I’m not saying they should only publish good news. It’s just that much of the stuff presented as THE END OF THE WORLD AS WE KNOW IT on closer examination turns out not to be.
Right now, the number of new cases & deaths from Covid-19 seems to be falling in the UK, to the great disappointment of the “Gotcha!” journalists. The crisis has revealed their political biases and the collapse of confidence in the media reflects that:
It looks like we’re through the most dangerous period without the National Health Service being overwhelmed. But what about the economic aftershocks coming down the track? What about the collapse of the economy? What about the trashing of public finances? Surely this will lead to a Great Depression?
Well, probably not. As long as we hold our nerve and are sensible, the economic damage need not be long-lasting and there is a way out of the problem of too much government debt.
The coronavirus has not reduced the productive capacity of the economy. No offices or factories have fallen down. No lathes or software have been infected. All the forklift trucks and spreadsheets still work. Yes, some people died (most of whom were retired, old or sick already) and that’s a tragedy for their families. But no real damage has been done to the supply side of the economy.
An extended lockdown would however seriously damage the economy. Recessions kill people (indirectly and invisibly) and reduce the resources that can be spent on health services. So its right that people press the government about the exit from lockdown and that we learn from other countries.
The supply side of the economy is not is the problem (once we’ve brought the medical manufacturing supply chain back to the UK). But right now we have a demand problem and a liquidity crisis where companies and people without emergency funds (and with debt) will struggle to bridge the gap to the recovery.
With the right policy response, the economy should bounce back quickly if we can ease the lockdown soon. The reason there won’t be a Great Depression is that governments won’t make the same mistakes they did in America in the 1930s where they allowed private sector demand to collapse (the fear of big government arguably led to laissez-faire policy errors…Discuss).
In Victory is Inevitable (20 March), I predicted that:
Governments will rip up the rulebook of economic and monetary orthodoxy and do whatever it takes. As they should. I suspect that a “helicopter drop” of money is coming for the many people that have been / will be laid off.
Sure enough, on 9 April came the announcement that The Bank of England will directly finance the extra spending needs of the UK government on a temporary basis:
What does that mean? The government has chosen to finance the deficit (the gap between what it spends and what it raises in taxes) with the The Magic Money Tree.
For those of you that are confused, here’s how The Magic Money Tree works. The government creates money out of thin air and gives it to people and companies who spend and invest it, thereby boosting economic activity and (eventually) tax receipts. Yes, I’m simplifying but that’s basically it.
At a very basic level, we all understand that the Government has the legal ability to print banknotes. But most money is electronic and the government can issue new currency electronically. The UK Government controls the sterling denominated money supply, just as the American Federal Government controls the issuance of US dollars (we’ll come onto Euroland later).
Isn’t that done by Central Banks, independent of government? Er no…The Bank of England (whilst independent in the very limited sense of setting short term interest rates) is an arm of the state. Its owned by The Government which can hire & fire its directors.
In the aftermath of the 2008/09 global financial crisis we learned a new phrase: quantitative easing (QE). Here’s how quantitative easing works. First, The Government decides that it wants to:
- lower interest rates
- encourage investors to move from safe assets (cash, bonds) to risk assets (equities/property)
- boost asset prices
- fight deflation (falling prices) / create inflation (rising prices)
- create a wealth effect to stimulate demand and boost output
So The Bank of England creates £1 billion of electronic money and uses that to buys £1 billion of gilts (bonds issued by the UK Government) in the bond market. Remember bank transfers are just electronic numbers on a screen, no more or less real than a video game.
The government now owns £1 billion of gilts, the private sector (made up of institutional and retail investors) has £1 billion of extra cash. What do the private sector investors do with that cash? Their options are to use it to buy alternative assets (e.g. equities, gold) or stuff (e.g. goods and services) or they may just leave it sat in their bank accounts (dangerous if inflation erodes its real value over time).
