That includes me, of course. I see many articles that try to explain how national finance works but most I find completely impenetrable. Recently, however, something clicked, the penny dropped and I think I can begin to see what it’s all about now. So before I lose it again, here’s my take on the subject.

The view most people have of the national economy is based on what’s termed “handbag economics”. This is the belief that the rules under which countries operate are much like those that apply to a typical household, only much bigger. It gives rise to some primary beliefs, among which are

  • You can’t spend money if you haven’t earned it first.
  • Taxation is there to provide income for Government to spend on roads, health and so on.
  • By cutting down on “overheads” (public spending) you increase the amount of money available to spend on things that are needed.

These beliefs are at the core of “monetarism”, which has guided government behaviour since the days of Margaret Thatcher.

It’s all wrong!

The sad truth is that the list above has it all the wrong way round, because national economies don’t work like households at all. Let me explain.

Suppose you want to buy a new car costing £25,000. (Do you get a good one for that? It’s been so long since I bought new.) You go to your bank and ask for a loan for the purchase. You may have to put your house up as security but let’s say the bank agrees. Of course you don’t actually walk out of the bank with a suitcase full of used fivers. What happens is the bank adds an entry to your account showing you £25,000 richer than you were an hour ago. The money isn’t debited from anywhere that would make the bank £25,000 poorer; it’s just a figure in a computer file.

So next you pop round to the car showroom and sign up for your new wheels, making a payment of £25,000 from your newly-bulging account to theirs. Then you drive out to show all your friends.

The money you paid the car dealer goes in several ways. A big part of it goes to replacing the model they just sold you, and of course if that came from overseas the money leaves the country. The rest goes to pay the wages of the salesman and the other staff, to the local council, to the cleaning contractor and so on. Each of these spends the money according to their own needs and much of it ends up in local supermarkets, who finish each day with a pile of cash in the tills.

The till money is returned to the bank the following day, going to replenish the cash machines people drew on to pay for the goods in the supermarket. The amount of physical cash in circulation – tenners, fivers and pound coins – doesn’t vary very much from day to day; it just keeps going round and round. It’s no more than a set of temporary tokens, while the actual value is now in the bank accounts of the supermarkets and others.

If you add up the total value of all these bank accounts you find they have increased in value by £25,000 (less the bit that went overseas). And here we come to our first revelation:

Money – £25,000 of it – has been created out of thin air, by the stroke of a pen or some keys on a keyboard!

This is a staggering revelation. Money is created from nothing every time a bank makes a loan. All our assumptions about having to earn it first are gone. They still apply to us as individuals, of course, but the rules for the banks are competely different!

Of course, in the case of your car loan you’ll have to pay it back eventually, thereby canceling out the extra value added to the system, but in the case of public investment this doesn’t apply as the money isn’t usually loans that have to be repaid. It’s more akin to grants, that never have to be repaid, and it’s what causes the economy to grow.

Payback time

OK, so I’ve explained where money comes from to get added to the national wealth, but that’s too easy. What’s to stop the banks just endlessly creating wealth via loans?

The answer is, Government policy. Which is to set a limit on the amount banks may lend in any given period, otherwise we’d all become rich, stop working, go on holiday and sit in the sun while the economy back home grinds to a halt. That doesn’t happen so something else must be going on.

As well as being created out of thin air, money can be removed instantly without leaving a trace. The mechanism for this is called – wait for it – Taxation.

When the Government levies taxes it forces the payers to extract a number of pounds (dollars, euros etc) from their bank accounts and hand it over. No physical cash changes hands (most of us don’t keep sums like this under the mattress) so it’s always going to come from bank accounts. The amount shown on your bank statement is reduced by the amount you paid in tax.

So if you now add up the value of all accounts, the total is less, by the amount of tax requested by the Government. But your money doesn’t actually go into a Government bank account; all that happens is the system records you as a good citizen who’s paid his/her tax. Time for a second revelation:

Money collected in tax leaves the payers a little worse off, but it also disappears forever!

Oh dear, it looks like we’ve just debunked another fundamental Monetarist rule, that the Government can’t spend money it didn’t earn in taxation.

The fact is, Governments don’t need tax money to fund projects. Like banks, they can simply write themselves a cheque then go and spend it. This causes economic activity, some cash whirls around for a while, things get done and bank accounts get healthier balances, so to keep everything under control a proportion of this notional value is extracted as tax. The job of Government is to maintain balance by creating the right amount of wealth and clawing an appropriate amount back as tax.

What matters in the end is not how much money is shown as being in the system but whether the country can afford the goods and services it needs from other countries and whether the economic activity it generates at home is compatible with the physical resources available – land, people, minerals etc. When a country generates an inappropriate level of activity the value of its currency drops, a self-levelling mechanism that generally keeps the international system in line. From which you may deduce that the way to increase the value of your currency is to slam the brakes on economic activity and create as much hardship as possible. Austerity, anyone?

Conclusion

Handbag economics has it’s basic assumptions completely the wrong way round. Nationally speaking, money is not collected; it’s created, and tax doesn’t provide the means for spending to take place; it’s there to reduce the size of the economy and limit the ability of citizens to overspend. And it takes effect after the spending has happened.

While I welcome comments I must point out that my grasp of this subject extends little further than the above, so please spare me advanced economic theories as I simply won’t understand them. It’s taken me years to get just this far.

Photo by Pina Messina on Unsplash.

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