In my opinion, if we want to understand government finances, the last people we should ask are businesspeople and the City of London.
That might sound surprising to those not familiar with a heterodox viewpoint. Businesspeople deal with money all day, whilst the City supposedly exists to understand finance. But there are very good reasons why neither provides a sound basis for understanding government finances.
The microeconomic problem
The first problem is that businesspeople almost invariably think in microeconomic terms. For a business, spending is constrained by the money it can obtain. It can spend its income, use existing cash or borrow. What it cannot do is simply create the money it needs to make a payment. The same is true of households.
That is not true of a government that issues its own currency. The UK government is not a household, and it is not a business. It is the issuer of the currency that households and businesses use. That difference is fundamental.
The government can create pounds. Ordinary businesses cannot.
Commercial banks are the exception because they create new money when they make loans, but that privilege exists because the state licenses and regulates them. Any other business trying to manufacture its own pounds is likely to find its owner spending some time inside a prison wall.
So, when businesspeople apply their experience to government and say, “You cannot spend what you haven't got”, they are applying the wrong model. The government does not have to get pounds from taxpayers before it can spend pounds.
Logically, the opposite has to also be true. Money has to be created before anyone can use it to pay tax. That payment would not be possible if government money creation did not come first.
The double-entry problem
This should be obvious to anyone familiar with double-entry bookkeeping. Every financial asset has a corresponding liability. Every debit has a credit. One person's financial asset is necessarily matched by someone else's financial liability. Government finances cannot, therefore, be understood by looking at the government's accounts in isolation. The government's financial position has to be considered alongside that of the rest of the economy.
That means a government deficit necessarily creates a financial surplus elsewhere. If the government spends more into the economy than it takes back in tax, somebody else must end up with the resulting financial asset. That is not an opinion. It follows from accounting. Businesspeople, however, rarely seem to appreciate this, or, if they do, routinely forget it when discussing government finances.
The status quo problem
The City of London has an additional problem. The existing understanding of our financial system suits it very well. The City likes the idea that governments depend upon financial markets because that supposed dependency gives financial markets enormous political power. It allows them to claim that governments must maintain “market confidence”, satisfy bond traders and design economic policy around the wishes of financiers.
Why would the City want to challenge a story that gives it so much influence? That makes them far from objective commentators when the media question them.
The money creation problem
There is another problem, however. The City, like much of business, talks about money as though it were a commodity that exists independently of the economy. It does not. Money has to be created.
In the modern UK economy, new money is created in two principal ways. Commercial banks create money under licence from the Bank of England when they make loans, and the Bank of England creates money when it makes payments on behalf of the government. These are the only sources of the sterling money that the economy uses.
The sequencing matters. Until money has been created, it cannot be spent. It cannot be taxed. It cannot be saved. It cannot be deposited. It cannot be used to buy government bonds. The money has to exist first.
The money is not a thing problem
This brings me to the biggest misunderstanding of all, and the most significant issue that business and the City do not appear to understand.
Money is not a thing. People talk about money as though piles of notes and coins somehow move around the economy whenever payments are made, but that is not what happens. Money is a record. A banknote records a promise. A coin is a token representing one. A bank balance is an entry in a ledger.
An entry in a ledger is profoundly different from a physical object. A chair can exist by itself. A financial asset cannot. If there is a debit, there must be a credit. If someone has a financial asset, someone else must have a corresponding liability.
Money can therefore only be understood as part of the system of assets, liabilities, income and expenditure of which it forms a part. Trying to understand money in isolation from those relationships is meaningless. But that seems to be exactly what business and City commentators on government finance and money seek to do.
And that is precisely why relying on them to explain government finance is so dangerous.
Businesspeople tend to apply microeconomic reasoning to macroeconomic problems. Their opinions are often wrong and, in most cases, diametrically opposed to reality as a result.
Meanwhile, the City has a powerful vested interest in maintaining the myth that government depends upon it. That makes it an unreliable storyteller.
And both routinely talk about money as though it were a thing rather than a relationship recorded through double-entry bookkeeping.
That combination is a recipe for wholly inappropriate comment on economic management on a disastrous scale.
If we want to understand government finance, we have to start somewhere else. We have to start by understanding how money actually works.
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This cannot be said enough.
These ‘last people’ exist in the micro economy and exist downstream of economic decisions – macro decisions that are increasingly hampered by their view. And part of that jaundiced view is rampant short-termism.
We also see the same attitude in the public sector I’m afaid.
A good post. I find I have to switch from household mode to government mode when thinking about finances and governments. Originally when I discovered about how governments were funded that seemed odd but now seems straightforward. I think one problem is that those who do not understand the difference use the argument “Its because its not your money, its other peoples” when you state that governments (with their own currency) can create funds rather than rely on taxes, borrowing etc.
