Government doesn't need your money - it needs you to need its money

This is the latest edition of the free newsletter from Scotonomics. To receive it direct to your inbox every week, please click here.

WHEN any government has a choice on how to provision itself, as the Scottish government do when considering independence, it almost always chooses to become an issuer and not a user of someone else’s currency.

The choice isn’t really about economics. It is about power.

One thing readers should consider as they read this story is this statement: the government doesn't need your money; it needs you to need its money.

This seemingly contradictory statement is at the heart of this story. It tells the tale of where money comes from, who creates it, who uses it, and its power dynamics. This understanding seems to have disappeared from our collective ken.

READ MORE: Watchdog rebukes UK Treasury over 'lowest tax in G7' claim

When considering how a new country provisions itself, we are really asking how a new state finds the resources to set up or maintain a legal system, roads and infrastructure, a police force, a health and education system, etc.

These resources are normally managed and allocated using the institution of money. The economist Hyman Minsky said, “Anybody can come up with money; it’s how do you get anybody to accept it.” And that is the story I am about to tell.

How did the British Empire ensure their money was accepted so that they could provision themselves?

It is the 1800s, and the British Empire is doing its thing worldwide.

After defeating the local army, it takes control of new territory in Africa. It means to stay. To do that, it needs to provision itself. It needs people to work for it and feed it. Once the army is secure, it wants to set up a government and fully provision the state.

To do this, it must choose between two options.

• Option one: To use the local currency which has been used in all the villages for hundreds of years, functioning like our money does back home.
• Option two: Persuade the locals to use the British pound so that the British Empire can become the local currency issuer rather than another currency user.

What do you think the British did in every case?

They chose option two. They understood probably better than anyone else in history that power was in the currency.

This decision to become the new currency issuer is referred to in the academic literature as “Financing colonial rule”, and we have examples in Natal from 1847, later that century in Sierra Leone and into the twentieth century in Kenya. Also, this was the modi operandi in Northern Rhodesia and Zimbabwe.

Let's first look at why the first option was dismissed despite it being much easier from a logistical perspective. There is no need to educate the population on a new currency, reprice everything, set up any kind of exchange rate or explain who the strange lady is on the notes.

In this scenario, the government simply has to earn the currency in use and then spend it. But how does it do that?

It has to either provide labour to someone who holds the currency to be paid a wage or sell things to someone who holds the currency to buy things priced in that currency.

READ MORE: IMF urges UK Government not to impose further tax cuts

So the British Empire could sell guns and buy food.

But at some point, it would start to run out of things to sell and become a drain on the British at home. This is not how the Empire is supposed to work. They have defeated an army but not the economists. So it would up sticks and head home.

Here is scenario two, AKA what really happened.

The General asks the locals to accept the new British pound and declares the old currency worthless. The population ignores the General and says that they are quite happy with the currency they have always had.

So, the General and his soldiers start to head off. The General then has a small Columbo moment: "Oh, one more thing." He says, "At the end of the month, we will come back to collect a tax that must be paid in British pounds. If you don’t pay that tax, we will burn down your hut."

READ MORE: Covid inquiry: Kate Forbes criticises 'flexibility' of Barnett Formula

“Sorry, what? Hang on a minute. That makes all the difference. How do we get some of the hut-saving currency?” say the locals.

Simple. The general respondents: “You provide us with labour, and we pay you with our money. You provide us with food, and we will pay you for it in these new notes with the picture of the funny lady in the big cloak."

So, a bizarre situation has arisen. The locals are expected to give up their material goods and labour in exchange for these new notes. “This is madness,” they say before deciding that life without a hut is even madder.

The British Empire has done it. It has provisioned itself by creating a tax liability in its own currency.

Money was and still is one of the most powerful institutions

The new rulers get all the goods and services pretty much for free. This is where the power lies in being a currency issuer and not a currency user. This is why the historical record, including Pompeii, Africa and the Colonial Governments in the USA, contains examples of countries using money in this way.

This story is one of the best ways to demonstrate the power of issuing your own currency. A government that is not the issuer of a currency must earn that currency to be able to provision itself.

If it creates its own currency, it can provision itself by exchanging its currency for goods and services in its own territory.

Money is where the power lies. And whoever issues the money has the power.

We created a short quiz last wee to explain the details and the consequences of the current Scottish government's plans for our economy after independence. Take our quiz.