bank, the State and the Capital Markets
In the current system, the state typically borrows money from the capital markets (by issuing bonds), rather than borrowing directly from the central bank. The central bank acts as a facilitator in this process by organizing and administering bond auctions. While banks are the primary purchasers of government bonds, insurance companies and pension funds also participate. The state borrows central bank money in electronic form, and both the state and financial institutions hold accounts at the central bank to conduct these transactions.
A key assumption in today’s collaboration between the state, the central bank, and banks is that banks—an integral part of the financial system—will purchase the government bonds being issued, despite the absence of a formal requirement to do so. The central bank provides banks with sufficient reserves to buy these bonds by lending them central bank reserves. Consequently, it can be argued that the central bank effectively lends money to the state—both by ensuring banks have adequate reserves to purchase the bonds and by later repurchasing a large portion of government bonds from banks and other holders. In other words, the central bank does not finance the state directly but does so indirectly through the banking system. The purpose of using the capital market in this way is to obtain market-based pricing of the national debt and thereby maintain confidence in the overall system.
Banks’ and other financial institutions’ willingness to buy government bonds rests on the assumption that such bonds constitute a secure investment and that government policies, including public spending, will not undermine their value—i.e., will not cause excessive inflation. This assumption mirrors the public’s view in 1694 at the founding of the Bank of England, when its banknotes were considered valuable because there was predictability in how many notes were issued and how many were withdrawn from circulation.
The Norwegian Central Bank (Norges Bank) and the Norwegian State
Under the current Norwegian Central Bank Act, Norges Bank is generally prohibited from extending direct credit to the state—a rule introduced in 2003. Before then, Norges Bank did play a significant role in directly financing state activities. From 1977 onward, the central bank’s financing of the state was outlined each year in conjunction with the national budget, and this practice continued until the first half of 1984, at which point it was no longer deemed necessary (NOU 2017:13, Section 21.4 “Credit to the State,” pp. 316–319).
The purpose of the 2003 restriction was to strengthen public confidence in Norges Bank’s conduct of monetary policy. When the legislation was passed, the Ministry of Finance noted that debt management would not be adversely affected because Norges Bank could still be authorized to trade in the state’s own holdings of government securities—meaning it can only purchase government bonds in the secondary market.
Under today’s system for borrowing in Norwegian kroner:
Norges Bank lends central bank reserves to commercial banks by crediting the banks’ accounts at Norges Bank.
The banks then use these reserves to purchase government bonds, transferring the reserves to the state’s account at Norges Bank.
The banks subsequently sell the government bonds back to Norges Bank, receiving central bank reserves in return (and can then repay the loans from Norges Bank).
As a result, the state’s account at Norges Bank is credited with central bank reserves equal to the loan amount, while Norges Bank holds a corresponding claim on the state in the form of government bonds.
Many observers view this as Norges Bank indirectly financing the state, with the capital market serving as an intermediary that ensures the state’s debt is priced on a market basis.
(Article 123 of the EU Treaty similarly prohibits the European Central Bank (ECB) and national central banks in EU member states from extending direct credit to their respective governments.)
From Full Reserve Banking to Fractional Reserve Banking, the Gold Standard and Fiat Money
When the English central bank was founded, its investors were required to contribute capital (“specie”—coins and certain other assets) that fully covered the principal of the loans it issued. In essence, the bank was meant to serve purely as an intermediary, channeling capital from investors to borrowers.
Over time, however, the bank was permitted to reduce the proportion of capital it held relative to the loans it made. It became necessary to cover only a certain percentage of each loan with contributed capital—a practice known as “fractional reserve banking”, in contrast to the original “full reserve banking” model.
Later, under the gold standard, the central bank’s money was tied to gold, meaning it could be redeemed in gold at a fixed exchange ratio. Rather than having to hold a certain amount of capital in coins and other assets, the bank was now required to maintain a specified quantity of gold (“gold as fractional reserve”) in relation to its outstanding loans.
With the collapse of the Bretton Woods system in 1971, the gold standard was abandoned and fiat money was introduced. No longer constrained by precious metal reserves, governments could potentially print unlimited money (“monetary financing”) to fund expenditures, with the central bank expanding its balance sheet each time the state borrowed more (Wolf, 2020). Today, the only real check on this activity is the bond market’s perception of whether government actions will erode the currency’s value through inflation. If investors believe that the government’s monetary and fiscal policies could lead to high inflation—or that future interest obligations might become unmanageable—they may demand higher interest rates or refuse to buy new government bonds.
