The magic and mystery of money

 

If nothing else of enduring benefit survives post Covid, let us hope it is a better understanding of money, where it comes from and how we can better use it for public good.

 

The $100 billion plus cost of Federal government stimulus measures to date was found without much fuss. Where did it come from? Most of it from thin air. The government raised some money from third parties by issuing bonds (IOUs) but subsequently many of these have been bought by our own bank, the Reserve Bank (RBA). Where did it get the money from? It’s not like you and me. It is in the unique position of being a currency issuer. It spends money simply be crediting other people’s bank accounts. Whether spending to buy bonds or by spending on behalf of the Federal government, the process is the same. It simply marks up people’s bank account.

There has been a lot of recent discussion in the media about how governments can finance their spending. Advocates for Modern Monetary Theory (MMT) have been trying to tell us for years that much of what is commonly believed about money, government spending and debt is not a reflection of what happens. We now have seen first-hand how the RBA has bought bonds from third parties simply by marking up sellers’ bank accounts.

All Federal government spending is done this way. People’s bank accounts are simply marked up. We the people don’t have accounts with the RBA so the RBA credits our banks with money (which are called bank reserves) so banks can then credit our individual accounts. Banks are intermediaries. One of their roles is to hold reserves on behalf of customers. Reserves are created by Federal government spending. Reserves are sometimes called inside money because they are passed around inside the banking system from bank to bank when customers with different banks spend money.

But most money circulating in the economy has been created by private banks, so called outside money, which distinguishes it from reserves or inside money which only circulates within the banking system to settle customer transactions.

Outside money represents about 97 per cent of all money in the economy. The balance is inside money.

Every time banks make a loan, money is created via a new deposit. When a loan is repaid, money is destroyed. It’s a digital world. Money doesn’t sit in a vault waiting to be lent.

With net credit growth averaging 15 per cent there’s a lot of money sloshing around the economy. Most of it has found its way into the hands of the top 5 per cent although much of the debt remains with others lower down the food chain. That’s how trickle-up economics works.

What does the top end of town do with all the spare cash originally created by private banks?

Two things spring to mind.

First, get everyone to believe that governments must borrow money from them if taxation doesn’t raise enough. At the same time campaign for reduced company taxation to promote economic growth knowing there’s little evidence it will work and the government will need to borrow more.

Second, open another public relations front scaring the public into believing that too much debt will cripple our grandchildren and one way of helping out is to buy government businesses, only the profitable ones of course or those with guaranteed or regulated returns. Overstate short term fiscal gains and gloss over long term social losses.

We now know the Federal government needn’t operate with the institutional strait jacket it has over the past 20 years. It needn’t raise every dollar by buying back excess reserves and issuing IOUs. It needn’t underfund government services or sell off business to help pay its way and balance its budget.  Current problems in the aged care sector are a reminder of the pitfalls of such an approach.

The concept of living within one’s means is something that applies to households, local and state governments. When applied to the Federal government which can issue its own currency, it’s an ideological statement not an accounting truism. Therein lies the suggested path for a reform of the Federation. We must use the power of the Federal government to put State and local governments on a long-term sustainable footing so they can provide the necessary services which will inevitably grow much faster than government revenue. Currently underfunding is the rule rather than the exception. It will get far worse without a radical rethink. To pretend otherwise is to engage in self delusion.

A belief that bringing forward infrastructure spending or a few major projects will provide the necessary impetus is also self delusional. This is no ordinary crisis. We have used up all our luck to get to our present situation. The role of governments and the funding thereof needs a major overhaul.

Living within our means shouldn’t be a self-imposed financial constraint, rather a goal to use all resources, especially idle labour resources, to better improve society.

Understanding the magic and mystery of money is a prerequisite.