In earlier days of Covid, I argued that we should spend whatever was needed to tackle the pandemic and not worry too much about the national debt. It seemed a no-brainer then but, as we move into post-pandemic or endemic times, things don’t look so straightforward.
To outsiders, including me, money and banking can look horribly arcane and complex. Still, it has a big influence on our lives. Active democrats need at least some understanding of it. I’ve tried to expand my own understanding and here, in summary, is how I see things:
In the UK we are in charge of our own currency, which is not pegged to any other currency or to gold or silver. We can borrow in our own currency. This means that we can’t involuntarily go bankrupt – we can create money to settle our debts. A sovereign state is not like a household.
We have to be careful. If we put too much money into circulation, by spending too much more than we raise in taxes, inflation can run wild and it can be difficult and painful to get it back under control. Too little money can mean unemployment, empty buildings and idle machinery. Things are particularly tricky at the moment because we have inflation driven by the world price of energy and by bottlenecks in supply chains from Covid and Brexit.
The size of the national debt doesn’t always matter much – it depends partly on who is financing it and at what rates of interest. At the moment, nearly 40% of the UK national debt is owed to the Bank of England, which the government owns, and there seems scant evidence that the debt is itself a problem. However, the debt is often used by right-wing Tories as an excuse for the austerity they love.
Before 2008, nearly all money in circulation was created by commercial banks through making loans. Economics textbooks used to claim that banks were mere intermediaries between savers and borrowers. But banks can lend out far more than they take in from ordinary depositors. They can borrow from the Bank of England, which can create, from nothing, whatever is wanted by the commercial banks – subject to regulations limiting the risks of their going bust and by the demand for loans at interest rates the banks want to charge.
Since 2008, the Bank of England has put nearly £900 billion into circulation by buying up mainly government debt from the commercial banks, using newly-created money, in a process known as “quantitative easing” or “QE”. This helped to rescue the banks after the 2008 crash and to keep the economy running when Covid struck. However, the banks used much of that money to increase mortgage lending on property, so raising the price of houses and making rich people richer at the expense of young people wanting to buy a home.
At any given time, there is an optimum level of government surplus or deficit. A government surplus is not always a good thing – it partly depends on the level of unemployment. More money circulating in the economy means that the private sector can invest more in productive capacity. The old textbook view that a government deficit “crowds out” private investment doesn’t always apply. The supply of money for investment isn’t fixed – new money is created in response to demand.
Today’s processes of money creation work well for the financial sector but not always for ordinary businesses and households. Most Liberal Democrats want an economy that gives everyone the chance of a good life while leaving for our children and grandchildren a healthy physical environment free from such threats as runaway global warming. We need an economy that does what we want it to do. That may mean channelling some newly-created money directly into public investment, while leaving plenty to let the private sector flourish.
Sometimes the government can safely spend more without raising taxes. When, and by how much, varies with circumstances. However, much of what we want – such as a properly funded NHS and a well-functioning social security system – means that we will need, somehow, to raise more tax.
Others may have come to different conclusions and I’d be interested to see what they are in the comments below.
* John Medway has been a Liberal Democrat member since the merger in 1988 and was an SDP councillor before that. He has an active interest in the economics of sustainability and is on the Executive of the Liberal Democrat Social Democrat Group.
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Inflation is always described as a sustained rise in the level of average prices but a better definition is a sustained fall in the purchasing power of money – in other words, inflation is the rate at which money is losing value. The effects of inflation therefore affect different groups in society differently – those with debt will see the value of that eroded and those with savings in bank accounts will see the value of those savings eroded. Those most at risk from inflation are those on fixed incomes or those whose incomes increase by less than the inflation rate. Those protected from inflation are those who own assets whose value increases by at least the rate of inflation. Governments generally like a bit of inflation as it allows government debt to be eroded, it can allow a stealth increase in income tax take by not increasing tax bands by the full rate of inflation, and it makes it easier for markets to adjust relative wage rates without having some workers getting pay cuts in cash terms (but they may be getting real terms cuts). That is why the Bank of England is supposed to aim to keep inflation in the range 0% – 2%.
The one bit that the author missed out, we got away with “printing” 400 billion because other countries did the same, had they not our currency would have depreciated quite heavily which would have led to even more inflation than we already have.
Most people are now locked into the UK by a combination of poor exchange rates and exclusion (unless they have language abilities and a nice pile of dosh to invest) from the EU and therefore easy targets for taxation ( the Conservatives being the least bad option on that front so basically no-one to vote for if you want low taxation).
