Money in, money out

At this time of political decision making, much of the debate on the media is about how an incoming government will finance the spending it proposes. Unfortunately, most of the discussion is full of misunderstandings, half truths or just completely wrong. There is no direct link between tax and spending when you are the UK government. 

Money in, money out

If I buy something, a financial transaction takes place. A number in my bank account is made smaller and another number in someone else's account is made larger by the same amount. This is how all financial transactions are carried out. The numbers represent multiples of a unit of account called the ‘pound Sterling’. The sum total of all the transactions carried out in the UK over a year is called the Gross Domestic Product or GDP. 

Where did my pounds come from? For the most part, I earned them by selling my labour to a company. Where did they get them? Most likely, they were subcontracted to do a job by another company. Continuing backwards, every trade that occurs passes those pounds from one financial identity to another, be it a person, household, small business, large corporation or other institution.

It should be noted that these pounds don’t physically exist any more than points on a scoreboard exist. The notes and coins that many associate with money represent only about 3 per cent of all the pounds in circulation and they are really little more than official vouchers that represent pounds in an account somewhere. The vast majority of pounds exist as a number on a ledger of some form, mostly bank accounts.

At what point did these pounds start their journey through the economy? After all, there are trillions of them out there. Where did they all come from? Who issued them? Did they instead spontaneously arise through some process of value creation?

We certainly have the ability to add value to something and we talk about 'making money' in the language. You can acquire raw materials from the earth; maybe clay, stone, metal or wood. By turning them into something desirable, even valuable using your craft, skill and artistry, you now have something that you can sell. You can make money from it. But you are not actually creating new money. Pounds are merely being passed from someone else's account to yours. You have gained pounds that you didn't have before but someone else had to take a loss of pounds of equal size.

New money

In the UK there is one entity that has the legal right to issue the pound. This is the UK government. How does it do that? Essentially all that has to happen is that somebody goes up to a keyboard in the Bank of England and, with a few clicks, makes a number in a bank account larger.

Here is the process in a bit more detail. Every commercial bank in the United Kingdom has an account with the Bank of England. It is called a reserve account because it represents that bank's reserves. If the government wishes to purchase something from company XYZ Ltd., it has to instruct the Bank of England to credit the reserve account of the bank with which XYZ Ltd. has an account. The commercial bank can then credit XYZ Ltd.’s current account and the government gets what it was after.

By this process, the UK government has created new pounds. This is because only the UK government has the power in law to issue the currency. It didn't have to get the money from anywhere. It merely created it.

From that transaction onwards, the new pounds in XYZ Ltd.’s current account can flow to the accounts of other identities; maybe to their employees or to equipment and raw material suppliers. The pounds jump from account to account, being decremented from one and incremented to another, enriching the population and increasing GDP. 

As an aside, there is another mechanism by which pounds in the economy can be created. Commercial banks are able to do so by creating loans to their customers. However, these pounds have a relatively short life because they have to be paid back, effectively cancelling them out.

The bank will also receive interest in addition to the return of the loan amount and those pounds represent real income for the bank. They can continue their journey from account to account, perhaps used to pay the salaries of the bank’s employees, cover the costs to the bank of its buildings and infrastructure, or be the profits that go to its shareholders.

The pounds’ graveyard

What is the ultimate destination of the pounds? Some will spend extended periods sitting in savings accounts. However, in the long term, pounds will end up being returned to the government as tax, to be destroyed, deleted, wiped out, removed from existence much like how points can be deducted from a scoreboard.

In summary, the UK government spends money into existence and then destroys it by taxing it out of existence. The reason they do this is all about power and control. 

Power and control

Whatever the style or politics of a government, it represents the most powerful entity in a country. It makes the laws and it enforces them. If it can’t do that, it fails to be the government and a more powerful force then takes over. In some instances, the switch from one government to another is bloody and violent. Fortunately, in many countries, the process has been refined to one where the population gets to vote on who has the power to make the laws and thus the changeover is peaceful.

