Why does the piece of paper in your wallet marked “One Dollar” have value?
Is it because the military tells us it has value? Is it because of our of blind faith in the United States government? Is it because it is backed by gold? Or are we just all lemmings hypnotized by central bankers?
No. All of those are wrong. The dollar doesn’t have value because of coercion, faith, gold backing or hypnotism.
The US dollar has value because it is the only currency the US government accepts to pay your taxes. It is the government’s choice of the unit of account. If you go to the IRS to pay your taxes with bars of gold, bitcoins or Yen, they will tell you to try again. The only thing the government will accept is the US dollar.
As Hyman Minksey said, “Everyone can create money; the problem is to get it accepted.”
The only thing an issuer has to do to get its currency accepted is to take it back for something of value. In the case of the US dollar, the issuer (the US Government) takes back its dollars as payment for your tax obligation.
However, this wasn’t always the case and that’s why countries sometimes fall back on the gold standard. In 1836, after Andrew Jackson killed the Second National Bank of the United States, instead of the US government, many banks issued their own currency. Some of those banks backed their currency with gold, making sure that it had value. Those banks that backed their currency found it was more widely accepted than other banks which did not provide that guarantee.
As long as the issuer redeems its currency for something of value, the currency will be worth something. For example, any corporation can create a currency with gift cards. That Barnes & Noble gift card Aunt Betty gave you for Christmas has value because Barnes & Noble will redeem it for a book. If you don’t want a book, you can exchange the gift card for dollars because Barnes & Noble has promised to honor that gift card, no matter who holds it. Gift cards are a form of currency.
In a similar way, the US dollar has value because the government spends it on goods and services and then demands it back through taxation. The government designates the dollar as the only currency to meet your tax obligation.
The US Dollar is simply a tax credit. You can argue this has no intrinsic value but it does. The government has a claim on your property and income if you don’t meet your tax obligation. If you don’t pay, the government takes your stuff. So a tax is an important tool for the government because it creates demand for its currency.
But taxation is NOT how the government raises money. The government does not have to increase taxes to raise revenues for its spending. Since it is the originator of the currency, it can just print the money when it wants to buy something. And by paying for military defense, economic security, and infrastructure, the government provides value to its citizens.
Taxation can also be used to regulate demand in the economy. If, for instance, unemployment is too high, the government can reduce taxes so that more money stays in the economy. Congress is actually quite good at doing this. President George W Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 to stimulate the economy during a recession and President Barack Obama signed an income tax cut and a payroll tax cut in 2009 and 2010 to help the economy out of The Great Recession. However, when governments increase taxes when citizens don’t have money, they get pissed. In 1991, George H Bush learned this the hard way, when Congress raised taxes while the US was still in a recession.
Likewise, when the economy is strong and the government lowers taxes, it can create inflationary pressure. In the 1980s, Margaret Thatcher’s government reduced top tax rates from 83% to 60% and the basic rate from 33% to 30%. After that large cut, the basic rate was cut in three successive budgets – to 29% in the 1986 budget, 27% in 1987 and to 25% in 1988. The top rate of income tax was cut from 60% to 40% in the 1988 budget (Wikipedia). While it’s a bit of a simplistic comparison since other factors affect the inflation rate, you can clearly see the resultant spike in inflation from each large tax cut. In sum, when the government wants to stimulate demand and increase inflation, it can cut tax rates. And when it wants to dampen demand and decrease inflation, it can raise tax rates.
So despite the fact the government constantly prints money, you don’t have to fret about the value of the currency. As long as the US government efficiently collects taxes in US dollars, you will need to get dollars. Otherwise, you will have your assets repossessed and you will potentially be thrown in jail. And that’s enough motivation for most sane folks to assign value the US dollar.
John McAfee, by the way, is insane.
Note: This post was updated to include the UK tax rate data on July 24th, 2019.