I often wonder when it might be that the idea that we tax and then spend will be replaced with a proper understanding of the government spending cycle.
As a matter of fact the thing that identifies the modern state is not its ability to tax. It is, instead its ability to create money. Impressive as the ability to tax is, the fact that a state can declare a currency to be the legal tender of a country and in most of those where the rule of law is reasonable that currency is then used for the vast majority of transactions within that place is the surest indication of state power that there is.
Many economists and most central bankers would have it that this power to create money is, however, devolved to commercial banks. I suggest to them that this is wrong. Those banks can create loans and overdrafts, for sure. And the money that these facilities create is used as currency, for sure. But they can only do this on two conditions. One is that they subject themselves to quite detailed regulation of their power to create money. The other is that they will clear all the payments that they make through the central bank reserve accounts that they must maintain with the central bank (in our case, the Bank of England) of the jurisdiction that creates the currency these commercial banks primarily deal in. In other words, these commercial banks are simply agents of the central bank when it comes to money creation.
What is more, the money created by commercial banks is particularly volatile. It behaves pro-cyclically (there is more of it in good times than bad). And it is always subject to relatively short-term notice when it comes to life expectancy, by which I mean all of it is subject to notice when it comes to its own destruction, which happens whenever the loan that created it is repaid. As a mechanism for funding the state it is far too volatile in that case.
So, we are ultimately dependent on state-created money to underpin the functioning of our economy, all of which is made by the government running a deficit. That deficit is simply a record of the fact that the government has spent more into the economy than it has taxed back out. The rest is left as a promise to pay (which is even printed on bank notes) that might one day be cancelled by way of a tax demand, in settlement of which the government promises to accept the currency it created.
So what comes first? Very obviously the spend. If tax destroys money (as it does) that cannot happen before the money was created. And since the money was created by government spending that spend has to come first. We live in a spend and tax economy.
Now note that despite this obvious fact the country's economic and political commentators have got very excited this week that tax revenues have proved to be higher than expected so far this year. They are saying that this creates a pool of money that Rishi Sunak might spend. It's as if they still believe that tax funds spending, when glaringly obviously it does not and cannot. And, of course, they do believe that: their ignorance of how government creates and destroys money is complete, as is their ignorance of the fact that money creation pays for all government spending.
So, for the record, let me make it clear that Sunak has no unexpected bonus. Instead what we have is a shortfall of cash in the economy. More money has been destroyed than was expected. That must mean there is less money in the economy than was anticipated. And, given that the economy is already under economic pressure from a cost of living crisis what that means is that the consequence of this overpayment of tax is not good news, but is instead bad news. If £30 billion of extra tax has been paid that is money not available for other use when keeping the economy solvent with readily available cash to fund spending is vital.
According to commentators, Jeremy Hunt is not going to be spending his 'windfall'. It will instead be used to reduce the national debt. That is one of Sunak's stated five goals if you recall his announcement of his five big objectives in January. So this money will not be replaced, which it could be by increasing government spending on decent pay rises for those who need them, for example.
If commentators really understood money (and they don't) they would appreciate that this is not the moment to reduce the amount of government money in the economy. In fact, it is the moment when more is needed. And if they properly understood what is happening they would see Hunt's windfall as an indicator of a problem that can only get worse if these funds are not reinjected into an economy that needs them. But they don't understand this. And that is why bad economic decisions are being made.
One day I hope we will have some politicians who understand how something as simple as the government money cycle works.
It does not go tax or borrow and then spend.
It goes spend and then tax to control inflation whilst offering a government savings facility for funds then left untaxed in the economy.
It's really not hard to work out unless you do not wish to understand it, of course. And that is the real problem that we face. Wilful ignorance is the last bastion that is supporting neoliberal economic thinking. But at least that means that one day things must change.
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It’s one thing claiming that taxing before spending is the wrong way around, but I think it has to be shown to be spending before taxing. Famously, Mrs Thatcher in her speech to Conservative Party Conference, October, 1983 claimed: “We know that there is no such thing as public money – there is only taxpayers’ money”.