Thus, the requirement that only the capital markets can purchase new bonds directly from the state functions as a restraint on government spending in a fiat money regime. Since neither fractional reserve requirements nor a gold standard limits how much money can be created, it is largely investors’ inflation expectations—their assessment of whether government policies will cause inflation and decrease the real value of bonds—that determine whether the bonds are viewed as a stable investment.
If the cooperation among the state, the central bank, and the capital market is to thrive under the current fiat money system, low and stable inflation must remain a credible goal. Should the markets lose confidence in the government’s fiscal policies or the central bank’s ability to control inflation, they will demand higher interest rates for government bonds or may decline to purchase them altogether (cf. the Liss Truss incident). As with the founding of the English central bank in 1694, credibility and public trust in the system are paramount—particularly the central bank’s credibility in managing inflation.
The Appropriate Money Supply and National Debt—A Question for Professional Economists?
Today, governments, capital markets, and central banks generally hold that matters concerning the size of the national debt and the appropriate money supply can be addressed objectively by professional economists, rather than through political debate. In line with this perspective, most modern central banks have been granted formal independence from their respective governments to bolster their credibility. This independence signals to external observers that central banks are guided by economic expertise rather than political interests.
From a political standpoint, central banks (and governments) now view money as a neutral tool for managing real economic variables, such as unemployment, interest rates, and inflation. These variables are assumed to have a “natural” level—one that brings the economy into equilibrium.
In many ways, ensuring that the public also sees money as a neutral coordinating mechanism is important for maintaining effective control over government spending. When the state is no longer constrained by a gold standard, it becomes more politically feasible to justify restrictive monetary policies if they are framed as necessary for maintaining this assumed equilibrium in the economy.
Most central banks currently strive to keep inflation within a range of about 2 to 4 percent, using interest rate policies to influence the demand for money and keep inflation in check.
Should the State Strive for a Balanced Budget?
Money, as discussed earlier, can be viewed as a social technology created by the state to transfer resources to itself. Establishing the central bank was one step in putting this strategy into practice, and taxation’s primary role is to generate demand for the state’s currency. This raises a key question: How much money can be injected into the economy—beyond what is withdrawn through taxes and central bank operations—without harming the economy or eroding the value of its currency?
When the first modern central bank was founded in 1694, it extended credit to the state based on the state’s ability to repay that debt through future tax revenues. In today’s world of fiat money, we must ask whether this principle still applies—and if so, what exactly it means in our current economic context. Should the amount of money the state injects into the economy (its expenditures) be matched by the amount it withdraws through taxation (its revenues), resulting in a balanced budget? Or is the relationship between government spending and tax revenue more complex than that?
The State Needs Real Resources (Not Money)
Because the state issues its own currency, it can, in principle, create as much money as it chooses (assuming a fiat currency and a floating exchange rate). Therefore, a state can never truly run out of its own currency. It can always “afford” to buy anything sold in its currency and can always settle obligations in that currency. Creating national fiat money does not require real resources—only a few keystrokes at the central bank. While central banks are organized as separate legal entities, they are effectively part of the state and will, in practice, always ensure that the state’s account at the central bank has sufficient reserves.
Thus, money itself is not something the state must acquire from others (the private sector). What the state actually needs are real resources. Put differently, money is not a commodity or a tangible item but rather a method or technology the state uses to access the resources—goods and services—it requires.
When the state spends money, it does not deplete a finite resource. This principle applies in today’s fiat system, where states use pure fiat money that is not tied to real resources, and where the means of payment itself is not linked to any physical asset. In earlier eras, when both the monetary unit and the means of payment were linked to real resources—through a fixed exchange rate between the unit of currency and a precious metal, and through coins made of that metal—conditions were quite different.
The State's Use of Money as an Exercise of Coercive Power
The state’s use of money is essentially part of its coercive authority, albeit in a less overt and more complex way than if taxes were paid directly in the form of real resources delivered to the public sector. This also applies when the state “borrows” money, since the state itself produces the very thing it is borrowing—namely, money.
