Today's Reply to George Kendall on Monetary Mechanics in the UK
I've tried repetitively to post my reply to Mr. Kendall, but Facebook seems to be having issues with posting in the group. Therefore, for that reason and to further a learning opportunity for the general public, here is my reply to George Kendall.
KENDALL: “The following is a response to these two statements:
‘no need to intentionally reduce the budget deficit’
‘what I am describing aren't policies. I am describing how the monetary system actually functions’
Perhaps, I've taken these statements out of context, if so, that wasn't my attention, and I'd appreciate clarification of what they meant.”
WINNINGHAM: Yes, you are not understanding and so, I will expand on this and hopefully clarify. Intentionally reducing the budget deficit is a discretionary act. It is a policy. What is not policy, is how the system functions:
1. All spending is done by crediting bank accounts with numbers (The government’s IOU = GBP). All spending is funded when government authorises that spending.
2. National taxation does not fund national spending in any way, shape or form. Because Bretton-Woods is gone, the government has no dollar reserves to defend. Because the Gold Standard is gone, the government has no gold reserves to defend. GBP is not on a fixed exchange regime. There is no constraint, save for accelerating inflation, on government spending. The pound is just a number with a “£” symbol in front of the number. The symbol denotes the government’s unit of account (pounds). Since numbers are infinite and GBP is just a number, the supply of GBP for the UK government post Bretton-Woods is infinite. Currency (numbers) are infinite. Real resources are finite.
3. Cash is but a physical representation of a number with a “£” symbol. When you withdraw £20 cash from your bank, the numbers in your bank account decrease by 20, your bank’s vault drops by £20 and you carry around a piece of paper that tells everyone that you have £20 and they believe you. So much so, that they are willing to sell you goods and services in exchange for that £20. When you spend it and that person deposits the £20 in their bank, their bank’s vault rises by £20 and the numbers in their bank account increase by 20. All that has happened is you have moved £20 from one bank to another.
4. Bank reserves never enter the economy. Reserves ensure that the payments system operates. Let us assume that you write a cheque for £20 to someone. When the person to whom you wrote that cheque deposits it in their bank, the numbers in your account drop by 20, the pounds in your bank’s reserve account drop by £20 then the pounds in their bank’s reserve account rises by £20, the numbers in their bank account rise by 20 and the cheque clears. Reserves merely shift between banks ensuring that payments clear. Reserves are never lent out to customers as “loans”.
5. Banks are not intermediaries. They do not take customer deposits, build up reserves and then lend them out. Banks lend by issuing their own IOU which they then denominate in the unit of account, in this case GBP. This then allows the bank’s IOU to act as money in the private sector. Because the central bank exists, the GBP in reserve accounts which are issued by the government ensures that all of the different banks’ IOUs clear at par. Bank IOUs are an asset with a corresponding liability. However, GBP is a “net” financial asset without a corresponding liability. In other words, you must pay back bank loans. You can only net save in the government’s IOU (GBP).
6. The “money supply” is not controlled by the BoE. The BoE can only set the price of money (interest rate). The “money supply” is endogenous and determined by demand for bank credit. If the BoE attempted to control the “money supply” then it would lose control of monetary policy. It cannot do both. Further, orthodoxy makes three grand assumptions concerning M(V) = P(Q), that:
a. the BoE controls the money supply. The reality is that it does not.
b. the velocity of money is constant. The reality is that it is not.
c. that the British economy is always at maximum output (full employment). The reality is that it is not.
Thus, any claims that an increase in M will equal accelerating inflation are motivated by ideology rather than sound reasoning and the orthodox viewpoint collapses.
7. The government does not fund itself by “borrowing”. Bonds, or “gilts” are not loans to the government. Post Bretton-Woods, bonds serve no necessary financing function. Because a government “chooses” to issue them, does not imply that they are necessary. Today, they drain away excess reserves from the banking system if need be and are interest-bearing savings accounts. To pay interest on bonds, the government moves the pounds used to purchase bonds from a securities account to a reserve account and then simply credits the reserve account with the correct number that equals the interest payment. No taxes involved. No borrowing involved. Since bonds are not necessary, the BoE could be ordered to maintain a zero interest rate policy and in doing so, Treasury could stop issuing bonds.
