How The Magic Money Tree works

One of the reasons I write this blog is because much of The News consists of a crock of shit scaremongering…especially when it comes to money and finance.

There are many things that the news media tries to scare us about. This is why no news is good news.

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. Skills atrophy among unemployed workers. 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 can print banknotes and make money out of paper. These days most money is electronic and the government can issue new currency electronically at the click of a keyboard. 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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  1. Freddie · · Reply

    Thanks EA – a good article with several helpful analogies to explain complex concepts. Care to comment on what you think the right amount of ‘shaking/climbing/lolling ‘neath the shade’ of the Money Tree is? Or alternatively, what too much is?

    How can we define the tipping point and act accordingly?

    1. With great difficulty and hence great care. Chaos Theory applies in complex systems…where the proverbial butterfly flapping its wings can cause a hurricane on the other side of the world etc etc. Precision is impossible so you have to apply what Taleb calls “The Precautionary Imperative”

  2. “Those who don’t read the news are uninformed. Those who do read the news are ill informed” Mark Twain 1874

  3. Ian Bowater · · Reply

    Great post Barney,

    I’d like to read your take on the potential/likely erosion of globalisation as a result of this period of history or will things soon revert eg will the price of China’s goods remain too attractive?

  4. The interesting thing is why we did not get high inflation after 2008/2009. Since then the UK (and many other countries) debt has ballooned year on year but inflation has been pretty subdued. One reason is hidden deflation. Take amazon prime as an extreme example. What started as just “free” delivery for £79 is now “free” movies, “free” music and lots of other “freebies” all included for that same £79. Technology is driving prices of many things down and in the absence of money printing we would have had real deflation over the past 10 years.

    So thus far, since 2008, cash and bond holders have not suffered that much – in fact bond holders have done really well for a long time now. All this money printing does, however, increase asset prices. Great for those who are already FI, not so great for those starting out now – not many young people will be buying houses in the South East without the bank (make that the gift) of Mum and Dad. As inequality grows I expect the demand for wealth taxes will grow with it.

  5. TheLuckyOne · · Reply

    Always a pleasure to read a “newspaper” where you agree with the editors views. I sort of already had some of the basics but your simple explanations do help me understand the “causes and effects”. Love the elastic and brick analogy. I’ve had a few of those wake up calls and I’m sure there’s another just around the corner. I suppose having an emergency fund and low(ish) cost lifestyle act as a financial crash helmet when an unexpected coconut drops out of the MMT. Please keep on keeping us informed Mister Tea.

  6. Ron Cameron · · Reply

    In the US we’re $24T in national debt. There is no repaying at this point. When we say it’s our kids who will pay for it, we’re inadvertently lying. That’s the same thing -our- parents said! Even Warren Buffet (who I normally love) is comfortable with an ongoing growing debt, which is even more awe inspiring. As for our economic future, I think you’ll see a lot of dominoes fall from all of this.

      1. Ron Cameron · · Reply

        I think that article sums up the general reality of our debt, but makes a huge assumption: That the world will continue to loan us money. If (and it’s a big if) we somehow slide and the perception of our financial strength tumbles, we’ll struggle to borrow more money to replace our bonds as they come due. ESPECIALLY at our ridiculously low current rates. I think this is a low likelihood for the foreseeable future, but worth considering.

    1. I think in practical terms we need to learn to live with this virus. It’s not going away and a vaccine is not round the corner.

      The potential damage and long term impact to the global economy could cost even more lives. But no one is looking at the trajectory of the impact of this economically…

      The fall out from this could mean ww3. That’s not as bonkers as it first seems. 1920s/1930s Germany… Led to some pretty extreme politics due to some extremely difficult economic times….I hope I’m wrong.

  7. Flashb. · · Reply

    Another good article! You’ve explained the concept of the ‘magic money tree’ really clearly. If only more people took an interest in economics and finance (which governs much of their daily lives) rather than the crap fed to them by the media.

    I just wanted to point out that that the Nazi Party (National Socialist German Workers’ Party) were not actually socialist and didn’t have socialist policies. The ‘Socialist’ title in the party name was just lip service (I think we’re all aware that what a politician says is often not what they mean). In fact, the socialist, left-wing party within Germany at the time was outlawed by the Nazi Party in 1933.

    If you want an example of failed socialist countries there are plenty of those but Nazi Germany was not one of them.

    1. It is very suspicious that you know so much about the Nazi party…I will be informing David Lammy

      1. Laertes · · Reply

        Nazism came to power between 1932 and 1933, the hyperinflation ended in 1924. They came to power after the stock market crash of 1929. Stop linking both, please.

