This note tries to answer a question raised by some non-economist friends: to what extent can Government pay for it’s expenditure by just printing the money? Is there a ‘magic money tree’, and what are the pitfalls and limitations on using it? I have simplified the argument in places, for ease of exposition to a non-technical audience. I have also included some speculation about the political implications. The emphasis is on the concepts – I haven’t done any analysis of the UK data, so the speculation is no more than that.
How does Government finance it’s spending?
Government has three options for financing an increase in spending. It can tax more, it can borrow more, or it can ask the Bank of England to create the money it needs – which sounds like having a ‘magic money tree’.
Government spending financed by taxes is fairly simple to understand. Government takes money from taxpayers and spends it instead – hopefully on purposes that most taxpayers agree are worthwhile.
If Government finances it’s extra spending by borrowing, the Bank of England sells Government bonds, which takes money out of the economy when those who purchase them reduce their bank balances in order to make payment. When Government spends the money it has borrowed, the situation reverses, as the bank balances of those providing those goods and services increase. There is no overall increase in money supply.
If Government spends without taxing or borrowing to pay for it, what happens is that the Bank of England increases the money supply by raising net credit to Government, with no offsetting reduction in bank deposits held by the private sector: overall money supply has increased. When Government spends the extra money, Government bank balances fall back to their initial level, but private sector bank balances increase as those providing goods and services to Government bank the proceeds. If it is easier to visualise, the effects of this process are exactly the same as if the B of E physically prints extra bank notes for Government to spend.
The Demand and Supply of Money
The Bank of England can create as much money for Government as it wishes. The interesting question is what happens as a result. The answer depends on the relationship of the money supply to real output and the price level.
The money supply consists of commercial bank deposits, plus net credit from the banking sector to Government, plus net foreign assets (foreign exchange reserves held by Bank of England and the banks). Commercial banks are also able to create money:- every time they extend a loan, they create a deposit in the name of the person receiving the loan. The limitation on their ability to create money in this way is that they must keep sufficient reserves to be able to meet the demand from depositors wishing to withdraw their funds. Reserves are normally a tiny percentage of their total assets, most of which are in the form of longer term loans and investments. If customers suddenly wish to withdraw more funds than the bank has provided for, the Bank of England steps in to advance funds to the banks, albeit at a punitive interest rate to discourage the banks from taking unreasonable risks. This happened on a massive scale after the 2008 financial crisis, when banks experienced a high level of withdrawals by customers no longer confident that their money was safe.
An important task of central banks like the Bank of England is to manage the money market in such a way that the commercial banks supply sufficient funding to support economic growth and allow the economy to operate at close to full capacity. If too little money is created, interest rates are pushed up, and investment and economic growth stalls; if too much is created, inflation may ensue, as a result of ‘too much money chasing too few goods.’ The Bank seeks to manage the growth of the money supply by changing the interest rate at which it will lend to the banks, and by buying and selling Government debt in order to either supply more funds to the market, or absorb surplus cash.
We have discussed the supply of money, but what determines the demand for it?
Economists like to decompose national output into real output Q and the price level p. You can think of Q as the physical bundle of goods and services actually produced in a given year, and p as a vector or list of the prices at which they were sold. Every time a good or service is sold, money is transferred from buyer to seller. It is true by definition that the total money supply (M) in a given period equals total output (p times Q) divided by the number of times each £1 is used, a number that economists call the velocity of circulation of money, or v. This is simply true by definition:
The monetarist economists turned it into a theory by assuming that v is broadly constant in the short term. The assumption that the number of times each £ is used in a year is broadly constant is quite a strong one -especially in a pandemic when everyone’s ability to spend is quite constrained. It continues to be debated to what extent v is stable, but the key insight is that there is a relationship between the demand for money and the monetary value of national output. The more we produce, the more money we need in order to finance the buying and selling of goods and services. This means that the Government (or, more accurately, the Bank of |England on behalf of Government) can indeed use the ‘magic money tree’ to increase the money supply as demand for money increases.
If we start from a situation where the supply and demand for money are in balance, then an increase in Government spending financed by increasing the money supply will be balanced by an increase in money demand, as Government seeks to buy more goods and services. If there is ample spare capacity in the economy, then real output will expand to meet the increased Government demand. Problems arise if the economy is at or near full employment, and firms are unable to increase their output to meet the extra Government orders.
