We are in the foothills of a new industrial revolution, caused by the development of new technologies such as A.I and the need to avoid climate catastrophe. It is driven by the market and has picked up sufficient momentum that policy makers could not stop it even if they wanted to. The task of Governments is to accelerate the revolution and to guide it in a way that benefits the maximum number of people. This is easier said than done in the Western world, because our current political and economic models (Neoliberalism and free market capitalism) ensure that governments minimise interference in the market, and that economic benefits are too often funneled mainly to those at the very top.

In order for people to accept the negative disruption caused by this revolution, radical changes will be needed in the way we do politics and economics. This post (along with part 2) looks at some of the new economic ideas that will help with the transition.

Understanding Money

The best place to start is to understand how money works in the 21^st century world. My main source for this first section is Richard Murphy, who is a Professor of Accounting Practice at Sheffield University and a Chartered Accountant, as well as a campaigner for tax and economic justice. I agree with those who describe his work as mind blowing because it challenges long-held beliefs. If we understand money, we can completely re-imagine how the economy really works.

I will start with perhaps the most important point. Murthy describes ‘money’ as just debt and a promise to repay the debt. If a bank agrees to a loan it has created money, which the recipient of the loan agrees to pay back in future. That loan is not backed up by physical coins and notes or gold in a huge bank vault. This also means that when loans are repaid, money no longer exists. Physical money in notes and coins is not really money. It is better to think of it as a reusable record of money, like an improved version of a piece of paper with IOU written on it. Coins can be used to repay one debt, and then reused to record or repay a new one. For example, when you get a haircut you agree to be in debt by the value of the haircut. Coins can be used at the end of the haircut to repay the debt.

For a long time, the value of money was linked either directly or indirectly to gold. As gold was generally in short supply, so was money. This changed in 1971 when President Nixon took the dollar off the gold standard, and other countries followed suit. There was no longer any link between the value of money and anything physical. Money is worth whatever people agree it is worth.

The next very important point is that money can be created simply by typing numbers on a screen. This is because only a small percent of money is physical, in the form of coins and notes. Almost all of it is digital money on bank balances. If a bank lends a mortgage of £100,000, the money is created digitally. The bank does not need to have an equivalent amount of physical money or gold in its vault. This means that banks can lend more than they receive in deposits, which allows them to increase their profits (because loans generate revenue in interest payments and deposits cost the bank money). There is a limit to the ratio of loans and deposits a bank can make, set out by the Basel Accords which were updated in response to the 2008 financial crisis. Without that, the amount that banks could loan (and therefore their profits) would only be limited by how many people they could persuade to take a loan. However, the more banks lend, the higher the risk of defaults. The loan-deposit ratio aims to ensure that banks always have enough deposits to cover the cost of defaults. To simplify slightly, under Basel III bank deposits must be at least 8% of loans. So if a bank had total deposits of £80 it could only lend up to £1000.

It’s not just governments (via central banks) that can create money — so can commercial banks. When commercial banks create money to lend to customers, they are effectively borrowing the money from central banks (e.g. the Bank of England or BoE). They still make a profit by charging customers more in interest than they are charged in interest by the BoE. However, commercial banks don’t need to ask for permission from the BoE to create the money. This means the BoE — and therefore government — have limited control over the amount of money being created by commercial banks, except through the loan-deposit ratio that limits the amount of loans.

Government Debt

Another very important point: government debt is not a bad thing and is nothing like household debt. Governments create currency (through the central bank) whenever they need to, so are never at risk of running out of money. Governments do not spend taxpayer’s money. Government instructs the central bank to create currency which they spend, and then repay the bank at a later point with tax income. This is one of the reasons why government spending is not like household spending. This means all Government spending is funded through creating money.

