The myths and realities of government spending

In the general election this May, many political commentators were talking up the Labour party under Corbyn as presenting a significant departure from established wisdom, with those on the left praising this as an opportunity to build a better society, and those on the right mocking labour as an embarrassment.

There is some truth to the claim of departure. Labour has distanced itself from the Conservative party with a bold stance against public sector cuts, promising improved services, and public investment. However, Labour still maintains the rhetoric of ‘balancing the books’ and reducing the deficit, with their manifesto taking pains to offset increases in spending with increases in taxes. This approach shows a number of key misunderstandings in how states are financed, and the nature of government debt.

The conventional wisdom is that states finance their expenses through taxation and by issuing government bonds, that there are limits on taxation and bond issuance, and that these set limits on government finance: the truth is that taxation and bonds do not finance the government. The British government, along with most of the world’s governments have ‘Monetary Sovereignty’, which means they can print their own currency at will, without limit. This means in effect that the government can never run out of money, and never needs to tax or issue bonds to finance itself. In fact, as well as being unnecessary, the government has never used taxation or bonds to finance itself. When a government taxes, it does not collect the money, but rather orders banks to wipe money off its account, effectively destroying it. When a government issues bonds, it destroys the money it is paid and records the bond as a new savings account at the central bank (for more on this, check out this book).

This is the reality, understood by economists across the political spectrum. The understanding is that taxation and bond issuance are not means to finance government spending, but rather they are ways to reduce inflation. Any time the government spends money, it is putting money into the economy. If this does not lead to productive enterprise, then it will simply inflate the moneys supply, causing the price of goods and services to rise across the whole economy. Taxation serves in this case to take money out of the economy, reducing the money supply. Issuing bonds does likewise; primarily bonds are issued to banks, reducing their excess cash. Taxation and bond issuance should thus be seen, not as ways to finance government, but rather ways to offset the potential inflation that comes with government spending (this video gives some more info on this).

Since the 2007 crash, politicians on the right began a trend of highlighting the level of government bonds, presenting them as a worrying burden to be reduced, for fear of prices rising in the future. The left has largely bought into this misconception, when they should have been challenging it.  If you understand the truth of bond issuance; that bonds are issued primarily to banks, their purpose is to reduce the excess cash held by banks, and that the price of bonds is determined by banks based on how much excess cash they have, then the supposed threat presented by bonds evaporates.

So long as bond issuance is being used pragmatically; to reduce the cash held by banks when they have too much, then bonds will always be cheap. If banks demand high interest for government bonds, then it is an indication that they need the money, and that government shouldn’t be taking it from them. This remains true whether you believe government is always inefficient, and should play a small role in society, or whether you believe it needs to play a large role. There is never need to fear rapid rises in the price of bonds, and cut government spending wildly. Spending should always be considered in terms of cost/benefit analysis (for more info, see here). 

With these facts in mind, we can return to Labour’s spending plans. Labour’s efforts to show that all of their increases in government spending are offset by increases in taxes show both an unnecessary fear of issuing bonds, and a lack of faith in the efficiency of government. As noted earlier, increases in government spending lead to inflation only when the spending does not lead to productive enterprise. If there are productive things the government could be spending money on, then doing such will not cause inflation, and does not need to be offset with higher taxes, or by issuing bonds.

The clearest indication that there are productive things the government could be doing is shown by Britain’s unemployment statistics. Figures released this year show that roughly 10% of Britain’s populace is involuntarily unemployed, and another 10% are underemployed. This represents a huge loss of productive capacity in Britain, which the government could address with a Job Guarantee Program. The Labour Party could employ all of these people, to improve Britain’s infrastructure, staff our schools, NHS, social care, insulting homes, or any other number of useful ventures. This could all be done through government spending, without raising taxes, or issuing more bonds, and it would not be inflationary because people would be doing productive work.

That the Labour Party does not do this shows either a serious misunderstanding of economics, or that they still do not believe the government can operate efficiently. Their insistence on balancing the books, and making small adjustments to the economy could cost this country dearly if they came into power.