A political choice with economic consequences
On the BBC News last night the budget was presented by the economics correspondent, who did such a very poor job of explaining the basics of debts, deficits and spending.
The talk of "getting the deficit down" and "the nation's credit card" is just pure nonsense yet is used continually by people who should know better. All government spending is a political choice that has economic consequences. My worry is we are constantly given a misleading impression of what money is for, and this narrows our political options.
A deficit is the difference between what a government spends and what it removes in taxation.
So if a government spends 100 on schools, hospitals, roads, care etc but only takes in 90 in taxes then it is running a deficit of 10.
But here is the bit they never tell you. That means the rest of the economy, which your household is part of, are running a surplus of 10.
That 10 travels around the economy creating demand. The money you spend in the supermarket pays the wages of the staff and the suppliers of the goods. They then spend the money they've received on their own purchases. This is known as the multiplier effect of money. Money isn't only spent once, it travels around until it is saved (at home or overseas) or taxed.
So why doesn't the government just spend 100 and tax 0? Inflation. Too much money chasing too few goods means that prices rise.
If we imagine the government literally prints £200 for every person in the country and gives it to them we would see a lot of spending that wouldn't have happened before. But probably not enough to move prices on an economy wide level. £200 is nice but not life changing.
But if the government printed £1m a person? Then we certainly would see behaviour changes. Why work for £8 an hour when you have £1m in the bank? Why ask £1m for your house when everyone has £1m? Prices would certainly rise. Existing cash based wealth (and debt, which they also never tell you) would be destroyed.
So at some point additional injections of money into the economy are inflationary but where that point comes will depend on the productive capacity of the economy.
In other words if you have full employment and a decent standard of living for all your citizens then adding extra money in will just lead to inflation. Once again inflation is caused by too much money chasing too few few goods. So a government embarking on massive spending on infrastructure when all the builders and construction companies have full order books is not a good idea. Too much money in the system causing general price rises is bad for everyone not receiving the additional spending directly.
However, if there is spare capacity (like IT consultants writing blog posts between contracts) then additional spending won't be inflationary. I've recently finished an NHS contract, they want me to stay, there is plenty of worthwhile work to be done, but they have no money. If the government gave them money they would employ me, the work would be done and the service would be better and the money I was paid would go into the economy, circulate around, and increase everyone's standard of living.
Spare capacity in the economy is "money on the table", if that private sector won't use that spare capacity by spending their savings (as happens in economic downturns) then the government should step in. As a country with a sovereign currency the only limit on spending is inflation. And inflation is only a problem when the amount of money circulating in the economy causes prices to rise.
Ah but what about debt? Deficits are one thing but they compound into debt and debt is bad. Have you seen how much we spend on debt repayments?
Earlier I showed that government debt = private sector wealth (ignoring bank credit which I'll get to).
When a government runs a deficit of 10 (spends 100, taxes 90) they borrow back the 10 from the private sector savings and pay interest on it. So that sounds bad doesn't it? We are all familiar with borrowing and paying interest. So who is getting paid all of that interest? Errr, us. 80% of UK government debt is held in the UK, mainly by pension funds. That scary government debt is actually what the money you put aside for pensions buys.
On this side of the economy everything balances. The government controls the supply of money. Government debt = Private Sector surplus.
But what about private borrowing? This is where things get trickier and should be way more political than they are.
Most people seem to be under the impression that when they deposit 100 into a bank that the bank can then lend out that 100 to other people, charging interest on that loan (5), paying you interest (3) and keeping the profit (2). That is full reserve banking.
What actually happens, is fractional reserve banking. Banks are allowed to extend credit based on the deposits they hold, so your 100 in the bank could allow the creation of 1000 in bank credit. So how is this not inflationary? Well the bank lends 1000 to someone to buy a house, they pay back 1000+interest. The 1000 that was originally loaned is effectively destroyed and the interest paid back is the profit to the bank and pays you the interest on your account. The huge amounts of money they inject into the economy is removed and destroyed so doesn't circulate like additional money injected into the economy would.
But this raises questions.
