How governments finance their spending (and its not from taxation).

Readers of this blog may know that Patrick Allen, founder of the Progressive Economy Forum (PEF) invited me to become a member of its distinguished Council in July this year. Other members include Professors John Weeks, Joseph Stiglitz, Stephany Griffiths-Jones, Robert Skidelsky, Daniela Gabor, Danny Darling, Ha Joon Chang and Doctors Johnna Montgomery, Geoff Tily, Will Hutton and Guy Standing. I am now supporting the work of the Council, and periodically writing for the Forum.  The following is a blog that appeared on the PEF website on 8 October, 2018.

PEF Council member Ann Pettifor explains how all governments finance their spending (and its not from taxation). She deconstructs Theresa May’s address to the Conservative Party Conference with its deliberate framing of Labour governments as tax raiders.

The use of the phrase “other people’s money” in Theresa May’s conference speech was not accidental. It was first used in the title of a famous work (1973) by Donald R. Cressy about the social psychology of embezzlement. The book was later made into a movie about a corrupt corporate raider, and starred Danny de Vito and Gregory Peck. Mrs May’s speechwriter wanted to imply that Labour governments are tax raiders.

That is both a calumny, but also a lie – twice over. First because no Labour government has ever run out of money – not even Clement Attlee’s which started life with public debt at 250% of national income, and then spent enormous sums creating the NHS, affordable housing, a public education system etc. As a result of that spending, public debt as a share of GDP fell precipitously, because the Labour government increased the nation’s income, through well-paid employment. Good, well-paid employment in turn generated tax revenues – to pay for the borrowing, and pay down the public debt.

Second, no government – including today’s Conservative government – finances spending from taxation. Instead governments finance spending by borrowing from their own Bank, the Bank of England, or from capital markets. If that borrowing creates employment and increases income, then tax revenues accrue to HMRC, and is used to pay for the borrowing. To keep the public finances balanced at a time of private economic failure, it is vital for government to borrow and spend, to expand the nation’s income and thereby to generate the tax revenues needed to repay the borrowing, and keep the public finances in order.

Mrs May intended to imply that a Labour government is likely to finance its activities differently – by increasing taxes and thereby ‘raiding’ or embezzling the purses of Britain’s taxpayers.

Let me illustrate why this is a false characterisation of government financing. An email popped into my inbox on 4 October – the day after Mrs May’s speech. It was from the Debt Management Office (DMO) of the British government. It informed me that on behalf of Philip Hammond the Chancellor, the DMO had the previous day held an auction of a precious government asset: the 1% Treasury Gilt 2024. In other words, on behalf of the British Treasury, the DMO had auctioned and then raised £3 billion from the sale of a government asset – a bond or gilt – from capital markets. The purpose of this sale was to finance the spending and activities of Mrs May’s government.

Many of the bidders for gilts would have been pension funds, but also insurance companies and other financial institutions. They all regard Treasury gilts as a very important safe haven for their financial holdings. So keen are they to buy British gilts that the auction was over-bid – 1.73 times over, the DMO tells me. Investors were willing to hand over £5 billion when the DMO, on behalf of the British government, only wished to raise £3 billion. As a result of this over-bidding, the interest rate on the gilt was very low – 1.3%. Given that inflation is 2.4%, the interest government will pay is negative. In other words, investors are effectively paying the DMO for the privilege of lending to the British government and parking their assets/savings in a safe British Treasury Gilt.

The Bank of England (via its Open Market Operations) has also purchased gilts, including those issued by George Osborne and Philip Hammond. It has done so for many years as a way of influencing the Bank Rate of interest.

And there is one other minor, but important point to make about the DMO’s auction. Given that most Treasury Gilts are bought by pension funds and insurance companies, the interest (yield) on the gilts serve as a source of income for the pension or insurance fund, maintaining its value until claims are made on the funds. Ultimately that income is returned to British taxpayers when pensions are paid out or insurance claimed. So, in a circular process, the money paid in interest by the British government for its borrowing ultimately returns to taxpayers when they claim their pensions.

That is why government bonds or Treasury Gilts are a vital part of the ‘plumbing’ of the private financial system.

This is all by way of explaining that governments like ours finance their activities, not from “your money” – i.e. taxation, but by auctioning valuable government assets – gilts or bonds in capital markets. In other words, by borrowing. That is how this government’s expensive HS2 project, estimated to cost £56 billion (up 71% on the initial projection in 2010 of £32.7 billion) will be financed. That is how £1,000 billion was found in 2009 to bailout the banking system. That is how £1 billion was raised to bribe the DUP into supporting the government.

And even at the greatest times of crisis – such as the 2007-9 Great Financial Crisis – the government assisted by the Bank of England was able to raise huge sums to finance the bailout of RBS and the rest of the banking system.

The key point is that financing for investment (via borrowing) comes first, and taxation later. Taxation – “your money” – as we all know from our own experience, is a consequence of public or private investment in employment or of other forms of activity. We take a job, and only at the end of the month, and as a consequence of our employment, are we paid, and only then are taxes deducted. Similarly it is only after the production and sale of a good or service, can VAT be charged. Only after profits are made, can corporation tax be paid. And so on.

All governments including your own Mrs May, borrow to finance their activities. Which is why the Debt Management Office yesterday raised £3 billion to finance activities sanctioned by your Chancellor, Philip Hammond. The process is as old as the Bank of England (1694) itself, and is both legitimate and transparent.

And as is obvious to all, Philip Hammond bears no resemblance whatsoever to embezzlers like the character depicted by Danny de Vito in that movie.

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