House price inflation has now blighted previously “cheap” areas so that it has become increasingly difficult to cash in on the house wealth by moving, so people who feel rich because of their house value end up shocked by how little they can make by moving. Unless they want to chance a dodgy apartment building or live in a caravan.
Getting rid of fixed costs – council tax, TV licence, standing charges on energy, etc – is the way to give the poorer end of society a decent boost but does not generate any jobs for the ever expending political class so is predictably a very unpopular idea.
An inheritance tax levy, paid by absolutely everyone who inherits anything, seems the fairest way forward, BTW.
Well said.
In the UK we are in charge of our own currency, which is not pegged to any other currency or to gold or silver. We can borrow in our own currency. This means that we can’t involuntarily go bankrupt – we can create money to settle our debts. A sovereign state is not like a household.
This was always my objection to joining the Euro as it took away the freedom to do this, as Greece found to their cost. Depreciating the currency through inflation has rather less serious political effects than cutting citizens’ wages and benefits as they had to do. A single currency can only work when there is a mechanism for transfers between different parts of the currency area. In the UK we have the Barnett formula which means that Scotland, Wales and Northern Ireland are not dependent only on the taxes they can raise.
@Brad Barrows
Actually the Bank of England is supposed to keep inflation within the range 1-3% not 0-2%. The latter would risk deflation.
@Lawrence Cox
I stand corrected – a careless error on my part.
@Brad Burrows – I agree entirely (apart from the figures you have since corrected). I may have given the impression that I think inflation is an unalloyed evil, which I don’t. You’ve set out some of the benefits of a bit of inflation. I would add that, when the monetary authorities are relying on interest rates to regulate the economy, a bit of inflation allows a nominal interest rate to go below the real (net of inflation) rate and postpones the moment when the nominal rate hits zero.
@FrankW – good point, I missed out the international dimension. That’s what I’m working on at the moment.
@Laurence Cox – I had the same misgivings about the euro when it came in and, given what happened after the crash of 2008, I think we were right. It seemed premature – an attempt to force the pace of political integration that probably had the opposite effect from what was intended, at least over the span of a couple of decades. Perhaps in the longer term it will turn out to be a success or perhaps we will see some national currencies re-emerging and running in parallel with the euro.
If and when there is another referendum on Scottish independence, the currency issue will be a very tricky one that I think was rather glossed over before the last referendum.
One aspect of the issue of money is what people who have a lot of money can do with it. An example can be seen in the countries of Russia, and other former Soviet republics. One way of safeguarding it is to buy property and other tangible assets in what is seen as a safe country.
Thus much money from these, and other, countries is used to but property in London amongst various other places. This helps to drive up the price of housing in those places. The reasons why people see other countries as safe havens are of course complex. However a good example is the USA which is able to ensure that it can get its own way thanks to its expenditure on its armed forces. Of course their is a danger of believing that the USA or any other country are acting on behalf of its citizens rather than a small group who manage to buy or otherwise acquire influence.
Really to analyse the situation we need to accept that a system has developed, and will give the results for that system. The results do not depend to a large extent on who exactly the players in the drama are.
We do though need to find ways of changing the system to get results that will get better results for the future of our planet than the present one which we are beginning to recognise has been such a failure.
Money is a lubricant not a fuel. Shortage of money can cause idle capacity, but once this capacity is mobilised more money does not allow us to consume more. What seems to confuse people is what happens when there is surplus currency in circulation. It used to be thought that there was an iron law linking surplus to inflation. That was always nonsense. Even in the days of physical currency people could hoard it. Inflation or currency depreciation is only one possible consequence. Destabilisation of our financial infrastructure is another. The difference that the pandemic has made is that it has gunged up the supply side of the economy, meaning that surplus demand cannot be met through increased trade, which was an enduring feature of the era of globalisation. In Britain we have added our own self-inflicted wound of Brexit. That makes inflation more likely. But if we are to raise consumption by improving health services and tackling poverty new capacity has to be created, or it has to be balanced by reducing consumption elsewhere, such as through taxes. That is the core issue, not the size of the national debt.
@Brad Barrows – “Inflation …”
What is interesting about the current increase in inflation is how ignorant and simplistic the traditional view of inflation is. There is no point in the Bank of England raising interest rates as the primary cause of inflation isn’t UK-based economic overstimulation, but the effects of the normal operation of global energy markets.
