How come the UK is so rich, and yet everything that matters is short of money? Because the stories we’ve been told about government finance and the workings of the economy are not true.
The Household Story
This is a story about government finances. It says that government spending is paid for with the tax it collects. So the government can’t spend money until it has collected enough tax.
The government puts the tax in the bank and then uses it to pay for public services, pensions and other social support.
The Household Story says that, like a household, the government can only spend as much as it can bring in. If it does overspend, it has to borrow the difference. Borrowing requires interest payments, and eventually has to be paid back, so some future tax income must be put aside for that.
This story is completely wrong, as we will see. But it’s the one that all governments are working with, so let’s stick with it for the time being. What does it mean for the government’s economic priorities?
The more people earn in total, the more tax is collected. So the government wants as many people as possible to be earning money.
The more an individual earns, the more tax they pay, and at a higher rate. So the government is keen to prioritise the activities of the highly paid.
The more that people spend, the more VAT and duty is collected. So the government wants people to spend as much money as possible.
Most tax is levied at the point when money changes hands, either when someone receives money (paying income tax and NI), or when they spend money (paying VAT and tobacco or fuel duty).
Measuring the total amount of money that changes hands in these ways is how the government works out the size of the national economy. The total of income and the total of expenditure are used to measure Gross Domestic Product, or GDP.
Both to increase the amount of tax it can collect and to increase GDP, the government wants as much money changing hands as possible.
The Transactional Story of the economy
GDP is a measure of money changing hands, but it is also used as a measure of the national production of wealth. In this story of the economy, therefore, money turnover equals wealth production. The theory is that nobody pays for something that has no value, so whatever someone pays, or is paid, must reflect the amount of wealth that has been produced.
This is the Transactional Story of how the economy works. It is a story that has guided all UK governments for the last 40 years, at least, and it says that more transactions equals more wealth. So when the current government pledges to pursue growth (i.e. more wealth production) as its main priority, it means that it wants to increase the total amount of money that changes hands - both as income and as spending.
It hopes that by doing this it will receive more in tax, which it can then spend on improving public services such as hospitals and schools.
Consequences of the Transactional Story
If the priority of the government is to ensure that as much money as possible is earned and spent, then certain consequences are likely to follow. Here are some of them:
There is no incentive to make things affordable. In particular:
Rents are likely to be high, because this means more income for landlords and more spending by tenants;
House prices are likely to be high, because this means bigger profits for landowners, developers, mortgage lenders, estate agents and others. Rising house prices also provide security for household borrowing, which increases spending;
The cost of living is likely to be higher than necessary, because the profits of large suppliers of essentials such as food and energy are loosely regulated;
Inequality is likely to increase, as money concentrates further in the hands of those who already have it. The government encourages the rich to get richer because they pay tax at a higher rate.
This creates a dilemma for the government. Having incentivised the rich to get richer it then finds that it cannot tax them as much as it needs to, in case they lose that incentive;Non-productive activities such as financial trading are likely to increase, because the government doesn’t mind how money is earned or spent. It is generally much easier to trade existing financial assets than it is to set up new, productive businesses;
The activities of earning and spending money are likely to be prioritised over other freedoms and rights, for example the right to strike or protest at government policy;
The activities of earning and spending money are likely to be prioritised over concerns for the natural environment;
The activities of earning and spending money are likely to be prioritised over concerns for people’s quality of life, their health, their leisure time, their economic security, etc. This means that regulations concerning health and safety, working hours, holiday and sickness pay, security of employment, the quality of housing, food and other consumer protections are likely to be watered down;
Little attention is likely to be paid to increasing the opportunities for people to create non-money wealth. This could mean reducing support for stay-at-home parents and other unpaid carers, or introducing financial sanctions to direct people into paid work.
This is not an exhaustive list, but it does all sound rather familiar! If you think that earning and spending money are the only ways of creating wealth in the economy, and that all activities that involve earning and spending are of equal value, then this is the direction in which government policy is bound to trend. It has been the direction of UK governments for many decades, and the current Labour government is no exception.
