If I ever had to teach money to kids I think I would use the following little story:
Ruritania, a land of agricultural bliss.
100 farmers and 1 king. The king provides the government in return for 10 kg of potatoes from each farmer. That is the tax.
One day the king say: “That is a bit backward, can’t we have some money?” He asks two professors:
Professor 1 (just print the money and tax): “Sure, you can have some money, but you have to run a deficit first, otherwise there is no means of settlement. If you have a deficit of £1,000 in your newly printed currency, each farmer can get issued with £10. You then tax £10, which will be enough to buy 10 kg of potatoes from the farmer. But you have to run a deficit first.”
Professor 2 (create bank to lend money and tax): “There is no need for a deficit. You can get 1 farmer to run a private bank and get the other 99 farmers to borrow from the bank. If they each borrow £10 at an interest of 10% the government does not have to go into debt. You can still tax them £10 then, and buy 10kg of potatoes, at £1 each, from each farmer. You have avoided the government deficit”
Right, says the king, I can see some problems. I have two questions for Professor 2:
1) Where will the farmers get the money for the interest from?
2) Where does the bank get its equity stake from before it is allowed to open? Because under Basel rules they have to have something like a 10% equity stake?
There are a number points we can learn from this little simple story. These things are also true in our economy today:
Without the Government spending money, the shareholders of the bank could not put their equity stake into the bank, so government money must always be created first.
Money can be created in two ways, either just issued by the government (printed), or through debt (bank borrowing). Nowadays more than 95% of our money is created through bank borrowing and is money in accounts of savers and borrowers. Less than 5% is notes and coins. Although notes and coins do not carry an interest rate.
If we just use money for paying taxes (as in example above) there is no money available for buying and selling goods, trade and commerce. So to have commerce, more money must be issued or borrowed into the economy.
However, the fact that money can pay taxes make money universally accepted, as everyone has to pay taxes.
Banks do not have to have deposits first to lend money. Bank money is just created out of nothing. The bank “creates” it by making a loan to a borrower.
All money created by banks means that the borrower has to pay interest. Here in the example 10% ends up in the bank. In reality it ends up in the bank (which takes a cut) and the savers who deposit money in the bank. Bank and savers share the interest income which is paid for by the borrower’s interest. But the fact remains, the interest money trickles up to the rich.
In the example above, there is not enough money in the economy to pay taxes and interest if money is borrowed from the bank. Let us assume that taxes get reduced from £10 to £9. Then there is enough money to pay taxes and interest. That reflects the reality. Banks would not lend unless they were reasonably certain that there is money for taxes and interest. Interest is just paid from the income generated, from total economic output. We really do not need to worry where interest comes from.
The perception created by this story is correct: All interest ends up concentrated at the wealthiest section of society. The wealthiest will be the bank and the savers, the poorest will be the ones having to borrow.
These are the points which are very clear from the story, but get often omitted when explaining money.
One last and important point – What are government bonds?
So what happens when the government wants to build a new £100 million hospital? It has already paid for normal government expenditure, which equalled the receipts it had from taxes. It had a balanced government budget.
But as the hospital is built, the government keeps paying for the builders. The government has an account at the Bank of England, and that is where the money comes from. The government effectively has an overdraft (a short term borrowing facility) at the Bank of England.
As the government does its budget again, after the hospital is finished, it turns out expenditure is £100 million more than tax receipts.
The government then declares it is in deficit and starts to issue government bonds for £100 million. It has already paid for the hospital, as it was built, but it now wants to regularize the situation. Pay off the overdraft at the Bank of England. Why? Because just running up overdrafts at the Bank of England is the same as printing money, and no government wants to be seen doing that. It asks its citizens with money, the rich ones, to buy these bonds. Bonds are just a promise to pay interest for the money which is borrowed from the citizens for a specified time, in return for a specified interest rate.
In the story money only gets created against an interest rate of 10%. That money ends up with the wealthiest in society who receive the 10%. The wealthiest then lend the money back to the government at, say, 4% interest for the government bond.
So the government created more money at 4% interest. So only an additional 4% trickles up to the top.
All the money borrowed from private banks (at 10% interest) is still outstanding.
So government created money is cheaper. Also, the bond interest rate (4%) gets paid by the government. The government might increase taxes on everyone to pay for the bond interest. Taxes share the burden.
Money created by banks (at 10%) is definitely more expensive, and of course only the borrower pays the interest rate.
Yet whatever happens, at 10% or at 4%. It is generally the rich who benefit from this automatic trickle up effect.
Can we think of a different way to build the hospital? Yes we can. The government could pay a lower interest rate on the bonds. As the monopoly issuer of money, the government can set its price. The “price” of money is the interest rate. And the government could make sure that rates stay low indefinitely.
That is in effect what we have at the moment. A situation where due to low interest rates relatively little money trickles up to the top. Of course there are still usurious interest rates for credit cards, student loans, etc. But the bank rate, the interest rate on which other rates are based is currently low at 0.75%.
So in reality interest rates for borrowers is perhaps 4%, 2% goes to the saver, and 2% to the bank. And the current interest on a 10 year government bond is 1%.
So this is much better for the economy. Less money trickles up to savers and providers of financial services. More stays in the real economy, with the borrowers. Trickle up economics has not been abolished, but lower rates tame it somewhat.
However, here is the catch. Should the UK follow the US, where interest rates have already increased by 2% from their historic lows over the last two years the situation will worsen. Interest for borrowers goes up, and interest for the government goes up, and again more money trickles to the rich people.
So lower interest rates means less money trickles to the rich, and poor borrowers are better off. Higher rates means the opposite. More trickle up economics, as the rich get richer, and the poor struggle with rising interest payments.
Under current structures there is nothing any government can do to keep interest rates low. If they go up, it will be the Bank of England deciding if they should go up. It decides if there is a danger of inflation and it will increase rates if it judges it prudent to do so.
So perhaps we should change the structures to insure interest rates stay low permanently, minimise trickle-up economics, and find other ways to fight inflation. The structures have been set up through a political decision. And a political decision can change structures.
Maybe tax increase would be better way if inflation should crop up.
And stop trickle-up economics.
Maybe a new government should consider it.