Britain Can’t Afford Rachel Reeves (5)

How government spending creates money

I realised that I was probably too generous to Reeves in my last post, by showing the government borrowing from the banks to cover its deficit. Instead, as someone who believes the economics she was taught at University, she probably believes that there is a “market for Loanable Funds”: that all the money that finances both government spending and private sector investment is lent by households.

This model assumes that there is a fixed amount of money available for borrowing by firms, or spending by government. If the government spends more, it has to borrow more back, and pay interest on what it borrows. This leads to less money for firms, and a higher interest rate, which discourages investment. The textbook drawing of this model, which I introduced in the first post, is the following:

Mankiw’s verbal explanation of this model emphasizes that government spending crowds out private investment:

Consider first the effects of an increase in government purchases… The immediate impact is to increase the demand for goods and services… the increase in government purchases must be met by an equal decrease in investment… Government purchases are said to crowd out investment.  (p. 73 of Mankiw’s 2016 Macroeconomics textbook)

The table below puts this vision of government spending and borrowing in double-entry bookkeeping terms. It is scarier than the model I put in the previous post, because there is only a fixed amount of money, and any that is borrowed by the government reduces the amount that is available to firms. This double-entry bookkeeping model thus reproduces the drawing Reeves would have learnt from her economics textbooks.

This model is bollocks, as I concluded in the previous post, because (while the government does have some accounts at private banks) the government’s primary bank account is held at the Bank of England. It’s doubly bollocks, because firms don’t borrow from households: they borrow from banks. When we correct this false model to make it consistent with reality, we get the table shown below.

There is one fundamental difference between it and the textbook fallacy shown in the previous table: the amount of money is not fixed.

All the operations highlighted in yellow in the table above change the amount of money in the economy:

• Bank lending to firms to finance investment creates credit-backed money—as the Bank of England said in its important 2014 paper that mainstream economists continue to ignore;

• Government spending creates money, and taxation destroys it; and

• Interest paid on government bonds purchased by banks creates money in the financial sector.

This difference between the real world, and the textbook models that Reeves learnt in her economics degrees, is why her obsession with “balancing the books” is so dangerous. If the government doesn’t spend more than tax revenues, then the government doesn’t create money. All the money in the economy will therefore be debt-backed money created by private banks. This is a less stable, more volatile system than one in which both the government and the private sector create money—the opposite of what Reeves hopes to bring about.

I’ll cover that issue in the next post.