Skip to content

Bank income and spending

One of the most common difficulties many people encounter in understanding the mechanics of the financial system lies in their failure to understand the difference between stocks and flows.

For example they have difficulty understanding why commercial bank interest income is a flow while at the same time the credit money created by banks is a stock.  One difference lies in the fact that bank credit money creation entails no change in bank equity (= assets – liabilities, also known as net assets, or net worth), while bank interest received represents at least a temporary increase in equity. That temporary increase in equity enables a commercial bank to spend in order to accommodate its many costs – including such things as interest paid to depositors, shareholder dividends, government tax, salaries and overheads – and to acquire new investments.

Bank equity is not money 

Bank equity may be visualised in terms of some combination of (a) loan securities, (b) investment securities, and (c) reserves. The loan and investment securities are bank assets, and also liabilities of the borrowers and/or security issuers. Reserves are also bank assets.  However none of these assets are directly matched by bank liabilities.

One should be aware of the difference between an operating account (which does not contain entities which can function as money) and a transaction account (which always deals with money). In order for something to function as money, it requires a marketplace of players who have access to it, who accept it, and who use it for transactional purposes.

When a bank wishes to spend into the real economy in order to accommodate any of its costs, it creates new credit money. Commensurately, it marks down its operating account , which reduces its equity. Bank equity is not money, so when a bank spends there is no monetary transfer within the real economy. That is, bank equity does not make up any part of the monetary aggregate M1. Any expectation that if something can be given a monetary value then it can function as money is unwarranted. When a bank lends or spends, the money supply temporarily increases. While when a bank receives a retail payment, the money available to the public is temporarily reduced.

One should also recognise that commercial banks have no need for bank credit money and do not store it. Banks can create or destroy credit money by simply adjusting the entries in the accounts of bank depositors.  If these entries are in credit, then they are at the same time depositors’ assets and banks’ liabilities.  For this reason, a deposit (of credit money) in a bank is not a loan to the bank, as some people suppose. Anything that is borrowed is necessarily an asset of the borrower.


Lending and spending by a bank are facilitated in large measure by the volume of the bank’s equity in relation to the totality of the bank’s risk-weighted assets.  Bank lending and spending also effectively transfer reserves between banks. We have used a broad definition of the word “reserves” in this explanation, which can embrace such things as (i) cash held in bank vaults and tills (currency reserves), (ii) exchange settlement funds (or creditary reserves), and (iii) bank-held short-term government securities (“near money”). The first two may be thought of as “narrow” state fiat money, while the last may be thought of as a component of “broad” state fiat money.

Reserves held within the banking system are not part of the money supply and are not interchangeable with bank credit money. We have a dual monetary system consisting of state fiat money (banking reserves plus currency) and bank credit money. These two forms of money tag along with each other with every transaction involving a bank, but they never mix. Members of the public and non-bank businesses have no access to banking reserves. Banks never lend or spend their reserves into the real economy – never. The line is never crossed. Bank reserves created by the central bank remain within the banking system, and are transferred between banks as and when required.

For countries like Australia and Canada which possess no formal requirements for reserves holdings by banks (other than that their credit balance must remain positive as a condition for the continuation of their depository facility with the central bank), the commercial banking institutions have no incentive to hold more creditary reserves than they require to satisfy their expected exchange settlement operations and their liquidity management. This is especially the case if they can obtain better interest returns  from holding investments.

Investment securities

Lets us suppose that a bank uses part of its income to purchase an investment security from a bond dealer. The  bond dealer might have purchased it from another dealer. Pursuing the sequence of such buying and selling by various dealers, we arrive ultimately at a first transaction in which a dealer purchased a newly created security from either (a) a corporation, (b) a government agency, or (c) the central bank in association with its open market operations.  In some of these transactions, reserves were returned to the government or the central bank.  And in particular the return of reserves to the government will have facilitated government spending and/or lending into the real economy.

The various operations described above occur as a result of the temporary increase in bank equity derived from interest payments and are monetary flows. Implying that bank interest income is not a static entity and is therefore a flow.

Retained earnings

It is sometimes supposed that the portion of bank income which is held in the form of “retained earnings” or “retained profit” represents a withdrawal of money from the real economy, thereby appearing to justify (at least in part) the claim by advocates of the “debt virus hypothesis” that money needs to be created specifically in order to accommodate the interest paid to banks for the loans they advance. However this claim may be shown to be illusory, when the various monetary flows associated with the creation of this component of bank equity are carefully investigated.

Bank retained earnings are part of a bank’s equity. Those assets overwhelmingly take the form of purchased Treasury securities.  This is because, as mentioned previously, banks prefer not to hold on to more than a very minimal level of reserves, and to retain only the estimated cash (coins and notes) required for the immediate requirements of their customers.

