How disillusioned Labour Party members can fight back against Reeves

The Short Read

A Tory Chancellor announcing plans to cut winter fuel subsidies for pensioners is something that Labour Party members would have cynically expected. But what is going on when that plan is announced by the first Labour Party Chancellor in over a decade?

The problem was one first identified by Keynes in the 1930s, with his characteristic literary flair:

the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. (Keynes 1936, Chapter 24)

We’re in the 2020s now, and the practical man is now a woman, but the same truths apply.

In fact, the situation today is worse, because Reeves hasn’t gotten these wrong ideas from “some academic scribbler of a few years back”, but from the modern economics textbooks she studied in her PPE and Master’s degrees. Economics textbooks teach ideas about how the monetary system works that are profoundly wrong, and those wrong ideas are why Reeves’s budget will, with the best of intentions, do the worst of things.

To fight these wrong ideas, you need the right ones, and you won’t find them in standard economics textbooks. Instead, you need a tool that shows how the monetary system actually works. That tool is called Ravel. I designed it to make it possible to properly model the monetary system, and in this post, I’ll use it to explain why Reeves is wrong that cutting the deficit will increase economic growth.

Reeves’s vision of how the Government interacts with the private sector comes from the textbook model of banking known as “Loanable Funds”. Figure 1 shows a typical textbook drawing of how Loanable Funds operates.

Figure 1: Mankiw's drawing of supply and demand in the market for Loanable Funds

The textbook explains the drawing this way:

Saving is the supply of loanable funds—households lend their saving to investors or deposit their saving in a bank that then loans the funds out. Investment is the demand for loanable funds—investors borrow from the public directly by selling bonds or indirectly by borrowing from banks.

According to the textbook, when the government spending exceeds taxation, it  has to borrow the difference from households. This causes the supply of Loanable Funds that is available to firms to fall, and drives up interest rates:

an increase in government purchases  … must be met by an equal decrease in investment. To induce investment to fall, the interest rate must rise. Hence, the increase in government purchases causes the interest rate to increase and investment to decrease. Government purchases are said to crowd out investment.

This unfortunate consequence of government spending in excess of taxation—which is what forces government to borrow from households, to make up the difference—is shown in Figure 2. Government borrowing reduces the amount of money available for firms to borrow, thus reducing investment and increasing the interest rate.

Figure 2: Mankiw's drawing of government borrowing reducing the funds available for firms to borrow

Figure 2 is just a drawing. To show how the model of Loanable Funds would actually operate, you need to show it in the fundamental tool of banking: the double-entry bookkeeping table. In double entry bookkeeping, all financial accounts of an entity—a person, a company, a bank—are classified as either Assets or Liabilities, and the difference between them is the Equity of the entity. All transactions are shown twice, in such a way that the equation Assets-Liabilities-Equity equals zero applies.

In Loanable Funds, banks are just intermediaries between savers (Households) and borrowers (Firms and Governments). Banks don’t lend themselves in Loanable Funds: instead, they act as agents for savers, who actually own any debt created, since it is their money—and not the banks—that is being lent out.

Figure 3 shows this model with all the operations between Households, Firms, and the Government. All three have deposits with the private banks, and all operations—Firms paying wages and Households consuming, Firms borrowing and paying interest to Households, Government taxing and spending, selling bonds, and paying interest on existing bonds—are transfers between deposit accounts at private banks. Banks make an income in this model by charging Households an “introduction” Fee.

Figure 3: How the Government interacts with the private sector in Reeves's textbook model of the monetary system

Focusing on the government’s actions, it levies taxes and spends on the private sector, and if its spending exceeds taxation, then it has to sell bonds to the private sector to make up the difference. If there are already outstanding bonds in existence—and Reeves emphasises that government debt is currently over 100% of GDP—then the government also has to pay interest on these bonds as well. If the government’s outgoings—spending plus interest on existing bonds—exceeds its incomings—taxation plus bond sales—then the government can run out of money. Its borrowing will also reduce the amount of money that Households can lend to Firms, which reduces investment and impedes economic growth.

If this was an accurate model of the real world, then Reeves’ actions would be justified. Just as a Household must balance its books, the government has to do the same. Figure 4 shows a very prudent government that always balances its books and never runs up debt.

Figure 4: A Prudent Government under Loanable Funds

In contrast, a government that spends more than it takes back in taxation eventually causes the sort of crisis that Reeves is trying to avoid, as shown in Figure 5. Even a deficit of just 1% of GDP, if sustained over time, leads to a catastrophe. Starting from zero, Government debt reaches 100% of GDP in 33 years; after 55 years, interest payments on government debt reach 100% of GDP, and after 65 years, the interest rate hits 50%, firms stop borrowing, and GDP collapses. In the real world, Households would stop lending to the government well before interest payments hit even 10% of GDP, let alone 100%, and the government would be bankrupt.

