I am beginning to see an increasing number of post-coronavirus economic myths emerging on twitter and other media. These need to be tackled now. I will do so as I note them. If people see issues to address, please let me know.
One such myth that appears quite commonplace at present is that the creation of money by the government to tackle this crisis will lead us, in very short time, to a situation like that of the Weimar Republic, with hyperinflation following. This is quite empathetically not true for a number of reasons.
Firstly, for there to be inflation there has to be something that drives it. For example, there has to be a shortage of available labour in the market which drives up wages. Right now there is a prospect of mass unemployment, meaning that the chance of wage driven inflation is, therefore, incredibly low.
Alternatively, there has to be excess demand for what is available in market, meaning that prices are pushed up by supply-side shortages. Whilst there is more risk of this, particularly with regard to some basic products at present, what almost invariably happens during a period of crisis, which in this case is likely to last for much longer than most people realise, is that people save because uncertainty creates that natural reaction. In that case excess demand for this reason is unlikely.
Excess demand for items in short supply is also unlikely because there is little chance that banks will be offering easy credit any time soon: their balance sheets are going to take a hammering during the course of the coronavirus crisis and if anything credit is going to be in short supply. Excess demand giving rise to inflation for that reason is also unlikely in that case.
There is also little sing that external price shocks e.g. oil price increases, are likely at present. Instead all commodity prices are falling because of declining demand which is likely to continue for a long time to come.
Second, we are in nothing like the situation the Weimar Republic found itself in during the 1920s. What happened in that case was that following the First World War it was obliged to pay reparations to the winning countries in that conflict. They demanded payment in what were their own gold standard backed currencies of that era, meaning that in an effort to pay Germany had to focus its entire economy on exports to earn the foreign currency it owed and crush an already defeated population with what was, in effect, a massive austerity programme that sold their labour at an undervalue to the winning states. It could not achieve that goal and in the economic turmoil that followed, and as a result of the effort to serve its obligations to buy the currencies of other countries to make payment to them, it crushed the value of its own domestic currency, with disastrous consequences. But we have no such obligations now. Crucially, nor do we have the gold standard now. As importantly, nor does the UK government borrow in foreign currencies. And, as a matter of fact the rest of the world still seems rather keen to save in sterling. So we are not remotely in a situation like that of Weimar Germany even if we will see a lot of government-created money this year, and in the years to come.
There is a third, and perhaps most important reason why we will also not get inflation. That is because of the nature of modern money. It is crucial to understand that all modern money is just a promise to pay. We really should be familiar with that: it is written on our banknotes, after all. But it seems that we are not. As a result this requires explanation.
Electronic money, which represents about 97% of all money in use in the UK, has no more physical existence then an entry in an electronic bank statement. That is all it is: just an accounting entry. There is nothing to physically back it up. There is no gold in vaults, or cash in safes. There is just book-keeping. That is what our money is. It is accounting entries in bank ledgers.
Those accounting entries are made to record the real nature of money. That real nature is what is printed on our bank notes: money is always created by a promise to pay. The accounting records those promises.
So, for example, if you pay cash into a bank account the bank does not keep that cash for you. Instead, it records its promise to pay you back an equivalent sum when you ask for it on an electronic bank statement. You no longer have the cash: you have the bank's promise instead. That's it: you have now literally nothing else. You just have to trust that the bank is good to make the payment.
Such transactions in case are, however, the exception now: most electronic money entries in accounting records are made in a quite different way. In this other way they are always, and without exception, created by bank lending. This needs explanation.
When a bank makes a loan it does two things. It marks up its customer's current bank account with the amount of the loan, and then promises that the bank will then honour any payment that the customer tells it to make out of that account. This is one side of the promise to pay: that form the bank to the customer.
The other side is that the bank marks up the customer's loan account with the amount of the loan to record the fact that the customer has also made a promise to pay. That is the other side of the promise to pay.
With those two simple records being created, new cash has been put into existence. It did not exist before these two entries were made into the bank accounts in question. It does afterwards. And that is the way in which about 97% of all money in the United Kingdom is created, whether that be by commercial banks or, as importantly as I note below, by the Bank of England.
