Ellis Winningham is a retired US based economist, Modern Monetary Theory advocate and campaigner who works with relentless passion through his website blogs and social media work to inform and raise public awareness of MMT.
In today’s reblog Ellis discusses how the UK Government spends, what taxes are for and how banks make loans. The original post is here.
I: Introductory Matters
The pound is not a scarce commodity; it is actually just numbers on spreadsheets and there is a definite hierarchy of money starting at the top with government money, and then subordinate to that is bank money, and then on down we go to things such as coupons issued by manufacturers. All money that sits underneath government money is denominated in the government’s unit of account – the Pound Sterling – which makes it widely-accepted and which makes it behave like money in the private sector. Put simply, you can certainly buy things with bank money, but the payments for the things that you buy can only be settled with government money. And yes, though you might not think of them as ‘money’, manufacturer’s coupons are monetary instruments. To illustrate why, consider a coupon for £1 off two tins of Heinz beans.
Note that the coupon is denominated in the unit of account (£) and then the face value is declared (£1). In other words, this coupon is worth exactly £1 if you use it to purchase two tins of Heinz beans. What the manufacturer is telling you is that it will credit you £1 for your purchase. It is the same as the manufacturer standing ready to exchange its coupon for £1 if you gave Heinz its coupon back.
Contrary to what Theresa May would have you believe, there is no such thing as ‘taxpayer money’ at the national level. All UK government spending is accomplished through what is called high powered money creation. High powered money (HPM for short), is the technical term for government ‘money’ – central bank liabilities consisting of reserve balances held at the BoE as well as pound notes held in bank vaults. The process of government spending is actually quite simple to understand if we break the process down into three stages: legislative body decision, treasury action, and then central bank action.
II: How UK Government Spending Actually Works
In the first stage, the legislative body (politicians) decides how many pounds the government will spend in the fiscal year. This activity is what you understand to be ‘budgeting’. However, the word ‘budget’ is a misnomer because it implies that the government’s finances are just like a household’s. As the UK government is the monopoly supplier of the pound sterling, it does not require an income to spend. Furthermore, when it spends and taxes, the government is adjusting the supply of pounds up or down which clearly affects private spending and employment, which in turn affects poverty levels, crime rates, rates of physical and mental illness, and society as a whole. By spending and taxing, the government is pursuing a particular agenda that it wishes to see for the UK economy and society. Therefore, the so-called ‘budget’ of the UK government is, in all reality, the ‘fiscal agenda’ of the government of the United Kingdom. Once total spending is authorised, treasury is then directed to spend to carry out the agenda.
In the second stage, treasury makes deposits, crediting bank accounts by simply changing the numbers in the accounts upward via keystrokes. In other words, treasury simply makes the numbers in the accounts larger. For instance, if treasury is paying an individual £4,200 and that individual’s current bank balance is £1,000, treasury merely changes the £1,000 to £5,200 because 1,000 + 4,200 = 5,200.
The numbers in the individual bank accounts are bank money, but treasury doesn’t actually spend bank money. By changing the numbers in your account upward, treasury forces the bank to accept the increase in your available balance. At no time can a bank refuse treasury’s demands. It must comply. The third and final stage is the action of the BoE, where government money is created as an involuntary response to treasury crediting a bank account.
Because bank money must clear on par with the pound sterling in order to settle payments, the BoE is now compelled by treasury’s actions to add government money to the bank’s reserve account, and it does this the very same way that treasury did when it made a deposit: By making the numbers larger in the reserve account. If treasury changed the numbers in an individual bank account up by £4,200 then the BoE will also change the numbers in the bank’s reserve account up by £4,200. The numbers in the bank’s reserve account are government money (central bank liabilities), and again, the BoE automatically does this to ensure that when the account holder spends the bank money, the payment will clear.
In summary, the Bank of England emits government money, but cannot of its own free will just spend pounds (net financial assets) into the British economy because to do so requires fiscal policy: The actions of the legislative body first, then treasury. The BoE has no authority over fiscal policy. It is only authorised by the government to play a supporting, yet important role in fiscal policy. So, to be clear, authority over fiscal policy is reserved for the legislative body alone. Once spending is approved by the body, treasury’s actions then automatically compel the BoE to create and then inject government money into reserve accounts. Taxation is simply the reverse of the process.