It doesn’t help that the BBC themselves just this week stated “The government gets most of its income from taxes”. https://www.bbc.co.uk/news/business-50504151 I queried this with them, and they confirmed “this is correct, and backed up by IFS”: https://ifs.org.uk/taxlab/taxlab-key-questions/where-does-government-get-its-money The IFS do not actually say that the government spends tax revenue, only that it is a significant income, but its page is sufficiently ambiguous to be unhelpful. (Note: The Institute for Fiscal Studies, IFS, has been mentioned several times in this blog, e.g. https://www.taxresearch.org.uk/Blog/2019/11/08/dont-trust-the-economic-think-tanks-there-is-ample-to-do-with-100-billion-of-investment-and-the-resources-to-do-it/ )
So can we show that spending comes before taxes? I think the following example is useful:
Tax due: −£1,000
Tax paid: +£1,000
=======
Balance: +£ 0.00 (Net tax available for government spending)
And I think the following sources are adequate, though more reliable sources would be useful:
Beardsley Ruml, “Taxes for Revenue Are Obsolete,” American Affairs, vol. 8, no. 1 (January 1946), pp. 35–9. https://cdn.mises.org/AA1946_VIII_1_2.pdf
Berkeley, A., Ryan-Collins, J., Tye, R., Voldsgaard, A. and Wilson, N. (2022). “The self-financing state: An institutional analysis of government expenditure, revenue collection and debt issuance operations in the United Kingdom“. UCL Institute for Innovation and Public Purpose, Working Paper Series (IIPP WP 2022-08). https://www.ucl.ac.uk/bartlett/public-purpose/publications/working-papers/wp2022-08
Many thanks
I’m glad Ian posted the link to the ‘Self Financing State’ paper. I’ve found it very useful but even quoting their conclusion, which I copy here, does not convince people. What more can one do?
“At the heart of the government spending mechanism is the CF. This is best understood as a line
of sovereign credit that the government, via permission from Parliament, draws on, backed solely by the ability to raise taxes in the future. When spending occurs, Exchequer credits are allocated to the GBS and shifted on to the BoE’s balance sheet as public deposits. This, in turn, creates deposits at the commercial bank accounts of government departments, thereby enabling
spending. The process is legally mandated and cannot be challenged by the central bank or any
other government department. We find the one-source view on public spending (Figure 1) reflects institutional reality, where all spending is financed by money creation.”
(link as in above post)
*Does anyone know of any critique of this paper which uses empirical research to cast doubt on its conclusion?*
I think it’s conclusions are right
“The Self-Financing State: An Institutional Analysis of Government Expenditure, Revenue Collection…”
Can find only three citations to the paper via Google Scholar
https://scholar.google.com/scholar?cites=3655973205218253584&as_sdt=2005&sciodt=0,5&hl=en
One is a Master’s dissertation, the other a conference paper, but not peer-reviewed sources.
Disappointing
Maggie asks, “What more can one do?”
This blog is beginning to be quoted for its political posts on Facebook. If I spot them, I ask why the poster won’t post the political economist’s blogs on economics as well, followed with a link to the latest on economics.
It’s a slow process – until one day it won’t be. 2019 research in physics showed that “a Quantum Leap is a rapidly gradual process” (their words not mine). A QL is an accumulation, not a jump.
However, a QL can be reversed mid-leap, so it’s vital to continue the pressure against the door. It will open. Thatcher found it easy to close. Don’t despair, Maggie!
Thanks
The Berkeley, Tye, Ryan-Collins, Voldsgaard, Wilson paper is excellent. I think I raised it in connection to debt, the Consolidated Fund and Whole of Government Accounts and the accounting ‘consolidation’ anomaly, in a thread a few weeks ago. I am really surprised it is not well cited; but more encouragingly Mr Tresman offers fresh news on the Eurozone front; I shall certainly follow up that interesting take.
The point about the nature of “independence” is an interesting one. Given the neoliberalism of the Eurozone we have known, I fully take Richard’s point; however I would qualify it. Scotland joined the Union in 1707 because it was the only way it could access Empire, closed off by the monarch it had helped put in power in 1690, and the Navigation Acts. It abandoned its Prliament for the opportunity. Scotland did not want Brexit, just for a little-Britain; whose time has gone. The point is, Scotland is a proven joiner of Unions, provided only it chooses what it joins.
