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Professor Michael Mainelli, Executive Chairman, The Z/Yen Group

[An edited version of this article appeared as “Let There Be Tax Risk: Currencies, Interest Rates and Tax Rates” in Journal of Risk Finance, Volume 12, Number 3, Emerald Group Publishing (June 2011), pages 242-245.] 

“Money and debt are as opposite in nature as fire and water; money extinguishes debt as water extinguishes fire.”
Charles Holt Carroll, June 1877

“Money is a matter of commerce independent of government”, argued Charles Holt Carroll [Carroll, page 363] Today though, the dominant forms of money are fiat currency. “Let there be” currencies issued by governments. “Currency comprises all the money, and the customary substitutes for money, offered to be exchanged for property of any sort, or to be used in the payment of debt, and in transfers sanctioned or accepted by custom as payment.” [Carroll, page 154] This article hinges on the premise that fiat currency extinguishes government debt. From that premise arise a few interesting points about the nature of financial risk.

When governments issue debt, they do so as bonds, a promise to repay over time. A bond creates future obligations for taxation, and thus creates currency. We are going to move in a moment to looking in a little detail at what government debt means for currency value, but first let’s look at the idea of ‘legal tender’. “Legal tender has a very narrow and technical meaning in the settlement of debts. It means that a debtor cannot successfully be sued for non-payment if he pays into court in legal tender. It does not mean that any ordinary transaction has to take place in legal tender or only within the amount denominated by the legislation. Both parties are free to agree to accept any form of payment whether legal tender or otherwise according to their wishes.” [The Royal Mint, 2011] Government-issued fiat currency is the most common form of legal tender, stipulated by governments around the world for their own legal jurisdictions. While private contracts can be written with any ‘tender’ for settlement, governments write contracts to acquire things in the form of their own debt. When governments issue debt they create legal tender. Legal tender commonly circulates as people use it for private transactions. But when you pay government its own legal tender for an obligation you owe, you extinguish government debt. We could equally call currency “fiat taxation”.

Currency is valuable because it can be used to extinguish future obligations to government, especially tax obligations. People are going to want more of their government’s currency if people believe it will be increasingly hard to find money to pay future tax bills. Money becomes more valuable. People will want less of their government’s currency if people believe it will be easy to find money to pay future tax bills. Money becomes less valuable. There are a few obvious reasons why people might believe it will be increasingly hard to find money to pay future tax bills, principally that taxes are going to rise, that their economic situation is deteriorating or that the amount of government debt in circulation is going to fall (deflation). Contrariwise, taxes are falling, the economy is improving or the amount of government debt in circulation is rising (inflation).

It’s fun to follow this thinking because you can look at foreign exchange rates as relative indicators of future expected taxation. A currency, other things being equal, grows in value if you think that future taxation levels in that country will increase relative to everything else. The same amount of currency will extinguish less future debt. But if you think that today’s currency will extinguish more future debts, i.e. taxation levels will decrease, then tomorrow money’s value is closer to today’s and interest rates should fall. There are numerous other considerations that affect the value of money, such as the quantity, velocity and distribution of money, or tax enforcement, which I’m ignoring to make this simplistic, but fun, point, derived from an overly zealous application of the definition of money as extinguishing tax debts. Although disputed, I happen to sympathise with Yellen’s summary that – “in a closed economy scenario, deficits retard capital formation and shift the economy to a growth path with lower per capita output and capital per worker. In an open economy scenario, current account deficits induce growing foreign indebtedness and result in a burden of future interest payments which will lower the disposable income of domestic residents.” (Yellen, 1989, page 18). Governments rarely transact much with each other – people and corporations do. People and corporations do have currency choices in their foreign trade, just not with their own government, controlling the monopoly of force over legal tender. When we discuss currency risk, taxation really ought to be one of our primary issues, perhaps the primary issue.

From Hyman Minsky to Carl Menger and the Austrian School of Economics, low interest rates and an increase in the money supply are presumed to lead to reckless, speculative borrowing, resulting in misinvestment and bubbles, followed by a recession and a contraction of the money supply. One quick objection from some economists to fiat taxation driving the value of money is that ordinary people don’t think about these things this way. These economists should get out more and talk to business people. The Barro-Ricardo equivalence proposition suggests that consumers understand government obligations and thus it does not matter whether a government finances its spending with debt or a tax increase, the effect on total level of demand in an economy being the same. [Barro, 1974] Further, economists’ own theories assume that people pay close attention to an equally complex set of interactions around interest rates and bank rates. People do both. Carroll saw too that people ‘value’ money itself, not discount rates:

“… to say, where the rate of interest is high, except momentarily sometimes in the crisis of a bank contraction, the value of money is low, and vice versa. Loss by the depreciation of the value of money is just the same in every respect to its owner as the loss by the depreciation of the value of wheat to the owner of wheat. The value of money is as simple an expression as the value of wheat; it is, of course, its purchasing power, and that can be expressed only in the thing it purchases. If ten dollars of money purchases a barrel of flour, so much flour is the value of so much money. If a bushel of corn exchanges for a dollar, the value of a dollar is a bushel of corn. Where little money buys much of other things its value is high: where much money buys little of other things its value is low. Nothing can be plainer; yet, and although this fact, and the distinction between the rate of interest and the value of money, have been clearly set forth by the best scientific authority in England - John Stuart Mill - we find the London Economist habitually calling the rate of interest "the value of money."” [Carroll, page 323]