If there is no spare capacity, then Government will only succeed in obtaining the extra goods and services it needs for it’s expanded expenditure programme if the private sector consumes less. This could happen through a reduction in v – perhaps the private sector saves more, or has to wait because of shortages of critical labour or goods and services. However, a large part of the gap between demand and supply is likely to be met through suppliers increasing prices as they realise that the extra Government demand gives them more bargaining power.
To summarise: if there is no spare capacity, the extra quantity of goods and services that Government wishes to buy can only be supplied if the private sector consumes less. Price increases are the mechanism by which the amount that can be purchased is brought into balance with what is available. Government is only able to secure the increased quantity of goods and services it has planned to purchase by reducing the supply available to businesses and households, just as would have happened if it had financed the spending through taxation. Everyone, including the Government itself, will find that, because of increased prices, planned levels of spending will buy less than expected, and the objectives of the spending will not be fully achieved.
In a trading economy of course, part of the excess demand can be met by imports. Introducing the external sector to the analysis adds some complications but does not fundamentally alter the picture. If goods and services can be purchased from abroad, there is no capacity constraint. If Government increases it’s spending beyond the ability of the domestic economy to supply, then money will flow out of the country as imports increase and less is available to export.
The country will have to buy more foreign currency in order to buy the extra imports. This will reduce the excess money supply, as £s flow out of the country to foreign suppliers. The increased demand for Euros will change the exchange rate, raising the £ cost of buying a Euro. The excess demand for foreign goods and services will eventually be self-correcting as the depreciation of the exchange rate reduces demand for foreign goods and services, in the same way that inflation frustrates demand for domestically produced output. If domestic demand continues to exceed the capacity of the domestic economy, then foreign holders of UK currency will eventually become wary. Interest rates charged by foreign creditors will increase to reflect the expected rate of decline in the value of the currency. Contracts will be denominated in Euros rather than £s. If continued for too long, the combination of a collapsing exchange rate and public and private debt denominated in foreign currency can eventually lead to unsustainable debt problems as African and Latin American countries found in the 1980s. I am not suggesting that this is a serious risk for the UK, but there is a need to manage domestic demand to be broadly consistent with a sustainable balance of payments position in the medium term.
Economists and central bankers generally discourage Governments from making too much use of money creation to finance their spending. The danger if Government continues to have recourse to the printing press to finance it’s expenditure is that a vicious circle can develop. Firms and households expect prices to continue to rise, and therefore seek to protect themselves by holding tangible assets rather than money, and seeking to adjust their prices and wages to the rate of inflation, building more excess demand into the system. In the jargon, the velocity of circulation can become very high. If not checked, the result can be hyper-inflation, banking collapse, and a retreat into a barter economy. This is not just fanciful theory, there have been plenty of real world examples from Germany in the 1920s to Zimbabwe more recently.
COVID 19 and the Magical Money Tree
The circumstances of the current pandemic in the UK make the risks of financing Government spending through borrowing or through money creation relatively modest, at least in the short term. To understand why, a short explanation of the national accounts will be helpful.
The key concept is that every good or service produced in the UK or any other national economy generates an exactly equivalent income for someone. Labour and capital are combined through a production process to produce outputs that are sold to produce income that is shared between the workers and the owners of the capital. Output consists of investment plus consumption goods, and equals income that consists of consumption plus savings. The output of consumption goods equals consumption expenditure by definition -because consumption goods that are not sold in the period are defined as an investment in stocks . This means that the condition for the supply and demand of goods and services to be in balance is that savings should equal investment. This is true by definition after the event.
The problem occurs when investment plans and savings plans differ. If firms plan to invest more than households plan to save, the physical capacity of the economy to supply the necessary goods and services will be exceeded. The banking system may create the money to finance the investment, but physical supply limits will push up prices and interest rates as firms compete for the available labour and capital equipment, reducing the profitability of investment. Conversely, if savings exceed investment, there will be insufficient demand to fully employ the available labour and equipment. The interest rate may fall, reducing the incentive to save and making investment more profitable. However, there is no guarantee that any positive interest rate exists at which the two can be brought into balance. The key insight of Keynesian economics was that, if the private sector is unwilling to invest the available savings, then Government can step in and restore full employment by spending more, increasing the Government deficit. This was the basis of economic policy from the end of the second world war until the rise of monetarist economics in the 1980s.