Your distinction between “central bank money” and “commercial bank money” is important but I am not sure I agree that “…commercial banks are simply agents of the central bank when it comes to money creation”.
Commercial banks operate as money creators/destroyers by advancing/withdrawing credit to/from their clients. This activity is all about profit maximisation (within rules laid out) rather than as an agent of the Central Bank.
Commercial Banks will act as they wish in creating money and it is part of a Government’s and Central Bank’s job to operate counter-cyclically – Government by taxing/spending; BoE by draining/adding liquidity (selling/buying gilts) – in order to achieve policy goals.
I completely agree with your point that “tax receipts are a “windfall” that is to be spent” is a nonsense… the power to spend is not dependent on this windfall. However, it is unclear to me that this reduction of reserves in the system is a bad thing – it seems unlikely that a lack of reserves is hindering our economy. What IS hindering our economy is a lack of spending on the things we need (health, infrastructure etc.) and high interest rates that choke both consumption and investment.
Also, this “windfall” should be no surprise… when government spending is (trying to be) controlled in nominal terms and tax revenue rise (roughly) with inflation and earnings we should expect to see bigger surpluses in January. Surely this torpedoes the idea that we “can’t afford” to pay our public servants.
All fair points bar the agency one
Agents are, of course, allowed to make money from their actions
What surprises me is that commercial banks don’t seem to know where their profits from individuals & businesses comes from (or as they call it interest).
Given that the repayment of loans effectively destroys the principle amount, the additional money they extract as profit (sorry interest) needs to come from somewhere else.
It must either come from Government spending or further loans issued by banks (seems like a Ponzi scheme to me).
The reality is a mix of the two, but as the Government is now removing money from the economy then the mix must be shifting towards the latter.
Commercial banks should vocal against this approach (as well as those from the banking establishment that are calling the shots in the BoE) if not for the suffering and economic damage it it will cause to individuals then at least about the risk of increasing defaults and potential hit in return to their shareholders.
I don’t get why they’re not.
How does this fit in with the price of energy crisis. One train of thought seems to be that we impose extra taxes (a windfall tax) on energy companies and then pass this on to consumers. What you are saying, and what has happened, is that money has been passed on to consumers before any windfall tax is imposed thus supporting your argument. My view on the energy price crisis is more simple, and more complicated. Increasing prices to cover increased costs is understandable, but increasing prices beyond the level of increased cost in order to increase profits is unacceptable. The government should enforce a reduction in price or nationalise. Vey naive I am sure but I have been somewhat maddened by all that is not being said about fuel prices and obscene profits.
On the subject of creating money, I was having a discussion with my elderly mother about what Scotland might do should it become independant. Would it retain the pound, start a new currency or rejoin the EU and take on the Euro. She, expressing commonly held views, thought the best option would be the Euro. After all, she said, its only a name. But it isn’t is it? Would taking on the Euro limit Scotland’s ability to create it’s own money?
Your first argument is good, and agreed
Your elderly mother is wrong. Using the euro would remove Scotland’s fiscal and monetary sovereignty. Why become independent of the UK to accept ECB / German sovereignty instead?
Fiscal and monetary sovereignty is what enables a country to issue its own currency.
However, Dirk Ehnts, author of “MMT and European Macroeconomics” https://www.amazon.co.uk/Monetary-European-Macroeconomics-Routledge-International-ebook/dp/B01M646N7V reckons that “The Eurozone is Fully Committed to Modern Monetary Theory”, that the European Central Bank (ECB) is now committed to MMT, and that “national governments have regained their sovereignty”. https://braveneweurope.com/dirk-ehnts-the-eurozone-is-fully-committed-to-modern-monetary-theory-mmt
I don’t know whether this circumvents the monetary sovereignty problems with the Euro, I can’t say that I understand it all.
I will have to catch up with that
Dirk is good and well worth noting
Indeed.
