Money Myths

Worked example A

State Spending minus Tax Receipts = Our Savings

To avoid reinforcing mythological frames, "The Budget Deficit" will be referred to as the Fiscal Balance and "The National Debt" as Non‑Government Savings[A]

To help clarify the money flows that determine the Fiscal Balance and thereby add to Non‑Government Savings, here is a worked example.

Suppose that the government decides to build a new hospital for an estimated cost of £100 million. The money is spent initially by marking up the numbers in the account of a private sector intermediary: the 'Hospital Contractor' (HC).

The state has thereby spent £100 million and the numbers have appeared in the HC's bank account. The numbers did not 'come from' anywhere [B], but once they appear in the private sector bank account of the HC, they are now what we refer to as 'money' and can be spent by the HC in the usual way. The state did not need to first acquire this money: as the money issuer, the state can always afford to buy whatever it needs from the private sector.

The HC will over time purchase the services of builders, electricians, plumbers etc. in order to construct the new hospital.

Joe the plumber
Knowing that he has ongoing work while the hospital is being built, Joe feels somewhat more flush than usual, and so decides he can afford to buy a new van. The state expenditure on the hospital stimulates others sectors of the economy: Joe's purchase of a new van stimulates vehicle manufacturers, and the increased sales trickle confidence around the economy.

Will Joe's purchase push van prices up? While one new purchase is unlikely to make a significant impact, the injection of £100 million may possibly have that effect if the economy is already working at full bore, with no spare resources available to be energised. If everyone working on the hospital feels confident enough to buy a new van, the chances are that van prices will start to creep up as the sellers realise that they can get away with charging more.

However, some of the extra £100 million will be removed from the economy through tax (around 34% of GDP in the UK). Other consequences of the hospital project include a multiplier effect and increased savings.

The multiplier effect
Joe's extra spending stimulates other sectors of the economy. The initial injection by the state expenditure on the new hospital multiplies up to encourage other sectors to make and spend more.

Let's consider Joe's spending and saving decisions to be typical of those that work on the hospital building project. To add some numbers, here are Joe's decisions, which we can take to be typical:

  • Joe considers that he now has an extra (say) £10,000 per year of income.
  • He needs to pay income tax (20%) leaving £8,000 of disposable income. [C]
  • Joe spends £5,000 on upgrading his van.
  • He decides to save 10% of his disposable income: £800. [D]
  • He spends £1,000 on imported food. (The UK supplies around 50% of the food consumed in the UK)
  • Joe spends the remainder: £1,200 on an enhanced (UK-supplied) lifestyle.

Joe has thereby spent £ (5,000 + 1,200) into the UK economy. The sellers of the items that Joe has bought are themselves stimulated to spend their increased income. Over time, the trickling into the economy of Joe's income boost looks as follows: Joe's £ (5,000 + 1,200) = £6,200 spend stimulates further spending, and so on …

[ Δ symbolises 'change in'. The 'Periods' are a rough time sequence, involving a number of people ]

Period Δ Income Δ Disposable income Δ Tax Δ UK consumption Δ Saving Δ Imports

In this example, Joe's extra income has stimulated more than twice that extra income overall. of Joe's income boost has been removed from the economy as tax (paid by Joe and by others).

The current UK tax is around 34% of GDP, so that in a more realistic model, a greater percentage (69%) of the initial state investment would be removed in tax. [C] [Recalculate]

The reckoning:

After the dust has settled, the Residuals = shows where the boost to Joe's income ends up: it goes to pay tax, savings, and imports.

The Fiscal Balance is the difference between state spending and tax receipts, being of the boost to Joe's income.

If, on the other hand, Joe feels that the good times are not going to last, and that he would be better to save his new income for a rainy day, then the multiplier effect described above will not happen.

If Joe's mood is representative of the general mood of the country, much of the payment for work on the hospital will end up as bank savings.

Δ Income Δ Disposable income Δ Tax Δ UK consumption Δ Saving Δ Imports

It is wrong to think that increased savings will lead to increased investment: if the mood of the country is low, the incentive to invest will also be low and these savings will just sit as numbers inert in computers. While some of the hospital investment will be still be removed from the economy through taxation, much of it will now be removed by people deciding to save rather than to spend.

Joe's spending on imports may boil down to a predilection for pasta sauce; in which case, his spend will end up in Italy. Or will it?

Joe's spend will go to an importer who then makes the purchase in Italy. In perhaps the simplest case, the importer will maintain bank accounts in both UK pounds and Euros and the bank will handle the conversion between the currencies.

Without delving into the details of how this happens, the bottom line is this: either Joe's spend on pasta sauce enters the UK economy; or it is saved in a bank account. If the money enters the economy, the above multiplier argument can be applied to this money with the Residuals being tax and savings. Otherwise, it adds to savings.

In summary, the state spend on the hospital ends up either as tax or as 'non-government savings'. With some effort, one can see that such savings will end up in accounts at the Bank of England. [E]

The state may decide to pay interest on these savings, but that is an ideological choice. [F]
In the accounts of the private sector banking system, every loan is balanced by a bank asset, being the contract between the borrower and the bank. When a loan is repaid, the contract with the bank is terminated.

Where did this state expenditure come from and what about paying it back?

Terming the Non‑Government Savings a 'National Debt' gives the impression that the state has borrowed money that it needs to pay back. This is mythology. Saving is a decision not to spend, and results in people accumulating numbers in a bank account. Until such time as people decide to start spending again, these numbers sit inert in computers and have no effect on the economy.

The state has decided that the public needs a new hospital. The real worry is not how to pay for it, but the effect of diverting real resources from other activity: is the hospital more urgent than the work that the people employed could have been doing otherwise?

The savers could equally well have bought expensive works of art and hidden the art in their basements, for all the effect it has on the economy. The state may decide to pay interest on these numbers, but that is an ideological choice.

When confidence returns, and people start spending again, at that point the savings can re-enter the economy with all the trickle down effects shown in the table above.

Banks make their living by issuing loans. In bad times, the demand for loans will be low and the banks will attempt to find the best return on the savings they are holding. If the worse comes to the worst, the banks can buy treasury securities, which will give them a very low return, but a zero risk investment when times are bad.

The state offers treasury securities to provide a risk-free savings facility, and in order to hit a target interest rate.

Treasury securities are a savings account at the Bank of England. When they come to maturity, the BofE transfers the principal to a checking account ("Reserve account") and stops paying interest. When a T-bond is sold on the open market, the ownership just changes hands. When a new T-bond is issued by the state, the state is essentially draining purchasing power from the economy. This has the same effect as taxation except that the T-bond principal is still in existence and returns to the economy at the point of maturity.