Most importantly, this is also the way in which the government spends. Like absolutely everyone else in this country, and any other country with a similar banking system, there are just two conditions that must be met before the government can spend.
First, it must decide to do so, which is something that ministers and Parliament must do. We hold them to account for these decisions.
Second, it must have available credit with its bank to let it spend.
Both conditions are essential: money is not created without the decision to promise to pay, which Parliament and ministers can deliver, and then the ability of the government to deliver on that promise because a bank will agree to make the resulting payment, in exchange, of course, for a promise from the government to make repayment to it in due course.
Note that there is no requirement that there be cash in the government's bank account before it spends, because that is not necessary. Instead what is required is a bank willing to extend credit — to mark up its ledgers in the way I have just described in other words — on behalf of the government.
It's important to note that nobody else's cash was involved in the process of making the loan I previously described: the making of the new money that loan created was a matter that only involved the bank and the customer who took the loan. That's also true when the government asks a bank to make a payment for it: no previous cash deposit, whether from tax revenues or third-party borrowing is required to enable this spending to take place. All that is necessary is that a bank agree to advance the government the credit it wants and then the government can spend as it wishes, or as parliament has decreed in a budget.
There is, however, a twist to this tale. It just so happens that most governments are in a quite exceptional position when it comes to asking for credit. That is because the vast majority of governments own their own central bank. It is important to appreciate that these central banks are real banks. They can make real loans in exactly the same way as I have already described. And they can, as a consequence, make loans to the governments that own them, subject to the rules and constraints that those governments have voluntarily or otherwise imposed upon them, as many have in areas like the Eurozone. Those rules and constraints have been put in place to restrict the ability of central banks to lend to their governments, largely for the benefit of the private banking sector which has, in most countries, considerably over-expanded and became too powerful as a result. But these rules and constraints apart, and however and whyever they are imposed, there is no reason at all why a government should not borrow from its own central bank.
But, in this exceptional case of a government borrowing directly from its central bank something quite unusual happens. Precisely because the government owns the central bank it borrows from any promise to pay that they make to each other can be open-ended. No date needs to be attached to it. There is good reason for that: you cannot, in effect, owe yourself money, which is what happens when a government borrows from its own central bank. And in that case when you repay is a matter of inconsequence: in truth it changes nothing.
Despite that, however, the government can spend from its account with its central bank based on promise that it has made. But, crucially, it need never repay that bank, if it so wishes, because if it did it would only be repaying itself, in effect. So something quite different from what happens in a normal loan arrangement happens in this circumstance: the money that is created can be left circulating in the economy in perpetuity if the government so wishes, at no cost to the government itself. In effect, what has happened is that the debt that the government owes its central bank has been turned into money itself.
This was considered a threat to economic stability from 1971 onwards, when the world did, in effect, come off the gold standard with the United States, which happened in that year. Because this whole process was so little understood at the time, and because many of the economic theories of money were also deeply underdeveloped back then, the whole school of monetary economics came into place to try to restrict the ability of the government to create money at will because it was believed that this would lead to hyperinflation. Instead economies were forced to rely solely on private-sector banks to create most new money through their lending, driving the economy into ever-increasing debt cycles that have had a significant adverse impacts upon income and wealth inequality, growth and economic stability. The policy has remained in place ever since, constraining the whole of the Eurozone, creating the policy of independent central banks, imposing austerity through the artificial constraint that it creates upon the government's ability to fund its activities, and causing untold harm as a consequence. The cost of not understanding money is enormous. But now we do: it works as I have explained.
As importantly, what we also know is that if there is an economic downturn — and the coronavirus crisis is going to create a massive economic downturn — then two things happen.
First of all, many banks trying to recover the loans that they have made. And, when a bank loan is repaid the money that it created is then destroyed: quite simply, the creation process is put into reverse. As a result of the money supply is restricted.