8. The government of the UK does not accumulate public debt in any other currency except that which it has the sole, monopoly authority to issue – GBP. Is the national debt in US dollars or GBP? Is it in Yen or GPB? The reality is that the national debt is the national savings, because the “debt” is merely all GBP issued by the UK government that it has not yet taxed out of existence. Public debt is not the problem; private debt levels are the problem. See point 5.
9. As long as there is a budget deficit, the government is adding GBP to the non-government sector. Hence, deficits are income for the non-government sector. If the government is running a surplus, it is withdrawing GBP from the non-government sector. The linear equation, known as the sectoral balances equation:
(G – T) = (S – I) – (X – M)
where government spending (G) minus taxation (T) equals savings (S) minus investment (I) minus exports (X) minus imports (M), is an accounting identity and holds. It is not subject to opinion. Whatever amount of GBP (G – T) is deficit spending will be found, pound for pound, in (S – I) & (X – M). Whatever amount of GBP (G – T) is withdrawing through taxation will be reflected as a pound for pound reduction of GBP in (S – I) and (X – M).
The above nine points are not policy, rather, they are a description of how a post Bretton-Woods monetary system actually functions.
KENDALL: “In September 2011, the UK inflation rate was 5.2%. At the time, the UK government deficit was around 8% of GDP.”
WINNINGHAM: Again, this statement is born out of Bretton-Woods thinking (deficits are the problem). In this case, there can be no comparison drawn between an inflation rate of 5.2% and a deficit of 8% GDP. In other words, whatever government was adding to the British economy was not the cause of the 5.2% inflation rate. In 2011, VAT was increased. If you are going to do such a thing, then the price of anything subject to VAT will increase.
When government spending results in output, there is no problem. If, however, spending cannot result in output, there will be a problem. When businesses cannot increase their production of goods and services, then they will increase the price of those goods and services. So, when it comes to deficits, the concern is not inflation per se, but demand-pull accelerating inflation. To achieve that, the deficit would have to be so large as to continuously exceed the real ability of the British economy to produce goods and services. An inflation rate of 5.2% due to VAT increases isn’t an example of demand-pull accelerating inflation.
KENDALL: “If the UK had changed policy and removed the independence of the Bank of England, then it could indirectly have ordered the Bank of England to lend money (by Quantitative Easing). However, that would have required a change in policy - removing the independence of the Bank of England - so that option isn't relevant to this discussion.”
WINNINGHAM: The BoE is not an independent entity outside of government. Secondly, Quantitative Easing (QE) is not lending. QE is an asset swap for liquidity. QE will not result in inflation for the above mentioned reasons found in points 4, 5, & 6. Banks do not lend out reserves and any GBP issued must be spent somehow on goods and services to be inflationary. Reserves built to excess in reserve accounts are neither inflationary nor will they expand banks’ ability to lend. Banks are not reserve constrained. They lend their own IOU and later seek additional reserves if needed to ensure the payments will clear.
KENDALL: “At the time, lenders were willing to lend money at a very low rate of interest. However, many in the financial markets warned that, if the UK did not reduce the budget deficit, then the markets could quickly lose confidence in the UK, and the rate of interest they would require would rise rapidly. If this fall in confidence continued, the Bank of England warned that the interest rate demanded could climb so high as to make borrowing unaffordable.
The Economist has described the problem as follows: “the risk, when a deficit is as high as 11% of GDP, is that the markets lose confidence and push up bond yields, making the fiscal situation even more desperate. The costs of such an outcome are so great that a government can hardly be blamed for trying to avoid it.
I appreciate that followers of MMT may believe the financial markets would have been wrong to demand high interest rates if the UK didn't address its deficit. But whether the financial markets were right or not is irrelevant. This was their sentiment.”
WINNINGHAM: Bond markets do not hold the UK government hostage, because the UK government issues the GBP and bonds that the markets use and buy with the government’s currency. The private sector is governed by the government, not itself. The same does not apply to an EMU nation like Greece for the simple fact that Greece does not issue its own currency. It uses Euros and as such, it must tax and borrow to fund itself and therefore, markets can affect Greece. This is not the case for the UK, US, Canada, Japan, Australia, et al. Bond markets are private entities that do not issue the national currency; they are mere users of the government’s currency, subject to the government’s regulatory authority and thus, hold no power over a sovereign currency-issuing nation.