        1. Uh-oh…a definite Nazi here!!! Activating blocking procedure, Cap’n!

  8. Good article man, as someone mentioned above in the comments in the US our national debt is already beyond payable, and now we’re pumping trillions of new money from the money tree into the economy. I have to admit, I’m kind of afraid as to what’s going to happen. As you stated though, economic systems are so incredibly complex no one can really predict it and it may not amount to anything at all, or it could be really really bad.

  9. I’m no financial wizard, so I would like your comments on my thoughts.

    Ok. When you deposit £10 in the bank, the bank then lends that to other people- maybe 3 times (it’s called Fractional Reserve Lending). YET, when you check your bank account it still says you have £10 in there.

    So where did the extra money come from? Like you said, nowhere. It’s made up. It doesn’t exist. It’s an illusion. However, if everyone believes the illusion the money system works.

    But know THIS – it’s an illusion.

    Back in the day, there existed the Gold Standard. That meant that the paper money you had in circulation was equivalent to the gold held in the Country’s vault. So the pound note was equivalent to a piece of gold in the Bank of England vault. It was a token that was worth its promissory value in gold.

    That proved a little too restrictive so all countries dumped the standard and just printed their own money leaving the markets to decide how much a currency is worth.

    So, the paper money you have in your pocket is only worth the printed value so long as we all believe in the illusion, and as long as we believe in the illusion the world works just fine.

    Enter stage left, the Corona Virus, and instead of the gilt issue you mention, Governments start borrowing gigantic amounts of money to offset the effect.

    Who do they borrow the money from?

    The International Monetary Fund and the World Bank.

    Where do these to organisations get their money from? Those contributing countries (like the U.K.) who deposit money there in case of emergencies.

    So, the world’s economies are teetering on the brink of melt down, and one recourse is to borrow money which we deposited with these 2 financial institutions.

    In case you missed the point, we’re borrowing our own money from a couple of organisations, and the repayments on borrowing our own money will cripple us in the future. Maybe for decades?

    AND, AND you can bet the IMF AND the World Bank are lending more money than they actually have on deposit (Fractional Lending again). But it all works providing we BELIEVE THE ILLUSION.

    So, my question is, if the whole thing is an illusion, and we’re borrowing made up money from ourselves, why can’t we just hit the reset button, wipe all the debt out and start again from factory settings? It’s another illusion, but it’s waaay better than the one we’re facing. Why shouldn’t we all believe this, and create a new world order?

    1. If we just hit the reset button, all the elderly retirees living off government bonds (which they were PROMISED would be safe) would be wiped out instantly…that is not fair and NOT how you get re-elected…so you have to reset slowly and gradually…using inflation

      1. ladyaurora · · Reply

        This is truly ….eye opening! fasinating

      2. It’s an illusion. The Government can create any illusion they want – including honouring bonds.

        My larger point is, if EVERY country is borrowing from wherever (IMF, World Bank), then a new illusion is merely an international agreement away, and what country couldn’t see the benefit of a debt right off – including the U.K. and US

        1. Since I can’t reply to your comment I’ll reply to my own.

          Wow ‘C+’? So a pass then?

          Wait until I tell my mam

  10. Thanks for explaining ,still trying to get my head around it !
    How long in lockdown ,would be too long?

    1. Well, I would be allowing healthy under 40s back to work NOW. You can probably see why I’m not a politician…

      1. In hindsight, from the outset we should have identified all those at risk and isolated them. The rest of us should have carried on at work, caught the virus, been ill for a week, and got back to work.

        I believe some form of isolation will continue until next year.

        Politicians will already be thinking about the blame game. There will inevitably be an enquiry into what could have been done better, faster etc, and opposition politicians and the media will blame someone for not acting faster and say something like ‘the blood of these people is on your hands for not doing xyz’. Politicians will already be considering distancing themselves from the tougher decisions as a result.

        There’s my prediction Barney

        1. Ron Cameron · ·

          Remember that two week period a month ago when no one was finger pointing yet? Gosh, those were the days…

    2. Guess this “short-term boosting of demand” will be just as short-term as the previous one was…

  11. I live and work in central Stockholm which by international media seems to be the most hated city in the world at the moment. That’s because we are not in a lockdown and many of us are out enjoying the spring and having meals or a beer outdoors at restaurants. Many of us however work from home and the city is much more quiet that normal. But by trying to slowly keep on rowing the boat we seem to be able to save a lot of jobs and businesses while the hospital’s still have capacity for more sick people. I truly believe that our way is the one that best serves the population as a whole and I must say that I am impressed how Sweden as a nation once again has walked it’s own way without failing under the pressure from bigger nations or the EU. But as stated in the interview with Johan Gisecke, the real answer to which strategy was the most efficient will not be handed to us until many more months or maybe even a year.

