Reality (2): the nature of money

In this post I continue to discuss elements of macroeconomics that are beyond dispute. One of these is our monetary system. While this is complicated it was designed by humans so should be readily understood. What is remarkable is that not only do very few ordinary people understand the monetary system, most of those working in or writing about the financial sector do not appear to fully understand it. This is a consequence of the highly misleading fact way that it is taught at University and described by economists.

The first important fact to appreciate is that most of the electronic money that is used by the private sector is created by private banks, NOT by the central bank or government. This money, which experts call bank money, is created when a bank makes a loan. When it does this it adds a number to your bank account using a computer. At the same time it gets you to sign a contract requiring you to pay that money back by some future date. When this loan is paid back the money disappears. This is analogous to how matter is created out of nothing but has a counterpart anti-matter. When the two come together nothing remains.

Central banks also create electronic money but this money, called bank reserves, is present at far lower amounts than commercial bank money. The relationship between central bank reserves and bank money is not well understood. Central bank reserves never actually leave the central bank account system. Instead they move between those who have accounts at the central bank, namely the government and licensed banks. Their primary role is to settle payments between private banks, and between the government and private banks.

When customers with accounts at the same bank exchange money all that happens is their accounts recording their bank money go up and down accordingly. No central bank reserves are involved. However when customers with accounts at different banks exchange money then the banks transfer central bank reserves between their respective accounts at the central bank to effect these payments. In essence banks have reserves to enable them to settle payments between their respective customers. They also use reserves when they issue notes and coins to customers. When they obtain cash from the central bank their reserve account is marked down by that amount, and vica versa.

Only central banks can create bank reserves, and they can do this unlimited amounts. The amount of money in reserve accounts bears little relationship to the amount of spendable money in the economy. Some central banks require banks to hold a minimum amount of reserves, equivalent for example to 10% of the value of bank deposits that they hold. Students are usually taught that this requirement enables the central bank to indirectly control the total amount of money in the economy just by changing the amount of reserves. This is wrong. In practice central banks always lend banks whatever reserves they need to meet these reserve requirements (if they exist) or to make payments between each other. They do this because failure to do so would cause the payment system and hence the economy to collapse. What central banks do try to control is the interest that banks have to pay to borrow more reserves. When a bank makes a loan of BANK money it is possible that, if that money is transferred to a customer at another bank it will need to borrow reserves to settle the transaction. Therefore the interest rate that banks set for that loan will be influenced by and always be higher than the interest rate that it would have to pay to borrow reserves.

The fact that almost all the money that is spent in the economy is bank money created by banks out of nothing when they make loans has important implications.

1. We effectively rent most of our money from private banks.
2. The amount of money circulating in the economy is determined by the balance between the rate that banks make new loans and the rate that old loans are repaid. If people take out fewer loans or increase the rate at which they repay existing loans then the money supply shrinks which reduces economic activity. This is why the government has been trying so hard to persuade people to take out more loans.
3. Increasing the amount of central bank reserves does increase the amount of money in the economy but changes in bank lending have much bigger effect on the amount of money. Since 2008 central banks have been increasing reserves by huge amounts but this has barely compensated for the reduction in the amount of bank money as people stop taking out new loans and continue to pay back existing ones.
4. As the economy grows the level of private debt grows since all bank money created to support growth has a corresponding debt. In fact in the past 40 years the level of private debt has grown much faster than the growth in economies. It should be obvious that it is not sustainable for private sector debt to grow faster than the economy as measured by GDP because the interest costs of this debt are paid for out of total income or GDP. Nevertheless policymakers allowed this to happen, and only a tiny handful of economists pointed out the fact that this would end in tears. By 2007 this debt level reached over 300% of GDP before, as predicted by economists outside the mainstream, the credit bubble collapsed.
5. Growth collapsed largely because the private sector switched from increasing their borrowing year by year, which they had done for up to 40 years non-stop, to paying down their debts. Unfortunately because of the fact that most money is created through bank lending, this resulted in a decrease in the money supply and has suppressed economic growth. That is why government are desperately trying to reverse this and encourage borrowing.
6. Given this scenario described above, and the fact that private sector debt levels are still so high, it seems foolish to try to restore growth by encouraging the private sector to once again increase its debt levels, especially when economies are shrinking because of cuts in government spending.

