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The Economics that George Osborne wants to hide

economicHow 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.

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 youmake money.  And the answer (with a small number of exceptions) is that neither you, me nor the organisations that we work for makesmoney.  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.

Austerity 2

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.

Austerity 1

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.

Austerity 3

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:


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.

UK Money Supply

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.

UK Private 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”.

Austerity 4

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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