Currency Issuing Governments Finance Themselves

There have been a lot of stories in the media around the debt and the ‘cost’ future generations will bear as a result of the spending required during the covid-19 crisis.

Each and everyone of these sports the same neoliberal garbage that taxes need to rise and suggest tax changes that work in favour of capital. Some more left leaning economist state things like we will to ‘invest’, in a financial sense, as a nation and ‘value add’ to our exports or we ‘borrow against future productive capacity’. This language is tied up in the neoliberal assumption governments need to find tax dollars in order to spend or need bond markets to borrow from.

For reasons perhaps of ignorance, it appears financial commentators haven’t yet grasped there have been different types of currency systems. There has been a gold standard, a system of fixed exchange rates, and fiat currencies, the latter of which we operate under today.

There were a number of economists during the mid-twentieth century that expressed under a fiat currency we were not restricted by tax collection. The below is a quote by Chairman of the NY Federal Reserve in an article from the American Affairs Journal.

The necessity for a government to be prepared to tax in order to maintain both its independence and its solvency still holds true for state and local governments, but it is no longer true for most national governments. Two changes of the greatest consequence have occurred in the last twenty-five years which have altered the position of the national state with respect to the financing of its requirements. The first of these changes is the gaining of vast new experience in the management of central banks. The second change is the elimination, for domestic purposes, of the convertibility of the currency into gold or into any other commodity.

Ruml, B. The New Economic Insight, American Affairs Journal 1950

Under a gold standard governments promised gold in exchange for their currencies. The standard was adopted by the UK in 1844 and was the system used up until WWI. Countries would express the ‘value’ of their currencies in terms of gold. $1 may equal 30 grams of gold. The monetary authority could set it at whatever it liked. Domestically it needed to ensure sufficient gold reserves to back the currency in circulation.

It was the principle method for making international payments. Trade deficit countries would have to ship gold to trade surplus countries.

Say NZ ran a current account deficit against Australia. NZ would literally ship the equivalent gold on ships to the surplus country. This would have effects on the money supply expanding (without an increase in productive capacity) and the loss of gold reserves for the trade deficit country would force a country to withdraw currency domestically (decrease spending/increase taxes) which is deflationary and cause unemployment and falling output.

The economist Bill Mitchell described the system as such

This inflow of gold would allow the Australian government to expand the money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the AUD in terms of grains of gold. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.

From the New Zealand perspective, the loss of gold reserves to Australia forced their Government to withdraw paper currency which was deflationary – rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

During the gold standard era countries balanced their external account (trade or what call today the current account) to maintain their gold reserves. In the meantime trade deficit countries experienced domestic sessions and rising unemployment.

WWI interrupted in the gold standard and currencies were valued at whatever each country wanted to set it at. Some tried a return to the gold standard – some floated their currencies – the USA had a floating exchange rate in 1945 before deciding to go with the Bretton Woods System in 1946.

After the WWII (where countries abandoned the gold standard) Western countries formed the International Monetary Fund and created the Bretton Woods System.

This was a system of fixed exchange rates. Rather than convert directly to gold, countries converted their currencies to US dollars and the US government would convert $USD35 to an ounce of gold.

This was the nominal anchor for an exchange rate system. Countries would then build up USD reserves. If running trade deficits, they would intervene in foreign exchange markets to ensure their currency remained at the agreed parity (running down US dollar reserves) Other options would be to reduce imports (usually via tax cuts/decreased public expenditure to cut spending), increase exports (a loss of a real good or service) or alter monetary policy (interest rates) to attract foreign investment.

Monterey policy was about helping target the agreed exchange parity. It meant fiscal policy (in contrast to a fiat currency) was more restricted.

The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).

This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.

So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.

Let’s take a step back in time and look at the history of The Bank of England. This was the world’s first central bank. Created in 1694 . The BoE website says

The Bank of England began as a private bank that would act as a banker to the Government. It was primarily founded to fund the war effort against France. The King and Queen of the time, William and Mary, were two of the original stockholders.

One could make the assumption the reason for private bankers holding shares in that original entity was to profit every time the government spent. There would be an accounting arrangement whereby the Treasury issued gilts (we call them bonds, treasuries or securities) the BoE would hand over £ and the bankers in turn would ‘own’ the government debt collecting the repayments. The bank was always governed under Government legislation and it was nationalised (removing the private stock holders) in 1946.

Pre-1844 any private bank could issue their own banknotes. Customers would deposit gold in a private bank and receive a ‘note’ that specified the amount. It was until 1725 that the BoE began to issue their own partially notes for amounts of £20 and upwards. These partially printed notes increased in denominations of £10, up to £90 and a bank cashier could increase the value of the note in writing by a maximum of £9 19s 11d

For the uninformed there were 12d to a shilling and 20s to the pound. You could further divide pence into farthings and there were 4 farthings to the pence. For the sake of staging it the (d) symbol for pence comes from the Roman ‘denarius’ a coin used in the Roman Empire.

Up until 1844 private banks had the ability to issue their own notes. The Bank of England began to open its own branches in 1826 as a result of banking crisis in the 1820’s that saw many country and provincial banks fail. The BoE website states:

One of the main reasons for establishing branch banks was to enable us to take further control of the banknote circulation, in order to prevent another crisis.

