Explaining modern money to friends is very challenging. I haven’t won many converts but I keep trying. I was in a café yesterday having a cappuccino with a friend and for once, I wasn’t the one who raised the subject. You can be the judge as to how I went.
The conversation went thus:
Friend: How can you say that Taxes don’t fund spending? Where else does the money come from?
Me: It comes from the Reserve Bank (RBA) or Treasury. All spending is newly created money.
Friend: What do you mean?
Me: When the government pays my aged pension, for example, Treasury simply executes an electronic transfer from the Reserve Bank (RBA) to my bank who then credit my account. It’s all just numbers in a computer.
Friend: Yes but they debit the government account.
Me: I’m sure they do. But that government account doesn’t need to have any money in it. The debit is just a number on one side of the ledger. Treasury keep score of debits and credits but that doesn’t stop them from paying their bills. They would never bounce their own cheques would they?
Friend: Then it must show up as being in the red.
Me: For accounting purposes it probably does, but they still pay the pension irrespective of the state of their account. The point is, the pension payment was just a number in a computer, money created out of thin air.
Friend: I don’t understand that. What I know is I pay taxes and the government spends those taxes on stuff. When those taxes are not enough, they borrow the money to make up the difference.
Me: And who do they borrow it from?
Friend: I don’t know. China, I suppose.
Me: No, we don’t borrow money from China, or anywhere else for that matter. We are the currency issuer. We make our own money.
Friend: Well, that can’t be right. We are currently billions in debt.
Me: Well, not really. This is where it gets a bit complicated. You see, while we call it borrowing, what we really do is issue bonds, which is like offering shares to anyone who wants to buy them. Bonds are good business because they offer a guaranteed return. The government pays interest on them twice a year.
Friend: So who buys them?
Me: Anyone can buy them. They are always sold in Australian dollars so it doesn’t matter who buys them. Finance houses buy them, superannuation funds, even Chinese investors, but mostly they are bought by banks. Every night, banks need to make sure they have enough reserves to meet their obligations for the next day’s trading. If they don’t have enough, they borrow from another bank that might have more than they need and are looking for somewhere to put their money and get some interest on it.
Friend: What happens if no bank will lend them any?
Me: Then the RBA will lend it. The RBA will always provide reserves to the commercial banks. Otherwise the whole system would collapse.
Friend: What if a bank has excess reserves and no bank wants to borrow them?
Me: Then they can use that excess to buy bonds from the RBA who will pay interest on them. The RBA sets the interest rate and that controls what interest the banks lend to each other. If one bank wanted to charge more interest than they should, the borrower could simply go to the RBA and get a lower rate. That’s why the government issues bonds; to control interest rates, not to make up the difference between taxes and spending.
Friend: But, but, hang on, if that is true, why does everyone make such a fuss about how much the government borrows?
Me: Because they don’t understand how things really work and because the government wants you to think that running the finances of a country is the same as running the finances of your own household. It isn’t.
Friend: Why isn’t it?
Me: Because households can’t create their own money. Some have tried but they’re mostly in jail. We have to work for it.
Friend: But the government has to earn it by taxing us don’t they?
Me: No, that’s making it sound as if the government is the same as an ordinary citizen.
Friend: But if we are not, don’t our politicians know that?
Me: Sometimes I wonder; especially when you hear some of the stupid things they say.
Friend: So, if the government can create the money out of thin air, why do we pay taxes and what happens to all that money?
Me: We need to pay taxes for two very important reasons. One is that it gives our currency value, i.e. people must have it to pay their taxes. The other reason is that it takes money out of circulation, which is one way to help control inflation. Too much money in circulation can be inflationary. Also, issuing bonds helps control inflation by taking money out of circulation.
Friend: But with these bonds, you say the government is paying all this interest.
Me: Yes but by paying interest, the government is putting money back into circulation which helps drive demand.
Friend: But where does it get the money for that?
Me: The same place it gets money for everything it spends on. It creates it out of thin air.
Friend: But what happens to all the tax money we pay?
Me: The taxes we pay are recorded as revenue and then Treasury has no further use for it. It’s just more numbers in a computer. We keep records of course, to keep the accountants and bookkeepers happy, but it is of no further use. It’s not a tangible asset, it just disappears.
Friend: Isn’t it used for spending?
Me: No, it’s not needed. We make our own money. We have no further use for it.
Friend: But what about the deficit. Couldn’t we use it to offset the deficit?
Me: Again, we don’t need it. The deficit is just a number in a computer telling us how much more we have spent compared with what we took in taxes.
Friend: But deficit spending is bad, isn’t it?
Me: No, when we have high unemployment, deficit spending is good. High unemployment is the result of bad planning by government and industry. Governments need to halt rising unemployment by creating projects that employ people. That means pumping more money into the economy than they get back in revenue. When unemployment comes down they can spend less which might then create a surplus.
Friend: But that’s what we want isn’t it; Surpluses?
Me: Not when things are bad and people are looking for jobs. Surpluses aren’t money in the bank to be saved for a rainy day. Surpluses take money out of circulation and limit people’s buying power. That forces people to go into debt…real debt that they must pay back or suffer the consequences.
Friend: If you are right, then all our understanding of how money works, is back the front.
Me: Yes, it is.
Friend: That would mean that, if the government wanted to, it could make sure every person that wanted a job could have one?
Friend: It would mean that we can never run out of money?
Friend: That means all this hoohaha about not being able to afford stuff, health care, education, government services, how we are going to pay for it and so on, is all rubbish?
Me: Yes it is.
Friend: Then what’s to stop us from madly creating money, dropping it out of helicopters, enabling people to buy whatever they wanted, building super highways and high speed trains, that no one would use, just to keep people employed or just let people hang around doing nothing and expecting everything to be laid out for them?
Me: For every buyer, there has to be a seller. If we did what you suggest, it would have a devastating impact on our economy, our balance of trade, our foreign currency holdings, no one would work, nothing would get made, no food would be grown, no goods would be produced, and prices would go through the roof. That’s what happened in Zimbabwe. The strength of a nation’s wealth is its GDP, its gross domestic product, its ability to produce goods and services that people here and overseas want to buy. Throwing money out of helicopters would not achieve that. Eventually, there wouldn’t be anything to buy. We would all starve after everything that had been made up to that point was consumed. We would not be able to import anything for the cost of it and not export anything for the lack of raw material. Get the picture?
Friend: Yes, I think.
Me: Everything must be properly balanced. At the moment everything is out of balance because we have high unemployment. We can fix that if we want to, but it will take a major shift in government thinking. We can fix it by making sure that everyone who wants a job can have one. They can earn a liveable wage and live a normal life. That will restore demand, get the private sector producing and increase our national income. We can achieve that by recognising the power of a sovereign currency-issuing country, and exercising that power. Only government can do that.
Friend: Should we be increasing taxes?
Me: Have you been listening to anything I said?
Friend: About what?
Many expletives have been omitted from this discussion to protect the sensitive. If you find this helpful, you are welcome to use this as a guide in your own café set.