What is a sovereign currency?

By L. Randall Wray

This post appeared as the sixth blog post in a series on Modern Money at New Economic Perspectives.

In recent weeks we have examined in some detail the three balances approach developed largely by Wynne Godley. In some sense all of that is preliminary to examining the nature of modern money. Further, as many of you have no doubt already recognized, a key distinguishing characteristic of MMT is its view on how government really spends. Beginning with the New Economic Perspectives blog we will begin to develop our theory of sovereign currency.

So in coming weeks we examine spending by government that issues its own domestic currency. We first present general principles that are applicable to any issuer of domestic currency. These principles apply to both developed and developing nations, and regardless of exchange rate regime. We later move on to analysis of special considerations that apply to developing nations. Finally we will discuss implications of the analysis for different currency regimes.

In this post, we examine the concept of a sovereign currency.

Domestic Currency. We first introduce the concept of the money of account—the Australian dollar, the US dollar, the Japanese Yen, the British Pound, and the European Euro are all examples of a money of account. The first four of these monies of account are each associated with a single nation. By contrast, the Euro is a money of account adopted by a number of countries that have joined the European Monetary Union. Throughout history, the usual situation has been “one nation, one currency”, although there have been a number of exceptions to this rule, including the modern Euro. Most of the discussion that follows will be focused on the more common case in which a nation adopts its own money of account, and in which the government issues a currency denominated in that unit of account. When we address the exceptional cases, such as the European Monetary Union, we will carefully identify the differences that arise when a currency is divorced from the nation.

Note that most developing nations adopt their own domestic currency. However, some of these peg their currencies, hence, surrender a degree of domestic policy space, as will be discussed below. However, since they do issue their own currencies, the analysis here of the money of account does apply to them.

Note also, following the discussion at the end of Blog Post 4, we recognize that individual households and firms (and even governments) can use foreign currencies even within their domestic economy. For example, within Kazakhstan (and many other developing nations) some transactions can occur in US Dollars, while others take the form of Tenge. And individuals can accumulate net wealth denominated in Dollars or in Tenge. However, the accounting principles that apply to a money of account will still apply (separately) to each of these currencies.

One nation, one currency. The overwhelmingly dominant practice is for a nation to adopt its own unique money of account—the US Dollar (US$) in America; the Australian Dollar (A$) in Australia; the Kazakhstan Tenge. The government of the nation issues a currency (usually consisting of metal coins and paper notes of various denominations) denominated in its money of account. Spending by the government as well as tax liabilities, fees, and fines owed to the government are denominated in the same money of account. The court system assesses damages in civil cases using the same money of account.

For example, wages are counted in the nation’s money of account and in the event that an employer fails to pay wages due, the courts will enforce the labor contract and assess monetary damages on the employer to be paid to the employee.

A government might also use a foreign currency for some of its purchases, and might accept a foreign currency in payment. It might also borrow—issuing IOUs—in a foreign currency. Usually, this is done when the government is making purchases of imports or when it is trying to accumulate foreign currency reserves (for example when it pegs its currency). While important, this does not change the accounting of the domestic currency. That is, if the Kazakhstan government spends more Tenge than it collects in Tenge taxes, it runs a budget deficit in Tenge that exactly equals the nongovernment sector’s accumulation of Tenge through its budget surplus (assuming a balanced foreign sector it will be the domestic private sector that accumulates the Tenge).

We will argue that the government has much more leeway (called “domestic policy space”) when it spends and taxes in its own currency than when it spends or taxes in a foreign currency. For the Kazakhstan government to run a budget deficit in US Dollars, it would have to get hold of the extra Dollars by borrowing them. This is more difficult than simply spending by issuing Tenge to a domestic private sector that wants to accumulate some net saving in Tenge.

It is also important to note that in many nations there are private contracts that are written in foreign monies of account. For example, in some Latin American countries as well as some other developing nations around the world it is common to write some kinds of contracts in terms of the US Dollar. It is also common in many nations to use US currency in payment in private transactions. According to some estimates, the total value of US currency circulating outside America exceeds the value of US currency used at home. Thus, one or more foreign monies of account as well as foreign currencies might be used in addition to the domestic money of account and the domestic currency denominated in that unit.

Sometimes this is explicitly recognized by, and permitted by, the authorities while other times it is part of the underground economy that tries to avoid detection by using foreign currency. It might be surprising to learn that in the United States foreign currencies circulated alongside the US dollar well into the 19th century; indeed, the US Treasury even accepted payment of taxes in foreign currency until the middle of the 19th century.

However, such practices are now extremely rare in the developed nations that issue their own currencies (with the exception of the Euro nations—each of which uses the Euro that is effectively a “foreign” currency from the perspective of the individual nation). Still it is not uncommon in developing nations for foreign currencies to circulate alongside domestic currency, and sometimes their governments willingly accept foreign currencies. In some cases, sellers even prefer foreign currencies over domestic currencies.

This has implications for policy, as discussed later.

Sovereignty and the currency. The national currency is often referred to as a “sovereign currency”, that is, the currency issued by the sovereign government. The sovereign government retains for itself a variety of powers that are not given to private individuals or institutions. Here, we are only concerned with those powers associated with money.

The sovereign government, alone, has the power to determine which money of account it will recognize for official accounts (as discussed, it might choose to accept a foreign currency for some payments—but that is the sovereign’s prerogative). Further, modern sovereign governments, alone, are invested with the power to issue the currency denominated in its money of account.

If any entity other than the government tried to issue domestic currency (unless explicitly permitted to do so by government) it would be prosecuted as a counterfeiter, with severe penalties resulting.

Further, the sovereign government imposes tax liabilities (as well as fines and fees) in its money of account, and decides how these liabilities can be paid—that is, it decides what it will accept in payment so that taxpayers can fulfil their obligations.

Finally, the sovereign government also decides how it will make its own payments—what it will deliver to purchase goods or services, or to meet its own obligations (such as payments it must make to retirees). Most modern sovereign governments make payments in their own currency, and require tax payments in the same currency.

Next week we will continue this discussion, investigating “what backs up” modern money.

UPDATE: The next part of this Primer can now be read here.