History

You can look on Michael Hudson's website for more info but here is a short summary in his own words.

Basically by eliminating the gold standard and ensuring that the US dollar became the international reserve currency and currency of trade, the demand for USD grew such that the US could finance itself and it's growing military presence through the sale of Treasury securities to other sovereign nations.

Essentially, the contemporary hegemony of the United States is founded on a "free lunch" to use Hudson's words, and this lunch is paid for by anyone wishing to trade with the US dollar. (which has basically been all international trade in the last 50 years but most notably the oil trade)

Sorry this is a bit late but I spent hours on it. Also I haven’t got the time to proofread/edit so it may read a bit clunky, but I hope the basic concepts are well conveyed.

To understand the power of fiat currency, we first need to understand how gold standard and fixed currency exchange work first, and their relations to government financing and taxation.

Note that I am greatly simplifying here to make the concepts as accessible as possible, so bear in mind I am omitting many of the nuances and that the technical details are more complicated than laid out here, but the principles stay the same regardless.

—— Gold standard

Before WWII, gold standard was widely used for very simple reasons: everyone agrees that the gold is a stable and valuable metal, and by fixing the currency a government issues to the value of gold, it allows the adoption of the currency because the users always have the peace of mind that you can always exchange the papers in your hand into gold, as it was a promise by the currency issuer (the treasury of the government).

Now, there are limitations when you peg your currency to a metal like gold. First, you need to make sure that you have enough gold reserves before you can issue a certain amount of your currency. If you issue more money that you have the gold for, you wouldn’t be able to keep your promise of exchanging them if everyone comes for the gold (especially when they think the exchange rate is overvalued), so you will either have to devalue your currency, or stop issuing more money. Or, if the government cannot keep its promise, it will have to default.

This is where taxation comes in. You see, let’s say you want to build a hospital that costs $5 billion. To hire all the contracting companies and the workers, and pay for the raw materials and resources, you have to inject $5 billion into the economy to pay them all. Here’s the problem: you are increasing the total number of currency in the circulation, but if you have not been expanding your gold reserve to accommodate that extra spending, you will now have an economy with oversupply of money - that means either devaluation, or you have to take some money out of the circulation.

So how do you do that? It’s called taxation, you tax the people so you remove $5 billion from the economy. This is where the notion that government spending needs to tax before they can spend comes from. But really, the essence here is not that the government needs your money - the government was the one who issues the money in the first place, why would they need your money to spend? The real reason is that they needed to take the money out from the circulation in order to make sure that the money supply stays constant.

Another way is for the government to issue bonds. Bonds work exactly like a certificate of deposit, you “lend” the government some money, and they promise to repay you with interests in the future. This works exactly the same way as taxes, by taking money out of the circulation, with the exception that you don’t lose your money, you simply “lend” it to the government for safekeeping so you cannot spend them in the meantime. When the bond matures, you get it back with interests. This is where the myth of national debt comes from - it’s not really that the government needs to borrow from its people to spend, the real purpose is to take money out of the circulation so, once again, the money supply stays constant.

So, there is a limitation on how much the government can spend its money at any given time when the currency is pegged to gold/another currency. You either have to build up reserves (that means exporting stuff to other countries, at the cost of your labor and resources that could have been better spent at home, for example), or you borrow (which makes you indebted to another country/foreign institution), or you increase taxes/issue bonds (higher taxes! national debt goes up!).

—— Bretton Woods

After WWII, European economy was essentially ruined. The British Empire went bankrupt. So, if you are one of those European country trying to rebuild from the destruction of war, how do you convince your people to use your francs, your marks, your sterlings, your liras? You have no economy, your currencies are worthless.

So all of the Western nations came together in 1944 and said, hey, why don’t we all peg our currencies to the US dollar, which itself was pegged to the gold? Surely this will stabilize the currencies and their exchange rates, and give people the confidence to adopt our currencies, and everything will work smoothly, right?