III: Taxation as a Monetary Operation
When taxation occurs, your individual bank account is reduced using the same process when treasury spent: The government changes the numbers in your bank account downward via keystrokes. If your bank balance is £2,000 and your tax is £500, then the government changes the number 2,000 to the number 1,500 and, thus, your balance is now £1,500. Next, £500 in government money held in the bank’s reserve account at the BoE is deleted from the banking system, and it is now gone forever. Nobody can ever save or spend that £500 ever again. The banking system now has £500 pounds less and, therefore, there are 500 fewer pounds in the economy. Once government money is deleted, payment of your tax liability is settled and, therefore, the tax liability is extinguished. The important thing to note here is that for you to be able to pay your taxes, you must first have possession of the pounds necessary to do so. Since the UK government alone issues the pound sterling, government spending is actually what enables you to pay your taxes. So, in reality, there is no such thing as ‘taxpayer money’ at the national level. All pounds used to pay taxes to the UK government are government money which came from government spending. Now then, you hear a lot of talk about how wonderful a budget surplus would be. But would it actually be wonderful? Let’s examine that.
Were the government not to spend and just tax, or spend less than it taxed, then the taxation would reduce the number of reserves available to the banking system. If the government continued on this course, a budget surplus would result.
A budget surplus is a condition where the UK government removes pounds from the economy and then destroys them, thus reducing the net financial wealth of the British private sector and the rest of the world in terms of pound sterling. In terms the general public can understand, a budget surplus is the act of the UK government reducing the number of British pounds available for people to save and to spend. Rarely is a budget surplus for the UK government appropriate unless the UK is exporting far more than it imports.
IV: Briefly Concerning Imports and Exports
You see, when the UK imports, British pounds created from government spending leave the hands of British citizens when they buy imported goods and those pounds flow into the hands of the rest of the world. This means that after the government spends, the pounds then make their way out of the British economy, and so, there are fewer available pounds for the domestic economy to save and spend. Should the government deliberately try to run a surplus on top of that, then the government will only be accelerating the reduction of available pounds to the domestic economy. So, when you hear a person say that the government should run a surplus, what they are actually saying is:
“Imports are already reducing the number of pounds available to British citizens, so I’ve got a brilliant idea. Let’s make British pounds leave the economy much faster by having the government step in and strip even more out of the economy through taxation!”
The end result of a budget surplus when the UK imports more than it exports is a recession. The reason for this is reflected in the equation:
(G -T) = (S – I) – (X – M)
where (G) government spending minus (T) taxation is equal to (S) savings minus (I) investment, minus (X) exports minus (M) imports. The above equation is a form of what is called “The Sectoral Balances Equation”, and it provides us with important insight into UK government budget deficits and surpluses.
In layperson’s terms, the equation states that whatever the UK government (G – T) gives, the non-government sector (S – I) – (X – M) will receive, and whatever the UK government takes away, the non-government sector will lose. Therefore, if the UK government runs a £500 billion deficit, then the UK government will be depositing £500 billion into the non-government sector, and so, the result is a £500 billion surplus for the non-government sector because if the government is spending, then somebody is receiving it. In short, somebody’s spending is somebody’s income. The UK government’s spending is the non-government sector’s income. A budget surplus is merely the reverse of the process.
If the UK government runs a £500 billion surplus, then the UK government will be withdrawing £500 billion from the non-government sector, and so, the result is a £500 billion deficit for the non-government sector because if the government is taxing British pounds away, then somebody is paying it with British pounds. Since a budget surplus reduces the private sector’s net wealth in terms of GBP, eventually consumer spending falls, so business income falls, then business lays off labour, and the result is a recession. When this occurs, the budget surplus will automatically become a budget deficit again. In short, again, somebody’s spending is somebody’s income. In the case of a budget surplus, the roles are reversed and instead of the government spending, the non-government sector is now spending to pay the tax. The only difference here is that the proceeds collected by the UK government from taxation are destroyed after the non-government sector spends to pay the tax, because, as you now understand, the UK government is the currency-issuer, it provides the non-government sector with the British pounds necessary to pay the tax, and therefore, it does not have an income. So, why tax?
