A reader here has written in response to recent posts on how government spending works:
“Thanks, Richard, for the patient and insightful explanation. In my mind it leaves a question that keeps bugging me: when commercial banks make a loan, and the borrower spends it, it puts money into the economy. As the loan gets repaid, that money disappears from the accounts.
When a government spends, it seems, the money is taken out of circulation by tax.
BUT, is that money taken off the accounts by a similar process? It looks from your explanation that the money sloshes around in the central bank reserve account and can be put into circulation again by public spending?
I'd love to know which account actually cancels the spending, or to know that government spending increases the amount of money in the system perpetually.”
That's a good question, and it goes to the heart of why the government's money is not like bank money. Let me break this down.
First, when commercial banks lend, they create new money, but only temporarily. A bank loan creates a bank deposit out of thin air, and then the moment the loan is repaid, that deposit vanishes again. Bank money is inherently self-cancelling.
Second, government-created money, or base money, is not of that kind. When a currency-issuing government spends, the Bank of England simply marks up the central bank reserve account of the bank that receives the payment. What appears is new net financial wealth for the private sector. In other words, someone's bank balance has been increased by the government making a payment, with that deposit being backed by their bank's reserves at the Bank of England.
Third, taxation reverses that process. It does not fund the government; instead, it erodes the purchasing power that the government previously created by spending new money into existence. When tax is paid, a commercial bank instructs the Bank of England to mark down its reserve balance. The commercial bank then reduces the taxpayer's deposit accordingly. That money is gone. It does not sit in a pot. It does not fund the next round of spending. It is eliminated.
So yes, tax cancels government money — just as a loan repayment cancels bank money — but with one crucial difference. Government spending creates money that is not automatically cancelled again. It only disappears if and when tax is charged.
Fourth, the amount of money left in the economy after tax is a policy choice:
-
If a government spends more than it taxes, the private sector ends up with more net wealth.
-
If it taxes more relative to spending, private wealth is drained, and the economy is deflated as a result.
This is why the guilt trip about “balanced budgets” is so dangerous. The goal is not to balance the government's books. The goal is to balance the whole economy.
So, lastly, what happens to those reserve balances? They do not fund anything. They are simply the central bank's record of what the government has already spent into existence. They can always be increased again by spending, or reduced by tax. The constraint is never that the government runs out of reserves; it is whether adding more money would create inflation.
Taking all these factors into account, the answer to the question is this:
- Government money only disappears when the tax deletes it or it issues new gilts, which deletes it until said gilt is redeemed.
- If that does not happen, government spending permanently increases the money supply.
- And that is how every pound in your bank account ultimately began its life.
That's not a flaw. It is the system working as designed.
And we should be honest about what follows, which is that so long as real resources, whether human or otherwise, are available in the economy, we can:
- Afford full employment.
- Afford fully funded public services.
- Afford to green the economy.
But what we cannot afford are the political myths that pretend the government is financially constrained like a household or a commercial bank.
The government's job is to ensure we have enough money in the system to let everyone live, work and care without exceeding the limits of what the real economy can supply.
That is what real fiscal responsibility looks like.
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An excellent explanation that is deserving of a much wider audience. Could Zack Polanski be a vehicle for broadcasting this? I particularly liked your line: “…the guilt trip about ‘balanced budgets’ is so dangerous. The goal is not to balance the government’s books. The goal is to balance the whole economy”. Powerful stuff, succinctly put.
Thanks
Should it go in the glossary?
Yes. The whole neoliberal mantra about household budgets needs to be challenged head on. I do not pretend that it will be easy because it has been constantly hammered in to the public consciousness for decades. However, constant repetition does not mean that it has any validity. Was it not Joseph Geobbels who said that if you repeat a lie often enough, people will believe it, and you will even come to believe it yourself. That is what we are up against at the moment. I would suggest that not only should it go in your glossary but also it could form the basis of a slogan or battle cry along the lines of “balance the nation’s economy, not the governments budget”. It should be up there with “tax the wealthy, not the workers”.
Yes please.
When thinking about what to say I had planned – “The goal is not to balance the government’s books. The goal is to balance the whole economy.” is a fantastic soundbite and sums it all up.
But you got there first!
One minor point I would make… although its omission probably makes sense for clarity/brevity.
“Government money only disappears when tax deletes it.” should read “Government money only disappears when tax deletes it or it issues new gilts which deletes it until said gilt is redeemed”.
