Time to be honest

A modern economy is incredibly complicated, and there is a lot that we do not fully understand. That is one of the reasons why making predictions is so difficult, and why there will always be plenty to argue about.

However, there are some complex things that we can understand because they were engineered by humans. There are no big controversies about how cars or smartphones work.

One example of a human-engineered system that we should understand is our monetary system. So why is there so much confusion and debate about it? I argue in this post that it is because the conventional description of how money works is intentionally misleading.

It is possible for anyone with an internet connection and sufficient time and determination to figure out the truth. But most people don't have the time and are not sufficiently interested in the topic. Others have found that, when they do manage to understand, it is very difficult to convince others. Why? Partly because it requires a counterintuitive conceptual leap, and partly because it requires people to ignore what they read in and hear from other trusted sources.

The key conceptual leap is to appreciate that money has to come from somewhere, and in modern fiat currency systems that somewhere is the government, which has monopoly power to create the sovereign currency*. Most governments have handed some of the authority for money creation to a central bank. However, for all practical purposes the central bank can be considered to be part of the government.

[*the Eurozone is different]

So how does this money get to us? In almost all cases by government spending. The action of spending introduces money into the economy for the first time. In practical terms when a government Department wants to pay, for example, a company for providing it with something, someone sits at a computer and types numbers to mark up the value in accounts that all banks have at the central bank. You could call it printing money but 'typing money' is more accurate.

If governments were very small relative to the size of the economy they could do this without any problem. However, when they get as large as they are now, they would be introducing a huge amount of new money into the economy each year, and this would cause inflation because the added demand for goods and services would exceed the capacity of the economy to supply them.

It is for this reason that taxation is necessary. It removes spending power from the non-government sector to ensure that overall demand does not exceed supply and cause inflation.

The sequence of events is important. First the government spends, introducing new money. Then it taxes to remove money. Creating the money is necessary before it can be removed. Removing it is not needed until it has been created. Governments must spend the money into the economy before it can be removed by taxation.

This simple reality of how money is created by spending and removed by taxation has two very important implications.

First, since the government does not need tax revenues to fund its own spending, or any other current or future obligations, it can never be forced to default on any of these obligations. It may choose to do this because of self-imposed rules, but this will be a choice made, ultimately, by the electorate. An analogy is a cricket scorer. They can never run out of points because they create them.

Second, there is no need to remove through taxation all the money introduced through government spending. In fact there are good reasons for wanting taxation to remove less money than introduced through spending. The main one is that it enables the non-government (private) sector to accumulate savings (net financial assets). If taxation always removed all the money the government spent then it would be impossible for the private sector to accumulate savings in the form of government money. When the government removes by taxes more than it spends, it is confiscating savings from the private sector.

Now you can see why the way that we talk about government taxation providing revenue to fund spending is misleading, and potentially dangerous. By implying that tax revenues need to be raised to fund government spending, and calling the annual shortfall a deficit, and the cumulative shortfall government debt, we give the impression that it is imprudent and unsustainable for government spending to exceed tax revenues. And we wrongly imply that it would be a good thing for the government to confiscate private sector savings, and that it is a bad thing for the private sector to accumulate savings. Surely this is wrong?

To repeat, a government deficit represents a private sector surplus, and government debt represents cumulative private sector saving. When understood this way it should be clear why it is potentially dangerous for the government to run a fiscal surplus and eliminate its debts, as this prevents private sector saving. It is only justified when the economy is operating at full capacity or there is demand-driven inflation. In fact whenever the US government has tried hard to run surpluses to reduce its debt this has ALWAYS followed by financial collapse and depressions. Coincidence?

So why we stick to an incorrect description of government spending and taxation?

Many people just accept the views of experts as it makes intuitive sense. We know from personal experience that we need to earn money before we spend it. So why do the experts not correct this misunderstanding. Some have admitted that the conventional (taxes fund spending) explanation is necessary to provide the 'discipline' needed to prevent excessive government spending. They reason that, if politicians and voters believe that increased government spending has to be funded by taxes, this provides a built in constraint on excessive public spending, since taxes are deeply unpopular. If they realised that this was not the case it might be difficult, in a democracy, to control government spending.

