Where does the money come from?

Where does the money come from?

Keith Rankin, 2 February 2011

On a number of occasions since his state of the nation speech promising to make the first $5,000 of earnings tax free, Phil Goff has been asked "Where will the money come from?", and as always it's a hard question for a politician to answer, and an easy score for a TV or radio journalist (eg TVNZ Breakfast, 1 February 2011). [see Bill English press release on Scoop]

For young children there are two difficult questions: "How are babies made?" and "Where does money come from?" We've become relatively comfortable about talking with children about sex, but have made very little progress on the money front.

Money is simply a circulating medium; a lubricant for market transactions. It circulates through buying/selling, and through lending/borrowing. Transactions are subject to taxation, enabling governments to buy goods and services with from money revenue.

If increasing numbers of people choose to park all or some of their savings as money, then the circulation of money becomes compromised (a kind of financial arteriosclerosis) and we need an increased supply of money to compensate. Fortunately modern money is very elastic; it can be created and destroyed at the will of the appropriate authorities, through processes of double-entry bookkeeping. Yes we do have pixies in the back garden; they are called central bankers. Unfortunately, if newly created money is parked - rather than spent - then the market economy remains congested. Money is only meaningful as money when it is circulating freely.

By suggesting we should remove income tax from the first $5,000 of each person's earnings, Phil Goff is suggesting a policy that will facilitate the circulation of money. Money is easy for central bankers to create, but can be hard to shift. Our incomes - and the government's revenue in particular - depend on the circulation of money.

The question "Where will the money come from?" is, in this case, code for: "How can you reduce taxes when your current tax revenue is insufficient to meet your present spending commitments"?

The answer for the present is, for every lender there must be a borrower. People cannot save more - ie lend more - in the absence of accommodating borrowers. When households and firms are borrowing less and lending more, then governments are required to borrow more. For every lender, there must be a borrower; for every party who sells more than they buy (creditor party), there must be another party (debtor party) who buys more than they sell.

Economic growth takes place, in large part, when business firms borrow and invest. (Note that it is borrowers, not lenders, who 'invest'. True investors are spenders, not savers; commonly they spend the savings of others). As a result of their investments, firms take risks with the expectation of increasing their future revenues, servicing their debts and making more profits.

Good governments also borrow and invest. To recover from a recession, they invest by implementing policies that facilitate the circulation of money. As a result of the success of such policies, tax revenues (which are determined in large part by the rate of circulation of money) increase.

If governments cut spending (or raise tax rates) at a time when the private sector is not increasing its spending (even worse if the private sector is reducing its spending), then less money circulates, economies contract, and government revenues end up falling; the exact opposite of what the governments intended when they cut their spending.

Conversely, when economies have substantial unemployed resources (as they do when in recession), if governments raise their own spending (or reduce bottom tax rates), then more money circulates, economies recover and eventually expand. Government revenues end up rising; the exact opposite of what the pundits said would happen when governments reduced bottom tax rates. When, in a recession, governments increasingly borrow and circulate money, then, as that policy takes effect, rising government revenues lead to deficits that are smaller than they otherwise would be.

It's a paradox. In a recession, increased government deficits lead, in a year or so, to reduced government deficits. Government retrenchment, on the other hand, leads to increased government deficits.

The loudest voices in our financial and economic debates are too often ill-informed, espousing mantra rather than logic. The mantra that people should save more and borrow less makes no logical sense. Likewise it makes no sense to claim that governments should spend less at times when private households and firms are also spending less.

ENDS