Amended. Thanks
You have mentioned before that the Bank of England, when instructed by the Govt and when Parliament has already approve the budget, has to create the money to allow the spend to take place (apologies if my wording is not totally accurate).
Is this included in any act/law and, if so, which one and where within it? Also, is there anything else that provides proof?
The reason I ask is that it would be very useful to have something to provide to those who think the Govt centrally has to raise tax to find spending. Not me, I hasten to add ☺. I do get it although it does still make my head hurts occasionally☺
Craig
https://www.legislation.gov.uk/ukpga/Vict/29-30/39/contents
Sections 11 and 13 seem particularly apposite.
Agreed, and note that this legisaltion has been kept continually up to date.
Thanks.
Craig
make your head hurt?
You are not alone, Mate.
Sorry
Don’t apologise. It is worth the effort. Seriously.
E- for this article in todays Guardian
https://www.theguardian.com/commentisfree/2025/oct/29/rachel-reeves-bond-markets-government-choices
Agreed.
I feel sorry for his students.
Have you by any chance listened to “The tax conundrum ” on radio 4? I haven’t caught all of it, but from what I have heard it’ll make your teeth curl!
I heard a bit and it was drivel.
I did get a personal reply from Ben Chu on Twitter – saying my questions would be answered in episode 2. When they weren’t – I did ask him whether he would air the views of economists who say there are other options for Reeves beyond ‘raising taxes, cutting spending, or increase ‘borrowing” – but didn’t get a response.
Thanks
Yes, it’s worse than drivel because it actively promotes misinformation.
Thank you
And if Reeves wants to “grow the economy” that means ipso facto: more government money & given the timing diff between gov spend and gov tax revenues…….an increase in gov debt. Reeves denial of this “is what real fiscal irresponsibility looks like” (she’s just in De Nile wit de crocs)..
Thanks Richard for the explanation and to the reader who asked the question.
Can you please help with this supplemental query?
When the commercial banks create new money does the UK government/Bank of England impose restraints on how much can be created?
Or put a slightly different way.
What mechanism is used to stop the commercial banks flooding the market with new money and fuelling inflation?
The answer is complicated.
Directly , no.
Indirectly via reserve requirements, yes.
Yes, it is complicated but it is not to do with Reserve requirements; it is related to capital and liquidity requirements.
Every loan is assigned a level of capital (mainly Common Equity Tier 1 (or CET1)) according to its perceived risk. Since the amount of CET1 is pretty fixed (only rises by new issue of common equity or retained earnings) this puts a ceiling on what banks can lend.
Furthermore, Liquidity regulations limit things. Sure, the act of making a loan to a company does create a deposit (to fund the loan), but that deposit is “at call” and the loan is “term”. That maturity mismatch is strictly regulated and, depending on who it borrows from, means that the bank also has to borrow “term” in the market. What it cannot do is borrow in the short term interbank market to finance its lending. (This was one of the key changes that came out of the Northern Rock run). So, banks can lend but it does require them to borrow in the market from non-bank lenders and for longer fixed terms… which is expensive.
In short, there are strict rules that prevent “lending without limit”.
If a government spends too much money, it may cause inflation (if there are insufficient resources available).
If a government spends too little money, then we get a dysfunctional economy (austerity, foodbanks, unaffordable energy, etc).
As Warren Mosler said:
“The government doesn’t want dollars,” Mosler explained. “It wants something else.”
“What does it want?” I asked.
“It wants to provision itself,” he replied. “The tax isn’t there to raise money. It’s there to get people working and producing things for the government.”
“What kinds of things?” I asked.
“A military, a court system, public parks, hospitals, roads, bridges. That kind of stuff.”
Source: The Deficit Myth by Stephanie Kelton. https://amzn.eu/d/9YruEhT
That tells us how much money the government should spend. Economist Abba P. Lerner wrote:
“The first financial responsibility of the government .. is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. [..] Source: Functional Finance and the Federal Debt, Abbas Lerner, Social Research, vol.10 no.1, February 1943, page 44. https://archive.org/details/functional-finance-and-the-federal-debt-1943-abba-p-lerner/page/38/mode/2up
Thanks Richard.
Thanks, Richard. Similar to Craig Sykes’ comment earlier – I think I understand it but my head hurts, too! I don’t watch your YouTube content – I prefer to read but I think that a visual would help me to understand the money flows in your descriptions. Maybe with your new augmented team a wee set of animations could be a useful tool for the thicker amongst us. Unless, of course, there are diagrams that illustrate your points in the YouTube videos? In which case, I’d bite the bullet and get over to that. But thanks very much for expressing these issues with such clarity.