So the fundamental reason for maintaining the fiction is that the public cannot be trusted with this knowledge. Is this ethical?

Leaving aside the ethics, another problem is that when people make decisions based on a misunderstanding, the consequences can be devastating. In fact one could make the case that the global financial crisis, and the six depressions that preceded this in US history were the direct result of operating our monetary system based on this misunderstanding.

Isn't it time for the truth?

What the words on you pound note actually mean

Ever wondered why x pound notes have the statement 'I promise to pay the bearer the sum of x pounds'?

If this statement makes no sense to you or seems ridiculous then it is because you do not understand modern money.

To understand it you need to understand what the essence of modern fiat money is, and what gives it value. Fiat money gets its value from the fact that it can be used to pay taxes owed to the government.

There are two sorts of money that are issued in all modern economies. First there is government money or state money, also called base money. Only the government or central bank (which is part of the government) can create this sort of money. Government money exists in two interchangeable forms: as central bank reserves, which are just numbers on a spreadsheet, and as physical cash (notes and coins). When notes and coins are issued central bank reserve accounts are marked down by the same amount. When the central bank or government receive cash they mark up the appropriate reserve account. The central bank reserves plus all the physical cash equals the monetary base. So physical cash is simply an easily transferable and anonymous form of government or state or base money.

The second form of money is commercial bank money. This is created by commercial banks and only exists in electronic form. 97% of the money that is available to the public to spend is this form of money. Commercial banks can create this money whenever they want and they do this whenever they make a loan. They simply increase the numbers in the bank account of the borrower by the amount of the loan. In return they get a debt from the borrower, which they mark as an asset, and they receive interest payment. Effectively they are renting the money to the borrower. It is important to recognise that bank money has no official status in that it cannot be used to make official payments to the government, such as paying taxes.

When you write a cheque to pay your tax bill to the government, on receipt of this cheque, goes to your bank and requires that your bank pay it that exact amount using government or state money. Banks can do this either using money in their reserve account at the central bank or by using physical cash.

It is because physical cash, unlike commercial bank money, can be used to pay taxes owed to the government that it says what it does on the notes. If you or anyone else produces these notes the government has to accept them as payments of tax owed to them or, if you are a bank, it has to credit your reserve account with that amount. You can't do this with commercial bank money.

So currency notes can be considered as transferable government IOUs that can be used to pay taxes or settle any other obligations to the government. If you are a bank and have a reserve account at the central bank they will credit your central bank reserve account by the same amount.

If this makes sense to you then you understand more about modern money than 99% of people, including most economists.

Rediscovering the obvious

A book by Richard C. Koo immodestly entitled 'The Holy Grail of Macroeconomics: lessons from Japan's Great Recession' is a good example of how mainstream economists are rediscovering what those outside the mainstream having been saying for years.

In this case the obvious is that when the private sector (households and businesses) are heavily in debt and their income drops they try to repay their debt rather than borrow more. The main contribution from this book is to provide empirical evidence for this by looking at actual behaviour during the Great Depression in the USA and the Great Recession in Japan. He shows that during these periods companies and household were reluctant to borrow and instead tried to reduce their debt or 'repair their balance sheet'. When the aggregate private sector does this demand remains depressed, resulting in what he call a 'balance sheet recessions'. He points out that this contradicts mainstream economic thinking, which is revealing about how wrong this thinking is.

The current stagnation across the developed world is exactly this kind of balance sheet recession. Aggregate private sector debt reached record levels just before the onset of the crisis and remains very high.

The practical importance of this is that during balance sheet recessions policies that try to stimulate growth by encouraging more borrowing are doomed to fail. Yet these are the main policies that have been promoted by mainstream economists today. They are not working and so central banks are coming up with ever more desperate measures to stimulate borrowing, such as quantitative easing. Banks are being accused of failing to lend when the real problem is the absence of any desire to borrow. Why should businesses take out loans to expand their businesses when demand is stagnant and there is excess capacity?

