When the government needs more money than it collects, it has three options by which to get its hands on additional moneys. It can borrow from lenders abroad, borrow from its own citizens or it can print the money. As always, however, there are advantages and disadvantages associated with each option but the purpose of this discussion is not to survey all these. Rather, it is to look at the effect that each option may have on the generations to come given that they will be affected by the decisions taken today.
To be clear what is involved here, we must understand that when the government borrows, it does so in the name of all the people under its jurisdiction. Therefore, while the lenders may differ from time to time, the borrowers remain one and the same. They are the people who live in the jurisdiction today and those who will inherit the place and make it their home tomorrow. So then, what will be the effect of today’s decisions on these people?
First option: When a government borrows from abroad to finance its current operations, to pay the interest on loans taken earlier, to redeem notes that have matured or to do all of the above, such government acquires a liability that will most likely last a long time. As a result, future generations will be saddled with a financial burden that will restrain their development at a time when many others, including the lenders, will most certainly be progressing.
Second option: When a government borrows from its own citizens, it widens the gap between those that have much and those that have little. This is because those that have much do most of the lending. The principal of the money remains intact because what is lent to the government remains the most secure loan in the jurisdiction. And to it will be added the interest which the government will pay out from taxes imposed on everyone, including the have not. Moreover, when the government borrows, it competes for the available funds, pushing the interest rates higher and hurting everyone in the process.
Third option: When the government prints money, it dilutes the value of the currency and makes everyone suffer as a result. These are the citizens who live in the jurisdiction and the foreigners who hold the currency but live abroad. Everyone pays the price, pays it in full and pays it now but that will be the total effect of this option because what is handed to future generations will only be a devalued currency and no obligation. However, as we shall see in a minute, a condition must be fulfilled for things to unfold smoothly and make this option the best one to take.
Before we go with this discussion to another level, we must develop an understanding of the concept of money. However, instead of giving a formal, dictionary-like definition of the word, I shall give a definition that highlights the relationship which exists between money and economic activity because the purpose of money is to facilitate these activities. And the best way to do this is to tell a story, so here is one.
Surrounded by subsistence farmers like yourself, you are a peasant living with your family on a plot of land in a far off kingdom. Since no one can grow the variety of the all the foods that a family needs, you each specialize in a limited number of items and you exchange among yourselves that which you have in surplus for that which you do not have. This is called barter.
One day, you realize that you need to establish a standard that will give your barter consistency, predictability and fairness. Since butter is the most cherished item of all, you make a pound of butter the unit against which the value of everything else is measured. Thus, if a goat is deemed to be worth the equivalent of 25 pounds of butter, and a cow the equivalent of 75 pounds, you exchange with your neighbor one cow for 3 goats, and so on.
Years later, commerce grows in your neighborhood so much that it outgrows the system of exchange you have enjoyed up to now. You are no longer satisfied with the fact that the items you wish to exchange are not always available at your closest of neighbors, that all the items do not come in season at the same time and that your needs vary depending on the composition of each family and the preferences of its members. Therefore, you decide to upgrade the system of exchange so as to make it more flexible and more universal.
At first, you and your fellow citizens of the neighborhood give each other personal IOUs that can later be exchanged for what you will need rather than barter on the spot what you have at the moment. Of course, for this to happen you must be trusting of each other, which you do, because you are neighbors.
But as you widen the neighborhood, new people who are mostly strangers to you, come into your sphere and make commerce even more complex. You set up a bank that prints the IOUs, a move that renders them even more impersonal. From now on the bank guarantees the IOUs, heretofore called banknotes, and the trust which used to exist between individuals now exists between the bearer of the notes and the bank itself. Welcome to the world of financial modernity.
The notes take on the name of money and those who have it can buy from anyone, do so anywhere in the jurisdiction and do it throughout the year. Appropriately enough, the unit of this money is called the "Pound" as in a pound of butter, it is printed in several denominations and minted in fractions thereof. Your system of exchange has now reached maximum flexibility as well as maximum universality. Welcome to the world of financial heartaches.
Now this question: Since trust is at the basis of the ancient IOUs and the modern money, what happens if someone learns to print exact counterfeits of the bank notes? Well, you must be aware that such acts do exist, that they create problems of trust but that the authorities take measures to guard against them.
This is reassuring but the reality is that the system may grow so complex it runs the risk of operating more on counterfeit money than real money without anyone noticing the transformation. This can happen, oddly enough, because of something called credit which comes from the Latin word meaning trust. And this word was chosen because to give someone credit is the same as to advance them money based on trust alone. What follows are two stories that further illustrate this point.
When in a small town the breadwinner of a family falls ill and stays out of work for a while, the store owners extend credit to the family so that they receive the goods and services to which they were accustomed. The courtesy is maintained until the breadwinner gets well and goes back to work. No IOU or banknote is printed or given out here but money is created nevertheless because trust was extended to be exchanged for goods and services as if money was used to complete the transaction.
Similarly, when in a big city, a jobber ships a million dollars worth of goods to a department store and sends an invoice to be paid in 30 or 60 days, the jobber trusts that the store will pay the money in due course. The invoice itself is not money but the trust that the seller exhibits in the buyer’s ability and willingness to pay constitutes the creation of new money. Some people prefer to call it liquidity but it is money by another name.
Thus, trust which is an elastic emotion varying in size with the amount of goodwill that exists inside an economic jurisdiction, is the currency by which the modern system of finance is made to work. And the more trust there is among the public, the more credit there will be in circulation. But like real money, an abundance of credit can cause the value of goods and services to rise thus forcing the stock of the companies producing them to inflate. And when things go too far in this direction, they create economic bubbles that end up in a burst.
The first casualty resulting from this development is the widespread loss of trust. To overcome it, the central bank and the treasury flood the system with real money, each using the tools available to it. If, instead of borrowing money, the government chooses to print it, one of two things will result: Either the government will drain the system of the excess liquidity it has created which will bode well for the economy or it will continue to print money which will have the effect of counterfeiting it. And this will trigger a hyperinflation and the inevitable economic collapse.
Thus, while the third option is the best one to take because it does not involve paying interest, its success rests on draining the money from the system once the emergency for which it was printed no longer exists. The trouble is that without the restraint of having to pay the money back and pay it with interest, the door is flung wide open for the politicians to keep printing money like counterfeit artists. And so the onus will be on the public to put pressure on the politicians to prevent them from turning the country into another Zimbabwe.