The Power of Money

money power

Money is obviously a vital part of an economy because it allows trade to occur more efficiently. Governments have a great power that no one else in the economy has—the ability to print money. Thus, the government can acquire more goods by printing more money, a process known as seigniorage. This power, however, brings with it a dangerous temptation. Imagine that you had this power; just think of what you could do with it! You could live a great life, feed the hungry and house the homeless. And all of this could be achieved simply by printing more money. This sounds wonderful. How can it be dangerous?

If the government prints too much money, people who sell things for money raise the prices for their goods, services and labor. This lowers the purchasing power and value of the money being printed. In fact, if the government prints too much money, the money becomes worthless. We have seen many governments give in to this temptation, and the result is a hyperinflation. Hyperinflations were observed in the 20th century in Germany (twice), Hungary, Ecuador, Bolivia and Peru, with Zimbabwe as the most recent casualty. Such episodes of high inflation can greatly impair the functioning of the economy or collapse it altogether. Thus, having the power to print money brings with it great responsibility to respect that power.

It is important to remember that the temptation to print money is not restricted to less-developed countries. In fact, the United States has suffered from high inflation several times. In pre-revolutionary days, many colonies had the right to print money and fell prey to their own excesses. The Continental Congress did the same during the Revolutionary War. In 1775, it gave the colonies the authority to issue Continental dollars to finance the war. Overissuance and counterfeiting by the British led to such dramatic increases in paper currency that by 1779, the value of a Continental dollar was 1/25th of its original value (giving rise to the phrase "not worth a continental"). During the Civil War, the Confederate government also succumbed to the temptation of printing money to buy goods. From 1861 to 1864, the stock of Confederate dollars increased 10-fold, and prices increased the same. Financing government spending via the printing press also occurred in the 20th century. Shortly after the founding of the Federal Reserve, the U.S. Treasury adopted policies that induced the Fed to monetize government debt.1 This led to a spike in U.S. inflation following World War I. These examples show that the U.S. government has a history of resorting to the printing press to pay for government expenditures.

Most governments have taken steps to discipline themselves and impose restraints on their ability to print money to pay for goods. A time-honored method of restraint was to tie the value of the currency to a commodity such as gold. Because the government did not control gold production, the amount of money it could print was limited by its holdings of gold. Although this restrained the government's ability to create seigniorage, it also unfortunately tied its hands during periods of high demand for currency, such as financial crises (a time in which people wanted to hold the government's currency rather than other assets) or during planting season (a time in which farmers needed cash to pay for seed, etc.). Other problems also occurred: New gold discoveries, such as during the California gold rush, led to an inflow of gold and new currency issue, which caused inflation. Conversely, if the economy grew faster than the supply of gold, then prices of goods and services would fall, leading to deflation. Finally, it is very costly to mine gold simply to hold it in storage to back up pieces of paper money. For these reasons and others, governments began to realize that using a gold standard to control the nation's money supply was too restrictive and costly.

As a result, governments slowly moved to a fiat currency system, one in which the money was not backed by a commodity but rather by the "full faith and credit" of the government. Under such a system, the government promises its citizens that it will discipline itself and not resort to seigniorage to finance government spending. In short, citizens have to trust that the government will do the right thing. But trust can be abused; therefore, the citizenry demanded institutional arrangements that backed up the government's pledge.

That is why most governments took steps to tie their own hands and make themselves credible stewards of their nation's economic interests. It became very clear that if elected government officials had direct control of the money supply, then they could cut taxes and print money to pay for goods to win votes. Consequently, promises by elected officials would not be seen as credible. To achieve credibility and avoid this abuse of public power for private gain, the control of the money supply had to be delegated to a nonelected group of individuals. These officials were to run the institution responsible for monetary policy, known as the "central bank." It was important that central bankers be independent of the political process to ensure that they could not be manipulated by elected officials. However, having such great power meant that central bankers had to be accountable to the electorate in some fashion, and accountability required the central bank to behave in a transparent manner. Thus a well-designed central bank needed to be 1) credible, 2) independent, 3) accountable and 4) transparent.

Endnote

1. Monetizing debt means the government borrows money to buy goods and then repays its debt by printing more money. This is equivalent to simply printing money in the first place to buy goods. [back to text]