I wrote the note, which is both attached as a PDF (which might be easier to read) and which I reproduce in slightly re-edited form below, a little while ago as a way of introducing my thinking on money to a meeting of fairly well-informed people who I did, however, wish to persuade of the virtues of this approach.
Within that professional setting, the note appears to have achieved its objective, so I thought I would share it here.
Comments are, of course, welcome.
The political economy of money
Richard Murphy[1]
November 2023
Published by Tax Research LLP
The power to create money belongs to the state
A state is defined by its ability to:
- Define and defend its borders.
- Legislate within its domain.
- Create a currency.
All other aspects of political economy flow from these issues. In that case, and presuming that the definition and defence of borders is not an issue of concern, the power of the state to create a currency and to tax is fundamental to its ability to create and enforce policy that meets the needs of its population. A proper understanding of the relationship between these issues is, then, fundamental to the creation of successful policies.
Definitions
Some terms need to be defined:
- A currency is the unit of account used to describe the money in use in a jurisdiction.
- Money is a measure of debts owing denominated in the currency of a jurisdiction. Money may also be used as a measure of the value of debt-based exchanges that have taken place within an economy.
- A fiat-currency is the currency declared to be the legal tender of a jurisdiction by its government. This is a legal concept: a currency is legal tender merely because the government of a place declares it to be so using its power to legislate.
- An asset-backed currency is a fiat currency that enjoys the right of convertibility into another asset if a debt denominated in it defaults due to the action of the currency-issuing state. The liability owing then becomes payable in gold or some other currency.
- Tax is a legal obligation contractually due to a state because economic events of a prescribed form have occurred.
- Government borrowing, if denominated in the currency of the jurisdiction in which the borrowing takes place, is a facility offered by the government of that place for the safe deposit of funds by those who wish to place them with a government-owned and backed institution always guaranteed to be able to repay its debts. This is akin to a banking arrangement.
- Government borrowing denominated in the currency of a jurisdiction other than that which has borrowed represents a promise to pay requiring that the government that has borrowed secure access to sufficient of the currency in which the borrowing took place by the time that repayment is due. This is a debtor relationship.
Some technical issues also need to be addressed:
- Base money is money put into circulation by the central bank of a jurisdiction. Base money is denominated in the fiat currency of the issuing jurisdiction. That money is issued into circulation as a record of the promise to pay made by the government of the jurisdiction in question that it offers in exchange for the supply of goods and services procured by it. Examples of base money include notes and coins. It also includes the balances held by commercial banks with the central bank of a jurisdiction that represents sums spent into the economy of its jurisdiction by a government and not recovered by it from within that economy either by way of borrowing or taxation. Base money is destroyed by the payment of tax and the issue of government debt issued in the fiat currency of the jurisdiction. There is no theoretical limit to the amount of base currency that a jurisdiction may issue. However, to issue such currency in an attempt to procure resources in a jurisdiction already at full employment will always result in inflation unless additional tax charges are simultaneously imposed. As such, there are practical constraints on the issue of base money.
- Commercial bank-created money is money created by the commercial banks of a jurisdiction when advancing loans to a customer who promises to make repayment of that debt in return. Commercial bank money is destroyed by the repayment of the bank loan that created it. The practical limits to the capacity to create money in this form are:
- The availability of borrowers with the ability to make repayments.
- The availability of capital within banks to sustain bad debts arising on debts that default.
- Regulation intended to direct credit or to limit its availability.
- The payment of tax has to always follow the expenditure of money by the government. Given that governments with stable currencies always demand payment of tax in their own currency (so creating a demand for it within their economies) this has to be true: if the spend did not come first then there would be no money available to pay the tax due.
Consequences
If these definitions are accepted:
- All money is debt: as a matter of fact, the nature of double-entry book-keeping, which is the only verifiable method available to record monetary transactions, does not permit it to be otherwise.
- Debt-free money cannot exist as a result. Money on deposit is always owed to the depositor. Money owed to a bank or other person is always a debt. There is no money that exists that is not a liability of one person and the asset of another.
- Money can only acquire value because of its capacity to settle a debt.
- Base money acquires its value because it is used to settle tax liabilities owing, which are legally created debts intended to impart value to a currency.