Second, banks tend to substantially reduce the amount of new lending that they make. Partly that is because worried people tend not to apply for bank loans, because they reduce their spending instead. More problematically, though, banks also refuse to extend new credit precisely because many of the potential customers do not look as though they can fulfil any promise that they make to repay the bank. This is precisely the situation that many UK businesses, homeowners, and others are facing.
The result is a reduction in the money supply. What that means is that if we were solely dependent upon our banks to create our money then the amount available to make the economy go around would be reduced. We would get what is called a liquidity crisis. And that is exactly what we now have: people and companies are going to fail precisely because they cannot get access to the cash that they need to make the payments that they owe even if they believe that their incomes might recover in the post coronavirus crisis period. Unimaginable harm might come to the economy as result, which the government's inability to deliver on its promises of support on a timely basis will only exacerbate.
Government can correct for this. Precisely because most private-sector banks will be reducing their risk at present by calling in their loans, or by refusing to make new ones, the government has to compensate by creating new money instead.
It did this after the 2008 global financial crisis. The process used at that time was called quantitative easing (QE). This was a bit cumbersome but what, in effect, happened was that central banks bought government bonds that were already in issue from the financial institutions like banks, pension funds and life-insurance companies that already owned them with the intention of providing more liquidity to the financial markets, which they hoped would do two things.
One expectation was that this would encourage investment in new assets. This failed. The money was mainly used for financial speculation instead.
Second, they intended to push the interest rate down, which the government also believed would encourage more economic activity. The objective of reducing interest rates undoubtedly worked: the official rates have been at, or near, zero per cent for almost a decade now. There is, however, little sign that this boosted economic activity, although it might, again, have increased inequality in all its forms.
The QE program was, then, deeply flawed: whatever success it achieved in helping people and businesses to afford their loan obligations was more than compensated for by the divisions in income and wealth that it produced in society.
Thankfully, we do not need to use the QE process again now. Precisely because no one wishes to reduce official interest rates any further, largely because there is considerable uncertainty as to the impact of negative interest-rates, QE is no longer needed because the type of liquidity it created was otherwise unhelpful. Instead, the process of direct funding from central banks to governments can be used instead.
And, importantly, and to return to the theme of this post, this will not be inflationary unless three situations occur.
The first is that full employment is restored and the policy is perpetuated. Then there will be wage inflation. It's a risk, of course, but not for a long time to come.
The second is banks start recreating money by lending again. They will, eventually, but not for a long time to come, I suspect. Everyone's balance sheet is going to be very weak after this crisis and that's always bad for lending.
And the third is that governments do not react to the first two situations when they arise by then (and only then) beginning to withdraw the cash that they have created from the economy, with the effect of cancelling it, just as loan repayment does in other lending situations. That's when tax increases will be needed. They serve this purpose of destroying money at that time. Until then they're wholly counterproductive, because they will drag money out of the economy and destroy it when that money will still be required to provide the essential liquidity that the economy needs to function as it returns to full employment, which should be the goal of any government.
So, there is an inflation risk, but it's at some time in the future. And we know how to deal with it then. That will not be by increasing interest rates — which creates debt insolvencies — but by tax increases, but these are required only when the pressure is apparent.
What chance is there of significant inflation in a year or so then? I'd call it zero, for all practical purposes. In fact, I would suggest that the chance is very low indeed for several years to come.
So might we do two things then? One is let's stop discussing inflation risk.
And the other is to stop discussing the need for tax increases unless those are designed to redistribute income and wealth i.e. the increases for those with higher incomes and wealth are matched by cuts for those with less of both. But generic overall tax increases are simply not required now.
There is much that we need to fear about this crisis. Inflation and tax rises do not need to feature on a list of those things.
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[…] This, of course, reduces worldwide inflationary pressure. […]
Richard – Thanks for this very clear and easily understood explanation.
Thanks
Thank you Richard, very helpful. Typo I think in sixth para from bottom , I guess you mean [taxes] “serve the purpose” not “swerve this purpose”!
Corrected, thanks
Wot – you spotted that but missed “empathetically” for “emphatically?” 🙂
Thanks very much, that’s a really good summary to an area I was unsure about on a post a week or so ago. Thanks again.