Ian Tresman’s references to the work of Dirk Ehnts are certainly worth reading. However the last paragraph, and especially the final sentence, of the article in Brave New Europe is worth noting –
“We can be cautiously optimistic that EU Commission president von der Leyen and ECB President Lagarde – admittedly a strange duo – will go down in history as the Euro saviours of 2020. As of today, the national governments have regained their sovereignty. Now they have to prove that they can solve the problems of their citizens. If they manage to do so, it will be difficult to take the steering wheel away from them again in 2021. Once the first two teething troubles of the euro have been eradicated, we can then think about a European Finance Ministry that issues (risk-free) Eurobonds and spends – for a European Parliament converted to a more democratic Parliament – with a view to full employment, price stability and sustainable resource management. But that remains a beautiful utopia for now.”
The government say it shall use this ‘windfall’ to pay down the national debt.
Surely to do do it shall have to create new money?
If so then what bothers me is who shall end up with the newly created £30 billion that ‘pays down the national debt’?
You recently blogged about the official figures for the national debt being wrong. So will it be used to pay the national debt held by the BoE? This seems an absurd notion, if it’s even possible. I don’t know.
Or will it be used to pay back the holders of gilts who don’t want it paid back?
Instead of paying back any national debt, it should be used to better the general quality of life in the country.
For instance, give public sector workers a decent pay rise.
The chosen mechanism will be to prevent further gilt issues, I suspect
A great post and one whose subject matter needs to repeated over and over again.
Sovereign currency produced governments created money into the banking sector when it’s own incompetence led to the 2008 crash and crisis. As far as I’m aware, they’ve never asked the banking sector to give it back.
So why can’t these governments print money into the wages of nurses, teachers, policeman, fireman, railway workers and others as they face a cost of living crises not created by them?
Central governments like ours are lying to us about what they can and cannot do. And yet, they have given the game away so many times since 2008.
It may be only until the message in this post gets through to a wider audience that the lying will stop.
But not in my household at least.
As you so often point out, it is not just the state financing they don’t understand but the causes and remedies of inflation.
https://www.theguardian.com/business/2023/feb/23/interest-rates-rise-bank-mpc-inflation-wages-prices
Catherine Mann. We have an inflation remit and will achieve it one way or the other.
Head -wall -bang.
I shouted at my computer when reading her speech an never got to the end of it
You weren’t the only one.
Meanwhile I receive notice from BT that my charges will increase by CPI 10.5% plus 3.5%. – just because they can. No doubt other utility providers that we cannot do without will be doing much the same. Which will of course feed directly into inflation, but silence from the government on these price increases whilst they shriek about the unaffordability of public sector wage increases, which as we know do not feed directly into inflation.
And the IMF suggests that the claims of wage price spirals are anyway dubious.
This monopoly price abuse is staggering
Seems a 10 year old has a better grasp of money creation than politicians…..
10 year old explains the truth about where money comes from…
10 year old Holly explains where money really comes from, why is there so much debt and what it means for you…
Have you ever tried to do a jigsaw puzzle but one of the pieces was missing? Well, the financial crisis and all the trouble since then is a bit like that.
Personal debt is at its highest level in history. We currently pay £192 million in interest to the banks every single day. Almost no-one under 40 years old can afford to buy a house. Over 2 million people are unable to find work in the UK, and millions more worldwide…
But the government’s ‘answer’ to this crisis is to get people to borrow even more!
No matter how many economists are working on the problem, they’ll never solve it because they’re missing the most important piece of the puzzle.
But once this missing piece is found, even a 10 year old can understand it.
https://www.youtube.com/watch?v=bmR4qtEdu0I
I admit I don’t quite agree with that
Positive Money really do not understand base money and the role of central banks so I think that video misleading
Using KISS amd simple logic
Go back in time before money existed. No one can pay taxes as there was no money and so no banks or moneylenders to borrow from. The government must then print money into existence and only then can the government collect taxes.
Now that’s something I can totally understand.
I listened to Paul Johnson (IFS) talking at the RSA yesterday, talking about the ‘cost of government. Desperate stuff, deeply conventional tax and spend thinking. Sunak and Hunt would have loved it. And yet he seems to be the go-to commentator for so many media outlets and organisations.
As was noted here yesterday, the BBC say that if the IFS say it then it has to be right