This is why housing is so expensive; why the rich get ever richer white increasing numbers of people struggle to make ends meet; why the traditional manufacturing heart of the economy has been ripped out, replaced by non-productive financial and business services; why rights to strike and protest have been so severely curtailed; why the state of our environment, and particularly our waterways, has been so degraded; why preventable, “life-style” diseases are rising so sharply; why mental health and personal relationships are suffering as a result of overwork and economic anxieties; why people who devote their lives to the care of family members are being sanctioned rather than supported by the benefits system.
The list goes on… The point is that all these outcomes, which are occurring before our eyes, are the direct consequence of government decisions about spending. These decisions are based on the Household Story of government finances, and the Transactional Story of how the economy works. That’s the firm belief that wealth can only be produced, and is always produced, through the turnover of money (earning and spending).
In other words - these stories of government finances and how the economy operates, stories which all politicians have worked with for many decades, do not have happy endings. They end up precisely where we are now, in a situation that is persistently getting worse. That’s because what they describe simply doesn’t work. It doesn’t have the outcomes that people generally want.
If it did have those outcomes, the UK, as the sixth richest country in the world, would be a paradise of prosperity rather than a showcase for substandard housing, foodbanks, potholed roads, ever-growing prisoner numbers, a sickening population and effluent-filled waterways.
Are there better stories?
If those are the stories so far, might there be better stories with happier endings? Is there a way of thinking about, discussing and ultimately managing the economy and the government’s finances that does have good outcomes for all, or nearly all, of a nation’s people?
The answer is: yes, there is another story, one which not only has better outcomes and a happier ending, but which, by combining the story of government finances with the story of how the economy works, offers a properly joined-up picture of how government decision-making is linked to the creation of wealth. And, not surprisingly, it all starts with money.
The Flow Story
Those old stories of the economy don't talk much about where money comes from. For the purposes of the Household Story and the Transactional Story it is just there.They talk a lot about businesses and industrious individuals “making money” (which can be taxed); and a lot about public services such as health and education “costing money” because they are paid for with taxation. But on the origin of money itself those stories are generally silent.
In the Flow story of the economy, however, the origin of money is the essential starting point. It’s a starting point that turns the Household Story on its head, because the origin of all money is the government!
The government prints banknotes; the government presses metal into coins. This cash amounts to about 4% of all money in the UK economy. But the government also creates electronic money - the money that flits from one bank account to another electronically without the need for cash to change hands. Some of this it creates directly, and some it is created by banks with the government’s permission. That’s the other 96% of money.
So the government doesn’t need to collect tax in order to spend money. It can create any amount of money that it wants.
That’s the starting point, but it is only a starting point. The government can’t solve all our problems by just creating and spending endless sums of money. That would cause rampant inflation. The money would just lose value.
So the story of money is a story of flow, where money enters and leaves the economy in a ceaseless rhythm. Think of the economy as breathing money in and out, like a person's lungs. The money is breathed in; some of it does useful things; then the rest is breathed out so that more can be breathed in.
Like air in a person’s lungs, the economy can only hold so much money at a given time. When it is working really hard (times of maximum activity) it can hold more money, just as an athlete's lungs can hold more air. At quieter times it breathes less deeply, so less is taken in.
The right amount of money
Money goes into the economy partly through government spending and partly through lending by commercial banks. That's because the government permits the banks to lend far more money that they actually have. Money then comes out of the economy through taxation and the repayment of bank loans, among other ways.
So what is the right amount of money for the economy to contain?
This is where another big difference between the old stories and the Flow story of the economy starts to appear.
In the old stories, the purpose of work is to “make money”. People who already have money can invest it to “make” more money; other people work in order to “make money” to live off.
So the question of how much money should be in the economy does not really feature in the old stories. It just contains all the money that people and businesses “make”.
Although it is common to talk about work and business as “making” money, in reality, no one is actually making money apart from the government. People and businesses are accumulating money that has been put into the economy. Work doesn’t make money; it’s money that makes work possible.