Therefore, when the state uses fiat money, it does not surrender any resources. Rather, real resources move from the private sector to the state through the state’s monopoly on coercion, enabled by the technology called "money," which incorporates tax obligations that must be settled in the state's currency.
From the state’s perspective, transactions between the public sector and private sector (money exchanged for real resources) are essentially one-sided. Despite appearances of reciprocity (the state appears to give money while the private sector provides goods and services), the flow of resources is fundamentally from the private sector to the state, compelled by governmental authority.
As a result, public expenditure does not require “financing” in the way the term is used in the private sector. When the state spends money, it is not funded by tax revenues; nor is it “financed” by borrowing or central bank money creation. In reality, state spending is an exercise of governmental coercive power. Even when the state issues government bonds, it is not borrowing in the ordinary sense, because what the state is effectively borrowing are claims on itself.
In contrast, when the private sector spends money, it is using a resource from its own perspective. Unlike the state, the private sector does not create its own money, so it must acquire money from others before it can spend. Consequently, the private sector must finance its expenditures. It does this by selling goods and services to the state or to other private entities. As a result, private actors—households and businesses—have less money (and thus fewer resources) after they spend. Money is therefore limited for the private sector but not for the state. Private actors can indeed run out of money and must, over time, balance their budgets. Money is an asset for the private sector but not for the state; to the state, money is a technology or method underpinned by governmental authority.
Because money is not a limited resource for the state, it does not rely on taxes to finance its spending. Taxpayers do not fund the public sector; rather, the private sector depends on the state’s money to pay taxes and fees. The state’s coercive power forms the basis of the financial system and allows it to function.
Tax revenues, therefore, do not finance the state’s monetary spending. In a well-known interview on 60 Minutes in 2009, Ben Bernanke was asked, “Is that tax money the Fed is spending?” and replied, “It’s not tax money. We simply use the computer to mark up the account.” Essentially, the state creates its own money as needed.
From this perspective, there is no requirement—unlike in a household or business budget—for the amount of money the state injects into the economy to match what it takes out in taxes and fees, because taxes do not fund the state. The real limitation is not the risk of running out of money, but rather the possibility of undermining the effectiveness of money as a tool (and, of course, the availability of real goods and services in the economy).
Thus, the central question becomes how the state should optimize its use of money. There is broad agreement that, for state-issued money to work well as a unit of account, medium of exchange, and store of value, the private sector must view money as a scarce good with a stable value over time (relative to goods and services). However, opinions differ about how the state should maintain this stability. For instance, how long can the state run deficits (where its spending exceeds its tax revenues), and how large can the national debt grow before confidence in the value of money is eroded?
Public Budgets as a Tool to Inject Money into or Withdraw Money from the Private Sector
Public budgets can be viewed as an instrument that the state employs to either inject money into the private sector or withdraw money from it:
Budget Deficit: When the state runs a deficit, it injects more money into the private sector than it withdraws.
Budget Surplus: When the state runs a surplus, it withdraws more money from the private sector than it injects.
Neither of these outcomes is inherently good or bad; what matters is how they affect the overall economy. The state needs to calibrate its monetary spending and tax collection (including fees) to balance the economy. Depending on the situation, this might require a deficit, a balanced budget, or a surplus.
(As noted before, a balanced budget is essential only for those who are strictly money users—not producers—such as the private sector. Unlike the state, households and businesses must acquire money from others before spending. Over time, they face bankruptcy if they spend more money than they earn.)
When the primary goal is a balanced economy rather than a balanced budget, the question becomes: Which principles and operational targets should guide the public sector in managing its budgets?
The overarching role of the state is to safeguard society’s interests. Its key responsibilities include:
Developing and Operating Infrastructure:
Schools, healthcare, law enforcement, defense, courts, and more.Ensuring Full Employment:
Enabling anyone who wishes to work to find employment.Promoting Fair Wealth Distribution:
Striving for a reasonably equitable distribution of societal prosperity.Maintaining Price Stability:
Keeping inflation low and stable, so that the currency’s purchasing power remains relatively constant over time.
In this context, public budgets should serve as a tool to achieve these objectives.