The purchased securities may be subdivided into those that are purchased directly from Treasury and those that are purchased from a securities dealer.  Direct Treasury purchases free up government fiscal space, thereby facilitating government spending into the non-bank private sector (limited only by the necessity to constrain undue inflationary pressures).  Purchase from a dealer enables that dealer to purchase more securities from another source, with the intention of making a profit from the interest margin.  In addition, a certain fraction of these assets also will be purchased by the central bank, as part of its open market operations. In practice a sequence of borrowing and lending operations by security dealers will occur, providing each dealer in the chain with substantial income, and the money thus obtained will be largely spent into the real economy in order to accommodate the dealer’s many living costs.

The important consequence of all this is that, one way or another, the purchase and repurchase of these assets assists the flow of money through the economy, rather than having the money saved or stored in some way.

Bank interest income

Let’s consider the repayments on a loan made by a commercial bank to a retail borrower.  One might ask why the loan interest received increases the bank’s equity while the loan principal received does not.  In order to fully understand this, one should carefully examine the way in which the respective transactions are accounted.

The simplest conceivable model for demonstrating the financial mechanics would have an economy containing a single commercial bank (and note that for such an idealised single-bank economy there will be no need for creditary reserves).

Let us suppose that the borrower possesses a loan account (account 1, into which the bank creates the initial demand deposit) and a savings account containing previous savings (account 2, which pays interest on deposits). In this simple model, the borrower does not actually spend the newly created bank credit money, but uses it to create a deposit in account 2 as collateral in support of business activities for a convenient period of time, after which time the full payment of principal and interest will have been made.  It should be recognised that the original creation of each of these accounts entailed no change in bank equity.

The original bank loan advance created two assets and two liabilities; thus the loan security is the bank’s asset and the borrower’s liability, while the deposit of bank credit money is the borrower’s asset and the bank’s liability.

Repayment of principal using bank credit money   The repayment of principal is an exact reversal of the original creation of two assets and two liabilities. The net result is that there is no change in bank equity.

Repayment of interest using bank credit money   The repayment of interest entails a reduction in the borrower’s assets and in the bank’s liabilities. This reduction in bank liabilities without a commensurate reduction of bank assets implies an increase in bank equity.

Repayment of interest using currency (coins and banknotes)   The borrower will withdraw from account 2 at some stage in order to obtain the currency (which withdrawal entails no change in bank equity) and at a later time will pay that currency to the bank as loan interest. There are two possibilities here. The first is that the two transactions will occur within the timeframe allocated for the bank to compute its equity (the accounting period), and for this case the net result is a reduction in the level of bank liabilities without a commensurate change in bank assets. The second possibility is that the borrower withdraws currency from account 2 and places it in a wall safe for a period of time exceeding the bank’s timeframe for computing its equity, before using it to pay the interest. In the latter situation, arguably the interest payment may be identified with an increase in the level of bank assets (more specifically, currency reserves) without a commensurate change in bank liabilities.

Analysis of the accounting procedures will be obviously more complicated for a multi-bank system, particularly if the existence of creditary reserves and the operations of a central bank are taken into account.  The model for a two-bank system is a little more complicated but still straightforward, and the transfer of reserves between the spending bank and the payee’s bank must be taken into account.

John Hermann


The biggest intellectual scandal of our time

If mainstream economists had thought and behaved differently after 1980, then arguably the world would not be in its current state of disarray, and much of the social and environmental dislocation that we have witnessed over that time-span would not have occurred. In a nutshell, these economists uncritically accepted as true the false analyses, promises and prescriptions of neoliberal ideology. The destructive outcomes of their attempts to implement those  prescriptions were greatly enhanced by their profound ignorance of the operational dynamics of finance, banking and credit money creation. To this day they continue to hold to barter-based models of economic activity, to the extent that money, credit and banking are missing from their considerations.

Mainstreamers possess several major blind spots. Firstly a failure to recognise the important role that the creation and flow of bank credit money plays in the evolution and development of every modern economy, through its essential contribution to income, aggregate demand, employment and economic performance. Secondly, they think that private debt growth does not affect economic performance. Thirdly, they think that every economy tends towards a stable equilibrium configuration. Fourthly, they think that private borrowing, spending and saving are always driven by “rational expectations”. Fifthly, they think that public debt (i.e. deficit spending) should be minimised, consistent with what they imagine is the universal validity of  the “crowding out” hypothesis – which falsely asserts that public borrowing always crowds out private borrowing, leading to rising inflation and rising interest rates.