V: The Purpose of UK Government Taxation
The UK government sits in authority over the entire nation, and therefore, it must endure if we wish the nation to endure. Since we know that the UK government requires paper, pens, computers, chairs, carpet, bullets, aircraft, tanks, buildings, etc., to operate as government, then the question becomes,
“What is the most efficient and certain way that the government can acquire all of the goods and services that it needs to act as government now, and in the future, without fear of one day being unable to do so, and without the possibility of an entity that is subject to its authority, or a foreign one, obstructing its ability to provision itself, thus usurping its authority?”
There are two ways: The uncivilised approach and the civilised approach.
The uncivilised approach is to take what the government needs to operate as government by force. In other words, to waltz into the private sector and force people at gunpoint to hand over their property, and also, to round up citizens, hauling them off against their will to perform work in service to the government.
The civilised answer, put simply, is to operate a monetary economy, creating a market of buyers and sellers, and then issue its own currency to buy what it needs. The UK government operates on the civilised approach.
Now then, in the uncivilised method, the mechanism used to guarantee that the government can obtain the goods and services necessary to function as government is obvious – brutal force. But, with the civilised method, we are left in a bit of a quandry. As the economist Hyman Minsky said, “anyone can create a monetary instrument. The trick is getting it accepted”. So, how then can the government ensure that every citizen and business will accept the government’s currency as payment for the goods and services that it needs to function as government?
It will need some kind of mechanism to compel the nation into accepting its own currency because begging won’t do. After all, the government is the supreme authority and issuing its own currency to buy what it needs means that 1.) it can operate a nation in a civilised manner, and 2.) it can never run out of its own currency, guaranteeing that it can always obtain what it needs to function as government without any possibility of some entity that is subject to its authority, or even another nation, holding it hostage. The government is ready, willing, and able to spend pound sterling into existence to do this and it has an infinite spending capacity, so, what to do? Some measure of force will be required, obviously. But that force must be conditional to be in keeping with a more civilised approach: “If you don’t do this, then I will be forced to become a tad bit uncivilised.” As the supreme authority, it certainly has the power to confiscate property and to imprison citizens.
The UK government will impose a tax burden and let everyone know that if they do not pay the tax, then it will be forced to become rather uncivilised by seizing their property, or imprisoning people. And nobody wants that, right? Right. So, when the people ask the UK government:
“Say man, what will you accept as payment for this tax? Because I don’t wish to lose my property or wind up in the penitentiary.”, the UK government tells them:
“Simple. All you people have to do is to sell me your goods and services to get my pounds. And since I am the currency issuer, I get to decide the price that I will pay in pound sterling for those things that I need, I will spend pounds into existence to pay for them, and you will have the pounds that you need to pay the tax that I am imposing. Whatever is left over after you pay the tax, you can save or use for whatever you wish. You can then buy and sell with my pounds because everyone else in the UK will accept the pound sterling as payment because they need the pounds to pay my tax. Look, don’t freak out, ok? All that I really want to do here is to create a market of buyers and sellers of goods and services which operates on my currency called the Pound Sterling. Imposing a tax is the civilised way to achieve this.”
So, some people begin selling their goods to the government to obtain the pounds necessary to lift the tax burden. The government then decides how much it is willing to pay for those goods in its own currency, and then spends to buy them. Some people sell their labour to the government, the government decides the wage it is willing to pay these workers in its own currency, and then spends the pounds into existence to pay the wages of these workers. Now people have possession of British pounds and they use some of them to pay the tax. They either save or spend the what they have left over. Businesses hire workers, and so, they pay wages denominated in pound sterling and then private sector workers can also pay the tax in case the government places a tax burden on them too. Before you know it, an entire market and nation is operating based upon the UK government’s unit of account. The pound becomes the most widely-accepted monetary instrument in the United Kingdom and now, the UK government has a guaranteed method to supply itself with the goods and services that it needs to operate as government, now and in the future, without fear of ever financially being unable to do so. In other words:
The UK government can buy anything that is for sale priced in GBP without fear of going broke. And all of this is possible because the government imposes a burden called ‘taxation’ on the nation which carries a severe, certain punishment if you fail to comply, and so, a wide-spread desire to avoid the punishment drives the demand for the government’s own currency. Hence, as MMT says, the pound sterling is a tax credit.