The experience in Japan, where 15 years of unprecedented loose monetary policy has failed to stimulate growth, is compelling evidence that this policy won't work. Japan has only managed to grow by remaining a net exporter.

So what is his solution? His big idea is that during balance sheet recessions fiscal stimulus is needed. He calls it the Holy Grail of Macroeconomics because it reconciles monetarism and Keynesianism, which have long been at odds.

Surely this is just common sense? As Wynne Godley and, more recently, proponents of Modern Monetary Theory have been saying for many years, the simple accounting dictates that the aggregate private sector can accumulate net financial assets and thus 'repair its balance sheet' only if the the government sector spends more into the economy than it removes through taxes. The government is the only possible source of net financial assets for the private sector. This is no theory. It is simple reality. Or should be to anyone who understands the monetary system and the constraints of sectoral balances as shown by Godley.

However mainstream economist do not understand sectoral balances. Instead of recognising that it is an absolute NECESSITY for government to run deficits in order to enable the private sector to save they argue that the government should borrow the private sectors savings and spend them. This sound like something that is optional and therefore open to challenge. It also sounds like a call to get the government to expand relative to the private sector. Since many people are, with good reason, skeptical about governments expanding, this line of argument is unconvincing.

The way to explain the need for deficit spending is that government should not remove all the money that they spend into the economy through taxes. Instead they should reduce taxes, thereby enabling the private sector to deleverage quickly while maintaining demand. It is not about expanding the government. Instead it should be about enabling saving, reducing private sector debt, and repairing balance sheets.

Conversely cutting the deficit by decreasing spending and increasing taxes PREVENTS the private sector from saving. Since they have no choice but to try to save they simply cut spending further, resulting in a deeper recession. This is why austerity has been such a dismal failure wherever it has been tried. When you understand the problem it is fairly obvious that it is almost exactly the wrong thing to do.

Those who worry that excessive government borrowing could lead to default should be reassured that in countries with their own currencies government can never default as they create the currency. There may be a risk of inflation, but there is no risk of default.

Worrying about the wrong debt

Those who worry about debt and think it is a major problem are correct. Unfortunately they often confuse two types of debt, namely, private sector debt and government debt. These debts are entirely different. They are best considered as opposites. Government debt is, in fact, private sector savings, and vica versa. Indeed the only way that that the private sector as a whole can accumulate net financial assets is by the government sector spending more into the economy than they remove through taxation, i.e. by running a deficit.

Sound confusing? Think of it this way. The government has a legal monopoly on creating debt-free money. It creates this money by spending. If the private sector AS A WHOLE is trying to accumulate money (i.e. save) this can only come from the government spending. When government's tax they are removing money from the private sector. The annual difference between taxation and spending (the deficit) represents the amount of money created each year by the government. To repeat, government debt represents the total amount of debt-free money that the government has created. It is also exactly equal to the net financial wealth of the private sector.

The big macroeconomic change over the past 40 years has been the rise in private sector debt relative to income. This has risen to over 300% of GDP in many countries. This change was simply ignored by mainstream economists and policymakers. The usual justification was that private sector debt was matched my private sector credit so net private sector debt was zero. This is odd since it is obvious that there is a limit to how much debt can be carried by anyone which is set by their income. As debt rises relative to income an ever greater proportion of income has to be spent on servicing the debt.

The financial collapse was a result of defaulting on this debt, which created panic in the financial sector, which froze up the payment system. This induced a deep global recession which prompted the aggregate private sector cutting its spending and increasing its saving. This is entirely appropriate but it has depressed growth, since growth requires spending, and when spending is diverted to savings, growth is depressed. Governments stepped in to prevent collapse. This resulted in a big increase in deficits and government debt, which had been at record low levels in most countries before the financial crisis.

Remember that the aggregate private sector can only save if the government sector runs a deficit. Government deficits will continue to remain high precisely because the private sector is desperately trying to save by reducing its spending, which depresses growth and thus government tax revenue.