The Bank of England could reverse the operation by selling the gilts back to the private sector at a later date. Or, more likely, it could just leave them sat there in its account to mature at some future point. In other words, the government keeps the proceeds and the money creation is never reversed. That there is The Magic Money Tree.
Do you remember all those scary headlines and news stories about the public finances in the years following 2009? Well, what you may not have realised is that about one third of all gilts (British government debt) were bought by the Bank of England with invented money. As far as I’m aware, not a single gilt bought under QE was ever sold back to the private sector. In other words, at the stroke of a keyboard, one third of the entire national debt was if not permanently eliminated, then certainly taken out of the equation.
What the government is now doing is bypassing the bond market and pumping newly created money straight into the bank accounts of
voters people (the self-employed income support scheme) and companies to pass onto their employees (the furlough scheme). These measures are remarkably generous…if generous is the right word to describe a government bribing people with their own money.
There is no free lunch in economics and someone has to pay the bill. With the Magic Money Tree, the bill is paid 1) by holders of cash and bonds (whose real value gets eroded by inflation in a slow-motion devaluation) and 2) by future taxpayers. Both groups get shafted. Whitney Houston once sang: “I believe the children are the future” …trouble is, they don’t have a vote right now.
It’s not just the UK that has a Magic Money Tree. Any country that issues its own currency has its own Magic Money Tree. The countries on the fringes of The Eurozone (e.g. Ireland, Italy, Greece) do not have the ability to deliver helicopter money to their own people. This is a big problem for the Eurozone.
Why haven’t governments used the Magic Money Tree before? Well, they have. The reason they didn’t go further is inflation. When you have too much money chasing too few goods (demand > supply), inflation results.
To illustrate, imagine a simplified economy where Bill and Ted are on a desert island. Bill has a spear and Ted has £10 and wants to buy the spear. Supply is constrained: there’s nothing else on the island to buy. If Bill is thinking about selling the spear to Ted, it makes sense for him to price it at £10. If the Bank of England gave Ted an extra £10…what would happen? Well, if Bill is sensible he will increase the price to £20. Increased money supply leads to higher prices. Yes, the real economy is way more complicated than that but you get the basic idea.
We know from history that when politicians start using the Magic Money Tree, things have not ended well. Think Germany in the 1920s, Zimbabwe and Venezuala in recent years or any number of Latin American banana republics throughout history. The government prints money, inflation takes off and the currency becomes worthless. Inflation messes up the price signals in the economy destroying people’s ability to respond rationally to relative prices. Businesses can’t make capital allocation decisions, investment crashes and supply falls.
Here we have to stray into politics. In April, the Labour Party elected Keir Starmer to replace Jeremy Corbyn (a big improvement). Magic Grandpa was wrong about almost everything. But he was right about one thing: there always was a Magic Money Tree. Fortunately, enough of us realised that putting him and Diane Abbot in charge of it was like giving loaded machine guns to 6 year olds and dropping them at primary school with the safety catches off.
The economy is an infinitely complex ecosystem. It is nothing like the simple machines imagined by engineers and amateur economists where you pull a lever (e.g. lower interest rates by 1%) and get a predictable response (e.g. GDP up by 1%). Complexity and non-linearity means that playing with inflation could be like pulling on a brick with an elastic cord…nothing happens for a while…then you get smashed in the face.
This is why the Government (and We The People) need to be very careful with the Magic Money Tree. The fruits may taste good and have medicinal properties in the short term. At times of a collapse in private sector demand, the Magic Money Tree can play an important role. But think of it like morphine: a valuable painkiller if used under medical supervision in the short term but highly dangerous and addictive after a while.
Here’s the summary. We can use the Magic Money Tree in the short term to boost demand, ease the adjustment process and get ourselves through this. In an environment of low demand and surplus supply, inflation need not be a problem. Longer term, the MMT is a drug we need to wean ourselves off whilst the economy (hopefully) grows enough to shrink the % ratio of debt : GDP.
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