Take, for example, a doctor. They might say, colloquially, that they are making money out of being a doctor, by which they mean that they are making their living. But they would never say that the output of their work is money. They would say that the output of their work is making sick people better. It is the money that is paid to them that makes this work possible (because it means they are not obliged to make their living (getting food, shelter, etc.) another way.
That's true of all sorts of making and doing activities, from haircutting and teaching to manufacturing, farming and film-making. In all these activities the output is something inherently useful, such as a table, or a loaf of bread, or a film, or a haircut. Applying money to the activity to buy materials and equipment, and to allow people the means to live, is what makes the output possible.
The correct amount of money in the economy, therefore, is the amount necessary to keep everybody busy with productive activity of this sort. This includes unpaid activity, which is often among the most productive work we do. A parent cannot cook a meal for their family if they do not have access to money to pay for ingredients and fuel.
In the Flow Story of money, therefore, the government should introduce money into the economy, via spending and lending, wherever it can be put to the most productive use, and it should take money out of the economy, via tax and in other ways, wherever it is not being used productively.
What is productive?
Government spending is not dependent on tax or borrowing, but on the amount of money that can safely be introduced to encourage useful production. Too much money will cause inflation; not enough money will leave people unable to make the best use of their productive skills. Where money is not being used productively it should be taxed, in order to make more money available for productive activity.
This approach raises a few questions:
What sort of activity is productive, and how can money be directed towards it?
What sort of activity is unproductive, and how can money be removed from it?
How can we change the way the economy is measured, to take account of productive and unproductive activity?
Deciding what economic activity is productive and what is not productive is easy in the Transactional Story of how the economy works.
All activity that someone is prepared to pay for is obviously productive (because it creates value that someone wants). Activity that is not paid for is considered not to be productive. This explains why the size of the economy (GDP) is measured only with reference to paid activity.
This, however, leads to some outcomes that are hard to explain.
How come the work of a parent preparing a healthy meal for their children is considered to have no value, while the work of producing a much less healthy meal in a fast food restaurant is considered to have value just because it is paid?
Similarly, how come activity that merely makes someone richer at the expense of another counts as productive, when all it has done is to transfer value from one to the other without adding anything new?
To address these issues the Flow Story of the economy uses a different definition of what is, and is not, productive.
All activity (whether paid or unpaid) that creates value that did not previously exist can be considered productive. Activity that only moves value from one person to another without creating anything new of value should be considered unproductive.
An example: housing
A good example of this can be found in the housing market.
When someone builds a house they are clearly creating something of value that didn’t previously exist. The work of building is what gives the house its value.
When the house is sold, however, a big chunk of the price will go not on that building value but on the land that it is built on. Probably somewhere between 30 and 70 per cent of the house sale price is paid for the land. That land did previously exist. It has not been created through someone’s work.
When house prices rise, as they tend to do, the house itself stays much the same, so the increase in price is mostly attributable to the increase in the price of the land.
In other words, a lot of money in the economy is going straight into the rising price of building land. The beneficiaries of this are landowners, developers, land agents, a host of other intermediaries and advisors and, of course, the banks and mortgage companies whom people have to pay for the loans for their homes.
The process of turning an acre of agricultural land (price maybe £10,000) into an acre of building land (price maybe £1,000,000) does not add anything real or productive in economic terms. The piece of land is, after all, still the same piece of land. But a million pounds’ worth, more or less, of potentially productive activity has been lost in the process. Instead of using that money to create something new, it has simply been transferred through the mortgage payments of homebuyers to landowners, bankers and various intermediaries.
To complete this picture, consider what would happen if the land price had stayed at £10,000. Either the houses would have been bigger and nicer (new homes in the UK are typically among the most cramped in the rich countries of the world) or people’s mortgage payments would have been a lot lower.
Bigger and nicer houses add real value by improving people’s quality of life. Lower mortgage payments free up money that people can use to create real value in their lives in all sorts of ways.
We all pay for everything
Some people may ask: What about all those jobs - the developers, the intermediaries, the agents, the bankers, the landowners themselves, and all their respective staff. If they get a share in that million pounds, isn’t that a good thing?