The lockdowns and the restrictions that have accompanied the COVI|D 19 pandemic caused a reduction in output in the UK economy, and therefore a reduction in people’s incomes. Government tried to limit the reduction in people’s incomes by measures such as the furlough scheme. Other things being equal, one might have expected the population to try to maintain their expenditure by drawing down their savings and borrowing more. This, combined with increased Government spending, might have resulted in total demand exceeding total output, with inflation the result. That was my expectation, in an earlier blog post. In practice, this did not happen.
Somewhat surprisingly, the lockdown has seen a big increase in household savings. Those towards the bottom of the income distribution have struggled, as have many in the hospitality sector and many self employed. However, those who are retired or remain employed have increased their savings, partly a precautionary response to a less certain future, but mainly the result of frustrated consumption as holidays and recreation plans were prevented by lockdown. This increase in savings has been accompanied by a reduction in investment. Banks and other financial institutions are reluctant to lend in uncertain times where the viability of firms is unclear. The combination of increased savings and reduced investment came at a time when interest rates were already close to zero.
This puts Government at present in a very strong position to finance a massive Government deficit. The Government stock of debt has reached about 100% of GDP, which is high but by no means unprecedented in our post-war history, while the cost of servicing that debt is very low, due to near zero interest rates. With such uncertainty over the viability of private sector investment, Government looks by far the safest place to invest savings, which means the Government can borrow as much as it likes for next to nothing.
The interesting question is what happens when the current unusual situation begins to unwind. Savings are likely to fall quite substantially as it becomes possible to spend on all of the things that have been denied us during lockdown. Investment will revive as easing restrictions removes the uncertainties that prompted delays to investment plans . The banks are very liquid at present, which means that they are well placed to expand their lending very rapidly if credit-worthy customers come forward. With investment likely to increase and savings likely to fall, it is likely that the economy will experience significantly higher interest rates and some inflationary pressures. This is manageable, but will require the Government to reduce the stimulus to demand represented by it’s greatly expanded deficit. This will partly happen automatically as the need for pandemic support eases and higher output brings in more taxes. However, the pandemic revealed the need to spend a great deal more to rectify long standing problems of insufficient spending on major areas including the health service, social care, and local Government, while the cost of servicing the debt will increase. The danger is that an irresponsible Tory Government intent on winning an election may be unwilling to raise the necessary taxes, and may indeed want to reduce them. With similar problems across the globe, there is a potential risk of a return to relatively high inflation and interest rates that could make debt management more difficult, but it seems a remote possibility at present.
As the economy revives, the demand for money will increase, and Government can in normal circumstances make increased use of money creation to finance it’s spending, without causing inflation. This also has the advantage of limiting the increase in Government debt stock and debt servicing costs. A significant caveat is that this depends on what happens in the commercial banks. If revived confidence leads the banks to greatly expand their lending, something they are well placed to do at present, then the Bank of England will become concerned about excessive money supply growth and inflation. In that situation, the Bank may need to reverse the Government contribution to money supply growth to make room for increased private sector demand . The Bof E will need to sell more Government debt than is required to finance the deficit – turning the public sector money creation into reverse, raising interest rates, and raising the cost of financing the Government deficit.
These strange economic times may also partly explain why a Government that appears to many of us to be hopelessly incompetent has nevertheless maintained a lead in the polls. The massive increase in domestic savings has enabled the Government to spend staggeringly enormous sums without raising taxes, and without causing inflation. Many in the country have improved their financial situation; many others have benefitted from generous support via the furlough schemes, enabling them to survive the pandemic with lower costs than they might have expected.
So far, nobody has had to pay for this generosity. Those who have suffered most are perhaps not Tory voters – and we have seen plenty of gerrymandering efforts to direct more of the available largesse to Tory seats. The incredible wastefulness of the chumocracy has yet to cut through precisely because it appears that nobody has yet been asked to pay for it.
The continuing Tory lead might thus be explained by the goodwill factor of the vaccination drive, and the extraordinary scale of the support to household incomes. This positive view might erode when economic revival puts more pressure on Government finances – but that does not look imminent. For the moment, enough people are positively surprised by the extent to which Government has succeeded in protecting them from a pandemic that the Government is not perceived as having caused. Those who have been paying attention may know that the impact in the UK is far worse than it needs to be, but enough people have had a better pandemic than they were expecting to give Government the benefit of the doubt.