I’m glad you’re putting QE to bed at the moment. It’s totally unnecessary in the current circumstances and continuing to discuss it simply gives unnecessary ammunition to the forces of darkness and reaction. I agree that it was covert direct monetary financing (DMF), but the defenders of the status quo will continue to deny this vehemently. Whether or not it will be unwound eventually is totally irrelevant now.
Governments can and should spend without limit now to compensate for the social and economic impacts of tackling Covid-19 effectively. With stock markets tanking there is a huge demand for safe assets and governments can borrow at close to zero cost. Once the central banks are committed to use DMF — and the key ones appear to be — any hedgies or disaster capitalists who attack particular countries’ bonds will be blown out of the water.
And you are correct that fears of future tax increases to service this debt are totally unwarranted given the cost of borrowing and the economic activity that this borrowing will sustain and generate.
And as for inflation, what planet are these scare-mongers on?
I’ve always put QE to bed
I argued against it and for DMF from 2010 on
That’s what Green QE always was
QE was always a mistake when DMF was better
Unfortunately, you’re indelibly associated in the public domain with People’s QE and its role in Corbynomics. Politically, it was astute, as a contrast to the QE being advanced to the 1% under the cover of a monetary policy technique to reduce long term rates and to increase the flow of credit, but from a technical policy perspective it was infuriatingly imprecise and exposed it to totally predictable, but unjustified and unwarranted, attacks. In reality, it simply was a threat to use DMF if the government, with the consent of Parliament, increased deficit spending and the hedgies and disaster capitalists decided to short UK government bonds and to drive yields through the roof.
It is identical to the threat of a wall of money via DMF that the US Fed, the BoE and the ECB are now deploying in response to Covid-19 to ensure the bond market functions efficiently and to suppress the damaging antics of the hedgies and disaster capitalists.
I’m not sure about what is unfortunate about being right
Can you explain?
Being right and being accepted as being right are two very different things when it comes to influencing policy formulation. The fact that the threat of DMF is being used by the key central banks to underpin government spending during this crisis does not mean that the use of this threat will be maintained once the crisis subsides. Indeed, the pressure from the powerful and the wealthy and their armies of well-heeled flunkies and functionaries to return to BAU will be intense and sustained.
Agreed – so we have to put in place the counter naratives to them now
Fully agree about the counter-narrative. Once Stalingrad fell, the last war was won; it was only a question of when. From that point Keynes worked himself in to an early grave trying to establish the post-war economic order. We have far less time now – even it will be sadly longer than it need be due to the wilful dithering of this incompetent and mendacious government. And it has to be a hugely collborative effort. No one person, or even a small group, can drive this.
The scare-mongering capabilities of the defenders of the status quo ante will be in full flow. In addition to future tax and debt burdens and run-away inflation, we’ll have “deficit bias”, irresponsible governments succumbing to populism, innovation and entreprise-killing statism, expropriation of wealth, restrictions on freedom and liberty, curtailment of property rights, excessive bureaucracy and red-tape and all sorts of other horrors and terrors.
All I want to see is a properly functioning mixed economy that promotes the welfare of all citizens, advances productivity and prosperity, spreads the fruits widely and seeks to prevent the sustained capture of economic rents in all sectors. We haven’t had anything remotely resembling this for more than 40 years.
Only one battle has been won with the key central threatening DMF during this crisis. This will be a long war and we need to gear up for it. This crisis will run its course and excessive focus on the daily twists and turns will waste time and energy. Much better to focus on post-Covid-19.
I hope that Krishnan Guru-Murthy from C4 News takes the time to read this, Richard, as once again in an interview last week he was asking ‘where will the money come from’ and then taking the old, tired line, of taxes or austerity.
Mind you, he’s not the only news person on TV who just can’t seem to get their head around the real nature of money. Then again, maybe they just don’t want to understand, as asking questions of the ilk of ‘where’s the money is coming from’, or ‘how’s the country going to pay for this’ are a staple of interviews with politicians.