@ Frank W,
“……..we got away with “printing” 400 billion because other countries did the same, had they not our currency would have depreciated quite heavily which would have led to even more inflation than we already have.”
The Japanese were conducting the process of QE long before anyone else. There is no evidence that the Yen’s value on the Forex markets suffered unduly as a consequence.
The reason for QE is to lower longer term interest rates. The BoE became an additional player to buy up gilts and other financial assets on the secondary market. Higher prices mean lower yields and lower interest rates. This reduction then encouraged those looking for somewhere to park their money to look for better returns which resulted in significant price rises in both the stock and property market.
However, once they are as low as they are further QE won’t make them go much lower unless the BoE intervenes to the extent of buying up government bonds at higher than their face value. They are supposed to be engaging in an asset swap, at least that is the official story, so paying over the odds would blow their cover on that one!
@Tom Harney – “Really to analyse the situation we need to accept that a system has developed, and will give the results for that system. The results do not depend to a large extent on who exactly the players in the drama are.” I’m inclined to agree. An organisation has an ethos that tends to perpetuate itself. Newcomers who find they don’t like the ethos soon leave.
“We do though need to find ways of changing the system to get results that will get better results for the future of our planet…” I couldn’t agree more and I wish I could with confidence propose ways of changing the system. I’ve got a lot of learning still to do.
@Matthew Green “Money is a lubricant not a fuel.” I agree but I think money functions also rather like hydraulic fluid in a mechanical digger. Where the fluid gets channeled, through valves operated by the driver, determines what gets dug. Whoever controls money influences priorities for the real economy.
I get the impression, from people like Adair Turner and John Kay, that the financial services industry, though essential, is also, to an uncomfortably large extent, self-serving. I have always sensed that people whose job is to help manage other people’s money have an uncanny ability to channel lots of it into their own pockets.
My fear is that the industry worldwide is one of the main players enforcing a race to the bottom in taxation and hence in provision for real human flourishing in a sustainable physical environment.
@Roland – “There is no point in the Bank of England raising interest rates as the primary cause of inflation isn’t UK-based economic overstimulation, but the effects of the normal operation of global energy markets.” My impression is that global energy markets are one factor amongst several driving inflation (eg Covid and Brexit) but you may be right about the futility of raising interest rates at the present time. Increased expenditure on energy will, for many households, enforce reduced expenditure on other things. There may come a time when inflation becomes internally self-perpetuating, at which point interest rate hikes might become more relevant. However, I don’t believe that you can rely on one lever (interest rates) to regulate a complex economy.
“Money is a lubricant not a fuel…..”
“…… money functions also rather like hydraulic fluid in a mechanical digger”
Analogies can be useful at times if something is difficult to understand, but I’m not sure about any of these. Lets keep it simple and try to do without them.
The possession of money gives us spending power. It is inert unless it is used to make a transaction to buy goods or services. The economy can only supply a finite amount so if there is too much spending, or too much demand, we can have an inflation problem. Price levels are a rationing mechanism. On the other hand if there is too little spending we tend to see recession rather than significant price reductions.
The role of a currency issuing government is to adjust its spending and taxation policies to keep the economy running close to full capacity but not exceed it and cause too much inflation.
However, the debt is often used by right-wing Tories as an excuse for the austerity they love.
“Right-wing Tories” like “hardcore Thatcherite” Sir john Redwood? Far from ‘loving’ austerity, he’s been campaigning for “Prosperity not Austerity” for years…
‘Maastricht should no longer rule our economy’ [February 18th. 2020]:
http://johnredwoodsdiary.com/2020/02/18/maastricht-should-no-longer-rule-our-economy/
‘Prosperity not austerity’ [October 26th. 2019]:
http://johnredwoodsdiary.com/2019/10/26/prosperity-not-austerity-3/
‘A pay rise for the NHS’ [March 21st. 2018]:
http://johnredwoodsdiary.com/2018/03/21/a-pay-rise-for-the-nhs/
Austerity was imposed on us by the EU who put us into Excessive Deficit Procedure. The prescribed spending cuts were initiated by Labour and implemented by the Coalition and Conservative governments until we were moved into the preventive arm of the Stability and Growth Pact in 2018…
https://www.libdemvoice.org/guardian-vote-liberal-democrat-in-north-shropshire-69276.html#comment-564214
A lot to like here but some differences.