And lastly, they hold to the idea that commercial banks do not create the money they lend and spend into the economy. But rather, they hold to the “loanable funds” hypothesis, which asserts that banks are able to on-lend their depositors’ funds. The reality however is that neither bank credit money nor reserves are ever loaned out to a bank’s retail customers. Moreover bank credit money creation occurs endogenously, meaning that banks lend or spend first and look for the regulatory reserves they might happen to need later. Central banks are always able and willing to provide the reserves that the aggregate of commercial banks require for their business operations. Flying in the face of this reality is the belief of mainstream economists that reserves are created proactively – under the discretionary control of the central bank – rather than reactively in association with their open market operations.

It seems that central bankers know a good deal more about these matters than do mainstream economists. This is evident from a 2017 monthly report on the dynamics of bank money creation produced by the Deutsche Bundesbank and also a similar 2014 report produced by the Bank of England The BoE report referred to here was discussed in a previous issue of ERA Review [v7, n4, 2015; p15]. The  findings of these reports are quite inconsistent with the false beliefs held by mainstream economists that we have listed above. Unfortunately, if their past history is anything to go by, that is unlikely to change the views of many of the (neoclassical) mainstreamers, who will simply adopt the tactic of ignoring the existence of these reports.

John Hermann

Reserve Bank decision time: good luck Australia!

On the first Tuesday of every month (except January, when they are all off on their holidays) the governor of the Reserve Bank of Australia (RBA) meets with the deputy governor, the Treasury secretary and six other worthies (all appointed by the government) to decide what to do about something called “the cash rate“.

It’s been a long time since they last raised it and, instead, since 2011, there has been a long series of cuts to an all-time low, in a forlorn attempt to get us all to spend a bit more.

Every month, the RBA board has been torn between a temptation to cut even further and an urge to leave the cash rate where it is. On the one hand, they need us all to borrow more, but on the other hand they are worried about us having too much debt already. What’s more, they are scared that one day the cash rate will reach zero and uncertain about what that will mean. It is all a terrible muddle.

The economy hasn’t been growing quickly enough to provide enough full time jobs for people and there seems to be no risk of runaway inflation any time soon. Everyone knows that really the government ought to be spending rather more than it has been doing and not matching this spending with higher taxes. But nobody is allowed to say this. It would contradict what Scott Morrison, Malcolm Turnbull, Joe HockeyTony AbbottUncle Tom Cobley and all have been saying for years now about “balancing the budget” and “living within our means”.

They have backed themselves into a corner. It’s all been political machismo. There is no budget emergency and there never has been.

And all this machismo is damaging the country.

The politicians would like the RBA to keep cutting in the hope that this will help, but there is nothing useful the RBA can do. They are out of bullets. Interest rates are already close to zero and although several other central banks have shown in recent years that zero isn’t a boundary you can’t cross – and have introduced negative interest rates for the first time in history – that hasn’t been a great success. It seems that the private sector, and in particular households, are up to their necks in debt and don’t want to borrow much more. Interest rate cuts are at most a very short-term sugar hit. The drug doesn’t work anymore. It might even further weaken the patient.

What is this thing called the “cash rate”? Just as you and I have deposits at our banks, so the banks themselves have reserve accounts at the RBA. The way our system works at the moment, the cash rate is the rate of interest at which the banks – the ANZ, Westpac, and so on – lend to and borrow from each other the digital “cash” they hold at the RBA. These reserves are used to deal with the millions of transactions that take place every day between account holders at the different banks.

In the run of things, on any particular day, some banks will gain reserves and others will lose them as a result of all this activity. It is normal for a bank with excess reserves at the end of the day to lend those reserves to a bank which is running short. This happens at the “cash rate”.

In principle, the cash rate is supposed to be determined by the private banks themselves — in other words, in the money market. In practice, in recent years, the banks have always used the RBA’s target rate. The RBA, in return, makes sure that the total supply of reserves in the system is exactly what the banks need.

The way they do this is a little bit more complicated these days than it used to be (involving things called “repos“) but the textbook story of the RBA buying government bonds from the private sector when it needs to feed cash into bank reserves and selling bonds when there is too much cash in the system, is still essentially accurate.

If there was too much cash in the system, the cash rate would fall below the RBA’s target; if there was a short-age of cash, it would rise above the target. To control the cash rate, the RBA has to make sure banks have just the right amount of cash in their reserve accounts. It is all a bit “Goldilocks” but the RBA and the banks are in constant touch and the system works pretty well.

So much so that all the RBA board has to do is to announce a change in its target for the cash rate on the first Tuesday of the month and, as if by magic, the cash rate used by banks automatically changes the following night. The RBA doesn’t have to do anything, except make the announce-ment. The banks then automatically fall into line with its wishes, as long as the supply of cash into their reserve accounts is “not too hot and not too cold but just right”.

