There are many visions about how we create a better nation, but almost universally they all aim for the same conclusion. What we also want to achieve is better schools, hospitals, research and development, infrastructure, public transport, policing and more. We want a better quality of life. Yet with every debate about the public sector there is one dividing factor between the two parties.
We must be fiscally healthy in order to give the best quality of life for everyone. But what if I told you we could afford it? Because there is a new school of thinking around economics that’s gradually making its way into mainstream debate, titled Modern Monetary Theory.
MMT quite talks about how the “fiat” money system works. The theory examines models in countries like the UK, US, Japan, Russia, China, Australia, Canada and Switzerland, because they all have their own currencies from their own central banks. They can create their own currency in the forms of notes, coins and simply using keystrokes on their laptops with transfers between banks. Key here is understanding that it is impossible for these countries to go bankrupt in regards to their own currency. This is quite different from other countries in the Eurozone, such as Greece, where they are unable to create their own currency. Eurozone nations share the same currency, the Euro, which is controlled by the European Central Bank. They do not have their own individual currency producing central banks.
Countries with their own central bank have one special advantage; they don’t have to first collect money before they can spend. This allows the government to purchase goods and services from the private sector, without needing to raise/tax money first. This also goes for spending on the NHS, education, police services, infrastructure or whatever they so desire. It is after this spending occurs that the government can collect taxes from the private sector.
So many of you will be probably be asking yourselves “If the government with its own central bank can spend money without collecting taxes, then what’s the point in collecting taxes at all?”
Before we go further on why tax gives currency its value we must go further back in time, when taxes were backed by gold. Under the “gold standard” a country’s currency was physically backed up by its access to gold. For example, if at a time gold was worth £30 an ounce, then the holder of £30 could, in theory, exchange their money from the banking system for an ounce of gold. This meant that the country’s currency could not exceed the value of the access to gold stores. But this changed when in 1971 the US president, the then president Nixon, took the USA out of the gold standard and was followed by the rest of the world
But when the system changed the textbooks didn’t follow. If we were on the gold standard and promised to convert dollars into gold at a fixed price, then we do have to be careful about how many dollars we spend into existence. There is only so much gold, so once we start running low on reserves then we compromise the whole monetary system if we spend too much. We may not be able to convert currency into gold. Yet despite this system being replaced we act as if we’re constrained by the same limitations of the gold standard.
The gold standard was replaced by a “fiat” currency. Fiat is Latin for “It Shall Be,” so money is essentially created upon decree. With a fiat currency system there is no physical commodity backing it. So with no gold or silver to give the currency its value we must now understand how tax does.
Instead of seeing tax as a source of revenue for the government we must understand it as a tool. Tax allows there to be continued demand for the currency, giving it value. When the government converts the currency fully over to everyone in the country then this allows people to accept it as their wages, to which then they can spend it on purchasing everyday items you normally buy.
Then we must also think about the taxes that government also impose on private businesses and households. The tax must be paid, and the Central Bank would facilitate these payments between the country’s smaller banks. This means that if you wanted to get a mortgage your local bank would happily do it. This makes you an agent/currency user, and others around you will be using the same currency for deposits, loans or even contracts.
1) Taxes are made compulsory by the government; we pay them by law.
2) The government makes it compulsory that taxes can only be paid with the sovereign currency that the Central Bank creates.
3) Therefore citizens must find a way to acquire this money to pay for taxes
4) Therefore this gives value to the sovereign currency
Countries can make currencies overnight, and they can be accepted as long as there is demand for them. But it isn’t just demand that taxes help with, it also allows the government to control inflation and maintain price stability. How does this work?
Let’s create a scenario that there is a shortage of cars. People have the income to purchase cars, but there simply isn’t enough to go around for everyone (so demand is greater than supply).
But let’s say I’m selling my car, I’ve advertised it across my local community and want to sell it for £700. We must remember that we’re in a time when there’s a lot more buyers than sellers. So if there is six potential buyers that wish to purchase my car, and have around about £2,000 with them, they will start a bidding war. The value of the car goes beyond its original value closer to how much they have to spend, meaning that they have inflated the price. This is a key example of price inflation.
Now imagine if someone came along to the bidding war for my car and obtained a shovel, threatening to hit the bidders with his shovel unless they give him some of their money. He would take the money, but also feel slightly bad for taking so much, and would then leave each person with £1,000. A final bidder might then put down the last bid of £900 and I could accept this price. This is far closer to the original value of the car.
