How do you make money?
If you are in the majority, then you sell your time over and over to the
same employer in exchange for wages.
Some of you will be self-employed, which means that you not only have to
sell your time but you must also spend additional time drumming up new
business. A handful will own businesses,
in which case you will make or provide goods and services to sell to customers
in exchange for money. You will either
sell directly to consumers, or you will sell to other firms. Either way, if you cannot supply your goods
or services at an affordable price and at a high quality, you won’t get paid.
So if you want to spend more money, what must you do? Well, either you have to work harder/produce
more, or you have to cut back on your current spending. You can borrow
money of course, but only within the limits of your current budget – you have
to be able to service your debt. If you
fail to do this, you risk being forced into bankruptcy. So you understand only too well why you need
to run a budget surplus when times are good in order to protect yourself when
things go wrong.
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So far so good – we are now at the level of understanding of
the economy that Osborne and his friends want us to be. Using the comely image of the small town
householder, Osborne would like us to believe that running the government
(which, incidentally, is not the same thing as running the economy) is pretty much the same.
“We can’t pay ourselves more than we earn.”
But let us just take a step back for a moment to consider
the question we began with. I did not
ask how you obtain money; I asked how
you make money. And the answer (with a small number of
exceptions) is that neither you, me nor the organisations that we work for makes money. We make widgets
(all of the goods and services we produce or contribute to in the course of our
work).
So who does make money?
Most of us – even politicians and economists – understand that the Royal
Mint makes money. They produce all of
the cash in circulation. Indeed, it is
illegal for anyone other than the Royal Mint to make cash. So most of us – including more than 70 percent of our politicians – believe that the Bank of England (via the Mint) makes all of the money in circulation. And if you/they believe this, then you/they must also
believe that government surpluses are bad for the economy.
To explain this, let me ask another question: what gives
money its value? Most people – again,
including most politicians – think that somewhere in a dark bank vault is a
pile of gold bars whose value corresponds to the value of all of the money in
circulation. After all, our banknotes
still carry the words “I promise to pay the bearer on demand the sum of…” harking back to the days when a One Pound note was equivalent to a pound in weight of
Sterling silver. In fact, Britain ceased
to operate a “gold standard” in the 1930s.
In the years 1944 to 1971 we operated on the Bretton Woods system in
which the US Dollar was tied to gold, while all other currencies were linked to
the US Dollar. So, by default, our money
was – at least in theory – as good as gold.
But the Americans cheated. They
printed vast sums of paper currency to fund their war in Vietnam, their cold
war arms industry and projects like NASA’s Apollo Program. When other countries refused to trade in
dollars and demanded gold instead, the Nixon administration simply reneged on
the deal. Since 1971, all currencies
have been free-floating and tied to nothing more than the trust people have in
the governments concerned.
So what gives money value? To put it another way, why should we trade in
money rather than widgets or even precious metals? Indeed, why don’t we trade in a whole range
of currencies like dollars, yen, euros and yuan? In our currency system, there are two
reasons. First, we have a law that
obliges us all to accept the state currency as legal tender. Second – and more importantly – we are
obliged to pay tax in the state currency.
So, let us return to how most politicians view the
economy. They believe that the Bank of
England (through the Royal Mint) creates money.
This money goes to the Treasury, where the Chancellor and his minions choose
where to spend it. It may be used to
fund pensions and benefits; it might be made available as grants to organisations;
or it may be used to fund public services.
Either way, the recipients of the money will use it to buy widgets in
the private sector. So, this is how (they
believe) money moves from government to the firms and households that make up
the economy.
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| Figure 1: The politicians' view of money and the economy. |
So what does running a government surplus involve? It has to involve some combination of
increasing the amount of taxes coming in and/or cutting the amount of money
being spent out.
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| Figure 2: How austerity would affect the private sector in this model. |
As an aside, this is where much of what passes for a political
debate occurs. Broadly, neoliberals
(like Osborne) opt for cutting taxes and cutting spending even further, while
social democrats (like Corbyn) prefer to increase spending and increase taxes
even further. Either way, in this two sector (public/private) view of
money, austerity and/or increased taxation must
result in less money circulating in the economy. And when you have less money in circulation,
you also get low or even no growth, deflation, underemployment and unemployment…
just like we have had since 2010.
Fortunately, all of this is a myth. For while it is true that government is the
only body legally allowed to create cash
it is far from the only body that is allowed to create money. This is because we live in a three sector
economy – public/private/banking. For
more than thirty years, private banks have created almost all of the money in
circulation. This is because almost all
of the transactions in the economy today are in the form of electronic
transfers between bank computers.
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| Figure 4: The role of banks in money creation. |
The real reason austerity will not work is not because cuts
and taxes prevent money getting into the private economy. Indeed, the austerity cuts made in the early
1980s paved the way for the long economic upswing in the 1990s and early
2000s. But the reason it worked then –
and why Cameron and Osborne are trying to repeat it today – provides us with an
insight into why it cannot work today. To understand this, we need to know how a bank creates
money. Most economists and politicians
think that banks operate a “loanable funds” model in which money is transferred
from savers to borrowers. Banks act
merely as middle men, taking a fee for arranging the transfer. In practice, however, no money disappears
from a saver’s account anywhere in the system when a borrower takes out a
loan. All that happens is that a computer operative in the bank types a series of numbers into the borrower’s account and
types the same numbers as an “asset” in the bank’s accounts ledger. Through the magic of double entry book
keeping, new money is created out of thin air.