- Tax does not, as a result, fund government spending: it cancels the money created by government spending, whose legal creation is permitted by a properly authorised government budget.
- All money is as a consequence, intangible in its nature.
- Money cannot be asset-backed: it can, however, be guaranteed, but that is not the same thing. The best guarantor of money is the government because it alone has the capacity create money without limit within an economy, which it can do because it alone knows that if this were to happen the sums in question would be redeposited with banks, who thereafter would return them to the government via its central bank. This means that this guarantee never has to be drawn upon to be effective, which is why it can be and is widely used (e.g. to guarantee all deposits to £85,000 in UK bank accounts).
- Tax, if not used to fund government spending, acquires a range of other social purposes:
- To ratify the value of the currency: this means that by demanding payment of tax in the currency it has to be used for transactions in a jurisdiction;
- To reclaim the money the government has spent into the economy in fulfilment of its democratic mandate;
- To redistribute income and wealth;
- To reprice goods and services;
- To raise democratic representation - people who pay tax vote;
- To reorganise the economy, i.e. fiscal policy.
- Governments do not spend taxpayers' money. They do, instead, create new base money to fund their expenditure. That base money is then cancelled, largely through the imposition of taxation charges.
- Banks to not lend depositors' funds to customers when advancing loans. They do, instead, always create new money when doing so based upon the mutual promises to pay that the bank and the customer exchange when arranging that loan. Money created in this way is cancelled by repayment of the loan.
- Governments do not borrow money in their own currency to fund government expenditure. Governments do, instead, provide a safe deposit facility for their own currency whether created by their own spending or by commercial bank lending. This is a banking arrangement. The funds in question might properly be thought of as part of the national capital of jurisdiction. If hypothecated for investment purposes, this might explicitly be the case.
- Commercial banks do not require deposits to make loans to customers. Deposited funds are never loaned in this way. Depositors' funds are, instead, part of the capital of the bank, and are available to meet its obligations to all creditors in the event of default by some or all of its customers.
Economic policy
Based upon this understanding, a government should in pursuit of a sustainable economic policy:
- Must determine the sustainable capacity of its economy, taking into consideration labour, natural, financial and manufactured capital resources.
- Determine the potential value in use of those resources.
- Decide on what part of those resources it might wish to procure to supply public services, and what value those services might have.
- Determine the quantum of its resulting expenditure, also taking into consideration any desire it might have to maintain, replenish or deplete capital stocks, and taking into consideration the multiplier effects of its own spending, if material.
- Decide the extent to which the remaining net injection of funds into the economy that it might make needs to be withdrawn from circulation by way of taxation as a necessary means of controlling inflation if that is a perceived risk.
- Determine the extent, if any, to which commercial credit creation needs to be controlled to facilitate the government's economic objectives and to consider the resulting necessary regulatory and taxation changes required to achieve this outcome.
- Determine the extent to which it might wish to change the sums it has borrowed, considering interest rate policy as a part of this process.
- Determine which taxes at what rates might fulfil its social, economic and environmental goals.
- Determine which policies might minimise the impact of interest charges and other rent seeking activity within the economy as a whole in pursuit of its social policies.
- Make clear its intentions and the reason for them.
- Communicate these issues, including to banks and others directly impacted as a result.
- Adequately resource those agencies such as HM Revenue & Customs that are critical to the delivery of these goals.
Conclusions
Most currently commonplace thinking, such as that which suggests that tax funds government expenditure and that deposited funds are loaned by banks to their customers, is wrong.
The latter has been explicitly recognised to be wrong by the Bank of England and other central banks.
The former is implicitly recognised within the operation of central bank reserve accounts, which have become commonplace and material within most developed economies since the 2008 global financial crisis.
Ben Bernanke summarised this very effectively when discussing how the money to pay for the 2008 Global Financial Crisis was found. He said[2]:
“It's not tax[payers'] money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So to lend to a bank, we simply use the computer to mark up the size of the account that they have at the Fed.”
And that is how the government pays for everything. It is also how most money is created. And it is why tax is essential to cancel the impact. Everything else is a footnote.
[1] Professor of Accounting Practice, Sheffield University Management School. © 2023. Contact via Tax Research LLP, 33 Kingsley Walk, Ely, Cambridgeshire, CB6 3BZ, 0777 552 1797, richard.murphy@taxresearch.org.uk
[2] Quoted at https://www.ft.com/content/5e5b2afb-c689-4faf-9b47-92c74fc07e66
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That was a very clear explanation of the issue. I think I will be referring a lot of people to this post in future.