Even though, in theory, a government faces no financial limits on how much money it can spend, there are clear constraints on what it can and should do. Every economy has an “internal speed limit” determined by its productive resources—technology, labor (both quantity and quality), machinery, factories, natural resources, and so forth. If the government demands too many resources when the economy is already operating at full capacity, prices will rise more than desired. Moreover, the state depends on public confidence in the legitimacy of its financial system, which further restricts how much the government can spend.
During a recession, when the economy has significant idle capacity—evidenced by high unemployment and weak private-sector demand—the government should reduce taxes to boost private purchasing power and/or increase public spending. By running a budget deficit, the government injects net money into the private sector, thereby strengthening overall demand.
Conversely, in a boom where capacity utilization is nearly maxed out and inflation becomes a threat, the government can scale back public consumption and/or raise taxes to lower purchasing power and cool demand. If the government needs resources during a boom yet wants to prevent inflation, it can raise taxes to reduce private-sector demand. In other words, the state might run a budget surplus, withdrawing money from the private sector.
A budget deficit by itself does not prove that the state is spending too much. Inflation is the real sign of overspending, while unemployment suggests underspending. Many believe that inflation is purely a monetary phenomenon—often called “monetarism”—which posits that an increase in the amount of money chasing a fixed supply of goods and services inevitably leads to higher prices. Consequently, monetarists are wary of government budget deficits, even during downturns. (The principle behind the Bank of England’s initial provision of credit to the state in 1694 can be seen as an early expression of monetarist thinking.)
History suggests that increasing the money supply when there is slack in the economy does not necessarily lead to inflation or erode confidence in a state’s finances (New York Times, 2020). For instance, after the financial crisis in 2008, the Federal Reserve, the European Central Bank (ECB), and the Bank of Japan injected huge amounts of money into their economies without triggering inflation. Between 1913 and 2008, the Federal Reserve gradually expanded the money supply from $5 billion to $847 billion. In the period from late 2008 to early 2010, the Fed raised the money supply by $1.2 trillion—more than doubling the amount of central bank money in circulation (Leonard, 2022)—yet inflation, as measured by the U.S. Consumer Price Index, did not ensue in the American economy.
However, since the end of the pandemic, the United States and other countries have experienced a surge in inflation, which some attribute to the large increase in the money supply since COVID-19 began (New York Times, 2022), and in particular to how that money was distributed (i.e., direct transfers to the private sector). Others believe the inflation is primarily due to supply constraints caused by the pandemic.
When assessing the effect of an increased money supply on the economy, it is essential to consider where the extra money ends up. If, for example, the additional money remains in bank reserves at the central bank and does not boost lending, it will likely have little impact on prices. However, if the extra money goes directly into the private sector—through public projects or increased subsidies (or if banks do indeed lend more)—prices are more likely to be affected. This direct approach was taken in the United States during the pandemic, and prices have risen significantly over a sustained period. Although inflation has eased from its peak, the long-term impact remains uncertain. It is not yet clear whether the surge in inflation in the U.S. and Europe is a temporary trend or if the expansion of the money supply during COVID-19 effectively surpassed the economy’s “internal speed limit,” suggesting more persistent inflationary pressures.
It is also worth noting that since 1776, the United States has run budget deficits and carried a growing national debt almost without exception—yet this has not undermined its economy or the value of the dollar.
The Crowding-Out Argument Does Not Apply in a Fiat System
A common objection to budget deficits is that they supposedly “crowd out” private-sector activity. This argument assumes there is a fixed pool of savings in society that both the government and private sector draw upon for loans. If the government taps into this limited supply of savings to cover a budget deficit, the reasoning goes, there will be fewer savings left for the private sector. As a result, interest rates rise, some private-sector projects become unprofitable, and investment falls—ultimately reducing society’s capital stock, productivity, and overall prosperity.
However, this viewpoint hinges on the idea that the state, like any private entity, is merely a user of money and that money itself is a finite commodity. Such was indeed the case when the Bank of England was established and was required to hold 100% backing for its banknotes in coins and other assets. But as fractional reserve banking emerged, and especially once economies shifted to modern fiat money, this argument no longer holds. In today’s system, banks do not simply lend out accumulated deposits; rather, they create new money when issuing loans.
