Don’t Fall For The Idea That Future Tax Revenue Are Required To Pay-Off Government Debt. In Fact, It Is A Myth That Taxes “Pay” For Any Government Spending
When an economy is at ‘full capacity’, (i.e. very low unemployment and all resources in the economy being used productively), a government may wish to spend say £20Bn on something everyone agrees is needed – it could be repaying govt debt, defending the country, building hospitals, whatever.
When it spends this money it inevitably causes inflation – this is because you have more spending chasing the same amount of goods and services. The amount of goods and services does not change because the economy is already at full capacity.
To enable the government to spend without causing an inflationary spiral, the government taxes by an equal amount to prevent the private sector spending by the same amount – so overall the spending (public and private) remains roughly constant, so no inflationary spiral.
So the extra tax is to prevent an inflationary spiral when the economy is at full capacity – it is not required to “finance” govt spending. This is why government economics is nothing like household economics.
However, when an economy is the position ours is in with excess capacity, spending by government is permissible without taxation as it doesn’t cause inflation.
Given that our economy has not been at full capacity for over 30 years (hence the high unemployment), the government does not need to increase taxes or cut spending elsewhere to “pay” the interest on govt debt or to “pay” for anything.
The big question is why does the government issue bonds at all and pay interest to private investors? Why doesn’t the government just create the money at the mint or Bank of England – this won’t be inflationary as there is spare capacity.
An answer often given is that when governments issue bonds someone has to surrender money to the government. If it wasn’t for the bond that money would probably have gone into the banking system instead. This is called a ‘reserve drain’ and was clearly necessary when we had the Gold Standard/Bretton Woods or some other type of Fixed Exchange Mechanism.
The theory is outdated and based on the idea that there is a liquidity trap in the banking system. This was true 1945 to 1972 when the Bank of England forced all banks to buy up 50% of government bonds in order to deplete bank reserves and so prevent the money supply rapidly expanding due to banks being able to lend out massive amounts into the real economy.
Since 1972 until 2009 the corset has been removed and the uk money supply ballooned as banks weren’t required to buy up government debt (pension funds did it in this period). This caused the massive build up of debts that caused he collapse in 2008-
Since 2009 over 90% of government debt is being bought up by UK banks (because gilt yields are so low pension funds cant make enough money from the gilt interest to cover their future liabilities).
The result of this is that the biggest risk of inflation we face is the eradication of the governments budget deficit. The £150 billion a year public sector deficit acts as a reserve drain on banks. The gilts the banks buy up from the government to allow the deficit means their reserves are depleted by £150 billion a year. Given leverage levels in banks this potentially means that £1 trillion or so is taken out of potential circulation.
Of course this doesn’t truly matter as since 2009 the Bank of England has been making good the difference by buying up an equivalent £150 billion or so a year of outstanding government debt from banks.
The overall effect of course is that the effect of deficit and QE are cancelled out. The only thing that happens is that the government cancels out about £150 billion a year of outstanding government debt. The money supply neither widens or contracts.
So the the theory of deficits and funding them via banks buying them is utterly destructive and irrelevant when we dont have the need of fixed exchange rates. By issuing bonds the government can take money away from the banking system and make sure that it is being spent. The issue is that it doesn’t need to be done this way and shouldn’t be. All that happens is that taxpayers pay another subsidy to the banks and we get crashes every few decades. This is also what causes inflation and recessions.
However, it’s pretty obvious that for countries with their own floating currency, deleveraging banks and with economies working at way, way below spare capacity that you can use QE to clear government debt at will without any inflationary effects.
This is obviously in the UK since there is £375 billion sitting in the Asset Purchase Facility. This money “unaffordable” government credit card bills. At the same time over a third of the debt they are moaning about is stuck in the government owned Bank of England with no hope of it ever being anything other than cancelled and retired.
To add to the hilarity the Treasury, through a wholly government owned agency called the Debt Management Office pays interest on the £325 billion in the APF to the wholly government owned APF. This money is just building up and will eventually (as all profits for the Bank are) be returned to the taxpayer. You couldn’t make this up.
So clearly in economic circumstances such as now you can print money directly, buy outstanding government debt and retire it with no inflationary consequences.
Nevertheless Governments are continuing to use an explanation built up at a time of Bretton Woods with full employment, fixed exchange rates and no deleveraging to explain why they don’t use the QE to clear down debts.
QE is a pure asset swap. No money is entering the economy. All that is happening is that outstanding public sector debt is being retired.
Look at the M4ex money supply figures. They are contracting despite £375 billion of QE and £150 billion a year deficit spending.
The Uk money supply is contracting very rapidly
Look at the graph half way down. It is showing M4ex is contracting (by 5% at last measure). M4ex needs to grow at a rate of at least 5-10% per year in order to hold off contraction of the money supply.
There is no prospect of core inflation.
Policy interest rates are at 0.5%, there are 5 million people looking for work, bank capital adequacy ratios need to double according to Andrew Haldane, Basel 3 and the Vickers reforms kick in in a few years meaning capital creation will slow down further.
It is perfectly and utterly safe to retire the £375 billion in the Asset Purchase Facility.
The arguments Lord Turner, the IMF and many others are making that is perfectly safe for the UK to retire the £375 billion of debt in the Asset Purchase Facility are of course absolutely moot.
The QE cannot possible be reversed until the government has eradicated its deficit. If the APF sold the debt whilst the government was running the deficit the effects would be two fold-
1. Gilt yields would go ballistic making the deficit difficult to fund.
2. The reserves in private sector banks would be very rapidly drained so the uk money supply would crash. Bank lending would plummet. We would enter a deflationary depression.
The deficit is not really being paid down at all. Even the OBRs wildly optimistic estimates have the deficit persisting until 2018.
This is without factoring in their idiotic under estimate of the fiscal multiplier (they were expecting 6% growth over the last two years remember). Now we know for certain that austerity is utterly self defeating and as long as it persists the economy will stay flat with only QE keeping it from entering a fully fledged depression. The deficit doesn’t decrease and all we get for our troubles is unemployment, declinging in living standards and reduced quality of public services.
By 2018 most of the gilts in the APF will have reached maturity and retired themselves.
S & L5 views