A recent Bank
of England paper explained it this way:
“In the modern economy, most
money takes the form of bank deposits. But how those bank deposits are created
is often misunderstood: the principal way is through commercial banks making
loans. Whenever a bank makes a loan, it simultaneously creates a matching
deposit in the borrower’s bank account, thereby creating new money.”
This debt-based money
now accounts for 97 percent of all of the money in circulation. And it comes with a big drawback… “Compound
interest”. Imagine for a moment that you
were the first person to borrow money into existence by taking out a loan for £100
at an interest rate of 10 percent. At
that moment, there would be just £100 in circulation. But the total amount of debt in the system
would be £110. Where is the other £10
going to come from? If you don’t find
that extra £10 from somewhere pretty soon, the process of compounding is going
to cause it to double up over time.
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| Figure 5: The massive increase in debt-based money. |
The fundamental problem with our currency system is
precisely that there is always more debt outstanding than there is money in
circulation. And the only legitimate and
politically acceptable way of addressing the problem is to keep borrowing ever
more debt-based money into the system. Might
there be a problem with this?
Back in the early 1980s when the Reagan and Thatcher
governments brought in the financial deregulation that allowed the current
system of fiat currencies to take off, borrowing money into existence was less
of a problem. This was in part because
there was plenty of unmet demand for goods and services, and in part because
very few people had debts – here you might begin to glimpse what Thatcher’s “home-owning
democracy” was really about, and what Osborne’s “Help to Buy” scheme was trying
to achieve.
Neoliberals like Thatcher and Reagan believed that politicians
and governments could not be trusted with money creation. It was all too easy for politicians to make
rash promises at election time, and then fraudulently fund them by printing
money. When they did this, the result
was always the same – inflation.
Although this was experienced as rising prices, in fact inflation is the
devaluation of money. But if governments
could not be trusted with money creation, who could? Enter the bankers! In the late 1970s and early 80s, chastised by economic
crises, bankers were a highly conservative bunch. The credit that they were prepared to extend
went only to guaranteed winners – those with the very highest credit
ratings. Who better to entrust with the
nation’s money supply? Let the banks
decide how much debt-based currency would be created and who it would go
to. What could possibly go wrong?
The trouble is that bankers are no different to you or me in
that we all think we are above average.
When bankers loaned new money to sure-fire businesses, their success
rate was high. This, they assumed, was
down to their personal abilities rather than to a general upturn in the
economy. So they became emboldened to
lend even more money into existence. But
there are only so many guaranteed winners out there. Once these have borrowed what they need, new
borrowing has to come from less credit-worthy firms and households. Fortunately, though, with the economy
booming, house prices rising and consumer demand going stratospheric, even
these “sub-prime” loans paid off; further fuelling bankers’ self-confidence.
In the up phases, the problem of the interest outstanding on
all of the debt-based money does not look so daunting. So long as new borrowing is increasing, there
is enough money in circulation. Does
this sound a little bit like a Ponzi scheme?
If it does, that is because it is.
A Ponzi scheme is a pyramid scheme that involves drawing in
exponentially more investors at each level of the pyramid in order to pay
earlier investors. The trouble is that
it eventually reaches the point that there is nobody else left to invest. At this point the whole scheme collapses.
Debt-based money can only survive so long as there are an
increasing number of borrowers prepared to enter into the system. When we reach the point – as we did in 2008 –
when nobody else wants to borrow, the system collapses… or at least it would have done had
governments not chosen to sacrifice the people in order to (temporarily) save the
banks. Today private
sector debt is close to 400 percent of GDP – dangerously close to where it
was in 2007.
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| Figure 6: The spectacular rise of UK private sector debt. |
So how does Osborne’s attempt to force governments to run
surpluses impact on the economy in these circumstances?
In order for austerity to work, the private sector would
need to be able to borrow more money
from the banking sector than the government takes out of the private sector in
taxes and austerity cuts. As we have seen,
this worked in the 1980s because few people had debts. Today we have the double-whammy of what has
been called “peak debt”, where there are not enough borrowers, together with a technically insolvent banking sector that is desperate to reduce borrowing. We might think of this as “banking austerity”.
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| Figure 7: When both government and banks take money out of an indebted private sector, growth falls and the economy stalls. |
So the reason that running a government surplus (or
even trying to cut the deficit) is a really dumb idea is that it is bound to
crash an over-indebted private sector.
It matters not one jot that we are able to produce lots of widgets. It will avail us of nothing if we all try to
work like the Chinese. With insufficient
actual money entering the system, the
result is bound to be low or even no growth, deflation, underemployment and
unemployment… just like we have had since 2010.
So where does this get us?
I think we are in a similar position to US General Pershing in
1918. He took the view that in order to
win the war, Germany had to be crushed and its people had to know from
experience that they had been defeated. By not marching into and occupying
Germany, he believed the allies would have to do it all over again at some
point in the future. Sadly, in 1939 his
fears came home to roost. In a similar
manner, the proponents of austerity and the nonsense of permanent government surpluses
will have to fail and be seen by all of us through direct experience to have
failed. Only when the policies of
Osborne and Cameron, and their equivalents in Europe, Japan and the USA finally
preside over the destruction of the banks and the writing off of debt that
should have occurred in 2008 will we be able to have a sensible debate about
the future management of the UK economy.
Until then we are in for something of a bumpy ride.
Tim Watkins' Book, Austerity... will kill the economy! is available in paperback and Kindle formats
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