Banking: Money Creation as a Method of Taxation (Keynes)

Money creation as a method of taxation 
(From: A Tract on Monetary Reform, J.M.Keynes, 1923, pp. 41 ss.)

[Taking due note that the below "government" must today be read as "central bank" for paper money, and "commercial bank" for the electronic money creation. Now you will understand how hypocrite is when a central banker speak about fiscal policies not being his responsibility....]

   A government can live for a long time, even the German government or the Russian government, by printing paper money. That is to say, it can by this means secure the command over real resources, resources just as real as those obtained by taxation. The method is condemned, but its efficacy, up to a point, must be admitted. A government can live by this means when it can live by no other. It is the form of taxation which the public find hardest to evade and even the weakest government can enforce, when it can enforce nothing else. Of this character have been the progressive and catastrophic inflations practised in Central and Eastern Europe, as distinguished from the limited and oscillatory inflations, experienced for example in Great Britain and the United States, which have been examined in the preceding chapter. The quantity theory of money states that the amount of cash which the community requires, assuming certain habits of business and of banking to be established, and assuming also a given level and distribution of wealth, depends on the level of prices. If the consumption and production of actual goods are unaltered but prices and wages are doubled, then twice as much cash as before is required to do the business. The truth of this, properly explained and qualified, it is foolish to deny. The theory infers from this that the aggregate real value of all the paper money in circulation remains more or less the same, irrespective of the number of units of it in circulation, provided the habits and prosperity of the people are not changed—i.e. the community retains in the shape of cash the command over a more or less constant amount of real wealth, which is the same thing as to say that the total quantity of money in circulation has a more or less fixed purchasing power.

   Let us suppose that there are in circulation 9 million currency notes, and that they have altogether a value equivalent to 36 million gold dollars. Suppose that the government prints a further 3 million notes, so that the amount of currency is now 12 million; then, in accordance with the above theory, the 12 million notes are still only equivalent to $36 million. In the first state of affairs, therefore, each note = $4, and in the second state of affairs each note = $3. Consequently the 9 million notes originally held by the public are now worth $27 million instead of $36 million, and the 3 million notes newly issued by the government are worth $9 million. Thus by the process of printing the additional notes the government [the central bank or the commercial bank] has transferred from the public to itself an amount of resources equal to $9 million, just as successfully as if it had raised this sum in taxation.

   On whom has the tax fallen ? Clearly on the holders of the original 9 million notes, whose notes are now worth 25 per cent less than they were before. The inflation has amounted to a tax of 25 per cent on all holders of notes in proportion to their holdings. The burden of the tax is well spread, cannot be evaded, costs nothing to collect, and falls, in a rough sort of way, in proportion to the wealth of the victim. No wonder its superficial advantages have attracted Ministers of Finance.

   Temporarily, the yield of the tax is even a little better for the government than by the above calculation. For the new notes can be passed off at first at the same value as though there were still only 9 million notes altogether. It is only after the new notes get into circulation and people begin to spend them that they realise that the notes are worth less than before.

   What is there to prevent the government from repeating this process over and over again ! The reader must observe that the aggregate note issue is still worth $36 million. If, therefore, the government now prints a further 4 million notes, there will be 16 million notes altogether, which by the same argument as before are worth $2.25 each instead of $3, and by issuing the 4 million notes the government has, just as before, transferred an amount of resources equal to $9 million from the public to itself. The holders of notes have again suffered a tax of 25 per cent in proportion to their holdings.

   Like other forms of taxation, these exactions, if overdone and out of proportion to the wealth of the community, must diminish its prosperity and lower its standards, so that at the lower standard of life the aggregate value of the currency may fall and still be enough to go round. But this effect cannot interfere very much with the efficacy of taxing by inflation. Even if the aggregate real value of the currency falls for these reasons to a half or two-thirds of what it was before, which represents a tremendous lowering of the standards of life, this only means that the quantity of notes which the government must issue in order to obtain a given result must be raised proportionately. It remains true that by this means the government can still secure for itself a large share of the available surplus of the community.

   Has the public in the last resort no remedy, no means of protecting itself against these ingenious depredations ? It has only one remedy—to change its habits in the use of money. The initial assumption on which our argument rested was that the community did not change its habits in the use of money.

  Experience shows that the public generally is very slow to grasp the situation and embrace the remedy. Indeed, at first there may be a change of habit in the wrong direction, which actually facilitates the government's operations. The public is so much accustomed to thinking of money as the ultimate standard, that, when prices begin to rise, believing that the rise must be temporary, they tend to hoard their money and to postpone purchases, with the result that they hold in monetary form a larger aggregate of real value than before. And, similarly, when the fall in the real value of the money is reflected in the exchanges, foreigners, thinking that the fall is abnormal and temporary, purchase the money for the purpose of hoarding it.

   But sooner or later the second phase sets in. The public discover that it is the holders of notes who suffer taxation and defray the expenses of government, and they begin to change their habits and to economise in their holding of notes. They can do this in various ways: - (1) instead of keeping some part of their ultimate reserves in money they can spend this money on durable objects, jewellery or household goods, and keep their reserves in this form instead; (2) they can reduce the amount of till money and pocket money that they keep and the average length of time for which they keep it, even at the cost of great personal inconvenience; and (3) they can employ foreign money in many transactions where it would have been more natural and convenient to use their own. By these means they can get along and do their business with an amount of notes having an aggregate real value substantially less than before. For example, the notes in circulation become worth altogether $20 million instead of $36 million, with the result that the next inflationary levy by the government, falling on a smaller amount, must be at a greater rate in order to yield a given sum.

   When the public take alarm faster than they can change their habits, and, in their efforts to avoid loss, run down the amount of real resources, which they hold in the form of money, below the working minimum, seeking to supply their daily needs for cash by borrowing, they get penalised, as in Germany in 1923, by prodigious rates of money interest. The rates rise, as we have seen in the previous chapter, until the rate of interest on money equals or exceeds the anticipated rate of depreciation of money. Indeed, it is always likely, when money is rapidly depreciating, that there will be recurrent periods of scarcity of currency, because the public, in their anxiety not to hold too much money, will fail to provide themselves even with the minimum which they will require in practice.