The problem of net exporters

One of the main sources of imbalances in the world economy are the countries who aggressively pursue a policy of becoming and remaining net exporters. These include countries such as Germany and China.

With floating exchange rates net exporting will eventually lead to an appreciation in the exchange rate, which by changing relative costs of exports and imports will reduce the surplus. Sometimes countries determined to remain net exporters try to prevent exchange rate appreciation by keeping the money that they received in payment for their goods in the importing countries. That is a self-defeating policy since it means that people in exporting countries are working hard to producing goods, sending them off to other countries, and receiving no real benefit in return other than a financial claim. All they have is some money in the importing country, but what use is that? It would make more sense for them to get something in return from those countries, such as imports of goods. In modern fiat currency systems exports are only of any real benefit if the proceeds are use to purchase imports. Countries that are net exporters are working hard and exporting the benefits.

If net exports are a cost, why do so many countries pursue net export policies? The short answer is the IMF. This organisation was set up to help countries that were temporarily short of the foreign currency reserves they need to purchase essential imports or pay back loans. When countries have run into problem in the past the IMF has lent them money under very strict conditions, which include a requirement that government sacrifice control over the budgets and impose austerity on their economies. Bitter experience of the hardship and humiliation that this resulted in has meant that many countries are determined to avoid ever having to seek help from the IMF ever again by building up large foreign exchange reserves. This is best achieved by being a net exporter and not repatriating earning from imports, building up large foreign currency reserves.

Other countries like to be net exporters because they believe it is prudent for both the private sector and the government sector to be in surplus, and this is only possible if they are net exporters. Germany is good example of this. Germany works very hard at maintaining its net exports by suppressing wage increase amongst its workers which keeps imports down by suppressing domestic consumption. Ironically it is the German people that stand to lose the most from this policy of aggressive net exporting since they are effectively creating things that other countries are using in return for a financial claim which will become worth less or even worthless as their currency appreciates or the importers default on these debt. Not so clever.

Reality (1): Money has to come from somewhere and go somewhere

There is much that is debatable in macroeconomics but some facts are beyond dispute. One such fact is that the flows of money between three different sectors of any economy with a given currency have to add up to zero. Understanding this and its implications is incredibly important.

These sectors are the domestic government sector, the domestic private sector, and the external sector or 'rest of the world'. The reason that the balance of these sectors must add up to zero is simply that there is nowhere else for the money to go. If any one sector has a surplus then at least one of the two sectors must have a deficit.

We often hear references to the balances of two of these sectors, namely the government sector and the external sector. When people discuss the government deficit or surplus they are referring to the difference between the amount of money flowing out of the public sector (through spending) and the amount flowing in (through tax revenue). Government debt is just the sum of the accumulated past annual deficits (minuses surpluses).

When people discuss current account deficit or surplus with the external sector they are referring to the difference between the money received from exports or remittances and money spent on purchasing imports. Saying there is a current account deficit is equivalent to saying that the external sector has a surplus.

What is seldom, if ever, explicitly discussed is the financial balance of the third sector, which is the domestic private sector, comprising individuals, households, and companies. This can obviously also have a surplus or deficit.

As noted a key fact is that financial flows between the three sectors will always balance each other.

What this means is that if a country is a net importer (i.e. the external sector has a surplus) then at least one of the other two sectors must run a deficit. Either the government must have a budget deficit or the private sector has to run a deficit.

Since it is widely felt that it is bad for the government to run a deficit and accumulate debts, when there is a government deficit policymakers frantically try to reduce it by increasing taxes or cutting government spending. The problem with this is that, because of the sectors must balance, this forces the private sector to run a deficit.

This is potentially dangerous. It is not sustainable for the private sector to run deficits as it will eventually lead to insolvency and financial collapse.

This contrasts with government deficits, which are sustainable indefinitely in modern economies since the state issues its own currency and, unlike the private sector, can never run out of it. That is the defining feature of modern fiat currency systems. Indeed it seems logical that if the government creates money then it needs to run a deficit as this is the only way for the private sector as a whole to accumulate money (i.e. save).

