Table of Contents

• Introduction
• Understanding Our Current Currency System
• Dollar Pricing in Global Trade
• Treasury Securities: Managing Banking Reserves
• Understanding Inflation in a Fiat System
• Public Money and Private Markets
• The Purpose of Taxes in a Fiat System
• Lessons from the Pandemic Response
• Conclusion
• References

Introduction

After publishing my analysis of how Congressional underspending creates our national debt^[1], I received thoughtful feedback and questions about how government finance actually works in our current monetary system. Today’s U.S. dollar, like most modern currencies, is a fiat currency – its value comes from government policy and legal framework rather than from precious metals or other commodities. Understanding how this system actually operates reveals important insights about government spending, Treasury securities, and their effects on our economy.

Understanding Our Current Currency System

To understand government finance today, we need to first recognize how fundamentally different our current system is from the gold standard era. Under the gold standard, dollars were essentially claim tickets for a specific amount of gold. Government spending was genuinely constrained by gold reserves. But since 1971, our currency has operated entirely differently – the dollar is no longer backed by or convertible to gold or any other commodity^[2].

In our current system, the federal government creates dollars through spending and removes them through taxation. This isn’t a theory – it’s simply how the operational mechanics work. When Congress appropriates spending, the Federal Reserve, acting as the government’s bank, adds dollars to the recipient’s bank account. These new dollars then circulate through the economy.

Dollar Pricing in Global Trade

Our current system creates some unique advantages for the U.S. economy. While many focus on the dollar’s status as a reserve currency, the more practical benefit is that global goods and services are priced in dollars. This eliminates a major challenge that other countries face^[3].

Consider how international trade works: When a business in Thailand wants to buy oil, they first need to obtain dollars since oil is priced in dollars. If their access to dollars is limited, the cost of importing oil rises in their local currency. The U.S., by contrast, simply pays in the currency it creates.

This arrangement allows the United States to run persistent trade deficits without facing the balance of payments problems that might cripple other economies. When we import goods, we pay in dollars that foreign sellers often reinvest in U.S. financial markets, creating a sustainable cycle of trade.

Treasury Securities: Managing Banking Reserves

Treasury securities serve a different purpose than commonly assumed in our fiat currency system. Rather than representing government “borrowing” to fund spending, they help manage reserves in the banking system^[4]. When the government spends, it adds reserves to the banking system. Treasury securities then provide banks and investors with an interest-bearing alternative to holding these reserves.

Think of Treasury securities like a bank CD. When you deposit money in a CD, the bank isn’t “borrowing” because it’s short on funds. Instead, it’s offering you a service – a safe, interest-bearing account. Similarly, when investors buy Treasury securities, they’re choosing a secure, interest-bearing alternative to holding cash. Understanding this reveals why concerns about government “borrowing” misunderstand the actual mechanics of our financial system.

Understanding Inflation in a Fiat System

In our current system, inflation stems from multiple sources that interact in complex ways^[5]. The key factors include:

When we talk about significant government spending, like my hypothetical $100 trillion budget scenario, the inflation risk isn’t about “running out of money.” Instead, it’s about whether the economy has enough real resources – workers, materials, productive capacity – to meet the increased demand. Without adequate resources, prices rise as too many dollars chase too few goods and services.

This understanding helps explain why similar levels of government spending can have different inflationary effects in different circumstances. During the 2008 financial crisis, massive Federal Reserve operations didn’t cause significant consumer price inflation because the economy had substantial unused capacity. The pandemic era saw different results because we faced actual resource constraints in specific sectors.

Public Money and Private Markets

Our financial markets reveal an important dynamic of the fiat currency system: much of today’s stock market wealth stems from government spending flowing through the financial sector^[6]. When the government spends, it creates reserves in the banking system. These reserves often find their way into financial markets, driving up asset prices.

This creates what we might call a “wealth-concentration cycle.” Government spending creates reserves, which flow into financial assets, potentially concentrating wealth among those who already own such assets. However, with proper policy incentives, this process could direct investment toward productive enterprises that benefit the broader economy.

The Purpose of Taxes in a Fiat System

Understanding fiat currency operations fundamentally changes how we should think about taxes. In our current system, federal taxes serve several crucial functions beyond revenue collection^[7]. They help manage inflation by reducing private sector spending power, create broad demand for the currency (since taxes must be paid in dollars), and can influence behavior and redistribute income to achieve social goals.

This differs markedly from state and local governments, which must obtain dollars through taxes or borrowing because they use, rather than issue, the currency. The federal government, as the currency issuer, operates under fundamentally different rules.

Lessons from the Pandemic Response

The COVID-19 pandemic provided an unprecedented test of how our fiat currency system operates under stress^[8]. Despite massive government spending to support the economy, we didn’t see the runaway inflation many predicted. Instead, inflation emerged primarily where real resource constraints appeared – in supply chains, labor markets, and specific sectors with capacity limitations.

This experience demonstrated that inflation in our system relates more to real resource constraints than to the mere quantity of government spending. When markets were effectively nationalized and supply chains disrupted, we saw moderate inflation rather than the hyperinflation many expected.

Conclusion

This deeper understanding of our fiat currency system strengthens and extends my original argument about Congressional underspending. When Congress consistently appropriates less money than needed to operate the government, it creates an artificial scarcity in the banking system’s reserves. The Treasury then issues securities to address this scarcity, providing banks and investors with safe, interest-bearing assets.

Rather than saving taxpayer money, this underspending redirects public resources into the financial sector through interest payments on Treasury securities. It represents a policy choice about how we distribute public financial resources, not a fiscal necessity.

Understanding these mechanics fundamentally changes the questions we should ask about fiscal policy. Instead of “How will we pay for it?” we should ask: “Do we have the real resources to meet our needs?” and “How can we best manage the distributional effects of our spending choices?” Only by understanding how our currency actually works can we make informed decisions about using our public financial system to serve the public good.

References

1. Chevan. (2024). “The U.S. National Debt is Created by Congressional Underspending.” Retrieved from https://chevan.info/the-u-s-national-debt-is-created-by-congressional-underspending/
2. Kelton, S. (2020). The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. Public Affairs.
3. Mitchell, W., Wray, L. R., & Watts, M. (2019). Macroeconomics. Red Globe Press.
4. Bell, S. (2000). “Do Taxes and Bonds Finance Government Spending?” Journal of Economic Issues, 34(3), 603-620.
5. Wray, L. R. (2015). Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems. Palgrave Macmillan.
6. Galbraith, J. K. (2020). “Economics and the Public Purpose.” Challenge, 63(4), 189-205.
7. Tymoigne, É., & Wray, L. R. (2013). Modern Money Theory 101: A Reply to Critics. Levy Economics Institute Working Paper No. 778.
8. Fullwiler, S., Grey, R., & Tankus, N. (2021). “An MMT Response on What Causes Inflation.” Financial Times, March 1, 2021.