Don’t think this is automatically right:-
“However, to issue such currency in an attempt to procure resources in a jurisdiction already at full employment will always result in inflation unless additional tax charges are simultaneously imposed. As such, there are practical constraints on the issue of base money.”
Increased productivity offsets inflation but the means are not strictly confined to employing human beings. Historically we have often witnessed more being produced using less human beings.
It’s sufficiently close to being right in the timescales in which inflation operates (and productivity gains are slow) as to be correct for all practical purposes.
Yes agreed it’s proximate but better I think to qualify that it can also depend upon the times otherwise you sail close to Monetarism.
I think what Richard said about the relationship between money creation, full employment, and inflation is near enough right for a general audience. In explaining any subject to a general audience a balance has to be struck between being over simplistic and dotting all the i’s and crossing all the t’s. I think Richard has got it about right.
That was my aim
Thanks
Analysing inflation is complicated economists cannot agree on its causes. The Monetarist line that inflation is always a monetary cause is now discredited. Here’s some of the complications:-
https://billmitchell.org/blog/?p=60860
Here also is the “Conflict Theory Of Inflation” from page 23 to factor in:-
http://www.untag-smd.ac.id/files/Perpustakaan_Digital_2/POLITICAL%20ECONOMY%20Political%20economy%20and%20the%20new%20capitalism%20essays%20in%20honour%20of%20Sam%20Aaronovitch.pdf#page=36
Productivity is an issue; it is typically the purpose of new technology (but not necessarily the outcome). Thatcher’s attempts to promote pure Friedmanite monetarism foundered on the inability of anyone (including her closest acolytes) to discover any productivity improvements in Britain’s post-Thatcherised economy; but that is a different matter associated with the deeply dysfunctional nature of neoliberal Britain, its Government and its endemically dis-functioning economy. It is, of course never the fault of those almost permanently running both: neoliberal business and politicians.
Nevertheless I take Schofield’s main point; productivity is a real issue; complex, but it determines the major changes in technology, and the impact is enormous (whether successful or not).
Reading Steve Keen’s blog – well, dipping into it I should say – his latest one points to the absolute lies being told by even recent economics texts about the sources of government money that portrays debt as owed to external bodies or the market.
It paints a picture of the state being a debtor like any other debtor in hock to some sort of shadowy powerful force.
Your blog above therefore cannot be repeated often enough Richard as long as this misrepresentation/false narrative continues in plain sight.
Keep it up is all I can say.
Thanks
A clear and largely correct summary of money as it works in the modern world.
Ther are a few areas that I would change.
First, your definition of an asset backed currency. The main feature is convertibility – the right of holders to exchange currency for some other asset (so far so good). But your mention of default does not make sense to me. Suspension of convertibility is not a default. If you and I have a contract in that currency it will still be settled in that currency… unless we have some fallback provision in our contract to settle in the underlying asset in the event convertibility is suspended.
Hong Kong is the main example today. HKD is backed with USD held by the Hong Kong Monetary Authority – they will sell USD as required to those wishing to convert their HKD to USD. But they could stop this if they wish without any default.
Second, local currency borrowing. Yes, it is a savings vehicle… but it is also a way to add or drain money from circulation (in the same way spending/taxing add/drain to/from the system). It is also the way that interest rate policy is transmitted to the market and economy.
Third, Foreign currency borrowing. I think there is a typo.
“denominated in the currency of a jurisdiction other than that which has borrowed represents a promise to pay “ should read…
“denominated in the currency of a jurisdiction other than that which it has jurisdiction represents a promise to pay”
I would also say, for clarity, I prefer local (or domestic) currency and foreign currency rather than “denominated in the currency of a jurisdiction….etc.”. If required you could define “domestic” and “foreign” up front.
Fourth The payment of tax has to always follow the expenditure of money by the government. Hmm – I understand you want to counter the opposite but in reality tax and spend go together; without spend there would be no money to tax but without tax the money government tried to spend would have no value.
In “Consequences”
7 You say asset backed money can’t exist…. Yet you try to define it at the start. Not sure what the purpose of 7 is – could you omit it all together?