Any government will have an agenda, things it wishes to achieve, whether it is creating new infrastructure, fighting a war or looking after the sick and needy. Such goals will require the physical resources of the land but more than that, they will require the labour of people. The government needs people to build things, to be soldiers on a battlefield or to care for others. It could simply try to force people into these roles, a strategy that has little long term success. Alternatively, it could pay them.

In order to pay someone for service to the government, a currency is required. This can be anything that represents a perception of value. This is where tax is useful. If a government (being the most powerful entity in a country) imposes a tax, an obligation to the government, it has to say what it will accept as payment.

In the UK, only pounds are accepted as payment for the UK government’s taxes. It won’t take US dollars, Icelandic króna, supermarket vouchers, pretty seashells or gold. It must be pounds Sterling.

With taxes in place and a currency in which it must be paid, the government has created a monetary system. The population must acquire the pounds so that they can pay their tax obligations. This frees the government to purchase anything it wishes to acquire that is priced in its currency. This puts pounds where the population can acquire them. It has created an economy.

Limits on spending

This monetary system has some interesting properties. First, since the government creates the pounds when it spends, there is no numerical limit to how many pounds it can generate. The logic of the arrangement is that the government can always make a payment. It can never go insolvent. It cannot go broke.

This is a scary statement to many folk who imagine visions of freely-spending governments bringing on hyperinflation. However, it is worth understanding up front that just because there is no numerical (so-called fiscal) limit, there are nevertheless real constraints to a government’s spending. The resources (mostly labour) have to be available in the first place. 

If such resources are scarce, their price will rise as government and everyone else tries to outbid each other to acquire them. This is inflation. As long as inflation is at a low level, the UK government is free to purchase what it requires to achieve its goals.

Why tax?

Another property of the UK’s monetary system is that the revenue from taxes does not pay for government spending. This is another scary statement that runs completely counter to the common notions of tax and spend. The vast majority of the public believe that taxation directly pays for government spending, yet it does not. However, it is required to make that spending possible, even though there is no direct link between the two.

Taxation is required for other reasons. As discussed above, it forces acceptance of the government’s currency. It makes the currency legitimate because we must have the pounds to pay our taxes. In a real sense, a pound is a tax credit.

Taxation also acts as a means to take the currency back out of circulation. If inflation starts to become a problem, the removal of money through taxation acts as a brake against the spending of people and businesses. Higher taxes mean they don’t have as much money available to outbid one another for resources and this puts downward pressure on prices.

A minor role for taxation is as a tool to help modify the behaviour of the population. Things and actions deemed bad for us are taxed in order to discourage them. Taxes on fossil fuels, smoking and alcohol are examples of these. In some cases, negative taxation is used to encourage other behaviours. For example, the US government offers tax credits to those who buy a new electric car in view of its lower tendency to pollute the environment.

Why borrow?

If the government is not limited fiscally (it can generate as many pounds as it wants and give them to somebody), then why does it need to borrow? It’s a good question and one whose answer lies in history.

Through the 19th and 20th centuries, the value of major currencies was directly linked to gold; this shiny, yellow metal being thought of as some kind of absolute measure of value. For example, in the late 1930s, 35 US dollars were directly exchangeable for an ounce of gold. This placed a severe restriction on the amount of money available to a country. A quantity of the metal had to be kept in vaults in case the government was called upon to exchange its currency for actual gold.

In this arrangement, governments are really currency users, not currency issuers. If such a user government wanted to carry out extra spending, they either had to raise taxes or borrow from the market. However, when it came to borrowing, and being the most powerful entity in the country, the interest offered by a government was considered to be very low risk, if somewhat low in rewards too.

Starting in 1971, the US pulled out of the ‘gold standard’ arrangement. The world’s major currencies followed suit over subsequent years and for the most part, they now exist as so-called ‘fiat’ or sovereign currencies. This is the situation we have today for the UK, US, Canada, Australia, Japan and many others. (As a side note, this isn’t the case for the Eurozone countries, each of which have essentially become currency users since the Euro is outside of their sovereign control.)

