In the context of the debate over fiscal deficits and debt, Barry Finger explains how fiat money works:
What is not appreciated by the public is that current state operations are in no way operationally dependent on the prior withdrawal of funds from the private sector. Whatever may have been true when currencies were backed by a fixed metallic content, modern money is a state-issued, state-enforced fiat currency. It is no longer commodity money and is not exuded by the system through the spontaneous functioning of the private sector. . .
fiat currencies shatter and invert the inherited logic of the metallic-based monetary system. Fiat currencies are not a byproduct of private commerce. They are a creature of the state, which has a monopoly on its issuance. . .Given that understanding, fiat money-issuing entities — such as the US, Britain, China, and the EU — have to spend in order to inject liquidity into the system in sufficient quantity to accommodate the interests of commerce. They have to spend, that is, prior to their ability to tax, reversing the polarity of economic causality. With the advent of fiat money, taxation and borrowing no longer exist as necessary adjuncts of state appropriation.
That is, payment due for state wages, for the rental of state buildings, for the purchase of infrastructural products, to fund Social Security and Medicare/Medicaid, to finance the interest due on the national debt, to share revenues with local governments, or, unfortunately, to fight imperialist wars does not require the state to mobilize funds, either in the form of additional taxes or by selling state bonds to the private sector — or foreign governments — prior to meeting its obligations. These obligations can be met simply by computer-generated entries from the state into the ledgers of its private-sector customers or its own self-administered trust funds, its private and foreign bond holders, and its employees’ payrolls. This adds to the budget deficit in a way that never has to be repaid, or paid down, and does so at a zero rate of interest. There is no “crowding out” — no competition with the private sector for loanable balances — simply because there is no need to fill the gap between spending and taxes with borrowed funds. It is with this recognition that wars are, as a practical fact, “financed” until they become so unpopular or counterproductive that politicians conveniently awake to the discovery that the treasury is “out of money.” All of which suggests that even mainstream politicians can with the proper motivation come to recognize that there is no functional requirement to maintain the fiction that a complex network of taxation and borrowing is the precondition for the state to function. The modern state cannot go bankrupt. The interest owed on the trade deficit is an accounting problem, not a social crisis waiting to happen. The state does not have to sell bonds to run a deficit. It does not have to tax its populace or borrow from them to pay the interest. The entire idiotic kabuki performance of haranguing over debt ceilings, debt defaults, or government shutdowns, or of acquiescing to mass unemployment, or of negotiating down social benefits to keep the state afloat can all be dispensed with. Once fiat money replaced commodity money, the genie of state financial reorganization was already released from the bottle.
This is not meant to suggest that there is no further need for the state to tax and borrow. It is rather that these activities properly fulfill different functional requirements: namely to cool down an overheated economy by draining excess demand for consumption and assets that may have been induced by additional state spending. Functionally, these should be tools not for the appropriation of operating funds, but for the regulation of aggregate demand and the adjustment of interest rates needed to preserve price stability including an access to investment capital commensurate with cyclical moderation.
In other words, with fiat money, there is no intrinsic incapacity to finance growing fiscal deficits. The kinds of debt-to-GDP ratios that are thrown around in the United States and Europe—40 percent, 60 percent, 100 percent—are just that, numbers. They’re arbitrary numbers.
The issue is not what levels of debt are sustainable but how does the state intervene to support (or not) social expenditures and to determine the nature and level of private business activity.