According to Murphy, the main purpose of taxation should be to control inflation. This deserves some explanation. National inflation is the increase in the average price of goods in the economy over time. It is caused by demand for those goods exceeding supply. Conversely, deflation (goods getting cheaper) is caused by demand being less than supply. An increase in demand relative to supply is normally caused by people having more money to spend, which is normally a good thing (unless that spending is fuelled by debt, which is unsustainable). Therefore, having some inflation is generally a positive thing. It does need to be kept under control however, to avoid the value of assets (including pensions and property) from being eroded over time. Government can influence overall demand, and therefore inflation, by changing taxation levels. For example, if demand is too high and is causing inflation, government can simply increase taxes so that people don’t have as much money to spend.

To return to the earlier point: if government spending is funded through creating money and not taxation, and taxation can be used to manage inflation, this means that government income and expenditure do not always need to be balanced. History shows us that it is possible for governments to run large deficits whilst maintaining acceptable levels of inflation.

Governments create their own money for spending so don’t need to borrow. The reason governments borrow is to provide people with a zero risk savings account. In effect the government is providing a useful service. Commercial bank savings accounts are guaranteed by the UK Government up to £85,000. If you want to save more than that at zero risk, the only option is to lend to the government. This is known as buying government bonds. In Murphy’s view, the main reason governments borrow is in fact political and not economic – it is unpopular to increase taxes. From an economic perspective, the overall level of taxation should be based only on achieving the desired level of inflation. From a political perspective, taxation is also a useful tool to tackle inequality and redistribute wealth, and to direct private investment away from harmful investments and towards those that benefit the public good.

Sometimes governments may want to reduce the amount of money it saves on behalf of others, in order to reduce the amount paid in interest. It can do that by buying back government bonds, which cancels the debt. Like all government spending, this is done by creating money. When governments create money to buy back government bonds, this is called Quantitative Easing (QE).

Governments buy bonds on financial markets, just like anyone else who wants to buy them. In line with supply and demand principles, increased demand for bonds makes them more valuable. Increasing the value of bonds is also useful for government because it reduces the effective interest rate it pays on the remaining bonds (government debt). The effect of increasing bond values is that people selling bonds normally make a good profit as a result of QE. They can then spend this money, in a way that potentially helps boost economic growth. This is why QE is seen as a remedy for weak economic growth.

The problem is that ownership of government bonds is not evenly spread. Bonds tend to be owned by or on behalf of people who have large amounts of spare money. This type of person is prepared to save money with relatively little financial return, just to keep it safe. The result is that QE disproportionately benefits a small number of very wealthy people. This type of person tends to spend the additional money on investments in assets, such as shares or property. Due to the extra demand for these assets, the price of the assets increases. Murthy provides evidence showing that the UK Government has spent more than £800bn on QE since the 2008 financial crisis (about half since 2020 due to Covid-19). This means that those people who are able to sell bonds back to the government are at least £800bn better off since 2008. This has been one of the key drivers of increased property prices in the UK. Even in London, £800bn still gets you a lot of properties.

Remember, governments always create money to spend, and this is only a problem if it leads to increased inflation. But, inflation is not necessarily sensitive to government spending.  As an example, the UK Government created several hundred billion pounds in money for QE during the Coalition Government and it had no noticeable effect on inflation. QE is not necessarily a problem, but the way it has been done creates two problems. The first I’ve already discussed; ownership of UK Government debt is not evenly distributed, so the benefits are uneven.

The other problem is that when the government spends money buying back bonds, it doesn’t treat the debt as cancelled. The money spent on buying bonds continues to be classed as government debt, and the government continues to pay interest on it. The issue stems from the relationship between the government and the BoE. The conventional view is that QE represents the government borrowing money from the BoE, which it has to pay interest on and eventually pay back. But as Murphy shows, the two entities are in effect the same. The BoE is in practice owned by the government, and has a legal obligation to do what the government asks it to do. Combined with the fact that QE money is created into existence by the BoE (as with all money), what is really happening is that the BoE is creating money for the government rather than lending it. However, the government still treats the money as a loan.