  12. Helicopter drops of money are a terrible idea in normal times. However, these are not normal times. Unemployment in the US, for example, could be as high as 30% this month. With so many people out of work, with restaurants and businesses closed, etc. the problem is clearly tilted to the demand side; there are now too many goods and not enough people who can buy them. (See crude oil at negative $36 per barrel this week.) QE / MMT / printing money seems like quite a good idea when the alternative is a deflationary depression.

  13. Chris B · · Reply

    Keynes was proven right in 2008-2009 and we’ve enjoyed a great decade instead of another depression as a result. However, governments never lowered their deficits after the crisis as he prescribed; wars against Muslims, low taxes, and extended propping up of asset prices were too alluring. Thus, the anti-cyclical effect of government Keynes had in mind became something more like standing policy. MMT was a bipartisan consensus long before it had a name.

    However, inflation (in USD) has barely stayed positive through it all. The reason is that Western countries are being sucked into the same disinflationary trap that caught Japan in the 90’s. US and U.K. demographics are similar to where they were at the time – tilted to older people who must spend less and less each year to stay afloat when they’re too old to work.

    Rather than facing an inflation brick being pulled by a bungee cord, Western governments face the risk of disinflation taking on a life of its own. If inflation is 2% while interest rates are 0.5%, then the Phillips curve died a long time ago and there is some outside force acting like undertow on inflation. Is it possible to overdo QE and the more efficient helicopter money being done in the US and U.K.? Probably, but I think we’re a long way from that point.

  14. The MMT has been used and abused since the world decided it no longer cared for sound money principles. If anyone thinks that our governments will ever run balanced budgets they are hopelessly naive. Our entire monetary system is predicated on the creation of new debt to keep it growing. A few at the top who own financial assets benefit disproportionately, the masses at the bottom who struggle just to pay their bills get continually shat on.

  15. […] TEA has a great article explaining QE and the Magic Money Tree (18) […]

  16. GregInCali · · Reply

    Gotta love when a guy from the Internet pretends to be smarter than everyone else because he did Economics 101 in high school.

    “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.”

    Yeah, no real damage at all to the supply side. 30 million people in the US filed for unemployment in one month. This makes no impact on the supply. The whole tourism industry, all passenger air travel halted the ground, not to mention fitness, restaurants or events but yeah no damage to the supply side. Lockdown? What lockdown.

  17. Hi E.A.
    With regard to the imaginary state of what money represents. The great Richard Buckminster Fuller got it right I think, in being the forward future energy provided by people on mass, governed unfortunately by those who control the masses into doing their dirty work.
    ‘Operating manual for Spaceship Earth ‘ is where that’s mentioned and I believe he called those in the know with their secrets well hidden, ‘pirates,’
    and how apt.
    Ruling by fear in any crisis ,will have all of us with that little bit we could lose jumping through hoops, mix that with a virus ‘Killer on the loose ‘ and, well ,see what happens.
    Thank you for your balanced view of this constructed drama, strangely a drama which arrived just in time to avert an oil crisis.
    Good luck in your escape.

  18. Really good article – no-one yet picked up the ‘Magic Money Tree’ / ‘Modern Monetary Theory’ reference yet, or is it me not being in on the in joke?
    Confirmation bias in full flow for me with this article: the environment was ripe for inflation for the last decade and I hadn’t really realised that the equivalent productivity improvements of Amazon Prime etc were balancing the monetary supply, hence the lack of inflation. It’s really hard to see how productivity gains can continue to match the hugely increased money supply now being created. So my expectation is a transfer of wealth from the asset holding old to the productive young (to generalise massively) through the magic of inflation (with politically driven low interest rates).
    Those who rail against fiat currency and the ‘imagined’ wealth this creates need to learn some old wisdom. The wealth is real because “Nothing is easier than self-deceit. For what every man wishes, that he also believes to be true.” ― Demosthenes. Humans are essentially optimistic and self-serving and this will again work in our favour. So I expect that that stock market graph will repeat itself yet again, with a crash being followed by a recovery. Obviously I have no idea when!

  19. Hopefully inflation will eat away at my mortgage

  20. […] Escape Artist wrote a good post on the magic money tree and how it works during and after the coronavirus pandemic is over. I liked the down-to-earth way […]

  21. SurreyBoy · · Reply

    Possibly the clearest and most engaging explanation of QE ive ever read. Excellent.

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