That’s the story, really – simplified a bit. The cash rate is the key interest rate in our financial system. Short term rates are linked to it very closely. Long term rates, like those on fixed-rate mortgages, depend largely on what banks expect to happen to the cash rate in the future.

There is only one problem with all this, as we said. Using the cash rate to manage total spending and inflation doesn’t work anymore. Household debt has trebled since the 1990s. People can’t or won’t borrow ever more, whatever the interest rate. What’s more, for everyone with a mortgage who benefits from a lower mortgage rate, there is a saver who loses out on a term deposit.

The low interest rate drug doesn’t work anymore. To the extent it ever did, it did so by loading the private sector up with more and more debt, and making our financial system increasingly fragile.

The rate of interest, as a tool for pushing the economy forward, appears to be kaput!

I’ll let you in on a secret. They all know this. Everyone in the know understands that the government should be stepping up to the plate, and doing the extra spending itself. Everyone in the know understands that the Australian Government can’t run out of Australian dollars. The RBA Governor knows. And the Treasury Secretary knows. They must know.

These people know all of this – but they don’t dare say anything. Remember the machismo: they have painted themselves into a very awkward corner. Nobody wants to appear irresponsible, so nobody takes responsibility.

It is all a terrible muddle. And mean-while, the threat of a property bubble is still hanging over us. Good luck, Australia. You are going to need it. 

Steven Hail

Creation and destruction of bank credit money

It is well known and understood that the nation’s money supply overwhelmingly consists of deposits within bank accounts of an intangible entity known as bank credit money. This form of money is interchangeable with currency (coins and banknotes) on demand. It fluctuates according to economic circumstances, and its dynamic is one of continuous creation and destruction.

However there is a widespread belief that credit money is only created by commercial banks when they lend to their retail customers. The reality is that bank credit money is created and destroyed by a variety of routes. These include:

Credit money creation:

(1) Retail bank lending
(2) Bank spending into the real economy
(3) Bank purchase of assets from the non-bank private sector
(4) Government spending
(5) Government lending to the non-bank private sector
(6) Reserve Bank purchase of assets from the non-bank private sector

Credit money destruction:

(1) Repayment of bank retail loans (principal and interest)
(2) Any other payment to banks from the non-bank private sector
(2) Government sale of Treasury securities to the non-bank private sector
(3) Taxation receipts obtained from the non-bank private sector
(4) Bank sale of assets to the non-bank private sector
(5) Reserve Bank sale of assets to the non-bank private sector
(6) Repayment of government loans by the non-bank private sector

John Hermann






Federal Treasury finances: a functional perspective

Modern monetary theory (MMT) offers an analysis of the flow of money within our economy, and in undertaking this task it proceeds from some basic assumptions, including the propositions that bank credit money and banking reserves are (a) destroyed when federal taxes are paid and when Federal Treasury securities are issued to the non-government sector, and (b) created when the Federal Government spends into the non-government sector. This article examines what the analysis implies within an Australian context, although the ideas and conclusions are more generally applicable. However we must firstly define what is meant by money.

  1. What is money?

Most economic textbooks tell us that money is any entity which (a) is accepted and used by the public as a means of payment for taxes and debts and for purchasing goods and services — in other words it behaves as a medium of exchange; (b) can be used as a store of value; and (c) possesses a unit of account (which in Australia is called the Aus Dollar). There is also an implication that the range of monetary transactions occurring and permitted within the real economy will embrace an adequately sized marketplace of players.

There exist three widely recognised forms of money:

(a) Currency, by which we mean coins and banknotes.

(b) Bank credit money, an intangible form of money created by commercial banks in the accounts of their retail depositors.

(c) Banking reserves (exchange settlement funds), created in the depository accounts of commercial banks with the Central Bank (CB).

Items (a) and (c) are collectively sometimes referred to as the monetary base. The “money supply” –  meaning money accessible and used by the nonbank sector – can be defined in various ways, the simplest definition (called narrow money) being the conjunction of bank credit money and currency in the hands of the nonbank sector.

  1. The Federal Treasury is not a bank

A number of economic commentators have suggested that the Federal Treasury behaves like a bank. In my opinion such a viewpoint is wrong, for the following reasons:

(a) Treasury does not take deposits from the public, or from the commercial banks.

(b) Treasury does not directly create credit money in the accounts of nonbanks (i.e. by contrast with commercial banks). When Treasury spends, it instructs the Central Bank to transfer reserves to the payee’s bank, which authorises that bank to create new credit money in the payee’s account.

(c) Unlike commercial banks, Treasury’s primary role is not the creation of financial assets via retail lending or the acquisition of commercial profit.

(d) Treasury does not lend reserves to commercial banks (i.e. by contrast with the latter, which often lend reserves to each other).