9….. “largely through taxation and net bond issuance”
10 …… Banks to not lend existing depositors’ funds to customers when advancing loans. Instead, they create money and the money lent immediately becomes a deposit that mirrors the loan. Money created in this way is cancelled by repayment of the loan.
12. First, it rather repeats 10. Second, you use the word “capital” in a way that anyone in finance would say is wrong… because “capital” (defined by regulators) is (largely) about Equity Capital.. Deposits are NOT part capital. Now, it is possible to argue that they are part of capital in some broad sense but this is very misleading and I think you should definitely change this. I would delete 12 and but in 10a
Depositors’ funds are part of the assets of the bank, and are available to meet its obligations to all (senior) creditors in the event of the bank being unable to meet its obligations..
In Economic Policy
5. I would add bond issuance (as well as tax) as a way to take money or of circulation to prevent inflation.
Overall, it is good…. But these things need continual refinement
You seem to have omitted government financing via the Gilts market from your analysis? Not all Gilts are bought by the Bank of England, so you can’t shortcut the issuing of Gilts by the Government and the QE process whereby the Bank of England buys Gilts. Many are bought by banks (more commercial credit creation), pension funds, private investors and overseas investors / foreign central banks. Until 2008, the holdings of Gilts by the Bank of England was extremely small by comparison with all of the other holders.
I have not done what you suggest
I just call them savings mechanisms because that is what they are
But saving mechanisms are a means whereby the saver defers their own expenditure today so that someone else (the person who the money has been lent to – e.g. the government) can spend that money today. The Gilts market is an important part of how Government spending is financed. If non-bank savers buy Gilts from the government, no new base money (or commercial money) was created to fund this government expenditure. Existing money (either base money or commercially created money) was instead transferred to the state with a promise that the state will transfer it back again later.
It is also not correct to say “Governments do not spend taxpayers’ money. They do, instead, create new base money to fund their expenditure.”. This is evidently not the case when you think through the taxation of earnings derived from the creation of commercial money – e.g. someone buys a new home from a builder. The home purchase is financed by means of a mortgage from a commercial bank (i.e. new commercial money). The newly created commercial money is paid to the builder who in turn pays their employees and suppliers. The income for those suppliers and employees (which is entirely from commercially created money) is taxed by the government and part of this newly created commercial money is then transferred to the state, which is then able to spend that money on public services. No new base money was created as part of this series of transactions – It was newly created commercial money that was taxed and then spent back into the economy by the state.
Thank you for your comments, Rupert.
Unfortunately, the range of misunderstandings you have presented is quite extraordinary. I will not have time to address them all here, but let me start with the one that you did, which concerns saving.
I do not dispute that people do save because they wish to defer part of their current spending power to use at some time in the future. They do this by placing sums on deposit in banks or through other institutional mechanisms, of which by far the most common is the purchase of government bonds. But, neither of these activities gives rise to further economic activity. That is because savings do not fund anything. If you need to understand why, read the Bank of England quarterly review in the first quarter of 2014, which is easily accessible on the web. They agree with me.
To make it, clear banks do not lend out savers funds. They create new money when making loans. No saver even comes close to that process of money creation.
Likewise, sums saved with the government (which is a transaction almost identical to depositing money with a bank) does not fund government spending. What it does do is take money out of circulation within the economy, thereby reducing spending power within it, and helping control inflation as a result. In essence, government borrowing (or deposit taking, more accurately) is simply an alternative to taxation as a tool to control inflation.
I am not, therefore, disputing your suggestion that money might be placed upon deposit with the government, but I am suggesting that this has nothing to do with funding government. The government is funded by money created by the Bank of England on its behalf when it spends. Some of that is reclaimed through taxation, some through the taking of deposits and, if the government decides not to reclaim all the money in question, it disguises the fact through QE. But the fact is that neither tax or borrowing actually fund spending.
You are also wrong when it comes to your claim about government being funded by taxpayers money. First of all, there can be no such thing as taxpayers money. Taxpayers do not create money. At best governments do, and commercial banks can do under license from governments, but taxpayers do not, except by borrowing. In that case, the idea that there is taxpayer money is an oxymoron.
