In two recent columns, I discussed two reasons not to worry about the possibility of “defunding” Social Security. First was the unlikelihood of Congress and the President ending Social Security payroll taxes. Second was the option for Congress to fund Social Security directly instead of through a payroll tax.
Several readers were shocked by my statement that Social Security funding could come from general tax revenue, with any shortfall coming from money that the Treasury would “borrow” from the Federal Reserve, which would create (print) the necessary funds.
The federal government has the ability to create as many dollars as it needs because in 1971, under President Nixon, the link between the US dollar and the government’s supply of gold was severed. This gives us a “fiat currency,” which is used as a medium of exchange but has no intrinsic value.
So here is a reality of a fiat money system: taxes are not needed to fund the spending of a currency-issuing country.
This is a confusing concept for any individual, company, city or state. These entities must earn money in some way (wages, sales, or tax revenue) and keep their expenses less than their income in order to remain financially viable.
This is not true of the federal government, which can spend money by creating it. It has no economic need to increase revenue through tax increases before any new spending. That means there is no economic reason for a “pay as you go” budget rule requiring that tax cuts, as well as increases in entitlement and other mandatory spending, must be offset by tax increases or cuts in mandatory spending.
I realize this is potentially a brain twister. I thought the gentleman who first introduced me to this economic principle was certifiably insane. It took a few years of unlearning and relearning for me to finally get it.
When you hear a politician say that we are going to need massive tax increases to pay back the national debt, they clearly don’t understand a fiat-money system. The federal government cannot run out of money and it will always have enough to redeem any dollar denominated bond and pay the interest.
However, the government still must restrain and manage its spending to avoid inflation. The biggest risk of creating currency is the potential for devaluing that currency through inflation.
This risk is higher during times of high employment and production, when creating more dollars can create the three components of inflation: too many dollars, increased demand for goods and services, and no corresponding increase in the available amount of goods and services. During poor economic times, creating more dollars to put people back to work can increase the supply of goods and services as well as the demand. This is less likely to increase inflation.
As the economy improves, higher interest rates and increased taxes can both serve as dampers to inflation. Taxes also serve to significantly influence social policy.
An economy based on fiat currency is often perceived as associated with the left. You are more likely to hear liberal politicians calling for increased spending and conservative politicians warning of deficits and the need to balance the budget.
Yet how a fiat economy works is apolitical. How much the government can afford to spend is separate from what it chooses to spend money on. The ability to create money is not political; deciding how to use that money is very political. The bottom line is that, as long as the three factors of inflation don’t combine, the US has the money to make the political choice to both fund Social Security and eliminate the payroll tax.