Put plainly there is a good chance everything you have been told about how our country, or other similar countries, function is pure fiction. Like a lot of my posts, I think, I’ll start by saying something that seems, at first, ridiculous and counter-intuitive but bare with me…
I am going to talk about three functions of the government: taxation, spending and borrowing (a.k.a. government / public debt). The biggest lie we are told, and largely believe, left to right, is that these three things are interrelated. In reality they are not operationally related in any way. They are related in the sense that they form parts of a strategy employed by the same governing body i.e. the government, but they are completely distinct mechanisms that exist to meet distinct objectives. Those objectives, again, form parts of an overall objective, but that is at a strategic level, not an operational one, and completely different to what we are told.
The intuition goes that government spending is funded by taxation and shortfalls met by borrowing; adding to the public debt. The debt must be financed by future taxation or more debt. The government cannot spend without raising finance from taxation or borrowing. This intuition relates to nothing in reality, and is based on straight-up lies and a few misrepresentation of facts.
Taxation and Spending
The government’s ability to spend is in no way linked to tax receipts. Have you ever gone to a cash machine and got a second hand note? No? Why? Banks buy cash from the Royal Mint. They don’t buy second hand ones, they want new ones. If you take your cash to the Treasury to pay a tax bill they just throw the money away. It doesn’t go into a pot or an account or a fund… it just ceases to exist. The treasury could keep it and they could reuse it, if they wanted to, but they don’t have to and usually don’t. Why? Pounds are of no value to the UK government. They can issue as many of them as they wish, whenever they like.
If the government wanted to build a hospital or pay housing benefits, or whatever, they just credit bank accounts and pounds appear. That’s it.
Debt and Spending
So if the government can (and does) simply issue money when it spends why are we told that the government incurs debts? The government does incur debts, that’s true, and those debts do show up on the government’s balance sheets because they are financial entities that need to be tracked. The government, however, doesn’t need to incur debt to spend. It’s ability to spend is not linked, at all, to the sum of it’s debt and tax revenue. The idea that the government incurs debt to allow spending is, again, a pure lie.
Why does the government Tax, Spend and Borrow?
So, if the government doesn’t need to tax or incur debt to spend why does it tax and incur debt? In order to understand this and to see what the core of the misunderstanding is (and how it’s exploited) you first have to realise that the government is not part of the economy in the way private firms or people are. If the economy were a game the government would be in god mode, if the financial system were a game the government would be the score keeper. The government has it’s own rules and it’s own limitations, of course, but those rules and limitations are not commercial or market based and fall outside of what is generally referred to as ‘the economy’. Much of the confusion about all of this comes from the insistence that the government is part of the economy and is like a firm or a household.
The government does have to interact with the economy if it has any chance of doing anything effective. Once it interacts, it’s actions take on the form of economic or financial operations. This is why the government incurs debt. Or at least debt is one of the ways it chooses to interact with the economy. It lends, it borrows, it buys, it sells. It has bank accounts and asset sheets. The government debt is really just one channel for controlling the level of reserves (bank money) in the economy and controlling interest rates. It shows up as a ‘debt’ on the balance sheets. The government is constrained by the basic principals of accounting, which is why it can be said to have a balance sheet with a huge liability on it called debt.
The mechanism of government debt is familiar to you: it’s a huge collection of savings accounts. A savings account is when you give someone some money, they keep it for a while and then give you it back with interest. The treasury offers this service to banks in the form of bonds. The treasury sells bonds to banks and receives money (reserves). When the bond matures the government will buy the bond back at the sale price plus interest. The government does this to effectively bribe the banking sector into temporarily giving up some of its reserves for a short time. This, in financial terms, reduces the banks liquidity (that is their money is tied up and therefor less liquid). It also gives the government a channel to pump new reserves into the banking sector in the form of interest payments on the bonds. Banks buy government bonds simply because they can earn more interest than whatever else they were doing with the reserves. Doing so ties up their reserves. That’s why they offer savings accounts to us. We send money to the bank, the bank sends the money to the treasury (by buying a treasury bond), they take a cut of the interest earned and give us what’s left in the form of interest payments to us.
So, all in all, the total government debt is the sum total of our savings accounts. It’s our asset and the government’s liability. That’s it. Not a big terrible monster that’ll engulf the world.
The government chooses to give the banking sector a high interest / low liquidity option and chooses the terms. It’s debatable whether it is necessary to do so and how it should be done. What isn’t a matter of debate, however, is that firstly the government can continue making interest payments of any amount forever and never become insolvent. Secondly, it can do so without ever needing to increase taxes. And thirdly, it chooses the interest level it pays, and can choose any, including zero. One of the (intentional) effects of the government doing this is that it sets the minimum interest that can be earned lending reserves out. This is because if a bank can get 5% interest by giving their reserves to the government why would they give them to someone else for less? In this case the government is intervening in the market to push the interest rate above zero. Note that the government could, I think, stop doing this. We would still have savings accounts because the banks could still offer them. It’s just that the base interest rate would be at it’s natural value: nothing.
The primary function of taxation is to create demand for the pound. That’s it. So long as the tax burden is big enough to ensure sufficient demand for the pound then taxation is doing it’s job. The government could arguably choose, far valid reasons, to increase taxation if it needs to suck money out of the economy (for example if the economy is expanding too quickly) but of course that’s never given as a reason to increase taxes. The secondary function of taxation is to steer economic activity, for example, putting taxes on certain things to reduce demand for them. These two functions are distinct. For the first, the overall number is what’s important, for the second it’s the specifics that are important.
There is a very clear indication that this is true. No matter how broke the UK government says it is, no matter how committed to austerity they are or how desperate they are for cash, have they ever even mentioned the possibility of you paying your tax bill with gold, or dollars, or bit-coins? Why not? They could spend those things, right? Surely everyone has old gold stuff they can get rid of to pay tax bills or fines. So why don’t they? Well, if they did they would risk destroying the economy, literally. Using the tax system to raise demand for bit-coins instead of pounds would risk making pounds worthless. The government wouldn’t have to radically increase it’s spending as the value of pounds drops. In the worst case the value could drop to zero and the government would cease to function. Public services would fail and the country would be a mess*. Sovereign currency systems that fail to maintain a tax burden always collapse.
Perhaps the most surprising thing about all of this, the thing that might be hardest to swallow, is that government spending doesn’t cost you anything. Of course the government could demand tax revenue to cover the cost of spending, in which case you are being charged as a result, but there is no inescapable reason why it has to cost you anything. At all. For example, the government pays for a hospital to be built. A new hospital is built. Did that cost you anything? It is possible that the resources being used to create that hospital are in limited supply, so the government bidding for them could push their price up. If you need those resources then you will have to pay a higher price (which is a very loose conception of ‘cost’). If you are selling those resources you will earn more. If you earn more you will have more money to spend on other things. If the resources used are not in limited supply then new resources will be sourced, in which case there couldn’t be inflation because there would be an increase in both supply and demand. This rough outline is about as far as mainstream (and Austrian) economic theory gets you. There are also lots of other indirect costs and savings that are hard to quantify but very important. For example having an extra hospital could save countless worker-hours lost through illness. The point is that it depends on the situation and the complexities of who supplies what to whom and why and the spending habits and interests of those whose incomes are altered. Unfortunately economists as yet have provided no way to model this outside of ludicrously unrealistic and simple thought experiments carried out in their individual heads, so don’t have much to add to the matter.
*Incidentally, if this were to happen, many economists would point to the inflation, blame it on government spending, and say “We told you so! Government spending causes inflation!”, not realising that the order of causation is the other way around.