I try to convert friends and neighbours to a better understanding of government finances, I guess its one way of influencing people!
It is, and thank you.
“misunderstanding”. There is no misunderstanding on the part of the City. As you note later, they have a powerful vested interest in keeping things just as they are. They know the narratives (lies) they deploy are wrong – but to be a successful liar one has to understand the mechanics of the lie. Thus they fully understand,……….. “I am a villain yet I lie”. A cursory glance at the history of the City shows that the focus has always been the retention of power & influence over government, it that requires lying and false narratives – so? Telling the truth against the might of the City’s lie-machine/megaphone is not easy. A different tack.
“The Scum” entertains its “readers” (?) with stories of trivia on the lives of the famous (pop stars and the like). Perhaps, more usefully, a diff publication could expose the unpleasant lives of the people in the City (rehab, drug-taking, mistresses, etc). Expose the liars for what they are – lairs corrupted by money. Don’t go after the facts, go after the trivia. Go after the apologists, Wolf, with whom did he dine? what words of wisdom were whispered in his ear etc?
Print publication? “The Shitty”?
This is a perfectly timed post. The final sentence sums up every discussion I have had about politics for the last 2 or 3 years, culminating in some quite heated discussions with family in the last week or so. Everything in politics always leads back to the economy and everything about the economy always leads back to almost everybody not understanding what money is and how it works. You wouldn’t believe the amount of times I’ve come up against – “*scoff* You really think you know more about the economy than Elon Musk?!” when I push back on the idea of sovereign currency issuing governments going bankrupt.
I’ll be keeping this post as a handy reference for all my future discussions.
Thank you
Rupert Lowe likes to think of himself as the next Prime Minister, but suffers exactly what you describe here
“Every pound government spends first has to come from somewhere. Ultimately, it comes from the productive economy, productive Britain. From the people working, trading, investing and taking risks. They are the ones who have my respect.
There are good people in the civil service. But the system is just so broken.
Government, and the people working within it, has become too insulated from the economic reality experienced by the people who actually have to fund it.
A Restore Britain Government will expect the state to understand something that every small-business owner already knows through brutal first-hand experience.
Money is finite, performance matters and failure MUST have consequences.”
Much of what Lowe espouses also relates to things you wrote about this morning in your other piece on Martin Wolf.
Agreed
But he is much more stupid
Apostasy.
The Government can create £s at will, but it can’t create $s or €s. They need to find someone willing to exchange their $s or €s for £s.
The conventional view is that the exchange rate between currencies depends on the balance of trade in goods and services.
I fear this balance may no longer be relevant. Exchange rates and currency movements may be determined by games in the financial markets. If so, this will have two unpleasant consequences.
1) UK bonds become important, because our ability to buy goods and services in other currencies depends, not on exports, but on the willingness of foreign investors to buy UK bonds. If the real role of the Bank of England is to keep UK bonds attractive to overseas investors, perhaps they are not as idiotic as they seem. Using bonds to prop up the £ may enable us to afford imports. (Whether or not it is a good idea??)
2) The Third World cycle. A Third World country may export far more than it imports, but its currency may remain weak. If the companies that create the exports are owned by foreign investors, then the profits will be converted to other currencies, keeping the country’s currency weak.
In both cases the poor become poorer, and wealth becomes more and more concentrated. Also, the system may be unstable and will break down catastrophically.
Perhaps this is all nonsense, but if there is a grain of truth, we are in a far deeper hole than we realise. What is the way out?
I often hear someone say “one person being rich doesn’t make other people poor” but considering that every asset corresponds to a liability, I think that is disproven.
Hi Richard.
Sorry, Richard, but could I just check I’ve got this right please (because I’ve referred to this in arguments with other people!) – but have you not in the past said that there is a 3rd way that money is created – Quantitative Easing…? It was a point I relied upon because the other person was suggesting that government creating money (by spending on “the good stuff” that we might actually want – welfare, health service, education, infrastructure etc) would lead to economic meltdown / completely trash the pound etc, which I countered with QE (not having done so, although i think it did probably cause a bit of inflation), & which I had already referred to as being the 3rd method of money creation. Just how back to front have I got all this please?!
QE is just a disguise used to hide large scale government money creation without intention to withdraw the resulting new funds from the economy for a period of time, or ever, without having to admit that is the goal. It is not a form of money creation in itself.
It’s noteworthy that when Burnham proposed taxing banks 5 Live Money programme went straight to the City of London to ask their view. Not economists and certainly not economists like Richard and Stephanie Kelton who know and can explain the truth. No doubt they would ask turkeys for their views on Christmas. It’s difficult to conceive of a bigger conspiracy than the money creation lies.