The best kept secret in politics

Taxing does not funding government spending. So what is it for?

Posted on 10 June 2015 by Andrew Berkeley


A few years ago I was on the long train journey from London back to Glasgow with my friend, Andrew. We were talking about economics, of which neither of us had any particular expertise, but both had an increasing interest. As Andrew was explaining to me what he had recently learned about John Law and the South Sea Bubble, a stranger sharing our table interjected to confirm something in the account. It turned out that this stranger knew a thing or two about economics and we ended up chatting at some length. The stranger was Chris Cook and he casually asserted two things that astonished me.

The two claims were:

  1. Banks do not lend out their customers’ money
  2. Governments do not spend taxpayers money

Obvious, eh? Well, not to me at the time. I think the first claim is probably less perplexing than the second one, as many people have some vague idea that banks somehow lend out more than they receive. In any case, I pretty quickly satisfied myself that it was true by learning how money is created by banks when loans are issued. But the second claim took a bit more work and that is what I want to focus on here.

So the government doesn’t spend its tax revenues? Then what are taxes for? And what does the government spend?

I initially found coherent and convincing answers to these questions from a school of economics called Modern Monetary Theory (MMT). The basic gist is this: government spending creates money; taxation destroys money. The government therefore has no spending limit from a financing perspective - it cannot run out of funds. But the government’s spending and taxing operations do impact the economy. If spending and taxing are not equal then this means the government is either net adding (deficit) or removing (surplus) money from the economy. This may or may not be desirable. It depends.

I found this fascinating, particularly in the context of the government spending cuts that the UK was (and still is) being subjected to. We were (and still are) told in no uncertain terms that the government cannot afford to provide some of the services that it currently does. Do these politicians mean it literally? Do they misunderstand? Or worse, are they pulling the wool over our eyes?

One publication that I found particularly useful is The Management of Government Debt by Simon Gray, part of a series of handbooks on central banking published by the Bank of England. Here are two quotes:

A government’s budgetary policy will have a neutral impact on the creation of high-powered money, if the government is able to offset the combined liquidity-creating impact of its budget deficit and repayments of any previous loans by issuing new debt to the non-state sector. (page 5)

and,

The central bank needs to consider how to accommodate growing demand for cash balances. If the real economy grows by 5% a year, and the velocity of money circulation is constant, then a 5% growth in the money supply would not be inflationary. Indeed, attempting to hold the money supply constant would tend to be deflationary. But if the government is not creating base money (because it is covering its financing requirements fully by debt issuance to the non-state sector), how is the non-state sector to obtain the required increase in high-powered money (M0)? (pages 6-7)

Okay, the language is certainly exotic. High-powered money (also called base money or M0) is cash (notes and coins) in circulation plus the money that commercial banks hold in their accounts at the Bank of England and use to settle payments between one another. A government’s budget deficit is just the amount of money it spends in exceedence of its tax revenue in any given time period. Liquidity relates to the ability of commercial banks to facilitate payments and in this context is more or less just a fancy word for money.

So the first quote states that when the government spends more than it taxes (and when it repays loans), it creates base money. And in order to remove this newly created money the government needs to “issue debt”. The second quote reiterates the same ideas but adds another piece of context - that the economy needs this extra money if it is growing. The implication is clear. The government creates money when it spends in exceedence of tax revenue. This implies, at least, that spending creates money and taxing destroys money - therefore the net spending of a budget deficit is net money creation. Government “borrowing” - the issuance of debt - is not for funding the budget deficit, but for neutralising the effect of the spending in the economy. Borrowing removes the money that taxation was unable to.

But don’t take my word for it - here’s the rationale given by the Treasury’s Debt Management Office for the “full funding rule”:

An overarching requirement of debt management policy is that the government fully finances its projected financing requirement each year through the sale of debt. This is known as the ‘full funding rule’. The government therefore issues sufficient wholesale and retail debt instruments to enable it to meet its projected financing requirement. The rationale for the full funding rule is: 1. that the government believes that the principles of transparency and predictability are best met by full funding of its financing requirement 2. to avoid the perception that financial transactions of the public sector could affect monetary conditions, consistent with the institutional separation between monetary policy and debt management policy (page 7)

So not much mentioned about funding spending there - that is not what the rule is for. But even the existence of a rule tells us something. If there wasn’t the possibility of spending without funding there’d be no need to create a rule for it!

There are plenty of other technical publications, macroeconomics textbooks, etc. where these ideas are implied if not outright stated, but the passages above are about as explicit a description I have found that the government creates money when it spends. And coming from the government itself, is definitive. And once you reflect on it, it’s pretty uncontroversial assuming you had some vague understanding that the government was responsible for the currency. What else could that have meant?

But so what? Well, the implications of this require more consideration that this post can accommodate. But at least the most obvious one is this: the government cannot fail to pay its bills and cannot default on its debts. When the government tells us “there’s no money left” (which it is very keen on doing, armed with a note scrawled by the previous government stating the very thing) they are talking utter crap. The government is always able to pay.

It is usually at this point, when I have convinced a detractor that this is how the government spends, that the “… but, INFLATION!” argument is rolled out. To which I say, “EXACTLY!”. The question is not about what the government can fund but how much money the economy can take.

And it is a question. Inflation is not an inevitable consequence of adding money to the economy, and the conditions under which inflation occurs are therefore precisely the context under which the government’s arguments about austerity should be judged. An adequate discussion of what these conditions are would require a further post (partial explanation here), but suffice to say one of the times when an economy can handle more money without causing inflation is during or immediately after a recession.

That last point was made in a different way by Chris Cook on that train journey when he told us that cutting government spending during a recession is like “applying leeches to a person who is bleeding to death internally”. I think that metaphor sums it up well.

Here is Chris Cook himself talking about these issues in an article called The Myth of Debt.

Errata

My friend Andrew has unfortunately contested my version of events…

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