One premise that has guided governments since the dawn of Economics is that they must gather tax revenue from people in order to have money to spend.
The basis for this premise was simple. Wealth was created through the acquisition of valuables such as gold. Initially gold itself and subsequently paper instruments that denoted the exact amount of gold that one held, was used as currency to carry out commerce. And since such acquisition and exchange of valuables was done by private individuals, all that the government could do was to enforce its power and “tax” individuals to give up a part of their earnings. People paid the tax because the government used some of it to provide security and infrastructure like roads. But mostly they paid out of fear because the king or ruler could get very nasty if they didn’t pay up.
This system worked very well until the governments found that they could dilute the amount of gold they held against the paper currency they issued, without the people being any the wiser. And soon they did away with the gold altogether and said the paper currency would be just that – paper. But because everybody used it in commerce it continued to be legal tender.
This was a huge revolution in the money system. The fact that a sovereign government could just issue currency and it would work just as well as currency backed by gold. Termed “fiat currency”, what made this kind of money work was its acceptance by citizens. When governments issue currency to their people, the people do not stop and ask “Does my government have the power or the legitimacy to issue these?” They simply use it to buy the goods or services they need. The value of the currency is what is printed on the paper.
The unseen revolution brought about by this fiat currency was that the government could quite simply create any amount of money it wanted. All its developmental and welfare programs could be funded by just “creating” money. It no longer had to ask or force its citizens to give it gold or money backed by gold. It was the controller of money.
But the problem was that there was no revolution in the minds of economists and they continued to believe that the government had to tax people in order to gather funds. They continued to advise governments on how to maximize tax revenue and how to be prudent with expenses. This was the primary reason why countries continued to remain poor. When sovereign countries across the world could create money in order to spur the productive activities of their people and thereby create wealth, the economists advised that the governments must instead concentrate on balancing their revenue budgets and not spend on welfare.
For the first time in history countries had a system to get out of poverty and economists by their short-sightedness kept them poor.
It is only lately that some economists began to realize that if the sovereign government had the power to print or create money they could do just that. They did not need to tax and gather funds first. This realization is now creating a revolution not just in the economics of poor countries but also in the way rich countries act when they get into trouble. The Quantitative Easing program adopted by the US after the mortgage and banking crash of 2008 is a prime example. When liquidity dried up with banks refusing to lend, the US government simply created tons of money and calibrated the system again.
But if governments didn’t need to tax in order to gather money, then why tax at all? The answer is simple. As the government creates money to ensure liquidity in the system, the production of goods and services catches up to this liquidity only with a lag. In other words, in the short term there is more liquidity compared to actual goods and services in the economy causing what is well known as “inflation”. In order to cool down this inflation the government needs to levy taxes so that the excess liquidity can be sucked out and prices can be maintained at a stable level, until production catches up with demand and with the liquidity in the system.
This Modern Money Theory is a revolutionary concept in economics that is only now beginning to be understood across the world.