  1. Are Federal Treasury’s CB credits a form of money?

Given that the Federal Treasury is not a bank, the credits in its account with the Central Bank cannot be banking reserves (unlike those of commercial banks). And clearly these credits do not consist of bank credit money, which can only exist within the depository accounts that commercial banks make available to citizens and businesses. Neither is it currency, because it has no tangible form.  So the question arises, are these Treasury credits a form of money in any sense at all? Officially, they are not a form of money for the simple reason that they are excluded from the monetary base and also from every measure of the money supply.

The following propositions relate to this question.

  1. A monetarily sovereign entity, i.e. one which has the power to create and destroy money, has no use for that money — and in particular does not need to store it.
  2. If the Federal Government Treasury is not a bank, then its “deposits” in the Central Bank necessarily have a different status to the deposits of commercial banks in the central bank.
  3. One of the essential requirements of any entity entitled to be called money is that it is used by (traded, loaned/borrowed between) a sufficiently large number of marketplace players who have similar status and objectives in regard to those operations.  Bank deposits in the Central Bank satisfy this criterion, since all of the players are in competition with each other with the common objective of maximising their financial profit.  In contrast, the Federal Government maintains an account with its Central Bank for a quite different purpose, and its spending has a different objective.
  4. These days Federal Australian Treasury bond sales do match net spending (deficit spending), and so appear to top up the notional Treasury balance at Australia’s Central Bank – the Reserve Bank of Australia (RBA). However this is a relatively new development, having been introduced in Australia under the guise of ‘sound financial policy’ in 1982, and is not the practice in some comparable economies, such as Canada. Thus the Australian Treasury has not, since 1982, borrowed directly from the RBA – by selling bonds directly to the RBA or by using any other accounting mechanism (sometimes described as Overt Monetary Financing). Prior to 1982, it did sell bonds directly to the RBA, which meant – to take the logic to its obvious limit – that any number appearing within the government account at the RBA was rendered functionally meaningless.  The post-1982 voluntary constraint on government-RBA relations does not in any sense undermine monetary sovereignty, but it does appear to do so – by obscuring the fact that the Australian Government cannot ever become insolvent in its own currency, and is not limited by its ability to attract ‘money’ into its account at the RBA.
  1. The situation in the United States is a little different, in that the constraint on direct borrowing by the Federal Treasury is not voluntary, but is enforced by legislation. However even in this case the constraint may be easily bypassed if there happens to be a need to do so. Within Australia and the U.S. there exist statutory regulations to the effect that, whenever a difference over policy exists between Treasury and CB which cannot be resolved by negotiation, the will of Federal Treasury will ultimately prevail. So even if there happened to be a legislative constraint on direct borrowing, the Treasury could – if it so wished – issue a quantity of new bonds to the private sector and arrange for the CB to buy the same quantity of bonds from the private sector. The net result is obviously the equivalent of direct borrowing.
  1. The economic mainstream hold that the Federal Government’s “deposits” in its Central Bank account are a form of state fiat money, moreover one which is interchangeable with reserves. However the above propositions imply that such “deposits” are not money in any real sense of the word, but are merely accumulated credits in an operating account.  An operating account records a financial reality, but this does not imply that it is a form of money in a functional sense.

On this basis it may be held that the central government stands alone – that is, not in competition with any other entities possessing accounts with the central bank, and that the entries in the Government’s RBA account do not function as money.

John Hermann

Paying for public services, in a monetary sovereign state

If our national Government was to spend more than the currently budgeted amount on your health care system next year, it would be good to know how they would finance that spending. It is a question that advocates of more health spending are always likely to be asked. More generally, exactly how is the total public spending which is currently budgeted for across the next year going to be funded? Do the various charts you see, linking the total tax take and government borrowing to items of government expenditure make any sense? If not, then why not?

The conventional view

This is that public spending must be paid for through taxation, government sales of assets, or issuing government bonds – in other words, through taxes now, ‘selling off the family silver’ now, or borrowing at interest now money which will have to be repaid in the future, and presumably setting up a burden of additional taxation for future generations.

Your reaction to this conventional answer might be a “conservative” one, which is to say, austerity to keep government spending down and privatisation, in order to keep taxes low: or a “progressive one”, which is to say, tax the rich and the multinationals much more highly, because the Government needs more money from rich people so it can pay for our public services.

Both of these reactions are wrong, or at least misleading, because they are based on that conventional view of public sector finance which I mentioned above. It is a conventional view which suits many conservatives, but is also (wrongly) accepted as being valid by many progressive people. It is – and this might surprise you – a view which the majority of highly credentialed economists, including Nobel Prize winners, know to be incorrect, but which many of them justify as a mechanism for imposing some restraint on politicians. They believe that if politicians only knew the financial options which are actually available to them, they would abuse these freedoms, ‘spend like drunken sailors’, wreck the economy.