Okay, sounds a bit silly right? But in this scenario the man with the shovel has managed to prevent the car from being grossly inflated and managed to keep it closer to the original price. This is what, in effect, the central government does when it imposes taxes. The man with the shovel represents the government. Central governments take money out of the economy/circulation to keep leveled price stability and stop excess inflation. This works if there is more demand than supply.
I understand that libertarians will be losing their minds and screaming “TAX IS FORCE” with my given analogy. I’m honestly quite happy with that.
We can also turn the tables in a second example. What if there is more cars than there are those willing to purchase them (so supply is greater than demand)? Those selling the cars may be pushed to reduce the price of the cars so those with lower incomes can afford to buy them. But when the central government faces a scenario when supply is greater than demand (possibly because people are deciding to save their money at that time rather than spend it) then they can help increase spending power in the economy. This can be achieved by lowering taxes so that people have more disposable income to spend. So taxes are a tool for balancing the economy.
If you want another cheesy example, look at the private economy as if it was a bird bath. You want to maintain a good level on water in the bird bath in your garden, so that both big birds and small birds can splash in it. What happens if it rains overnight and the bird bath becomes full? Clearly we would need to remove a fair amount of water from the bath. What happens if it doesn’t rain for a long period of time, leaving the bath to have little water or dry up? We would then need to add water into the bath.
If you want to add money to the private economy, we can:
1) Increase Government Spending
2) Increase Private Investment
3) Increase our exports (depending on the value of the product)
“Ah,” cry those on the right “so what you’re saying is that there is truth to the neoliberal argument for cutting taxes, as a tax cut for the rich means that it will trickle down to the bottom!”
When studying economics we use a term called the “marginal propensity to consume” (MPC) which helps us understand how much every extra pounds we receive will be spent into the economy.
The wealthiest have already consumed what they’ve always wanted. By increasing their disposable income they won’t actually add anymore new spending into the economy. We won’t see new spending help create jobs for those who seek work. What this tax cut really allows is for the wealthiest to buy shares, stocks and real estate. These investments with their new disposable income benefits the top 10%. Instead we discover is that such investments actually driving up prices and lock out millions of consumers. Whilst real estate markets could go up in wealth what we won’t see is a large increase in growth and employment. A good economist understands that the only tax cut that creates an economic stimulus is a tax cut on the poorest citizens.
Within the theory of MMT we also empathise the importance of deficit spending in order to create growth. So let’s take it back a step and look at deficits as a whole.
Before we talk about deficits we need to have a greater understanding of about two important sectors of the economy; the public sector and the private sector. Remember, in a country where the government can issue its own currency it is not financially restrained, so for the government sector can receive spending before taxes are collected. This is in contrast to the private sector, which is made up of two parts. There is the private domestic sector where we as individuals and firms consume domestic goods and services that are produced, bought and sold into the economy. Then there is the private foreign sector, which exports and imports goods and services to and from other countries. However, unlike the government sector, the private sector is financially restrained, since it must have money before it can spend. This can be achieved through getting money from the government or exports to other countries.
The deficit is the difference between how much a government spends into the economy in a given year and how much it gets back from taxation. For example, if a government spends, say, £100 million into the economy but only collects £80 million from taxation then our government deficit is £20 million. Neoliberals will screech to no end at how horrible such a scenario is and will label this as uncontrolled spending and want to “balance the books”. But not only do neoliberals wish to avoid deficit spending, many Keynesian economists only support deficit spending at the worst of times. It does sound fiscally irresponsible, so is that the case?
Let’s look at the bigger picture when the government has a deficit. This graph is used by Professor Stephanie Kelton:
The red highlighted line shows the US government’s budget balance (in terms of a percentage of GDP), compared to the black highlighted line showing the private sector’s balance. The bigger the US government deficit became the greater the surplus was for ourselves. Yet when a government budget manages to reach a surplus, the private sector eventually dives into a deficit. This is the other side of the story neo-liberals don’t want to talk about. A government deficit of £20 million means that there is a public surplus of £20 million for the rest of society. So really a government deficit adds pound assets to other parts of the economy. This is completely normal and necessary in order to run a healthy economy. The chart shows this almost like a mirror image between both the government and private sector
If the government seeks a surplus then the private sector would have to run a deficit, unless it ran a trade surplus. To have a government surplus the state has to introduce austerity measures (or directly increase taxes, but the Tories would rather be burned alive before they would try that). For the private sector to afford this they would need to cut into their savings, sell their assets or take our loans on credit (and they would have to pay interest). With less money in the private sector to be spent on goods and services this then strangles growth with increased private debt. Yet politicians on both sides of the spectrum seem to miss this out entirely. We must remember that if a country can produce its own currency then government can never go bankrupt and eventually pay its debts.