Do the diagrams from page 409 onwards here work for you? https://taxingwealth.uk/wp-content/uploads/2024/04/Taxing-Wealth-Report-2024-Full.pdf
They do. Thanks very much. I’ll endeavour to work through the whole document.
Thanks very much.
Thanks for this and your previous post on the subject. It’s the nitty gritty details that really get me thinking! I’d just like to check I’ve understood correctly.
So when the government pays my state pension, it increases my bank’s BoE reserve account by the payment amount. That is effectively new money that the bank just passes on to me and doesn’t need to make a loan to create new money itself.
The reserves backing that payment remain until tax is paid and the reserve account is reduced by the tax payment.
But my state pension is paid gross, with my tax allowance set against it. So I don’t pay tax on it. My other pensions are paid net of tax. Does that mean the reserves remain in my bank’s BoE account permanently?
Does the government pay its employees, such as civil servants, net of tax? I’m guessing it does. If so, is only the net amount of new money, and the appropriate reserves, created? If so, they will never be reduced by taxation will they? But bank reserves don’t increase all the time with new government spending I believe, or do they? Confusion reigns!
Sorry if these are silly questions but understanding the mechanism of all this is vital to me grasping what is really happening when government money gets spent.
Thanks for this — it’s an excellent set of questions, and I can assure you they’re not silly at all. They go right to the heart of how government money creation and taxation actually work, and I wish more economists bothered to ask them as carefully as you just have.
Let me unpack the points in turn.
First, you’re absolutely right about how your state pension is paid. When the government pays it, the Bank of England increases your commercial bank’s reserve account with the Bank by exactly that amount. That is new money creation by the government. Your bank then credits your account with the same amount, creating a matching liability on its own books. The key point, as you say, is that the bank does not make a loan to do this. The government has created new money by spending.
Second, those reserves remain in the banking system until taxation takes them away again. Taxation is, in effect, the means by which the government reverses the money creation process, destroying the money that it previously created when it spent. That’s why I so often say that taxes don’t fund spending; they instead tidy up after it.
Third, when you receive your state pension, it’s paid gross — but, as you say, your personal tax allowance is already set against it. The result is that, for you, there’s no tax deduction at that point. That doesn’t mean the reserves created for that payment will remain in your bank forever. Someone, somewhere, will pay tax with some of the money you spend from that pension — whether it’s the supermarket when you buy food, or the energy supplier when you pay your bill. At that later stage, when those taxes are paid, the reserves that were originally created are cancelled again. So the process still completes, just not by you personally.
CONT’D
CONT’D
Fourth, you’re right that the government pays its employees, like civil servants, net of tax. The gross salary is accounted for within government spending, but the tax that would have been deducted is simply a bookkeeping adjustment within the government’s own accounts — effectively cancelling part of its own payment immediately. So, yes, new money is only created for the net amount paid into employees’ bank accounts. The tax portion doesn’t add to reserves because it never leaves the government’s own balance sheet.
Finally, you’re quite right to note that bank reserves don’t just go up forever. They fluctuate all the time depending on the net position between government spending and taxation, and also because of central bank operations — such as quantitative easing, bond issuance, and loan repayments to the Bank of England. The total reserve balance in the banking system is managed to ensure stability in the payments system and control over interest rates. But fundamentally, the mechanism you’ve described is the correct one: government spending creates new money; taxation deletes it.
You’ve seen the process very clearly, and your question shows why thinking at this detailed level is so important. When we stop imagining that taxes are a precondition for spending and instead see them as the balancing act after spending, the whole logic of fiscal policy — and the false obsession with “balancing the budget” — starts to look rather different.
That’s not confusion. That’s clarity.
Many thanks for the detailed response. Understanding the money creation process in detail is key for me when trying to communicate it to others, so I really appreciate being able to bring questions here. It’s a very valuable service you and your regular contributors provide.
No problem.
Richard.
Does the point you make in the first paragraph of this response not underline the fact that tax cannot fund government spending because, for those on PAYE, the tax component of their gross pay never becomes ‘money’ in the first place. It is simply two figures on a spreadsheet which cancel each other out instantaneously. It never becomes any taxpayer’s (or anyone else’s) money and be cannot therefore be spent by the government (or anyone else).
Correct.
ChatGPT estimates that around £150Bn, or about 12%, of annual central Government spending doesn’t enter the economy for the kinds of reasons Pauline raised. So the true value of public spending is that much smaller. Fascinating.