But then let’s note the situation that you outline where a mortgage is taken to buy a new home from a builder. First of all, the mortgage might well be used as security by the lender with the Bank of England: hundreds of millions have been in recent years. This should not be overlooked. But even if this is not the case, the money only has value because the government guarantees it in use by declaring it a fiat currency, and guarantees it when on deposit with banks, and by guaranteeing the banks are properly regulated to create money under license. In other words, this supposedly newly created commercial money only exists because the government has permitted its creation.
You are right that this transaction in isolation might not create new base money, but money creation and taxation cannot be appraised against singular microeconomic transactions: aggregate macroeconomic issues are what matter in this case. And, in aggregate taxation is paid to cancel government money created. You may wish to pretend otherwise, but then you have to pretend that there is no macroeconomy. That is an option available to you, but not a good one.
Finally, let me turn to one other issue. You are suffering from the common mistake that somehow money moves. So, your language suggests that you think that when money is deposited in the bank by you then somehow or other something has tangibly relocated from your possession to that of the bank, but that is not true. Money has absolutely no tangible existence. It is just a promise to pay. There is nothing more, or less to it than that.
So, when you deposit sums in a bank they make a promise to pay you, and in exchange you promise to deposit money with them. They cannot, however, assign your promise to someone else. That is not contractually possible. So they cannot lend your money to anyone else.
And remember, a government bond is the same as a bank deposit account. So, the government cannot assign the promise made to the original depositor of funds for gilts to make the payment to someone else (although in this case, the depositor Ken’s, because the gilt is tradeable). The fundamental point is that the promise to pay exists throughout the life of the deposit account, or bond. As such the money that it represents cannot be used for any other purpose: it is retained for the sake of making repayment. It never goes anywhere until it is repaid. In other words, it does not move. Money never does, because promises cannot.
This is fundamentally why it is impossible for tax, or borrowing to pay for anything, because all they can do is create new sums to be repaid in the case of deposits or gilts, or cancel existing obligations to settle tax liabilities in the case of tax paid. That is it. The funding equation is independent of them, even though the aggregate control of the money supply requires these elements to be managed in combination.
What is true is that this stuff is mind blowingly difficult to get your head around. But if you nwant to understand economics that is what you need to do.
Thanks for your comprehensive response and the suggestion that I read the 2014 Bank of England bulletin about money creation, which I have now done.
I think you have misunderstood my comments and you also seem to confuse money creation with funding, which are actually two different things. As I think we both agree and the Bank of England agrees, money is ONLY created by banks – Either the Bank of England for base money or commercial banks for commercial money. As the Bank of England notes in its 2014 bulletin, commercially created money is much the largest aspect of the total money supply and this is primarily driven by the commercial relationship between the bank and the borrower, not the government.
By contrast, the funding for Government spending is sourced BOTH through the creation of brand new money (issuance of new Gilts, which are purchased by banks (either commercial or indirectly by the Bank of England via QE) AND by collecting up pre-existing money (either via taxation or by issuing new Gilts that are purchased by non-banks). Most Government spending does NOT involve the creation of new base money as you suggest – As the Bank of England notes, new base money is only created by the Bank of England carrying out issuance of bank notes or carrying out QE (i.e. buying of assets in return for newly created bank reserves).
The important point here is that once money has been created, it can be exchanged with others multiple times before it is eventually destroyed again. Economists refer to how quickly this occurs as being the velocity of money. Each time money is used in a financial exchange, it usually also leads to the government taking its cut in the form of taxation which leads to that money being part of the funding of its own expenditure. This is clearly true not just at individual transaction level (as previously commented) but also in aggregate as government expenditure is way higher than newly created base money each year.
It is also not true to say that all money paid in the form of taxation to the Government is money destroyed, as commercial money is only destroyed when the bank lending that created it is repaid) and bank base money is only destroyed when the Bank of England withdraws bank notes from circulation or carries out quantitative tightening (i.e. sale of assets it owns in return for its own reserves which are then cancelled).
You can argue all you like about whether government funding is called taxpayers money or government money – Ultimately, that is just a label describing the money the government spends. We all have a stake in electing government and we all want the government to spend its money wisely and not wastefully to create the best economic impact. Governments and their central banks also have to be very careful to avoid creating too much new money as otherwise the general public will lose confidence in it being a store of value and that is when money velocity increases exponentially and you end up with hyper inflation.
