Musing on The Deficit Myth

It has been drummed into us, by government after government, that ‘we must live within our means’. The question rings out, ‘do you think that money grows on trees?’.

Such sentiments are entirely true for our household budget; it is also true for companies, councils and any other group that uses money.

It is not true however for our government, which is an issuer of money. Every child and stoned-adult has mused, ‘Why can’t we just print more money then?’ and lo, these poor naive souls are instantly shot from the sky, with the thunderous rejoinder, ‘Because then money would lose it’s value!’

Indeed, this is the real constraint to government spending: inflation, and NOT how much money can be gathered back in taxation.

Why then do we mix up the government’s finances with that of a household and go on to imagine that it must balance it’s outgoings with income?

It is an economic fact that, the government creates and spends money first and then, only secondly deletes some of it as taxation. So our hard earned tax pounds are not used to fund public finances. They are not required, because the spending has already occurred. In fact taxes are just a deletion of money. One figure is changed to another on a computer screen. If someone did insist on paying their tax with actual banknotes, the money would have to be shredded!

But if taxation is not necessary to pay for spending, then why the heck do we have it?

Here are the reasons:

  • Having taxes give value to money. Government has the power to command by law that taxes be paid in the currency that it operates. Hence if everyone has to pay tax, then everyone needs to earn money. If people didn’t have to pay tax, the main driver for using the currency would be gone.
  • Another reason for taxes is to reduce aggregate demand. If people have less money in their pocket, they spend less and inflation can better be kept under control.
  • Taxes are also used to incentivise and dis-incentivise. Higher taxes are put on things the government doesn’t want us to buy or do, such as smoking, eating sugar and drinking alcohol etc. Conversely, government schemes and tax breaks are set up to encourage us to do ‘good’ things, like scrap diesel cars and buy solar roof panels.

Of course this way of looking at money is a boon to the left-leaning who now see that money can be added to the economy at the press of a button without reciprocal taxing or taking from elsewhere in the budget, as long as inflationary pressures are carefully assessed.

Billions of pounds have already been pumped into the economy recently, in so called ‘quantitive easing’ programs. This isn’t tax payers money and tax payers aren't required to pay it back! It is ‘magic money’ and, if it does not create inflationary pressure, then we don’t need to worry about it.

The right-leaning are also excited and prick up their ears at the idea that taxes don’t necessarily need to go up in order to pay for spending, just so long as inflationary pressures are taken into account.

In fact as taxes are used to reduce demand and consumer spending and not to pay for government spending, then taxing the rich is not really very effective. Deleting an extra £10 billion from the wealthy, with a ‘rich tax’, would have a negligible effect on demand, compared to a broader tax to reap £10 billion from the pockets of the poorer, because the rich tend to save and the poor have no choice but to spend their money.

The frightening sounding ‘government deficit’ is merely the difference between all the cash the government has spent and all the taxes it has collected. A deficit signifies that the private sector — you and me — are holding the difference. So if the government is in deficit the flipside is that the private sector is in surplus.

The government’s debt is primarily made up of ‘securities’ it has issued; So-called gilt edged securities or bonds. The government takes in money that was in circulation and gives out an interest bearing bond in exchange.

It does not need this money; It is not giving out bonds to raise funds. Instead they are used to mop up excess bank reserves (The surplus of money in the private sector), thereby creating a shortage of reserves in the market so that the system as a whole must come back to the government central Bank for liquidity.

In principle a government with its own central bank does not need to issue gilts to cover its deficit: it can simply run an overdraft instead, and pay no interest. It does not need to have a debt and the debt could be cancelled with a few key strokes on a computer.

But why then does the government continue issuing debt?

  • It gives people a safe place to save their money. With bonds and gilts they get a return on their money without risk.
  • It gives those with pensions a locked in and guaranteed income stream.
  • They are used by banks as security against overnight deposits

Things to take away from modern monetary theory:

  • Austerity measures, at least for a currency issuing government, are a political decision, not an economic necessity
  • There is a magic money tree!
  • Government spending does not need to be costed against savings and taxation revenue
  • Government debt is not the same as household debt. The government chooses to issue debt and it could banish it with a keystroke.
  • Margaret Thatcher and later, David Cameron were mistaken or lying when they pushed the idea that the government has no money except that provided by taxpayers
  • It is not true that the government has limited funds and must repay its debts or it will fail future generations. The government, as an issuer of money and like the banker in ‘monopoly’, can never run out of money!

Head in the clouds, but really quite practical. Fine art trained, but frequently seduced by the promise of science.