This was the Bretton Woods system. Pretty soon, many of these countries started to feel the limitations just like when it was under the gold standard, except this time they need to accumulate US dollars as their reserves. They have limited fiscal space to operate unless they build up their reserves, so that means export your goods to the Americans to earn their sweet dollars. Or borrow. Or raise taxes. That means everyone has to work harder, sacrifice more. The governments cannot really issue too much money to invest in large scale projects unless they have a certain amount of reserves.

This would precipitate in the fall of the Bretton Woods system. In the 1960s, the US became embroiled in the Vietnam War. The US government spent so much on military in Vietnam that an abundance of US dollars ended up in French Indochina banks in Southeast Asia (Michael Hudson said about one ton of copper per American soldier for its ammunitions). All those dollars were remitted back to France’s central bank because they didn’t know what to do with them.

It became clear by the late 60s that there is no way that there are enough gold reserves in the US to sustain such excessive US military spending in Vietnam. So the French, who had accumulated an oversupply of dollars in their central bank, began to demand the US to pay them in gold instead. The dollars are junk, they now want the gold - the real stuff. Nixon basically replied “lol, no” and ended the Bretton Woods in 1971 abruptly, in what is known as Nixon Shock. The French didn’t get their gold, obviously.

—— Fiat era

Nixon Shock sent the world into panic. What do you mean we can’t peg our currencies to dollar anymore? Who would want to use such currencies? Strangely enough, people started to realize that economies actually don’t crash when the currencies are not pegged to anything. Yes there was the inflation and the oil crisis in the 1970s, but there weren’t any catastrophic disaster as people had thought. We have now entered the fiat era, in which currencies are not determined by the value of a metal, or another currency.

America has accidentally discovered the power of fiat currency, not by choice, but by the circumstances forced on to it.

How does the currency gain its value then? It’s actually very simple: it’s the very act of taxation.

Very important note: we’re not talking about the amount of taxes you pay/the government collected, we’re talking about the act of taxation itself.

Let’s say the government wants to build a hospital (again), it needs to hire labor and those labor need resources and raw materials to build the hospital (assuming the resources and technology are obtainable domestically, and not imported). The government issues the money to pay for all these: labor and resources. But who would want to sell their labor for the government?

However, if the government now requires you to pay taxes every year, in the specified currency that they issue, now the situation becomes very different for most people. You now need to earn that currency in order to pay your taxes, and to earn that currency, you need to sell something to obtain that currency. Your labor, goods and services, whatever. The most direct way is to sell it to the government, but you can also get it from people who had earned those from the government. Whichever way, the very act of taxation itself drives the value of the currency, and suddenly the entire population of the country adopts that currency as their medium of transaction.

Note again: this still does not mean the government need your tax money to spend! It simply means that the coercion from taxation forces you to sell your labor and resources to earn the currency that the government then issues.

The advantage of fiat currency here is that the government is no longer limited in its spending by having to accumulate certain reserves anymore. In other words, the government spending is not limited by the taxes they collected, but the availability of labor, resources and technology. You can definitely build a dozen hospitals that benefit an entire population of the country so long as you have the manpower and resources that can be sourced domestically. For imported goods and services and technology, yes, you still need to trade with other countries to earn the foreign reserves to import stuff from overseas, but for anything else that is sold in your local currency, the government spending has no limit on that as long as the labor and productive capacity are not already maxed out.

As such, lot of the legacies in finance and banking from the gold standard and the Bretton Woods era are no longer required for actual banking operations these days, for example, monetary policy controlling interest rates is merely tools to prevent the overnight policy rate between bank reserves to be driven towards 0%. It’s fully co-opted by the neoliberals to push for austerity, nothing to do with the actual spending of the government, or used for “curbing inflation” as neoliberal economists like to espouse. Taxes (where is the money going to come from?) and national debt became tools of the neoliberals to institute austerity that impoverish the people.

(continued next post)