When understood this way it should be clear that attempts by the government to cut the deficit prevents the private sector from saving at their desired level. Does this austerity seem sensible when private sector debt is still at record high levels? Of course not. In fact it is counterproductive because, by depressing growth and increasing unemployment, austerity increases the private sector's desire to save. When you see your income go down and everyone else's is dropping, does it make sense to borrow more money?

Of course many will argue that, despite the damaging effect austerity has on the economy it is necessary to reduce the deficit because if we don't the government would have to pay very high interest rates to borrow money. This is an understandable mistake to make given what we have seen in the Eurozone. The difference is that Eurozone governments do not issue their own currency. They have to borrow it, and they do not control the interest rates for borrowing. This is unusual. Normally governments issue their own currency and they can set interest rates at whatever level they choose. Because of this they can never be forced to default on their own debt. That is why interest rates on government borrowing are so low in the US, the UK and Japan. There is no shortage of people keen to buy government debt even at low interest rates. Why? Because we are all still worried about the banking system, and when governments issue the currency then their debt is the safest place to store savings.

Instead of worrying about government debt policymakers should be focusing on accommodating the private sector's desire to save by increasing their deficits. Probably the best way to do this is to cut taxes, especially regressive taxes such as VAT and National Insurance. This would provide an immediate boost to demand. The deficit should be kept high until there are signs that the economy is running at full capacity. The clearest evidence of would be an increase in inflation. When this happens the deficit should be cut. If unemployment is till high then this suggests that there are structural constraints causing bottlenecks to economic growth. That is the time to focus on structural reforms to increase efficiency and eliminate bottlenecks. It should be clear from where inflation is greatest where those bottlenecks are.

Instead what the government is doing now is:
-aggressively trying to cut the deficit, when demand is already low
-trying to encourage private sector borrowing, when private sector debt is too high
-wasting time and money on structural reform without there being any evidence for structural problems.

The scale of their ignorance and incompetence is breathtaking.

Are we preparing the way for a new Hitler in Europe?

The strong preference of Germany for 'sound money', which was a major factor in the design of the Eurozone monetary system, may be based on a tragic misunderstanding of it's own history. Many Germans seem to believe that the hyperinflation during the Weimar Republic was somehow to blame for the shift of Germany to the right, which culminated in the disaster of the Third Reich and WWII. In fact there is no direct connection between hyperinflation and Hitler's rise to power. The sequence of causes and events was as follows.

1. The German government, saddled with huge reparation demands imposed by the rest of Europe, which it could not afford, printed money in order to devalue them (they were denominated in German currency). This succeeded but wiped out the cash savings of the German middle class. Economic growth began to recover but then slowed as governments around the world introduced 'sound money' (essentially a reintroduction of the gold standard) at the same time as balancing budgets. A new government was duly elected.

2. This government attempted to introduce sound money policies in the face of economic headwinds by cutting government expenditure and increasing interest rates. The result was a severe recession and mass unemployment. Hitler, campaigning on populist xenophobic and racist ideas that allocated the blame for this crisis on other groups (mostly Slavs and Jews) soon rose to power by popular vote.

3. Once in power he dramatically increased government spending (and the deficit) in order to rearm the country. This classical demand stimulus restored vigorous economic growth and living conditions improved rapidly. His popularity rose and his hold on power became unbreakable. The rest is well-known.

What lessons are there from this? Austerity and sound money policies do not work in a recession and when the money supply is contracting. Stubbornly pursuing them in a democracy will hand power to anyone who is prepared to abandon them. We must just hope that the politicians who eventually do what is obviously necessary to restore economic growth in Europe are not extremists. It would be tragic if the same mistake was made within living memory due to a misunderstanding of history.

Intellectual paralysis

It was painful to watch the budget speech, but even more painful to watch Ed Ball's response to it. George Osborne had to paint a picture of a stagnating economy which will not grow significantly for the foreseeable future. This was widely predicted by those relatively few commentators who understand how our monetary system works. As they also predicted, the stagnation has been accompanied by continued deficits and ever rising debts. So what was his solution? Continue with the austerity. There is no alternative. Why? Because if the government shows any signs of reducing its commitment to fiscal 'responsibility', and cutting the deficit, the markets will punish it by refusing to lend the money the government needs to finance this deficit. The credit rating agencies will downgrade the UK's credit rating and the interest rate that the government has to pay for for its 'borrowing' will rise, increasing the 'burden' on taxpayers. the government may even find itself unable to borrow and have to go grovelling to the IMF for loans, which will impose even tougher conditions than his austerity measures.