For one, money emphatically IS fuel. (It’s also a lubricant but that’s less interesting.)
For example, the economy of many university cities – some quite large – is hugely dependent on student spending in bars, restaurants, and the rest. It records in economic statistics as economic activity, in GDP etc. And yet much of this isn’t investment in education in any economic sense because, IIRC, it is expected that about 70% will never be repaid.
Effectively it’s just taking money from the future (which is what borrowing does) and pouring it into now. Take it away (or even just the 70%) and the economies of many cities would collapse overnight.
Mortgage lending is similar. For now, it boosts the economy and all its formal measures; if it ever stops the economy will catch a very bad cold indeed.
We have yet to see the end game of the student loans and property lending booms, but we know they ALWAYS end badly. Historically, this story played out in 1929 (mainly lending for share buying) and 2008 (dodgy property lending).
So, bad lending is always a potent fuel while it lasts; but the economy crashes when it stops.
The big conclusion is that institutions and regulations matter. The public believes that and demands it but the Tories don’t believe in regulation and usually aim to subtly neuter it which is why we have building regulations – but also the Grenfell Tower tragedy.
@Jeff I have found your post very informative, about both J Redwood and the detailed workings of the EU – thanks.
@Gordon Analogies for money like fuel, lubricant or hydraulic fluid have their limitations. That’s a pity, as I had fantasies about the Hydraulic Fluid Theory of Money still circulating in a hundred years’ time, an unwitting memorial to a long-defunct economist whom modesty prevents me from naming.
“And yet much of this isn’t investment in education in any economic sense because, IIRC, it is expected that about 70% will never be repaid.”
It depends on how you define investment. A narrow definition is spending that produces a direct financial return in the future, such as loan repayments with interest. A broader definition would be spending that produces benefits, possibly non-financial, extending into the future.
“So, bad lending is always a potent fuel while it lasts; but the economy crashes when it stops.” I agree about its potency – certainly in 1929 and 2008.
If you think subsidies for higher education (for fees and living expenses) are a bad investment, I don’t fully agree, though I suspect that increased subsidies for apprenticeships, at the expense of some university provision, might be money better spent.
I agree with you about regulation – and I would stress regulation of the way financial institutions are legally structured. This is a challenging area.
@Peter Martin For some reason I missed your most recent post until after I had sent mine off – sorry.
Analogies can be useful at times if something is difficult to understand, but I’m not sure about any of these. Lets keep it simple and try to do without them.
On reflection, I agree. The point I was alluding to via the hydraulic fluid analogy was that the financial services industry probably has a major (and to my mind malign) influence on matters such as levels of taxation as it has huge bargaining power versus governments. But that’s a colossal subject in itself that is probably best kept for a fresh blog post.
@John Medway – My introduction to investment was in a ‘real economy’ company (not financial services/markets) where it was, in principle, straightforward – will this proposed capital spend produce an adequate return? For companies that’s a financial question but sometimes you can’t quantify all the elements so the best you can say is, ‘This project works only if we believe the intangible benefits of A and B are worth more than £X’.
That didn’t happen often but there was never any pushback when it did.
For governments it’s a little different. The ultimate aim should surely be to enable people to thrive individually and collectively, by creating the necessary hard (roads, hospitals) and soft (education, institutions) foundations. Also, benefits are often to firms and individuals rather than directly to government.
So, for university spending, I agree we shouldn’t be looking for a simple financial return because there are big intangibles. I could believe these might be worth, say, 20% but 70% fails the sniff test. Past governments’ perennial worries about youth unemployment and poor training speak to confused motives etc. etc. and all add to the bad aroma. Ultimately, the financial calculations should mirror the real world; a big difference signals that something, somewhere is wrong.
But I totally agree with you that apprenticeships are a better bet. Unfortunately, there isn’t a good institutional framework (despite >90% public support!). Properly done, it could be delivered at whatever scale there was demand AND be a good investment AND great politics.
@Gordon I don’t think there’s anything in your latest post I could disagree with without getting into some serious nit-picking. My main student days were in the 1960s and all my fees were paid by the local authority so I was very privileged compared with today’s students who, according to your 70% figure (which I haven’t been able to confirm), are contributing 30% of the cost of their higher education. I haven’t looked at today’s arrangements in any detail and so I can’t comment on whether that 30/70 ratio of repaid to not repaid is reasonable or whether the net cost to the government is good value. I’ll have to leave it at that but thanks for your comments.