Unfortunately there is widespread belief that public sector deficits are not sustainable and have to be eliminated. That is simply not the case. Indeed most governments run deficits most years. Surpluses are rare. On the rare occasions when the US government has tried to run surpluses for several years they have always precipitated financial collapse of the private sector and depressions. It is repeated public sector SURPLUSES that are not sustainable, as this forces the private sector to run repeated deficits.

The only way that they government sector can avoid deficits and the private sector simultaneously run surpluses is for the country to be a net exporter. In other words for the government and the private sector to have surpluses the external sector has to run a large deficit. The problem with that approach is that not all countries can be net exporters. Globally exports and imports have to balance to zero as, until we connect with alien life, there is nowhere else for exports to go! So if some countries are net exporters that forces other countries to be net importers. Because many countries (e.g. China, Germany, Koreas, and until recently Japan) actually have policies committing themselves to being net exporters this forces other countries to be net importers. Most large developed countries (Germany excepted) are net importers. It follows that in these countries, which include the USA and the UK, it is necessary essay for governments to run deficits to match the external sector surplus. If they don't they will be forcing their domestic private sector into deficit.

In summary, the requirement for money flows between sectors to balance means that in countries that are net importers governments need to run deficits in order to ensure that the domestic private sector does not become insolvent.

The student loan scam

The government has pulled of a huge scam which screws the young in order to to ensure that their own generation does not have to face higher taxes or cuts in benefits.

The scam works as follows. The government lends money to students to pay their fees and maintenance and then collects payment in the form of increased taxes. Because repayment is only required when earnings rise above a threshold level, and the outstanding loan amount is cancelled after 29 years, there is a perception that the terms of the loan are very favourable. This is not the case. The key fact is that the interest payable on the loan is set at 3% above the retail price index or inflation rate. The current inflation rate is 3.6% so the interest rate would be 6.6%.

The huge cost of these loans can be determined by using the government's own student finance website (www.studentfinance.direct.gov.uk).

Students doing a standard 3 year degree who borrows the whole fee of £9000 pa as well as £3750 pa for living expenses will owe £38,000 when they graduate. If they earn the average graduate starting salary of £25,000 they will end up paying a total of £103,000 before the loan is paid off.

Medical students who take out the full loan for fees and maintenance for their 6 year degree will owe £100,000 when they graduate. If they have the average doctors starting salary of £35,000 they and will eventually pay £255,000.

These are huge sums. There is little chance of escaping payment as they are charged through income tax. Graduates with loans effectively pay a 9% higher income tax rate for most of their working lives.

One wonders how long it will take for graduates to realise that the only way to escape payment is to emigrate? If the system stays in place it could lead to emigration of graduate in huge numbers, doing enormous damage to the UK economy, and leaving the elderly who introduced these charges to protect their own pensions to fend for themselves. Perhaps then they will appreciate that the money is useless when there is no one left to actually do the work. And it will serve the misers right.

Why it would not matter if no one wanted to 'fund the deficit' by buying government bonds.

Let us consider the mechanics of government spending and borrowing. In a fiat currency system when governments spend numbers are added to recipient bank reserve accounts at the central bank. The money in reserve accounts earns little if any interest. When governments sell bonds what happens is that money in reserve accounts is moved into special interest-bearing accounts. If no-one wants to buy the bonds the money simply stays in the reserve accounts, earning no interest. Does this mean that the government is broke or will default? Of course not. In fact they are better off as they don't have to pay any interest. Government bonds are a benefit to the public and a cost to the government. The requirement to sell bonds is not needed to fund spending. Typically it is needed to execute monetary policy, as it enable central banks to target interest rates that banks pay to lend reserves to each other. When there are excessive reserves in the banking system and base rate is very low, as is the case now, there is no longer a need to sell bonds to execute monetary policy. If the economy recovers and starts growing rapidly, and it is felt necessary to reduce reserves then there are other ways of doing it that don't require the sale of new government bonds. The central bank could sell some of the bonds that it has purchased through the quantitative easing programme. The government could reduce the deficit or even run a surplus by increasing taxes and reducing spending. In fact this will happen anyway as the economy grows since tax revenues would rise and welfare payments such as unemployment benefits etc would fall.