So fiat taxation backs fiat currencies. And we know that how currencies are backed matters. With apologies to hardened gold standard bugs and softy fiat currency apologists, the ultimate backing of currency is its ability to extinguish debts in future. The depth and distribution of debt obligations are what give a currency value. If one person in the world has all the money, then the money is worthless. If every person in the world both holds and owes a currency in some depth, then that money is valuable even if it is ‘unbacked’. There is no God-given right for money to earn returns; in fact the religions of the book prohibit usury. An old joke runs, “Jesus saves but Moses invests”. The pun obviously contrasts salvation with putting money away, while investment is to put money into productive assets in the hope they will provide future value. Like Moses, people have to invest in productive assets that will fulfil long-term values.

Jevons enumerates seven characteristics of successful money, viz. “utility, portability, indestructibility, homogeneity, divisibility, stability of value, and cognizability”. [Jevons, 1910, page 31] One of the reasons for gold’s historic success is that its characteristics suit most of the characteristics behind the concept of money. However, the supply of gold – the sixteenth century’s new discoveries in South America, shortages as economies grow, the threat of the “philospher’s stone” – has been a problem. “The paramount law in commercial finance, I conceive to be, that the currency should never for a moment exceed its natural volume.” [Carroll, page 80] Gold is an element that comes close to being money, but…

New technology permits us for the first time to create a new, virtual element, call it Pecunium. We can develop new currencies with Pecunium using technologies that can automatically sense its velocity and distribution, and then automatically adjust its ‘atomic’ quantity. For example, the Ripple network intends to be a peer-to-peer distributed social monetary system based on trust among people in real-world social networks; financial capital backed by social capital. But Pecunium and technology are not enough. People need new relations with each other and the state. We have a lot of discussion ahead if we are to design a monetary system that can handle long commerce transactions across time.

The liquidity that comes with inflation friendly currencies comes at a price. Does the cost of liquidity in fiat currency obscure the true price of assets? Are we overvaluing liquidity? Are positive interest rates a constant fiction and the values of fiat currencies always decline? That’s been the historic record. So, to some pointers. First, we have seen that we should be paying a lot more attention to taxation and future perceptions about taxation. I hope to see sets of country tax tables and expected tax tables at every FX desk. Second, we need to pay a lot more attention to true asset prices. This seems to be a constant message from recent financial crises – we let ourselves dissociate money from value at our peril. Third, we need to get a tighter grip on what’s happening with the monetary system; we need to expand from economics as practised, to economics incorporating the primary economic measure we use, money. We need to rethink money.

Money is a gargantuan virtual abacus that helps us trade, decide and keep track of what’s going on. Through money we make decisions through time and space. The physicist John Archibald Wheeler, said: “Time is nature's way of keeping everything from happening at once. Space is what prevents everything from happening to me.” We can paraphrase Wheeler’s invocation about time and space; money is man’s way of envisioning all of time and space in one place. The discount rate is our way of ensuring it doesn’t happen all at the same time and place. The nearer in time and space are more valuable.

However, this is not a Fukuyama Moment, the end of history. Money is one of mankind’s great unfinished inventions. Money evolves. About 600 BC the great transformation was to gold. In 1694 the momentous event was the foundation of the Bank of England and modern currency. In 1971 it was realising that money didn’t need a gold standard. More recently we’ve seen the creation of the Euro. The end of monetary history has certainly not arrived. There will be further evolution, if not revolution. But if we wish to be equitable with future generations, we should probably get started rethinking money.

Further Reading

  1. BARRO, R J, “Are Government Bonds Net Wealth?”, Journal of Political Economy, Volume 82 (1974), pages 1095-1118 -
  2. CARROLL, Charles Holt, Organization of Debt into Currency and Other Papers, D Van Nostrand Company, Princeton, New Jersey (1964), pages 392-401 contain a reprint from Bankers’ Magazine and Statistical Register, XXXI, pages 961-968 (June 1877) -
  3. JEVONS, W S, Money and the Mechanism of Exchange, London (2005, 1910, originally 1875)
  4. THE ROYAL MINT, “Legal Tender Guidelines”, (2011) -

On Charles Holt Carroll (1799-1890) -

Professor Michael Mainelli, PhD FCCA FSI, originally undertook aerospace and computing research, followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen ( Michael is Emeritus Professor of Commerce at Gresham College ( and a Visiting Professor at the London School of Economics & Political Science.

Z/Yen operates as a commercial think-tank that asks, solves and acts on strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (, such as developing an award-winning risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks. Z/Yen’s humorous risk/reward management novel, Clean Business Cuisine: Now and Z/Yen, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.