Another way of looking at it which might help some of you to understand, is to view the pound as you would a movie ticket. A cinema produces movie tickets, and factually, it can produce an infinite number of tickets if it chooses to regardless of the number of seats available. Now, from your perspective the cinema produces tickets so that you can watch a film. And it does. But it also produces tickets so that it can accept them back. That might sound bizarre, but as bizarre as it sounds, it is still true.
The cinema issues a ticket and promises you that it will accept the ticket back if you have one, thus allowing you to watch the film. If you have no ticket, you don’t get to watch the show. When you hand the ticket to the cinema, the cinema destroys the ticket. Don’t deny it, you’ve seen them do it. They just throw your ticket away. The ticket isn’t the point; the movie is. UK government taxation and the pound function the same way. The government first spends pounds into existence to buy stuff, and then promises all persons who become a target of taxation that it will accept the pounds back, allowing citizens to avoid the confiscation of their property or imprisonment. The government then destroys the proceeds it collected, because the point isn’t the pounds themselves. The point from your view is to avoid punishment, and from the government’s view, the point is to cause you to use the government’s currency. Those who do not have any pounds when the tax man cometh are sort of screwed. Therefore, everyone in the UK will accept the pound for food, clothes, cars, TV, toothpaste and anything else that you can think of.
So, to sum up, taxation is the clever mechanism that allows the government to cause everyone to accept the government’s own currency so that it can use its own currency to buy stuff that it needs. The main purpose, then, of UK government taxation is all about creating and maintaining a demand for the pound sterling, and as long as the UK government can enforce tax collections, people in the UK will demand GBP. Then, there are a few other reasons why the UK government taxes.
Taxation reduces the spending power of the private sector. Let us assume that the UK has reached the limit of the economy’s production capacity and further government spending has pushed past this limit and is creating inflationary pressures. By increasing taxes, the UK government removes pounds from circulation, thus, decreasing the number of pounds available that consumers can spend. As the currency in circulation drops, consumers slow their spending and inflationary pressures drop.
Third, taxation is used to alter behaviour. Smoking is a good example. A cigarette tax raises the price of cigarettes to the point that, hopefully, some people either cannot afford them anymore or simply refuse to pay the high price. As a result, the number of smokers drops. The goal of the tax, then, is to reduce smoking. Consider also small nations with congested roadways. The nation might consider placing a very high tax on car purchases, in order to discourage people from buying cars and to encourage them to seek alternate forms of transportation. Denmark did exactly this, levying a 180% tax on car registration. As a result, people ride bicycles or use public transportation and congestion is reduced. The purpose of the tax isn’t to fund health care and welfare spending, but to modify the population’s behaviour.
Fourth, taxation creates better equity. By targeting large tax increases at the opulent (the extremely rich), while reducing taxes on working and middle-class citizens, the government destroys the wealth built up by the rich in terms of GBP while leaving more GBP in the hands of everyone else, and the result is better equity among the populace.
Fifth, taxation creates unemployment. When the UK government taxes, it is requiring people to pay the tax. Therefore, it is creating a situation where people need to obtain the government’s currency to pay the tax. The way this is usually accomplished is through employment. By taxing, the UK government is causing people to look for employment and the government hires the unemployed labour, using it for public projects. In other words, taxation allows the UK government to provision itself with workers. So, should the UK government wish to hire workers to fill some public purpose initiative, it can use taxation to unemploy labour in some sector of the economy and then hire it.
So, that is the answer to “why tax?”. When it comes to government spending, taxation doesn’t mean revenue; it means what it’s supposed to mean: “a burden”. When the populace complies, the UK government achieves its economic and social goals. The question, then, for tax policy is, “What kind of society do the people want?” and then once the voters speak, the UK government aims its spending and tax policies towards creating and maintaining that kind of society. If the economic and social agenda is persistent involuntary unemployment, underemployment, low wages, poverty, recession, high crime rates, vast income inequality, costly university education, expensive private healthcare and crumbling infrastructure, then the UK government will continue to maintain its current economic policies. If the economic and social agenda is persistent full employment, price stability, decent wages, low crime, better equity, tuition-free university education, a fully-funded NHS, and a modernized, functional infrastructure, then the UK government will alter its fiscal stance and direct its deficit spending and tax policy towards those goals.
