Fiscal Myth of Tax and Spend

Discussion

By Chris Cook:

"The fiscal myth of tax and spend shared by virtually all schools of economics is that tax is first collected and then spent. This has never been the case: the reality, as we have just seen, has always been that government spending has come first and taxation later. The reality is that taxation acts to remove money from circulation and to prevent inflation: it does not fund and never has funded public spending.

The Treasury does not, as we imagine, bank with the central bank in the same way that we maintain a bank account where our interest-bearing bank deposit asset is the bank’s interest-bearing debt liability and vice versa. The central bank creates credit/money on the Treasury’s behalf which it exchanges with the Treasury for gilts or lends to the clearing banks as necessary for them to balance their interest-bearing lending and deposits.

The clearing banks of course have their own power to create money, for the purposes of lending. They are responsible for most new money in the modern system, accounting for about 97% compared to 3% from the Bank of England.

Incidentally they too are the subject of a well peddled myth, which is that deposits are first collected by banks and then spent or lent into circulation on the basis of requiring a certain reserve level of deposits to be maintained. In fact, there is no constraint on UK credit/money creation of reserves: the constraint on modern money creation by private banks is the capital required to cover losses on loans. Private banks first lend or spend what are essentially ‘lookalikes’ of central bank money, and then fund their dated interest-bearing loans (assets) with dated interest-bearing deposits (liabilities).

Putting most money creation into the hands of organisations whose raison d’etre is to make money from lending (and more recently, from speculation) is behind much of what has gone wrong with the financial system. As with all historic bubbles, the profit motive drove excessive credit creation. Bank lending departments were abetted by everyone from bank lobbyists persuading the authorities to allow dangerously low capital ratios to trading departments devising increasingly complex instruments for shifting loans off bank balance sheets to make more and more lending possible.

From out of these observations, I reach two conclusions. First, the clearing banks cannot be trusted to freely create the credit which is modern money. If money is to be created by a middleman or intermediary then it should be the Central Bank or the Treasury: the question is, how and by whom such State credit issuance and allocation should be professionally managed and accountably supervised.

For instance in Hong Kong, there is no central bank. The Hong Kong Monetary Authority supervises the issuance of virtual currency and physical bank notes by three commercial banks including HSBC. The Hong Kong dollar is kept pegged to the US dollar between upper and lower rates which are defended by a currency board mechanism, putting strict limits on the amount of money that the commercial banks can create.

The idea of direct Treasury creation of money should not seem alien, by the way. During the First World War, UK Treasury notes known as Bradburys were temporarily issued as money to surmount a shortage of credit. In the US to this day, there remain a small amount of US Treasury Notes (greenbacks) in circulation which are worth exactly the same as the Federal Reserve Bank dollar notes which replaced them.

My second conclusion is that we must revisit the concept of the National Debt itself and recognise it for the National Equity it is in reality. We have only saddled ourselves with this debt delusion because we have forgotten what the true relationship actually is between public spending and taxation.

All existing UK gilt-edged stock could be consolidated as happened before with Goschen’s Conversion in 1888 which created the single class of undated Consolidated Stock (‘Consols’) which remain to this day. We could again create a single class of undated stock and the absence of dated ‘debt’ obligations would drastically reduce the UK’s funding costs to the rate of return paid in respect of this ‘National Equity’.

In fact, one could argue that the creation of £375 billion of quantitative easing (QE) reserves – upon which the Bank of England pays interest at 0.5% pa – has partially achieved such a Consolidation by the back door. These reserves of fiat money created and used by the Bank of England to buy and hold gilts are assets which are functionally equivalent to gilts, since both are created as claims over future tax income, just like the broken tally sticks from days long forgotten.

Such a centralised re-architecture by the UK government of the national balance sheet is admittedly difficult to foresee at present. But once you dispel the myth of the national debt, it creates a space for discussion of more practical solutions now emerging as a result of technological innovation. With the prospect of a Scottish Treasury emerging in the near future, this is worth serious consideration." (https://blogs.ucl.ac.uk/resilience/2013/03/11/the-myth-of-debt/)