You really need to undertsand money
I wrote this morning’s post on money not moving before you posted this – but it might as well be addressed to you
You cannot claim money moves since it does not
But if it does, show me the double entry and explain to me how the person who has what they think to be “money in the bank” will feel when they find it has gone – and someone else now has it.
I look forward to your reply – fully worked out.
Use this as an example. https://www.taxresearch.org.uk/Blog/2022/06/21/the-double-entry-behind-the-money-creation-in-the-central-bank-reserve-accounts/
Ideally this piece requires more time to reflect on it. The nature of Blogs and comments is, time is not on your side.
My comment is therefore a little hasty. I like your approach, but as an admirer of Minsky and Mehrling, I think always in terms of the test of money as necessarily a function of money only realised or realisable in a money crisis; only then do you discover what really is ‘money’ in the community defined by the currency. The test of crisis reveals an essential, natural hierarchy of money, and in a fiat currency that is only what, it seems to me you define as “base money”. Commercial bank ‘money’ is only money to the degree the sovereign issuer chooses to guarantee it. Where commercial bank money is guaranteed this is not really the operation of a market; but a monopoly opportunity to make profits.
I agree re commercial bank money
As a lay person I am struggling to understand point 11. Are you saying that governments don’t borrow money but just create more as needed and keep it in a special account? I understand that government spending is via new money but don’t they borrow as well?
They create money by spending it
It does not sit around unused (well, notes can, but let’s ignore them)
And it is the spending that creates the money, literally
And borrowing is a savinghs mechanism: it is there to take created money out of circulation, not to fund anything
I think the problem people have with the notion of government borrowing is that according to your account of how money works it seems unnecessary. It is quite possible to have an economy in which the government issues money that is not commodity backed and taxes but does not borrow in its own currency. This was the case in Yuan dynasty China.
However as a way of taking money out of circulation there are advantages to having this mechanism in addition to taxation. The first is that it is obviously more flexible and the second is that while people will not voluntarily pay taxes they positively want somewhere to save their money.
Using the word “borrowing” for this saving mechanism is highly misleading as it is not, in the normal sense, borrowing at all. If you do not think through what is happening then “government borrowing has increased by X%” sounds like a bad thing whereas “national savings have increased by X%” sounds like a good thing.
That is why I call it savings
I suspect that this note will be updated
I note your comment about the government constraint due to a lack of resources. If this is the case then the government can provide the resources. For example it can train doctors and nurses, builders. It can also build infrastructure such as railways, roads, insulate buildings, and provide green energy generators.
Thanks for your comment, Ben.
In principle, you are, of course, right: it is within the power of government to make good a shortage of resources. There are, however, two constraints on doing so. One is time, and it is certainly practically possible to have created inflation by spending during the period when resources are not available, and so this aspect of the issue has to be taken into consideration.
The other issue is to consider what happens if the economy is already at near full employment. In that case, the government might have the ability to create new resources in a desirable time but when doing so it is competing with others, most, especially when it comes to employment of the people who it wishes to retrain. This could also, potentially, be inflationary.
Therefore, whilst your comment might be true in the long term, in the short term the reality that overheating of the economy during a period of transition could take place is very real, and because of that, more taxation to take resources out of circulation within the economy is necessary during that period. Spending money is not, in other words, without consequences and timing is a matter of particular concern when considering political economy.
The employment demographics, however do not work without immigration.
In Scotland the demographics problem is already in crisis, and the issue is existential; with a fertility rate down to 1.3 per woman: and the core of that problem was, and remains Brexit. We simply can’t go on like this. It is literally insane, and I say this because the problem is primarily a function of the self-destructive politics of elderly Unionists; i.e., those first and most likely to be seriously affected by the immediate, and sharply increasing hard consequences of their own folly (by essentially voting for a declining population, whether they understood what they were doing or not); which will become harder, and harder to fix in their lifetime.
Money moves resources. So does equitable taxation remove inflation to continue moving resources.
I thought your piece beautifully clear (althought the resultant comments have also been illuminating) and saved the PDF for future reference.
Not long ago you had a bit of navel-gazing when you wondered whether your blogging was worthwhile – it certainly is if it means you hone your thoughts so well.
Thank you