Figure 5: An Imprudent Government under Loanable Funds drives the Government into bankruptcy

Cutting the government deficit—the excess of government spending over taxation—is therefore being prudent, unlike the Tories who preceded her. Even things like cutting the Winter Fuel Payment, and keeping the 2-children cap, though painful, are “tough decisions” made by a responsible Chancellor.

However, the Loanable Funds model of banking is not the real world. Even Reeves’ one-time employer, the Bank of England, has said so:

The reality of how money is created today differs from the description found in some economics textbooks … banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits… Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits. (McLeay, Radia, and Thomas 2014)

Economic textbooks are therefore teaching a myth. Why they do this is something I cover in the long read part of this post. But the upshot is that people who don’t realise this, and act as if the textbooks are correct, ends up doing incredible harm while trying to do good.

There are three core differences between the real world and this false textbook model. In the real world:

• the Government banks with the Central Bank—the Bank of England in the UK;

• Firms borrow from Banks, not from Households; and

• In the first instance, Banks buy Government Bonds, not Households.

Making these changes to the textbook model gives you the system shown in Figure 4.

Figure 6: How the Government interacts with the private sector in the real world

What happens in this real-world model when the government runs a deficit? You get economic growth, because government spending in excess of taxation creates Fiat Money. Government debt, which reached 88 times GDP in the Loanable Funds model, reaches just 30% of GDP in this model—1/3^rd of the UK’s current government debt level. GDP itself grows enormously—to 600 times the GDP shown in Figure 5 over 65 years (this is monetary GDP, not real GDP—I haven’t included a model of production in this simple model—but no real-world economy has grown without its money supply growing as well). There is no crisis.

Figure 7: The impact of a sustained deficit in a real-world model of banking

What happens in this model if the government “behaves prudently”, as Reeves defines it, by spending no more than it takes back in taxes? Then you get the outcome shown in Figure 8. The economy still grows—because bank lending to firms still creates “Credit Money” (money backed by private debt, rather than by government bonds)—but it grows much more slowly. GDP is 30 times the level shown in Loanable Funds, but after 65 years it is 1/20^th the level achieved by a government that runs a sustained deficit.

Figure 8: "Prudent Government" in the real-world leads to a lower rate of economic growth

The numbers in these simulations are unrealistic: the model was built simply to compare the textbook model of Loanable Funds that Reeves is following to the real-world in which both bank lending and government deficits create money. But the general results are realistic. Austerity always fails to bring the prosperity that its advocates expect—and whatever Reeves believes she’s doing, by trying to limit government spending to no more than taxation revenue, she’s imposing austerity—because it’s based on a naïve model of how the monetary system operates. Rather than encouraging private sector growth, it stifles it, by reducing growth in the money supply. Only growth created by private bank lending occurs—and this is far more chaotic than shown in this simple model.

If you’ve followed my explanation, then you know why what Reeves is doing is a mistake.

But my explanation won’t be enough.

Not enough people read my posts, and those that don’t will still fall for “the government is like a household” analogy. Instead, we need as many people as possible to be able to give their own demonstrations of how the monetary system actually works to their friends and associates. We need activists who not only understand how the monetary system works, but who can also teach it to other people.

If we don’t develop such a cadre of well-informed people, then we will forever be stuck in this austerity loop. Both sides of politics fall for this model these days, because both sides learn it in PPE degrees, and both think they’re being taught how the economy operates by experts on the economy.

But mainstream economists aren’t experts on the economy. Instead, they’re experts on a model of the economy which is wrong. They cling to this model, not  because it is realistic—far from it—but because it’s the worldview they’ve been committed to since they were students themselves. After 50 years of working with academic economists, I’ve given up on them ever abandoning this worldview for reality. So, if we are ever to consign this false vision of the world to the dustbin of intellectual history, it will be because people outside the University sector challenge it, not because academic economists finally grow up.

Therefore, I will follow up this “Short Read” with a very “Long Read” which will show just how I built this model in Ravel, and enable you—if you are willing—to do the same yourself on your own computer. This will not be everyone, by a long shot. It won’t even be most disgruntled members of the Labour Party. But a handful of such members, who are willing to devote the time to master Ravel, can convince their colleagues to fight against Reeves’ well intentioned bad ideas. We can’t kill austerity without killing the bad ideas that lead to it.

If you want to be one of this cadre, then please download a copy of Ravel from https://patreon.com/ravelation. It will cost you US$7 per month, but given what it can do—show that austerity is an insane economic policy—it may well be the best $7 you’ve ever spent.

I’ll follow up with a “Long Read” post explaining how to use Ravel in my next blog post.

References

Keynes, J. M. 1936. The General Theory of Employment, Interest and Money ( Macmillan: London).

McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. 'Money creation in the modern economy', Bank of England Quarterly Bulletin, 2014 Q1: 14-27.