If there is no need to worry about about our government being able to borrow to finance spending why is there so much anxiety expressed about the deficit? It is all down to mythology. There is a self-imposed rule that governments sell bonds equal to the value of the deficit, which gives the appearance that governments are financing the deficit. To implement this rule government have an notional account at the central bank. When tax payments are made this account is marked up by that amount. Similarly, when bonds are sold the account is also marked up. When governments make payments this account is marked down. Finally this account is not meant to fall below zero. These are all rules that the government imposes on itself to support the myth that government spending needs to be funded by taxes and borrowing. They can easily be bypassed or changed as the government enforces them. The myth is sustained because of the view of those who know better that the public and political leaders need to have a 'fear of bankruptcy' in order to convince them to raise or pay unpopular taxes and to restrain their impulse to spend excessively. It is analogous to the idea that religious belief in heaven and hell are needed to encourage virtuous behaviour. Myths can have tragic side effects. Suicide bombing is one example. The entirely unnecessary waste and misery induced by misconceived fiscal austerity is another.

Reconciling MMT with New Keynesianism

Simon Wren-Lewis's recent post and work that he cites provides a fascinating insight into how modern monetary theory (MMT) and mainstream neo-classical views on the effect of government deficits can be reconciled.

According to MMT government debt represents accumulated net private sector financial assets and, since government's create the money and can never default, the level thereof should not be considered as a constraint. It represents the private sector's desired level of net savings. It never needs to be repaid, and even if it did, it could easily be repaid as the government/central bank could just issue the money. MMT regards the only constraint of deficit spending to be demand-led inflation. The deficit should be reduced if inflation rises above an agreed target. It should be used a second tool of monetary policy, in addition to interest rates, to hit inflation targets.

The neo-classical view, based on the notion of rational expectations, is that the debt has to be paid off and so a rational consumer will view this government debt as a future tax liability and adjust their behaviour accordingly. In other words they would not consider the debt to be a net financial asset. Simon Wren-Lewis discusses the implication of using 'printed money', which he refers to as outside money, instead of government debt to fund the deficit. Would this have a beneficial wealth-enhancing effect now that this debt did not need to be paid of by future higher taxes? He cites work suggesting that it would, but then argues that it may not if the authorities had an inflation target, as the printed money would be expected to expand the monetary base and inflate prices. He argues that, in order to hit the inflation target the authorities may increase taxes to contract the monetary base, neutralising the wealth effect of outside money.

The problem with this argument is that it assumes that the authorities to act in a way that conforms to the neoclassical view, and that this will be anticipated by the the rational consumer. How realistic is this? The authorities would surely not contract the monetary base under circumstances he cites (a liquidity trap) to counter inflation. First, the liquidity trap arises because there is a recession that the authorities will be trying to counter by loosening monetary and fiscal policy. Why would they raise taxes and contract the monetary base? The whole point of QE is to increase the monetary base. Second, the usual way to decrease the monetary base is by the authorities issuing securities (e.g. government debt), or reverse QE. Why would they not do this instead of increasing taxes? Third, the monetary base has a very weak, if any, relationship with the broad money. Look at the data. This is what you would expect if you understood how broad money is created, by bank lending, which is not reserve constrained.

The MMT view is that the rational consumer, if they really understood the monetary system, should and would consider government deficit spending to be financed by 'outside money'. In reality when government spend they introduce new (outside) money increasing the monetary base. Taxes remove most of this new money in order to ensure that demand is not excessive. Current self-imposed rules require that the difference or ’deficit' is borrowed back by issuing government debt certificates. In reality all this involves is them moving the money from reserve accounts at the central bank to interest bearing accounts at the central bank. In some countries this 'reserve drain' is necessary in order for central banks to hit their overnight interest rate target. The key point is that this government debt really represents government backed savings accounts for the 'outside money' that has already been introduced, much like National Savings Certificates in the UK.

So government debt actually is 'outside money' and represents net financial assets of the private sector. There is no need for it to be fully repaid and so no reason to expect tax increases just to pay this debt. A truly rational agent would not expect tax increases unless growth was so vigorous that it resulted in inflation, which would be associated with full employment and an economy functioning at full capacity. A rational agent would expect such growth to result in a reduction in the deficit (as tax revenue increase and welfare spending drops) and a reduction in debt/GDP ratio as GDP increases, and historical experience backs this up.

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?