One of the main reasons for establishing branch banks was to enable us to take further control of the banknote circulation, in order to prevent another crisis.

In 1844 (the formalisation of the gold standard) the UK Parliament introduced The Bank Charter Act which formalised the issuance of banknotes in the UK. It started to place restrictions on private banks issuing their own notes and stopped new banks from issuing their own notes.

In 1931 the BoE suspended the the Gold standard as confidence collapsed as a result of the depression, the Bank lost much of its reserves. The simplest way to spend when you don’t have gold in a currency system backed by gold is to remove the gold standard.

Governments that issue their own currency have always been able to finance themselves, even under a gold standard. Over the period of WWI the BoE issued war bonds to ‘finance’ the war. The public didn’t buy enough war bonds and the BoE used its own gold reserves to purchase treasury war bonds. I suppose this was to remain the rouse that governments are ‘borrowing’

In January 1915, the Treasury prohibited the issue of any new private securities without clearance, and UK investors were banned from buying most new securities (Morgan (1952)).  As the war dragged on, and capital became increasingly crucial to the Allies, the net would tighten further. And this episode was to be the first of several instances during the war where the Bank used its own reserves to provide needed capital.

Over the period 1797 – 1821 the UK entered a period known as ‘The Restriction’ As a result of the panic over the war there was a rush on withdrawals of gold and the BoE reserves depleted by £14 million. They suspended the convertibility of gold as they entered a war with France.

To try to preserve the already depleted gold reserves, the Prime Minster, William Pitt the Younger, placed a Privy Council Order on the Bank of England, ordering it to stop paying notes in gold.

The power of the state by legislation ended a system that restricted supply of currency to gold and by legislative fiat they had a free floating exchange rate giving them the capability to invest in their productive capacity. In this case to fund war efforts against Napoleon.

A fiat currency is a currency that a government issues is not convertible (to gold) and floats it on foreign exchange markets.

The float allows a government to target domestic policies such as full employment without the need to worry about ensuring the exchange rate remains at an agreed parity. It means rather than needing to find foreign currency to purchase back its own currency to defend the exchange rate, it is the exchange rate that takes the hit. It means it doesn’t need to ensure gold reserves to the currency in circulation.

The modern fiat currencies began when Nixon ended the Bretton Woods System in 1971 and no longer promised gold in exchange for US dollars. Australia floated its dollar in 1983.

You can appreciate that under previous regimes like the gold standard, taxation ensured the spending the government did was offset to ensure the currency in circulation was in line with the supply of gold. Under a fiat currency the obligation to watch a gold supply is no longer there. The government can purchase whatever is for sale in the currency it issues. There is no need to find gold.

These types of monetary regimes are different. There is no point applying ‘gold-standard/fixed exchange rate’ thinking to a modern day fiat currency. Under a fiat currency a governments limit to spending is limited by the available real resources. There is no need to defend an exchange rate or maintain a gold supply.


Over the 19th century The British Government (through its agent the BoE) started to crack down on private note issuance (under a gold standard) to stop prevent financial crisis. Similar things where done in the USA and Australia to ensure ‘integrity’ of the financial system. It was the nation state that held power (and still does) not the financial sector and private bankers.

Australia used its wartime powers to establish a central bank and forced financial institues to hold exchange settlement accounts with the Commonwealth Bank (and in 1959 handed the role over the newly created Reserve Bank of Australia) This allowed the Commonwealth Government to have control of monetary policy (the overnight interest rate).

Broadly speaking we can divide monetary systems into two types

  1. Gold standard/fixed exchange rates – where governments promise a commodity (such as gold) for a fixed value or they agree to maintain a particular exchange rate. These systems place institutional restrictions on governments spending because they have agreed or promised gold or a foreign currency in exchange for their currency of issue.
  2. Fiat currencies – these allow governments to spend up to the productive capacity of the economy.

Today treasury departments have accounts with their central bank. There is usually an institutionalised accounting arrangement where by when the government taxes the equivalent tax collection is marked up in the ‘offical account’ if the account is short a department within treasury will auction bonds to make up the difference between what it has taxed and what it has spent. However, bonds can only be purchased with reserves which are the result of previous deficits.

The flow (deficit) is then represented as a stock (debt). Under current institutionalised arrangements you can view the debt as every dollar that has been spent and not taxed back. It is the savings of the non-government sector.

The British government through this crisis has done away with the bond market and have used Ways and Means facility (W&M)

The Ways and Means (W&M) facility functions as the government’s overdraft account with the Bank of England (the Bank), i.e. the facility which enables sterling cash advances from the Bank to the government.

Sovereign currency issuing governments would all have overdraft facilities with their central banks. But why go through the rouse of pretending a currency issuer needs to find funds. Combine the operations of the central bank and treasury and credit the relevant bank account and do away with the bond market all together. All reserves within the financial system are a result of government deficit spending as it is. Why hand out corporate welfare?

Hopefully this little bit of history can help you understand how different currency systems operate and see that the a currency issuing Government can do away with the bond market all together.

© Jengis 2020

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