The Mystery of Banking

calls
it “a dollar,” treating it as
the equivalent of a gold dollar or 1/20 gold ounce. 
If
the public will accept the paper dollar as equivalent to gold,
then the government may become a legalized counterfeiter, and
the counterfeiting process comes into play. Suppose, in a certain
year, the government takes in $250 billion in taxes, and spends
$300 billion. It then has a budget deficit of $50 billion. 
How does it finance its deficit? 
Individuals
, or business firms,
can finance their own deficits in two ways: (a) borrowing money
from people who have savings; and/or (b) drawing down their
cash balances to pay for it. The government also can employ these
two ways but, if people will accept the paper money, it now has a
way of acquiring money not available to anyone else: It can print
$50 billion and spend it! 
A crucial problem for government as legalized counterfeiter
and issuer of paper money is that, at first, no one will be found to
take it in exchange. If the kings want to print money in order to
build pyramids, for example, there will at first be few or no pyra-
mid contractors willing to accept these curious-looking pieces of
paper. They will want the
real thing
: gold or silver. To this day,
“primitive tribes” will not accept paper money, even with their
alleged sovereign’s face printed on it with elaborate decoration.
Healthily skeptical, they demand “
real
” money in the form of
gold or silver. It takes centuries of propaganda and cultivated
trust for these suspicions to fade away. 
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The Mystery of Banking
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At first, then, the government must guarantee that these paper
tickets will be redeemable, on demand, in their equivalent in gold
coin or bullion. In other words, if a government paper ticket says
“ten dollars” on it, the government itself must pledge to redeem
that sum in a “real” ten-dollar gold coin. But even then, the gov-
ernment must overcome the healthy suspicion: If the government
has the coin to back up its paper, why does it have to issue paper
in the first place? The government also generally tries to back up
its paper with coercive legislation, either compelling the public to
accept it at par with gold (the paper dollar equal to the gold dol-
lar), or compelling all creditors to accept paper money as equiva-
lent to gold (“legal tender laws”). At the very least, of course, the
government must agree to accept its own paper in taxes. If it is
not careful, however, the government might find its issued paper
bouncing right back to it in taxes and used for little else. For coer-
cion by itself is not going to do the trick without public trust (mis-
guided, to be sure) to back it up. 
Once the paper money becomes generally accepted, however,
the government can then inflate the money supply to finance its
needs. If it prints $50 billion to spend on pyramids, then it—the
government—gets the new money first and spends it. The pyra-
mid contractors are the second to receive the new money. They
will then spend the $50 billion on construction equipment and
hiring new workers; these in turn will spend the money. In this
way, the new $50 billion ripples out into the system, raising
demand curves and individual prices, and hence the 
level
of
prices, as it goes. 
It should be clear that by printing new money to finance its
deficits, the government and the early receivers of the new money
benefit at the expense of those who receive the new money last or
not at all: pensioners, fixed-income groups, or people who live in
areas remote from pyramid construction. The expansion of the
money supply has caused inflation; but, more than that, the
essence of inflation is the process by which a large and hidden tax
is imposed on much of society for the benefit of government and
the early receivers of the new money. Inflationary increases of the