Government spending is presented as being constrained by tax receipts. We can't have more NHS spending without tax increases inevitably following.
But bank credit is only constrained by the ability of people to repay the debt. So what happens if the banks just lend to anybody? To begin with the amount of personal debt in the economy soars, the banks enjoy huge profits, governments are able to spend more as tax receipts increase, asset price inflation (houses mainly) soars as money becomes freely available and the bubble rises. Welcome to the financial economy and the bubble of the early 2000s.
But these financial credit bubbles burst, the level of demand in the economy drops (you save more and spend less as a private citizen) and the government has to spend more than it receives in tax revenue to keep people in jobs and the economy ticking over. This is why we've had very high budget deficits for the past decade.
Everything in economics comes down to one political question. Who knows how to spend money better, the government or the markets?
The framing of this question is in itself political. The markets implies millions of rational transactions by individuals with success or failure based on making the right decisions.
But that doesn't accurately reflect how it works. In the banking bubble people were approving huge loans to people with no income, no job, no assets (NINJA). There was no realistic way of these being repaid unless the value of the asset they were buying continued to climb. This doesn't sound like rational decision making. But it was, because the person making the loan had no long term incentive for that to be repaid, they were paid for the sale. The loan debt was then repackaged and sold on by the bank to insurance companies as an asset.
The market failed. Spectacularly. And when the government stepped in we were asked to endure 10 years of austerity, reduced services, lower pay as a consequence. Remember quantitative easing? We put in hundreds of billions, not directly into the economy as cash but into banks balance sheets to allow them to start lending again.
Even with the failure right in front of us there was never any possibility presented to us of changing the system so that the supply of money into the economy was controlled by anybody other than private banks. Monetarism (this process of adjusting interest rates to control demand for money) was left unchallenged.
Is now not the time to have a rational conversation about allowing governments to target spending where it needs to be spent? Fiscal spending by increasing deficits and building up public services, proper redistributive economics through a universal basic income, the time for radical change is now.
Update 2020: I never published this blog, it seemed a bit dry, but even now in the face of a global meltdown the mainstream view presented to the public is pure monetary policy with loans. We need fiscal expansion to save us from the worst recession in memory.
The talk of "getting the deficit down" and "the nation's credit card" is just pure nonsense yet is used continually by people who should know better. All government spending is a political choice that has economic consequences. My worry is we are constantly given a misleading impression of what money is for, and this narrows our political options.
A deficit is the difference between what a government spends and what it removes in taxation.
So if a government spends 100 on schools, hospitals, roads, care etc but only takes in 90 in taxes then it is running a deficit of 10.
But here is the bit they never tell you. That means the rest of the economy, which your household is part of, are running a surplus of 10.
That 10 travels around the economy creating demand. The money you spend in the supermarket pays the wages of the staff and the suppliers of the goods. They then spend the money they've received on their own purchases. This is known as the multiplier effect of money. Money isn't only spent once, it travels around until it is saved (at home or overseas) or taxed.
So why doesn't the government just spend 100 and tax 0? Inflation. Too much money chasing too few goods means that prices rise.
If we imagine the government literally prints £200 for every person in the country and gives it to them we would see a lot of spending that wouldn't have happened before. But probably not enough to move prices on an economy wide level. £200 is nice but not life changing.
But if the government printed £1m a person? Then we certainly would see behaviour changes. Why work for £8 an hour when you have £1m in the bank? Why ask £1m for your house when everyone has £1m? Prices would certainly rise. Existing cash based wealth (and debt, which they also never tell you) would be destroyed.
So at some point additional injections of money into the economy are inflationary but where that point comes will depend on the productive capacity of the economy.
In other words if you have full employment and a decent standard of living for all your citizens then adding extra money in will just lead to inflation. Once again inflation is caused by too much money chasing too few few goods. So a government embarking on massive spending on infrastructure when all the builders and construction companies have full order books is not a good idea. Too much money in the system causing general price rises is bad for everyone not receiving the additional spending directly.