Laws of Public Finance

I don’t believe there is ever a good reason for remaining in ignorance about something this important, and I think we have other ways of restricting what politicians do than telling blatant lies to the public, so I want to share the truth with you.

To keep this as brief and as straight-forward as I can, I am not going to dwell on the current institutional practices, conventions and rules, as they are applied in 2017. Current practices are very different indeed from how things were done before 1979. All the sets of conventions and rules which have been applied down the years have, to a greater or lesser extent, obscured the truth about public finance, which I can summarise in two sentences. Let’s call them two ‘laws’ of public finance (based on Lerner’s laws of functional finance, from the 1940s).

1 A government with its own currency (like the dollar), its own central bank (like the Reserve Bank), a floating exchange rate, and no foreign currency debt, faces no financial budget constraint at all.

2 Such a government faces real and ecological constraints, but no financial constraint.

Let’s be clear what we are talking about here. We are not talking about Greece. We are not talking about an independent Scotland, if Scotland were to keep the pound or join the euro (which I have recently advised a Scottish political party to stop saying they would do). We are talking about a genuine ‘monetary sovereign’. We are talking about the USA, Japan, Australia and the UK, among many others.

Monetary Sovereignty

The Australian Government is a monetary sovereign. Every time the Australian Government spends a dollar, it does so by crediting the reserves of a commercial bank which are held at the RBA (Australia’s central bank) by that dollar, and having the commercial bank credit the bank account of whoever has been the beneficiary of that spending. In other words, every time the Government spends, it creates money. Not some of the time – every time. All of the Governments spending creates money, and all this money is created using the equivalent of keystrokes on a computer.

The Government does not need to receive your money in taxes, or borrow your money by selling bonds, or raise money from you by selling you shares in government owned utilities …. before it spends. Think about it for a moment. It isn’t, in a literal sense, your money in the first place. Who issues the nation’s currency? The RBA. And who owns the RBA? The Australian Government. The Government doesn’t need to collect its money, which it creates, from you before it can spend.

Every time our national Government spends, it creates some of its money for the purpose. I know commercial banks create a great deal of deposits for themselves, and a great deal of what is normally defined to be ‘the money supply’ by lending to their customers, but they can only do this because they have access to Government money, in the form of their reserves at the RBA. There are two ways for this money to be created. One is the Government spending this money (permanently) into existence, and the other is the RBA lending this money (temporarily) into existence.

We have come to the answer to our initial question. How can we pay for an increase in health spending? The same way that we pay for all public spending. The Government will spend the money into existence. The way the accounting is done these days, and current institutional practices, obscure this truth, but they do not change the fact that it is a truth. It is not a theory. It is a plain fact.

Let me put it more simply. Money does not grow on trees. It is easier than that. Money comes from nowhere. It exists mainly in the form of electronic entries on spreadsheets (these days), and you can say it is typed into existence. Our Government can no more run out of dollars than the scorer at a cricket ground can run out of runs, perhaps something to remember the next time our Australian boys go over to England to win the Lords’ test match. In this sense, the Government really does have a ‘magic pudding’.

You might ask me whether I am talking about ‘printing money’ to pay for the Government’s spending. You might conjure up visions of Zimbabwe or Weimar Germany. I’ll deal with those briefly in a footnote below, but let us be clear – in a sense, all of Government’s spending always involves ‘printing money’. Except, I hate using that term, because of its associations, and because it is a little misleading. Very little modern money is actually printed, remember – it is nearly all electronic.

The Purpose of Taxation

The question is, then, why do governments tax people at all? Taxes do not ‘pay for government spending’, after all. Taxes do not pay for the education service. Taxes do not pay for Medicare. It might make you feel better to know that your taxes are not paying for military weapons. They really aren’t. The Government doesn’t need to get money from rich people before it can spend. Your taxes, in a literal sense, do not pay for anything. Taxes, at least in a monetary sovereign state, pay for nothing at all. 

So, why do we pay taxes? There are many distributional, or microeconomic, functions which the tax system fulfils. However, at the macroeconomic level, the purpose of taxation is very simple. It is necessary for people to pay taxes to destroy (to use a provocative word) some private sector spending power, to make room within the economy for the government to conduct its desired spending on public goods and services, without pushing total spending in the economy beyond the productive capacity of the economy and causing inflation. Taxes limit inflation, helping us to maintain the spending power of money, so that people maintain their confidence in the value of money.