As stated before, countries with sovereign currencies can always make their payment. Their governments therefore do not need to borrow, yet they still do. The UK government sells certificates known as bonds or gilts that guarantee that, upon return of the original sum, a payment will be made which we call interest. As we have seen already, they can always make this payment.

The government does this because the financial institutions who trade in these gilts expect it of them. Also, many of those in government still act as if the gold standard is in place. Gilts are therefore a major means by which the government spends money into the economy. This spending benefits investors and pension funds. However, the government didn’t need to borrow the money. They just thought they did.

Gie’s a job

This discussion of sovereign money throws up other important aspects that concern a government’s role in society. By showing that a government is not fiscally constrained but only resource constrained, it begs the question, ought not the government be managing those resources for the best?

By imposing taxes on the population and forcing everyone to use the sovereign currency, the government has essentially created the phenomenon of unemployment. Here it is defined as being anyone who wishes to work in order to pay the taxes but who is unable to find work for whatever reason. In those cases, the government could employ them in some capacity and pay them a wage. This notion is called the Job Guarantee.

The Job Guarantee is a means to manage the available but unused labour in the economy. It can be thought of as a ‘buffer stock’ of labour, ready to be bought up by the private sector when needed. There is no end of jobs needing to be done in the country and the government could use local authorities, charities and other civic institutions to offer employment opportunities. The rate of pay would, purely by market force, set a baseline for wages without there being any need for minimum wage legislation.

There is already an arrangement for a buffer stock for the country’s labour. It’s usually referred to as ‘the dole’. It is an unproductive, means-tested, bureaucratic system which catches people who have been made redundant or can’t otherwise find work. It pays them very little, and it tries to find jobs for them in a private sector which, at that point in time, clearly doesn’t want them.

When work cannot be found, the current system leaves people unfulfilled, unskilled and unfamiliar with the discipline of work. In doing so, it damages them in the eyes of the private sector who are even less likely to take them on. A Job Guarantee would benefit society by maintaining a person’s employment record, giving them skills, experience, references from managers and the habit of regular work attendance. 

The Magic Money Tree

With a proper understanding of what money is and how it works, we can see that the current popular conceptions are deeply flawed. The money that the government spends is not ‘taxpayers’ money’. It’s the people’s money because the government are elected by the people, whether or not they pay taxes.

When someone says the rich should be taxed to pay for the things society needs, they have it the wrong way around. Sure, the rich should be more heavily taxed but only because they are too damn rich, Their excessive accumulation of money raises profound issues of influence and power. However, their money is not required by the government to pay for things.

When someone says that we need austerity in order to balance the books, they are either ill-informed or they are being mendacious. It isn’t the government’s books that need balanced. It is the economy. The government’s deficit is our surplus. Any attempt to balance the government’s budget must extract money from society as a whole and, as we have seen in the UK over the past decade, this can have an especially detrimental effect on those with the least margin.

Counter intuitively, the government must spend into the economy in order for the private sector to be able to spend and save, as well as to pay our taxes. In a sense, there is a magic money tree, but this version of MMT is called Modern Monetary Theory.

It confounds the left because their mantra or taxing the rich to redistribute to the poor is undermined. The government is perfectly able to lend support to the more impoverished parts of society without targeting the rich. This doesn’t mean to say that the billionaires shouldn’t be taxed. We merely need to know the real reason they are.

But MMT also confounds the right. Their ideology of small government acting like a household, balancing their budget and punishing the poor with a programme of austerity is shown to be false and pointless, unless the point of it is to deliberately impoverish those who are already short of resources.

With an understanding of MMT and a clear moral compass, the UK government can spend as necessary to raise all parts of society, and it can tax only as necessary in order to permit that improvement to take place.