If a government has a trade surplus combined with a government deficit, then we can better create growth which takes us one step closer to full employment and price stability.
But this is where we must understand the very limits of MMT, as it’s not a magic money solution. If, for example, the UK wanted to kickstart a massive infrastructure project then it would need the labour, machinery and materials to do so. Money cannot train nurses, doctors, engineers, police officers or teachers. MMT can help pay to utilize resources, but it is not the solution to magically making them appear. Thus, MMT tells us we can only go as far as the real economy will let it, as anything beyond the means of what a nation can actually create is inflationary. It is also worth noting that MMT shows that countries with their own sovereign currency can still go bankrupt if they have too much foreign denominated debt, thus leading to them to devalue their currency and lose the ability to pay for foreign bonds. This is one of the main problems with Venezuela.
However, this is why it is more beneficial to run a government deficit and private sector surplus, since this then creates a greater healthy equitable balance.
The news that the UK government has managed to achieve a lower government deficit brings little joy. Do you seriously picture a family who are forced to choose between heating their home or feeding themselves jumping with joy with such news? Can you imagine public sector workers who haven’t seen a decent pay rise in years leaping over the moon? Will the homeless see their spirits lift and applaud their grand masters in the halls of Westminster? No, they will continue to feel the hardship of Conservative fiscal policy, because austerity is not ending anytime soon. Paul Johnson, Director of the The Institute of Fiscal Studies (IFS), argues that there is still massive spending cuts and social security cuts still to come. He points to the disastrous prison system in England, incredible pressure on local government budgets and a struggling NHS as a consequence of austerity.
But perhaps you don’t have much faith in the IFS? Fair enough, then we can look at the report by the Equality and Human Rights Commission titled “The cumulative impact of tax and welfare reforms”. They’ve analysed the impact of austerity in the UK amongst various groups, finding that if you’re a woman, disabled, have kids, from an ethnic minority or all of the above then you’re disproportionality worse off. And not by a little bit.
As rich men in suits raise their champagne glasses with the cheer of “balanced books” the rest of us pay the price.
So you can see why right wingers despise the MMT argument. It suddenly turns the deficit figure on its head and creates a new debate away from their agenda. How big should the UK’s deficit be?
You see? Suddenly when Conservatives cry that a Labour government would borrow more it doesn’t seem so ugly, and that’s because it really isn’t. This thinking around the theory is backed by numerous academics and economists such as Professor Stephanie Kelton, Professor Richard Murphy, Professor Pavlina R. Tcherneva, Professor Bill Mitchell, Professor Warren Mosler, Professor Abba P. Lerner, Professor Steve Keen, Ellis Winningham, Professor L. Randall Wray, Professor Scott Fullwiler, Rodger Malcolm Mitchell…the list goes on.
And it won’t create hyperinflation. We’ve already mentioned above how we can control inflation by using tax as a tool, but others are simply not convinced. Many on the right argue that simply by printing money we are causing inflation, which leads to hyperinflation. But modern economics shows that we don’t physically print money for everything, we usually just credit accounts online (and in doing so create reserves).
But printing money is normal. It happens, quite literally, every day. The printing of money alone does not cause inflation, it is when a government attempts to spend beyond the resources and productive capacity it has. Any suggestion that money in isolation is inflationary is incorrect. In the examples of Venezuela, Zimbabwe and Weimar Germany a large factor for inflation was due to supply-side economics (cutting taxes and decreasing regulation).
Other reasons that currencies generally tank can be because there is a catastrophic failing in a nation’s output, they could choose to peg their currency or take on large foreign debts. If you still don’t take my word for it then take the word of the Cato Institute. They looked at every single case of hyperinflation in recorded history and found that none could be attributed to policies seeking full employment.
Nor will the taxes create inflation. It is true that taxes on business activities will get passed on to consumers, assuming they can get away with it. But, technically, this isn’t inflation. Inflation is defined as a continuous increase in the general price level of goods. When we see a tax hike imposed on businesses it is a one-off price increase, so it is not a continuous rise. While taxes can serve several other purposes besides just fighting inflation, the goal with an inflation-fighting tax is to reduce private sector spending.
We must remember that there is more than one tax and not all will be as equally effective at such a task. While taxes function to prevent inflation, that does not mean that we should use adjustments in the tax code in order to fight inflation. We could use a job guarantee scheme for such a task, but again that can be a discussion for another day.
Labour could promote truly progressive policies if it embraced Modern Monetary Theory, it could go about it’s radical transformation of the country whilst staying fiscally responsible.