Wednesday, March 21, 2012


People who think that taxes pay for government spending need to ask themselves where the money comes from. Once you've accepted that you don't have a good answer, you will correctly conclude that it must come from the government in the first place.

This is obviously the case. There are no money trees and no business actually creates money. What businesses create are goods and services that consumers buy. Those consumers must get the money from somewhere. But where?

One source of money is from bank loans. Most of us believe -- wrongly -- that banks take in deposits and then lend them out. Some are more sophisticated and believe that banks make loans backed by the deposits they have in some proportion. They believe this because a/ banks generally have "reserve requirements" and b/ those reserves are somehow involved with the government bank. Reserve requirements say simply that for a given volume of loans outstanding, a bank must have a proportionate amount of reserves. People mistakenly believe this means the bank must have x amount of reserves to cover the loans in some way. However, there are countries -- I believe Canada is one -- that do not have reserve requirements and banks still make loans.

In fact, banks will make loans to anyone who is creditworthy and wants money. They find the reserves afterwards, and this is easily done, because (b) is true. If a bank is short of reserves at the end of any given day, it can borrow them at the target rate from the central bank. It does not onlend the reserves.

It should be common knowledge by now, but it doesn't seem to be (hats off to our education systems, which are excellent at ensuring that we are very poorly equipped for our world), that when a bank makes you a loan, it simply writes the amount into your account and credits itself with an asset. Say the bank lends you $100K. It does not go into its vaults and find $100K. It simply credits your account for it. The bank has an asset (the loan it made you) of $100K, and you have a liability (the loan you have to pay back) of $100K.

The asset and the liability net out, but you also pay interest. That has to come from somewhere. Where?

(It's important to understand that in the private sector, assets and liabilities do net out, so the private sector's net financial position has to be zero. It cannot create new financial assets because there is no available source of money: no free assets.)

Furthermore, when you pay taxes, that money must also come from somewhere. It cannot come from bank money (if it did, credit would have to rise by the amount of government spending every year before growth in the economy was even possible: this in fact has been happening in most Western economies because governments have refused to run big enough deficits, among other reasons).

It comes from government spending. When the government taxes the economy, what it is doing is taking away liquidity that it has injected. It can at the same time redistribute the national wealth by deciding where it will reduce that liquidity. It doesn't need the taxes to pay for anything: if it didn't spend in the first place, there would be nothing with which people even could pay taxes.

Why do people think taxation is needed to raise revenue? Well, there are basically two reasons they think that. First, when our economies were on the gold standard, it was somewhat closer to true. Dollars were proxies for the state's gold holdings, and were exchangeable for gold on demand. The state could, in theory, only spend as much as it held in gold, or would have to borrow the deficit.

We are not now on the gold standard. We have fiat money, which is not exchangeable for anything but itself, or for foreign money for those who need it to spend in our economies or settle contracts made in it.

The second reason is that conservative governments pretend that their budgets are constrained as though they were on the gold standard so that liberal governments cannot use the government's unlimited spending power to help the poor. There are vanishingly few governments, whatever their professed politics, that are not conservative economically.

I mean, I say pretend, but actually, they are basing their policies on neoclassical economics, the horrendously wrong orthodoxy that has gripped that dismal science. But surely it must be right? Tons of guys with doctorates say so.

Well, they do, but they are like scientists in a lab who never walk outside into the real world. They are like botanists who theorise plants without leaves, because leaves don't fit their model; like chemists who imagine a world with only one element, because they can't figure out how it would work with 100 and however many; like linguists who pretend everyone speaks English. With a vocabulary of a hundred words. It's that bad. Almost every time neoclassical economic models are measured empirically, reality just refuses to confirm the models. No wonder. They are built on mostly ridiculous assumptions, which cannot hold in this or any other world. It would be fine if economists stuck to playing with toy economies, with easily controlled variables, but they do not. They pretend that what works with one idealised consumer buying one idealised good from one idealised seller works in the real world.

Sadly, most of us get our views of the world from some of the least educated, laziest, intellectually void people in our society: journalists. That's right, we have our understanding of the world mediated by people whose idea of "investigation" is to ring up the contact on the bottom of a press release and ask for a quote. And who pays and directs the agenda of those guys?

Well, not the poor, let's put it that way. Not anyone who would benefit from us having an informed view of what actually goes on.


Anonymous Looney said...

Thank you for taking the time to write that. Eye-opening. I'll need to explore it further, but now I understand what you mean.

Of course, that makes the point even more clear. Edifice that is government run and purposed for government can't display any religious preference. It really doesn't change the point, though it does show up my misunderstanding of our financial system.

So perhaps it's safe to say that the concept being driven by conservatives is that spending should net to money recovered by taxation? It seems taxation then would be necessary more to control inflation by limiting the amount of money that needs to be issued than actually funding government operation... Anyway, need to do some more reading about it.


March 22, 2012 at 7:04 PM  
Blogger Dr Zen said...

No, conservatives are simply saying that budgets should be balanced because they use a model of the household of the thrifty, deserving poor, and misapply it to government.

Taxation does discipline inflation. The theory is that the government has a certain amount of spending that it does to advance its public purpose (IOW, to do the things we believe a government ought to do). In bad times, it should on top of this spend enough money to create demand so that everyone who wants a job has one (so it follows that deficit spending should be targeted to activities that create jobs). Taxation removes liquidity from the system, so that there is room in the economy for further government spending. How much the government taxes is a function of how much room it desires to spend. It would certainly be the case that lower spending would require lower taxation (the other way round from the way we usually think of it), but governments have to make political judgements about whether they or the private sector are best placed to make decisions on resource allocation and provision of certain services. There are all sorts of reasons you might feel one sector is better than the other in one area or another.
In times of deficient demand, such as we have now, the government can and should spend much more than it taxes. It doesn't have to fund that spending -- that's quite simply a myth, and a quick look at the recent operations in the UK and US would make that clear: both central banks have created plenty of money that has not come from anywhere, let alone taxes, and does not require repayment. The reasons for government issue of debt are different, and the purposes that it serves can be served by other means.
If the economy is at full employment, a careful balance needs to be made between spending and taxation (in that order though, because taxes do not fund anything: when you pay your taxes, the funds are simply "disappeared" from the economy). One way of ensuring that you can cope with inflationary pressures at full employment is to use a job guarantee to create a buffer when you have unemployment: the government spends by paying workers to do jobs that are not essential, and then when they are hired by the growing private sector, spending naturally falls. Another way is to have some forms of taxation that you do not apply at less than full employment, only applying them when inflation becomes a concern. An example of a tax that can serve this purpose is payroll tax: some people who correctly analyse the monetary system believe you should now be enjoying a payroll tax holiday.

March 22, 2012 at 7:20 PM  

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