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The mysterious case of the burnt banknote

Image credit: Wolfgang Claussen on Pixabay

According to legend, members of the Bullingdon Club would show off their wealth by burning a £50 note in front of a homeless person.

Serious economists and politicians tell us that the government must balance the books. But is the burnt banknote a simple illustration of why this is impossible?

Money for nothing

Most economists accept that, behind some smoke and mirrors, governments create the money we use every day out of nothing. They spend it, watch it circulate, collect it as tax, spend it again, collect it again and so on. We need money for anything to work, so there must be some in circulation. How much is the right amount is a question for debate, but what is not is that money is useful and that governments have a key role in its creation and cancellation. Banks also create money, but governments are the creators of last resort.

Governments can increase the amount of money in circulation at any one time by simply spending more. They can reduce it temporarily by issuing bonds, or more permanently by collecting it as tax. Balancing the books implies the government will use tax to retrieve as much money as it creates and spends: tax less and it must spend less, spend more and it must either borrow or tax more.

What destroys money?

However, tax can never recover all the money a government creates and spends if some of that money no longer exists. So how might it disappear?

The banking crisis of 2008 was caused because banks had made enormous numbers of loans that could never be repaid. After the crash, governments used quantitative easing, creating large amounts of new money to replace that which the banks had lost.

But what happened to the money the banks had lent? Should it not still exist somewhere? If it had been used to buy a property, surely the seller now had money to spend? But as far as I can see, the money is gone. So what happened to it?

Black holes and houses

Most bank loans are secured against assets, for instance houses. But the availability of mortgages creates more buyers and pushes up house prices.

Then it gets tricky. The mortgage has value because the house has value. But the house’s apparent value depends on the housing market. If demand exceeds supply because fewer houses are for sale, the price of houses rises. However, although the mortgage appears to be safer and the house appears to have greater monetary value, some of that value depends on the house not being sold. That’s because value assumes given levels of supply, demand and affordability. Should any of those variables change, so too does value.

When the house is eventually sold, the proceeds may not return to the wider economy. For this to create a black hole for money, several elements need to come together:

  • If a house is sold for less and there is no mortgage, the only harm it creates is to its seller’s bank balance.
  • Only a tiny fraction of the money held in housing or other assets is ever realised at any one time. Most of it is virtual money. It only appears to have value because it is not realised.
  • Critically, when a house or other asset is sold, the money received may never become tangible money but, after the mortgage is paid off, may simply remain virtual money, reinvested in another asset/house. This is the key part of the model.
  • Prices drop when there are more sellers than buyers, so the houses’ presumed monetary value no longer exists.
  • Some of the mortgages on those houses will default. The money no longer exists and shows as an increase in bad private debt. If you do the accounting, bad private debt is always made good with government-created money. This is the black hole.

The magic money tree

Politicians and economists agonise endlessly about public debt but ignore private debt. The UK’s private debt mountain is about four times greater than its public debt and is, I would argue, the main channel through which money disappears.

In contrast, much government spending creates working capital. When a state benefit is paid, that money is spent immediately, indirectly creating jobs and profits, then spent again as it performs its proper function and circulates in the economy. That sort of money remains in the economy: it may be recovered as tax and spent again, but it will not disappear.

The government, however, is also expected to create money to make good the money lost via bad private debt. It can’t do this and ‘balance the books’ at the same time.

Conclusions

Balancing the books, the idea behind the Tory austerity drive from 2010 onwards, is a fallacy. The government can never balance the books if some of the money it created no longer exists. Money drops out of circulation constantly as a side effect of private debt. The proper target should be to maintain an optimal amount of money in the working economy.

So private not public debt is the danger. Worse, if the government refuses to use public debt to provide essential capital, the money may have to come from even more private debt.

Ideologically driven austerity was wrong after 2010 and would be disastrous now. To kick-start the economy post-Covid, the government must put money back into circulation by increasing its direct spending. It will need a lot more than it thinks, because some unspent private money has been diverted into assets that cannot easily be realised.

Footnote: Forget the Bullingdon Club, it was recently reported that £50 billion worth of banknotes were missing. To ‘balance the books’ we would have to spend £50 billion less on public services, or raise £50 billion more in tax, to replace those notes.

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