Modern states issue national fiat currencies and do not need to obtain them from a third party before spending—that is, the state does not need to finance its spending of money beyond instructing the central bank to facilitate the issuance of government bonds. As previously described, this is essentially an indirect method for the central bank to provide central bank reserves to the state. The state's expenditure of money fundamentally requires only a budgetary decision, and the money supply increases to the extent that the central bank credits the banks' accounts to ensure they can purchase government bonds. Therefore, the crowding-out argument does not hold in a fiat money system with a national currency.
When the state runs a budget deficit in an economy with national fiat money, the effect is actually the opposite of what the crowding-out theory suggests—the state injects more money into the economy (the private sector) than it withdraws through taxation. The larger the budget deficit, the more the banks' reserves at the central bank increase. For example, if the state spends 100 units of currency and collects 90 in taxes, it has net injected 10 into the economy (and the banks' central bank reserves increase by 10). If the state borrows 10 from the private sector to achieve a balanced budget, it merely withdraws from the economy the 10 that were not collected through taxation. The banks' central bank reserves then decrease by 10, returning to the same level as before the budget deficit. Thus, even if the government borrows from the private sector to finance a deficit, the total amount of money in the private sector is not diminished; the injection of money into the private sector is neutralized.
In short, under a fiat money regime with a sovereign national currency, the crowding-out argument—which presumes a fixed pool of savings—is no longer valid.
The State Borrows Money to Manage Interest Rates, Not to Finance Public Expenditures
When the state issues government bonds, one way to view this is that it trades interest-free, perpetual debt (denominated in its own currency) for interest-bearing claims with fixed maturities in the same currency. From the standpoint of bond purchasers—mainly banks and other financial institutions—this process is akin to moving money from a “checking account” at the central bank to a “savings account” with the state.
Thus, when the state “borrows” to cover a budget deficit (the gap between its spending and tax revenues), it is not truly financing the deficit in the conventional sense. Instead, the state is pulling back the extra liquidity injected into the economy that was not collected through taxes. Its real aim in “borrowing” is to prevent the interest rate from dropping below the central bank’s target.
If the state continued running deficits without offsetting the injected money—meaning the central bank’s balance sheet expanded accordingly—the interbank interest rate would drift toward zero. Such a scenario would likely be seen as illegitimate and might erode market confidence in the state’s economic management.
For this reason, describing the process as the state “borrowing” money is somewhat misleading; it is more accurately an instrument for managing interest rates than a way of financing public expenditures.
Government Debt Is Not Like Other Debt
A frequently cited concern regarding budget deficits and the resulting government debt is that we are borrowing from future generations, imposing a financial burden on them. However, government debt is not the same as regular debt. In practice, it is a record of how much money the state has injected into the economy without reclaiming it through taxes and fees. As noted earlier, the state does not require tax revenue to repay debt denominated in its own currency. Taxes and fees do not finance the repayment of government debt.
Put simply, all the government “owes” to its creditors is an entry in an account statement. The government could, if it wished, repay all of its debt instantly without anyone becoming poorer or richer. Owners of government bonds would essentially swap an interest-bearing claim on the state (denominated in the state’s currency) for an interest-free, non-maturing claim on the state (e.g., reserves at the central bank, or bank deposits in a commercial bank) in the same currency.
Thus, government debt does not necessarily impoverish future generations. On the contrary, budget deficits and government debt can benefit them if the state uses its money effectively—by, for instance, investing in infrastructure or education. Indeed, in the United States, budget deficits and rising government debt over more than two centuries do not seem to have burdened future generations or diminished their prosperity. Rather, the standard of living has risen alongside growth in government debt.
Accordingly, one could argue that government “debt” in its own fiat currency should not be referred to as “debt” at all, but rather regarded as part of the overall money supply..
References
Desan, C. (2014). Making Money: Coin, Currency, and the Coming of Capitalism. Oxford University Press.
Leonard, C. (2022). The Lords of Easy Money. (1st edition). Simon & Schuster
Wennerlind, C. (2011). Casualties of Credit: The English Financial Revolution 1620 – 1720 (1st edition). Harvard University Press.
Wolf, M. (2020). Monetary financing demands careful and sober management. Financial Times. 9 April 2020
New York Times, 2020; https://www.nytimes.com/2021/12/03/opinion/inflation-friedman-money-supply.html
New York Times, 2022; https://www.nytimes.com/2022/01/12/opinion/rising-federal-debt.html?searchResultPosition=1