What’s certainly clear is that by the time the coronavirus crisis is over the currency (no pun intended) of the infamous ‘there is no money left’ note that Gordon Brown’s outgoing Treasury Minister, Liam Burn, left for the incoming Cameron government will be well and truly rubished. Sadly, the damage it caused in providing significant cover for the austerity that followed will never be undone.
Thanks Richard. Really useful for those of us not on the academic circuit. Will be able to share with a wide variety of friends in health,social care and housing. Regards
In general I agree though I wouldn’t be so sure on the inflation front. Yes labor shortages can cause inflation, but so can shortages of raw materials. Shutting down everywhere for weeks at a time is undoubtedly going to cause unforeseen shortages of this and that with the result being inflation. The worst thing in the world would be for everyone to blame the resulting inflation on MMT and point to MMT promising no inflation.
It all depends upon then time horizon. If we look way beyond now to a point where economies are back on their feet. The danger is believing the printing of money can sort out all economic, political and social problems. And some political parties may well try and sell that idea to get in power. We also don’t know where our productive capacity really lies. It is impossible to calculate. Also taxation to control inflation is a myth..why? because the electorate won’t stand for rising prices and falling disposable incomes (through taxation). A government suggesting that will be voted out of office. The more likely outcome will be turning off the fiscal taps. In other words a return to boom bust economics. I re-emphasise this isn’t an immediate problem and it might never come one. But it will if a Government or Governments print to increase the abandon to satisfy current populist agendas without looking at the problems this will cause further down the line.
So, I have an answer to the problem you face
No one thinks conventional fiscal policy will now work
And monetary policy is dead in the water
What are you proposing instead?
Before you tell me I’m wrong – what have you got to propose that is better – because no one else knows what it is
Explain please
“So, I have an answer to the problem you face. No one thinks conventional fiscal policy will now work. And monetary policy is dead in the water. What are you proposing instead? Before you tell me I’m wrong — what have you got to propose that is better — because no one else knows what it is. Explain please”
I am pointing out how money printing can and will cause inflationary problems further down the line..to believe it cannot is naive in the extreme. It must be seen as an emergency measure to offset the collapse in economic activity now and not a cure to all economic and social problems when the world returns back to some normality.. like it is by many people.
Why will it do so?
Please explain
I am not saying it cannot, but why will it on this occasion, which is exceptional as I have explained?
Just saying it is is not good enough
Nicky
Who says taxes have got to rise? Who says that income tax will have to rise? For everyone?
What Richard is proposing I think is a selective taxation – new things like land might be taxed, or how about financial transactions or how about raising corporate taxes and taxes on the very wealthy (who have done rather well out of 10 years of austerity). Some taxes could be reduced – VAT raised by the Tories from New Labour’s 11% to 20% was horrendous in 2010 and could be reduced for household goods and VAT smacked on a whole load of other things at the higher end of the market. I’m all for taxing assets more to be honest related of course to their value. Income tax for those below £50K might be lowered. All these are choices that could be made that would actual benefit more people who are strruggling already.
As for inflation, it depends not just on timing but also what staples in the economy are being taxed or not. The Government might also want to issue bonds at this time to soak up inflationary cash in the private sector. Allied to this other things would need to be going on – we’d need to be looking at regulation in the banking sector and bringing the delinquent banks and markets in line and seriously curbing their ability to cause bubbles and disruption to make short term profit.
And if this money was to be printed into green technology – even better. Your questions are rooted in what happens now – not what needs to happen next, and this calls for a real leap of imagination.
Try it yourself.
We could reduce NI too – for the lower paid – and add it to the higher paid plus an equivalent charge on investment income
That would work very well
Many thanks Richard for a comprehensive, and excellent analysis. Useful in so many ways to counter the bleurrggghh being spouted by so many media reporters and neoclassical economists.
Thanks are also due for your many comments directed at what some are calling “British exceptionalism” in the face of Covid-19.