Deficit Budgeting

We have reached the second law I wrote down above. As a society, we cannot run out of dollars, but we can run out of people, skills, technology, infrastructure, natural and ecological resources. There are limits – but the limits are ‘real’ and not financial. When planning for the future, governments should use their freedom from financial constraints to plan wisely to manage the real and ecological constraints which will always be with us.

The Government, then, cannot spend without limit, because it would push total (private sector plus public sector) spending beyond the current capacity of the economy, and be inflationary. So we have to pay taxes.

This does not, however, mean that governments need to ‘balance the budget’, or should ever attempt to balance the budget, or limit its deficit to a specific proportion of GDP. In fact, most Governments (including Australia) have hardly ever run balanced budgets or budget surpluses in modern times, and when they occurred they tended to be just prior to economic downturns. For example, there were very small and very temporary fiscal surpluses in the UK in the late 60s, the late 80s and the late 90s. The rest of the time, the UK Government has been in continuous fiscal deficit, since the early 1950s.

This is true almost everywhere, with almost all the exceptions being relatively small and oil rich countries, like Norway. In the case of Norway, what makes it possible for the government to run fiscal surpluses is not the ‘sovereign wealth fund’ you may have heard about. It is simply Norway’s consistently large trade surplus with the rest of the world.

Most governments most of the time historically have run budget deficits. This is essential, because if the rest of us want to build up our savings in dollars (including foreigners in ‘the rest of us’) it turns out the Government will be forced, one way or another, to run a deficit. A good deficit will prevent a recession from happening, and a bad deficit would be the consequence of a recession happening and tax receipts crashing while welfare payments rise, when everyone wants to save and not spend. To explain the logic properly would mean going into too much detail here, but believe me it is a mathematical (or accounting) fact of life.

Sovereign Government Debt is Different

Doesn’t all this mean the Government getting further and further into a burdensome ‘debt’, which future generations will have to repay, so that government borrowing is somehow immoral, and especially so if it isn’t to pay for investments in the future?

Not once you understand that monetarily sovereign governments don’t and can’t really borrow in their own currencies, at all, in the conventional sense of the term. If you or I, or a business, or a local authority, borrow in dollars, then later on we will have to repay that debt and the interest on it, or we will go broke. We are (obviously) not monetary sovereigns. We face a financing constraint.

It is different for our national Government. I have already said that the Government spends new money into circulation, and then uses taxes to destroy some of that money so that there won’t be rising inflation. Ideally, the Government should spend more than it taxes, when it is running a deficit, to ensure that total spending in the economy is at the right level to maintain full employment. The total level of public spending, how it is divided up between public goods, and the structure of the taxation necessary to limit inflation, are then political issues.

Until the Global Financial Crisis, and before some central banks started doing quantitative easing, it was necessary for their governments to sell government bonds to more or less match government spending net of taxes, in order to keep control of interest rates. The reasons are a bit dull, but if you bear with me I will try to explain.

Interest rates in general depend on the interest rate banks charge each other when they lend each other money for liquidity management purposes for very short periods of time. A fiscal deficit effectively feeds cash reserves, or liquidity, into the banking system. In the past, it was necessary to remove those reserves again by selling government bonds, or this interest rate would fall below the level the central bank wanted it to be at. Banks with plenty of reserves of cash don’t need to borrow from other banks. Sales of government bonds were about keeping the supply of cash to the banking system limited to the right level to stop interest rates falling.

That’s all changed now – at least in the UK, the USA, Japan and the Eurozone. The central banks of all those countries first cut interest rates to virtually zero, after the Financial Crisis, and then used quantitative easing to deliberately flood the banks with cash reserves, by purchasing large amounts of (mainly govern-ment) bonds from the private sector. The so-called ‘bank rate’ is now not a rate of interest at which private banks lend to each other – it is now the rate of interest that central banks pay on the huge amount of reserves the commercial banks have on deposit with it. Rather than seeking to limit those reserves, the central banks have been deliberately increasing them.

Yet the old practice of each government selling its bonds goes on. It is rather ridiculous at the moment, because as the governments concerned are selling new government bonds – in a conventional view, to raise money – their own central banks (which are owned by each government, remember) are kept busy buying those same government bonds second hand from the private sector, in order to increase the amount of money in bank reserve accounts. It’s very strange and anachronistic. Economists like me view it as something of a muddle.

We have learned in recent years that there is no genuinely good reason for selling government bonds at all, if you are a monetary sovereign government. Indeed, it would be better to convert them into term deposits at the central bank, and to regard them as a form of money. 

After all, at the moment bank reserves held at the central bank are (in an accounting sense) Government liabilities, on which the central bank as part of the Government pays interest, but are not seen as Government debt: government bonds are also government liabilities, on which the central bank on behalf of the Government also pays interest, but they are seen as Government debt.