VI: A Few Words on Bank Lending
Now that you understand the process of government spending, it will be easier for you to understand what happens when a bank ‘lends money’.
When you obtain a loan for, say, £10,000 from a bank, the bank does not lend you its reserves. It can’t. Banks cannot and do not lend out reserves. To lend, the bank merely does what treasury and the BoE do: It types the number 10,000 into an account. It doesn’t worry about reserves beforehand. It just creates its own ‘money’, which is a bank IOU, to fund the loan. The important point to understand, though, is that the bank ‘money’ is denominated in the government’s unit of account (£). If it were not, then nobody would want the bank’s money because everything is for sale in pound sterling only. Denominating bank money in the government’s unit of account means that when you spend the loan, the bank must then exchange its ‘bank money’ for government money (pound sterling). It is also important for you to understand that until the loan is spent by the borrower, the ‘money’ that the bank created to fund the loan is not yet ‘money’. The deposit must be spent first, and only then will the bank’s IOU behave as ‘money’. Until then, it is nothing but more or less ‘pre-money’ waiting to become ‘money’.
So then, the bank simply creates a deposit and then hopes that you will spend it. And the reason why it hopes that you will spend it, is because when you do, you will be demanding government money. The bank will dutifully exchange its IOU for government money, and because of that, the bank will now be able to earn a profit in government money (interest) when you pay back the loan. Now, let us assume that the borrower will spend the £10,000 loan to purchase something from a seller who has an account at a different bank.
The 10,000 in bank money is spent by the borrower to purchase something from a seller, and when that happens, the 10,000 in the account that was created by the lending bank is changed to zero and 10,000 is then credited to the seller’s individual bank account at different bank. The borrower has the product and the seller has payment, but the payment is not yet settled between the two banks. The seller’s bank needs the £10,000 in reserves to account for the seller’s £10,000 deposit. To accomplish that, government money must now be transferred from the lending bank’s reserve account to the seller’s bank’s reserve account. The reserve accounts are held at the BoE and reserves never leave the BoE.
At some future point when settlement must take place, the BoE will delete £10,000 in reserves (government money) from the lending bank’s reserve account and then credit the seller’s bank’s reserve account with £10,000 to clear the payment. This activity is what we call ‘the payments system’ and it is the job of banks to operate it, and it is the job of the BoE to ensure that it does not collapse by standing ready to provide the banking system with reserves when they are needed.
As you can see, when a bank lends it does not take into consideration its reserves beforehand. It simply creates its own ‘money’ to fund the loan which are denominated in the government’s unit of account (Pound Sterling). Lending activity is not constrained by reserves because, again, banks cannot lend out reserves, and lending doesn’t necessarily leave the bank short of reserves either as each day, deposits and transfers are coming into the bank along with individuals and businesses opening new accounts. It is only when the bank finds itself short of reserves as a consequence of all daily business that it will need to acquire more reserves, and the only reason why is because the bank must operate the payments system – it must ensure that all payments drawn on accounts at the bank will clear. The bank can obtain reserves in a few ways:
1.) Obtain reserves on the interbank market from a bank which has a surplus.
2.) Sell bonds to the BoE.
3.) Borrow from the BoE which is expensive and the most undesirable method.
4.) Attract new customer deposits which is the least expensive method.
In summary, bank lending is not a phenomenon where banks create all of the money and the UK government is broke and helpless. Bank lending is a process that only leverages government money. The bank takes advantage of the fact that government money exists by creating its own product called a bank IOU (bank money) which it then denominates in pound sterling, and then offers to creditworthy customers with the intent to earn a profit in government money by charging a fee called “interest” for using the bank’s IOU to buy a car, house, or anything else for sale in pound sterling. As the borrower makes monthly payments, the borrower is shifting government money to the bank. When the loan is paid off, the original £10,000 principle is returned to the bank’s reserve account, and all interest charges, say, £4,500 are kept by the bank which it divides between a tax account that it maintains to pay any taxes owed, and its equity account.
VII: Conclusion
The thing to note here is that the bank is not earning a profit in bank money. That would make no sense. If banks were the currency issuer, they would not have any use for an income and so there would be no reason to create loans. Bank executives could just create all the money they would ever need and go off to live a life of luxury. Unlike the UK government, banks need to earn an income, and to do that, they must earn the government’s money.