I wonder if you listened to BBC Any Questions on Friday? One of the questions was whether there is a trade-off between saving people from Covid-19 and saving the economic future of future generations. Not the wording of the actual question, but the BBC’s Chris Mason “helpfully” translated it into those terms. All of the panellists thought saving lives is the priority for now, but nothing of interest was said to counter the “future generations” nonsense.
I did not hear it, but that does not surprise me
Could you explain this please.
“The other side is that the bank marks up the customer’s loan account with the amount of the loan to record the fact that the customer has also made a promise to pay.”
I’m assuming this is a bit of double entry, and not being an accountant I struggle with this.
There’s a current account and a loan account
That’s all I am saying
And they have equal and opposite but otherwise identical amounts in them
That’s how bank loans work
And yes, that is the double entry
If you’ve ever taklen a bank loan you will have seen this in action
Could you explain this please.
“The other side is that the bank marks up the customer’s loan account with the amount of the loan to record the fact that the customer has also made a promise to pay.”
I’m assuming this is a bit of double entry, and not being an accountant I struggle with this. But surely at the time the customer agrees things with the bank, they make no promise to pay as such, only to repay at some future point. And the customer only repays if the money is in fact advanced.
What are the entries on the banks book? Presumably when the money is advanced to the customer, the bank then has an asset (the customer’s debt) and presumably there is a corresponding liability, but who is the liability to?
Thse are the entries in the books of the bank
Dr Loan account (a debt owed by the customer)
Cr Current account (A sum owed to the customer)
That’s it
Could I ask a couple of Qs for my own understanding?
1. I understand cash comes from CB reserves, but is it actually possible for a business or individual to get this new cash without first having an electronic deposit to swap for it? I was discussing with someone whether there could be any £ saving that didn’t come from a loan.
2. The statement that all deposits come from lending – how is that affected by QE, which also created deposits? Perhaps the argument is that before QE turned gilts into deposits, those gilts came from deposits in the first place, so QE is merely replacing them rather than adding ‘new’ deposits? Thanks!
Cash does not come from CB reserves
They are deposited cash
Cash comes from lending
QE is created by lending – within the BoE
And you’re right gilts are deposits – they’re just like bonds in a building society or bank – and that is what they should be thought of as being – savings accounts
Not sure if this is right, but won’t there be a great deal of inflation in the food market? Along with housing the most basic commodity, so it will impact on the poorest the most.
There’s already talk of crops rotting in the fields while people starve because we don’t have the cheap labour to pick fruit and veg. We only produce about 55% of our own food. Without exports to prop up foreign exchange food prices will inevitably rise.
I know your answer has been rationing of food, but I really can’t see this government doing anything so sensible, their responses to the crisis so far have been “how little do you think we can get away with?” except for the bankers in Govt who are thinking “how much can we get away with?”
Without rationing, how can inflation in the food market be controlled?
If there is inflation in food there won’t be in other things
Clothes, for example, are crashing in price
Inflation is an overall measure
I think price controls and government support to increase wages in agricultural labour will be essential
Eurozone countries cannot turn to their own central banks because they are in the euro and so are severely limited in the creation of money as seen by the Greek debacle. They have to turn to a supranational entity – the European central bank. The bank of England and the US federal reserves have more power and leeway as we have just seen with them both creating new money.
[…] Cross-posted from Tax Research UK […]
Will the current spending cause inflation? Possibly, but if we don’t do what is needed NOW there will be nobody left to care!
Besides, Japan have been at it for decades with the explicit aim to create inflation…. and there is none. They have been buying not just JGBs (“conventional” QE) but corporate bonds and stocks! We have a long way to go before we need to worry about inflation.
Precisely
If I may offer a briefer explanation.
The current stimulus measures will not cause inflation because they do not represent an expansion. They are relief measures that do not increase overall demand, if anything they will struggle to maintain existing demand levels.
That then leaves us with the possiblity of shortages or a collapse in the value of the currency as the only sources of inflation. Both are unlikely and no one has offered any reason to believe otherwise.
Agreed
[…] paranoia of ‘how do we pay for all this?’ appears to be ongoing. I reiterate what I wrote on this issue here, but will no doubt return to it […]