Money is Wealth

on Monday, April 25, 2011

Steve Landsburg makes a classic fundamental error in understanding modern currency. He believes that it is literally impossible to tax a man who holds $84 million in his bank account but has no plans to spend the money. Landsburg correctly states that when the government taxes and spends, someone else must own and spend less, but his explanation is about as convoluted as they come. He doesn't understand that money is wealth; it is a financial asset like a stock, bond or IOU from your neighbor. His extrapolations become unnecessary if money is regarded as a financial asset.

There are two ways in which US dollars enter the economy. The first is via bank-lending, in which new dollars are created to finance new bank loans. When a bank makes a loan for a house it creates new dollars "out of thin air," and exchanges them for the ownership of houses and cars. The new dollars are "IOUs" for the houses and cars that are the basis of its loans. It is these forms of wealth that back the US dollar, and most new currency is created in this way. Dollars can always be returned to the issuing bank to take ownership of the "real" wealth that generated the its loans. The dollars are therefore financial assets entitling the owner to take possession of physical wealth at fixed exchange-rates. In this way dollars are no different than gold certificates entitling the bearer to a certain amount of physical gold at a fixed rate.

The other way in which new dollars are created and enter circulation is via "quantitative easing." The Federal Reserve creates new dollars "out of thin air," and exchanges them for real-world assets, but makes no agreements (as banks do) to return the assets to the owners of the new dollars if they return the currency to the Fed. This is analogous to the old banks issuing silver certificate dollars, secretly printing "fake" notes, and spending them. The certificates (and Fed notes) still have real value, because they can be returned to the bank to take ownership of precious metals or homes, but because there are "fake" certificates in circulation, the value of all existing certificates falls when fake notes begin to circulate. If all new dollars were created in this way, they would be worthless, imaginary, and would in no way be considered wealth or a financial asset. 

This fundamental confusion about the assets that back US dollars is common, and makes even people who have the correct ideas regarding taxation and government spending (like Landsburg), to come to some bizarre conclusions about exactly what is happening when government taxes people who are not spending their money. Instead of making the obvious conclusion that it is the rich man who is penalized when the government takes dollars from him, Landsburg is forced to offer a complex solution because he does not believe that US dollars are a form of wealth.