However, if there is spare capacity (like IT consultants writing blog posts between contracts) then additional spending won't be inflationary. I've recently finished an NHS contract, they want me to stay, there is plenty of worthwhile work to be done, but they have no money. If the government gave them money they would employ me, the work would be done and the service would be better and the money I was paid would go into the economy, circulate around, and increase everyone's standard of living.
Spare capacity in the economy is "money on the table", if that private sector won't use that spare capacity by spending their savings (as happens in economic downturns) then the government should step in. As a country with a sovereign currency the only limit on spending is inflation. And inflation is only a problem when the amount of money circulating in the economy causes prices to rise.
Ah but what about debt? Deficits are one thing but they compound into debt and debt is bad. Have you seen how much we spend on debt repayments?
Earlier I showed that government debt = private sector wealth (ignoring bank credit which I'll get to).
When a government runs a deficit of 10 (spends 100, taxes 90) they borrow back the 10 from the private sector savings and pay interest on it. So that sounds bad doesn't it? We are all familiar with borrowing and paying interest. So who is getting paid all of that interest? Errr, us. 80% of UK government debt is held in the UK, mainly by pension funds. That scary government debt is actually what the money you put aside for pensions buys.
On this side of the economy everything balances. The government controls the supply of money. Government debt = Private Sector surplus.
But what about private borrowing? This is where things get trickier and should be way more political than they are.
Most people seem to be under the impression that when they deposit 100 into a bank that the bank can then lend out that 100 to other people, charging interest on that loan (5), paying you interest (3) and keeping the profit (2). That is full reserve banking.
What actually happens, is fractional reserve banking. Banks are allowed to extend credit based on the deposits they hold, so your 100 in the bank could allow the creation of 1000 in bank credit. So how is this not inflationary? Well the bank lends 1000 to someone to buy a house, they pay back 1000+interest. The 1000 that was originally loaned is effectively destroyed and the interest paid back is the profit to the bank and pays you the interest on your account. The huge amounts of money they inject into the economy is removed and destroyed so doesn't circulate like additional money injected into the economy would.
But this raises questions.
Government spending is presented as being constrained by tax receipts. We can't have more NHS spending without tax increases inevitably following.
But bank credit is only constrained by the ability of people to repay the debt. So what happens if the banks just lend to anybody? To begin with the amount of personal debt in the economy soars, the banks enjoy huge profits, governments are able to spend more as tax receipts increase, asset price inflation (houses mainly) soars as money becomes freely available and the bubble rises. Welcome to the financial economy and the bubble of the early 2000s.
But these financial credit bubbles burst, the level of demand in the economy drops (you save more and spend less as a private citizen) and the government has to spend more than it receives in tax revenue to keep people in jobs and the economy ticking over. This is why we've had very high budget deficits for the past decade.
Everything in economics comes down to one political question. Who knows how to spend money better, the government or the markets?
The framing of this question is in itself political. The markets implies millions of rational transactions by individuals with success or failure based on making the right decisions.
But that doesn't accurately reflect how it works. In the banking bubble people were approving huge loans to people with no income, no job, no assets (NINJA). There was no realistic way of these being repaid unless the value of the asset they were buying continued to climb. This doesn't sound like rational decision making. But it was, because the person making the loan had no long term incentive for that to be repaid, they were paid for the sale. The loan debt was then repackaged and sold on by the bank to insurance companies as an asset.
The market failed. Spectacularly. And when the government stepped in we were asked to endure 10 years of austerity, reduced services, lower pay as a consequence. Remember quantitative easing? We put in hundreds of billions, not directly into the economy as cash but into banks balance sheets to allow them to start lending again.
Even with the failure right in front of us there was never any possibility presented to us of changing the system so that the supply of money into the economy was controlled by anybody other than private banks. Monetarism (this process of adjusting interest rates to control demand for money) was left unchallenged.
Is now not the time to have a rational conversation about allowing governments to target spending where it needs to be spent? Fiscal spending by increasing deficits and building up public services, proper redistributive economics through a universal basic income, the time for radical change is now.
Update 2020: I never published this blog, it seemed a bit dry, but even now in the face of a global meltdown the mainstream view presented to the public is pure monetary policy with loans. We need fiscal expansion to save us from the worst recession in memory.
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