Moreover, if the central bank, as a part of QE, buys Government bonds from the private sector, it is just swapping one interest bearing government liability for another. No wonder QE doesn’t work! It isn’t ‘free money’ at all. It is basically swapping two very similar assets for each other. The private sector used to own Government bonds and receive interest. The private sector now owns reserves at the central bank, and still received interest.


Why would that arrangement act as much of a ‘stimulus’ for the economy? Why, indeed? To cut a very long story quite short:

1 When the Government spends it creates money.

2 When the Government taxes it destroys money.

3 Government ‘debt’ should not be thought of as ‘debt’ in the conventional sense at all. It is better thought of as a form of money.

4 The Government cannot run out of money, and as long as it doesn’t guarantee to convert its money at a fixed rate into anything it could run out of, it faces no financial constraints at all.

5 However it faces real and ecological constraints, because we can run out of people, skills, technology, equipment, infrastructure, natural resources, and ecological space.

6 The Government is NOT a household and NOT a business, and has nothing at all in common with a household or a business, where financial matters are concerned.

7 When progressives understand this and start framing their arguments in this light, I believe they will be able to argue their points far more effectively and persuasively, and free themselves from what are sometimes called ‘neoliberal dogmas’ (i.e. conservative and ‘new labour’ nonsense).

Understand all of this, and I think that it will change your perspective on many things. And ought to make you a great deal more confident when dealing with interviewers. If they approach you using the conventional view as a framework, remember that it is either because they have never really thought these issues through or because they are being dishonest for some reason (sometimes it is a mix of the two, and people can, of course, be dishonest with themselves, or at least suffer from cognitive dissonance). 

Footnote: Mugabe’s Zimbabwe and Weimar Germany 

Zimbabwe 2008  If you engage in a poorly planned and violent land reform, regardless of your motivation, there will be consequences. Zimbabwe’s govern-ment managed to wipe out its vital agri-cultural system, while at the same time alienating most high income country governments, and facing sanctions. The supply of food failed. The Government then (literally) printed vast amounts of money to buy non-existent food, and inevitably the price level sky-rocketed. Ever higher prices then led to ever more money being printed, so that at least the friends of the government and the army could be provided for. The result was hyperinflation. The lesson is that if you destroy the supply side of your economy and try to make up for it by printing loads of money, you will be able to create hyperinflation. Zimbabwe 2008 has no lessons for Australia 2016.

Germany 1923  Germany’s productive capacity had been destroyed by war and by the resolution of that war. In addition, Germany had been required to pay vast amounts of gold to its former enemies. The only way to obtain the gold was to buy it, using marks which could then only be spent into a German economy already on the brink of famine. There were some other issues, but it’s basically similar to Zimbabwe 2008. If you destroy the supply side of an economy and then print loads of money, you will push spending far beyond the productive capacity of the economy and create inflation.

Steven Hail

Try fiscal policy, stupid!

The Bank of England is actually finding it difficult to persuade investors to sell it sufficient government bonds to facilitate its planned bank reserve for government bond swap (sometimes called ‘quantitative easing’).

There is a problem with a lack of spending – not just in the UK, but throughout the high income economies, to a greater or lesser extent.

Yields (interest rates) on government securities are negative in some countries, and at record lows in others, such as the UK.

And yet governments still refuse to do what we know works, which is to SPEND more.

They are obsessed with the government as household myth.

And so central banks have to keep doing these desperate and ineffective monetary operations.

Everybody knows they don’t work. Central bankers know they don’t work. Only politicians and some of their more obstinate, head in the sand advisers, haven’t understood this by now.

And so we have more of the same, as they desperately try to convince a still over-indebted private sector to take on even more debt, and kick the problem further down the road.

This is a problem which is actually bigger in Australia than in the UK, and is nothing to do with Brexit, but of more immediate (and possibly medium term) significance than Brexit.

It doesn’t help that there is still at best a grudging and slight interest in these issues in the media.

Nobody is prepared to say that governments should be spending and investing more, and that there is no need to in the normal sense of the term ‘borrow’ to do so.

I recommend, as do many, a voluntary and equitable job guarantee scheme to eliminate involuntary unemployment, assist in regulating effective demand and inflationary pressure, and stabilise an unstable economy.

Right now, though, we also need more government investment.

Forget QE! It isn’t what people often describe it to be (‘free money’) and it doesn’t achieve anything worthwhile, even when performed on a record scale.

Outright monetary financing of government investment spending, done on a sufficient scale, would deliver.

Meanwhile, if you want a quick fix, just put some money into everyone’s bank accounts.

Easy to do.

And yes, UK Conservatives and Australian Liberals, you very definitely could afford to do it.

It might even make you popular, and right now would not be inflationary.

Steven Hail