The level of interest paid on these QE ‘loans’ is the BoE base rate. Until relatively recently this was around 0.1% x ~£800bn = ~£8bn a year. This is a lot, but now the base rate is above 5%, so the government is paying around 5% x ~£800bn = ~£40bn. This money is enough to pay the NHS everything it needs. QE accounts for nearly half of UK Government debt, but it doesn’t need to be classed as debt, and it doesn’t need to pay interest on it. The QE money was not lent by the government, it was created to buy back government bonds (debt).

Murthy notes as an aside that the money used by governments on QE generally ends up being used for savings and investments, such as property, shares or savings accounts. The majority of investments are subject to reduced tax levels relative to income tax, at a cost of several £10bns a year. ISAs for example are completely tax free up to £20,000. Government could raise significant funds as well as help direct these investments if those tax incentives came with conditions, such as only applying to green investments that help tackle climate change.

It is worth briefly considering who owns government debt. It is mainly owned by individual savers (anyone can invest in the UK Government via the National Savings and Investment Bank website), private investment funds, pension funds, foreign governments (who often own sterling to make trading with the UK easier) and commercial banks (via a scheme where the government guarantees commercial deposits up to a certain amount).

Many argue that government debt needs to be paid back because the costs of debt interest payments are unsustainable. However, government can influence debt payments. As already discussed, government can reduce their debt by paying it off via QE (as long as any resulting inflation is managed through increased taxation). In addition, some government debt interest rates vary with the BoE base rate, a bit like a tracker mortgage. The BoE could choose to reduce government debt payments by reducing the base rate. The reason it increases base rates is that the government instructs it to use interest rates to control inflation. This is not necessary if inflation can be controlled by taxation.

Higher interest rates in theory reduce inflation by making saving more desirable than spending, which reduces demand and therefore makes goods cheaper. However, interest rates are a flawed lever at best. This is particularly true in the current period of ‘stagflation’ (economic stagnation and inflation) where inflation is caused by insufficient supply rather than excess demand (e.g. insufficient supply of energy and food in the global market, and insufficient labour supply in the UK). Inflation is simply the level of mismatch between supply and demand for goods and services. Interest rates are unlikely to significantly reduce demand because many people are already struggling to pay for essentials. People with large mortgages will be heavily affected, but they represent a minority of the population so the impact on the economy as a whole is small. In other words, the BoE could reduce interest rates if the government chose to manage inflation with taxation instead of (or at least in conjunction with) interest rates. While it might be claimed that the BoE is independent of the government, the BoE has been wholly owned by the government since 1946. It is only ‘independent’ in the sense that government has delegated the decision over interest rates, but the decision is still driven by the government mandate to achieve inflation of 2%.

Murthy asks us to stop thinking of government debt as a burden and something ‘our grandchildren will need to repay’. This debt helps support the economy and provides a useful zero risk savings service. Remember that government debt is also private wealth. The main issue is that this wealth is not shared equally. Murthy suggests that the reason for the paranoia over government debt is more likely to be political rather than economic. It provides a reason to cut government spending and reduce the size of the state, in line with neoliberal orthodoxy.

Conclusion

The assertions made by Murthy are clearly counter to current economic orthodoxy and may appear surprising to say the least. Some of the foundational points are undeniably fact, for example that governments and commercial banks create digital money on computer screens, and this is where government spending comes from (not taxes or borrowing). The approach of controlling inflation by taxation has not been tested on a large scale, but it is based on evidence and logic.

If there is one thing to take away from Murthy’s work, it is the point that many things that are asserted to be economic facts, are not actually facts and not even driven by economics. They are driven by political ideology. It is important to recognise that there are alternative approaches, particularly given how current economic orthodoxy is performing. Surely the right balance is to be aware of the risks of change and enact the change slowly and cautiously. Through this approach, the possibilities of improving society are almost beyond imagining.

If you found this subject interesting, I would strongly recommend going to Richard Murphy’s blog to find out more: http://www.taxresearch.org.uk/Blog/