This is, of course, complete nonsense. Government with a sovereign fiat currency and floating exchange rates have no need to 'borrow' in order to spend. They create money when they spend. Borrowing is a self-imposed requirement that simply provides the private sector with somewhere very secure to earn interest on their savings. The government and its central bank can set these interest rates at any level they want to. [This does not apply to countries that do not issue their own currency such as those in the Eurozone.]

What was most painful about watching this was that the opposition, because they have the same mistaken understanding of the monetary system as the government, were unable to offer any coherent criticism. Ed Balls was reduced to accusing the government of failing to cut the deficit, which actually supported the Chancellor's previously mistaken austerity policy and his continuation of that policy. No wonder he looked flustered and confused. His head was grappling with a contradiction so large that it induced intellectual paralysis.

The tragedy of the current economic crisis is that across the world all policymakers are operating under the same mistaken understanding of how modern monetary systems operate. Most importantly, they operate under the same view that governments must not run deficits and should try to run surpluses, believing this to be prudent. In fact this is a very dangerous. In modern fiat currency systems the governments are the only source of debt-free money. When they spend they are adding this money into the economy. When they tax they are removing it. They need to spend more than they tax (i.e. run a deficit) in order to add debt-free money into the economy. This additional money is needed to satisfy the private-sector's desire to save. Without it the economy would shrink every year by an amount exactly equal to net private sector savings, as this 'hoarding' of money removes it from circulation, reducing demand. Running a budget surplus reduces private sectors savings. Government ’debt' represents net savings of the private sector. Reducing this debt will reduce their savings. At a time when private sector debt levels are still at very high levels this seems bizarre.

There are compelling historical demonstrations of the dangers of government surpluses. For example, there is the fact that every depression in the USA in the past 230 years, and there have been six of them, was preceded by many years of government budget surpluses. Conversely, on every single occasion that the US federal government has tried to reduce its 'debt' substantially by running multi-year surpluses this has been followed by a financial collapse and a depression. When you appreciate that by running budget surpluses the government is effectively confiscating private sector savings it is not surprising that surpluses are so damaging. Logic and experience are clear. When the government is the supplier the currency deficits are necessary and surpluses are reckless.

Taxes can encourage working

We keep hearing that taxes destroy the motivation to work. I am not aware of any evidence that supports this. In fact countries with high taxes (northern Europe and Japan) have some of the hardest working people, whereas countries with low taxes (eg Monaco and other tax havens) seem to be filled with people who do very little work at all!

In fact there is evidence that taxes have been used effectively to encourage people to work. This was the case when European countries colonised less developed lands and wanted to employ the native people to work on their farms or in their houses, factories and mines. They were understandably reluctant to do these jobs because, being subsistence farmers, they had no need for the wages. This problem was resolved by colonist by imposing a poll tax or hut tax on them, payable in the same currency that was paid to workers. Since payment of these taxes was enforced by threat of punishment it was now necessary to acquire the currency. This motivated them to work for wages. Taxation therefore encouraged working by creating a demand for currency needed to pay the taxes.

The simplest way for a new currency to be introduced and have it accepted is to impose a tax payable in the currency, or allow existing tax obligations to be settled using the new currency. It has been suggested in Greece, for example, that the Greek government start paying wages using government IOU's which would be accepted as payment for taxes. This is an ingenious solution to the key problem facing Greece and other Eurozone countries which is a severe shortage of currency in circulation.

If one considers that taxation is a debt imposed by the government, a good case can be made that the real value of any modern currency ultimately derives from the fact that it can be used to repay debt obligations. These could be debts to private banks or debts to the government (taxes). As long as there are debts payable in a currency, and payment is enforced, there will be demand for that currency.