The first point to make is this: isn’t there something more useful they could be doing? After all, creating real economic wealth requires people to do productive things, and if they are too busy accumulating the value produced by others then they won’t have time to be productive.
So what! you might say. That’s their choice. But the crucial point is that we are all paying for that. When it comes to all the activity in the economy, we all pay for everything. So it seems reasonable to ask what we are paying for, and it is what we really want to prioritise?
We know that we pay for an NHS doctor through our taxes, but do we know that we pay for a financial trader through our purchases? To see how this works, think of a loaf of bread. We know, when we buy it, that we are paying for the baker and the miller and the farmer and the various lorry drivers that connect them. But what about the lorry driver’s insurance broker? Or the insurance broker’s rent, or mortgage payments?
Ultimately, the money we pay for that loaf of bread filters right through the economy, with a big slice of it ending up in the hands of financial intermediaries in places like the City of London. And an even bigger slice ends up in the property market - those soaring house prices.
According to the old stories, commercial activity “makes” money, while social activity (such as the NHS) costs money. In the Flow Story, however, that difference disappears. All economic activity requires money input, whether it is financial trading or medicine. That money input reflects the willingness of other people in the economic system (or society) to “pay” for those activities with their own work.
Most people will willingly pay for doctors and nurses; but will they so willingly pay for financial traders? What, collectively, do people gain from that activity? Somebody gains, for sure, but whatever gains they make, other people in the economy are paying for. So there is a movement of money but no overall gain in real value.
And then some people say - what about all the tax that these successful financial traders are paying. It is true that people working in financial services pay a lot of tax, but the tax they pay is only a small proportion of the money they are given. If the government allows or directs a vast sum to be used for these non-productive activities, and then takes back, say, only a third of it in tax, who is winning?
The government is in charge. It just doesn’t know it.
This brings the story of money right back to where it belongs, which is with the government. In the Household Story of the economy, the government typically acts as if money is nothing to do with them - they only have what they can collect as tax, or can borrow. In reality, however, the government has no money at all because any money it receives is immediately destroyed or cancelled. The government doesn’t need to own money, because whatever it needs it creates (or, strictly speaking, tells the Bank of England to create).
That’s all simple enough: the government creates the money it needs for its own essential spending. What complicates matters, however, is that it also sub-contracts the creation of money to privately-owned commercial banks, allowing them to make loans with money that they don’t have. When a bank lends money, that money is created anew; when the loan is repaid the money is cancelled or destroyed.
The decisions about where these loans go is made by the banks themselves. The government doesn’t get involved. And because banks get the interest on this money they’ve created, they naturally look to lend the money where there is greatest security and the greatest profit is to be had. This explains why so much money ends up in the financial and property markets - because that’s where banks put it.
Since the banks are creating money on behalf of the government, it would not be complicated to regulate that behaviour, in order to direct new money towards productive activity. Instead, the government has surrendered control over where that new money goes, and whether that serves their political and social objectives.
Flipping the narrative - changing from an Extractive to a Flow economy
In the 1980s Margaret Thatcher promoted the Household Story, subtly merging the language of domestic budgeting and government spending. More recently, this has led to people to accept circumstances they might otherwise not have tolerated. While some have got rich, many have seen their household incomes stagnating or declining. That’s quite normal, the narrative suggests. If my own circumstances are getting worse, it’s hardly surprising that the government’s finances are deteriorating, too. We are all in this together, the story goes.
We can now see that the Household Story, and the Transactional Story that was told alongside it, are bothl about the accumulation of money, or money-based assets. In the Thatcher narrative of a property and share-owning society, that is what households were expected to do. The problem, of course, is that not every household can do that. With everybody trying to accumulate, or to extract money from the economy, there could never be enough money to go round. And the money that there was would inevitably gravitate towards the richest households.
That’s inevitable, because extracting money is much, much easier if you have money in the first place. And so it has proved. As typical wages (allowing for inflation) have barely increased in the past few decades, those money based assets have increased enormously, and have found their way into fewer and fewer hands.
If we stick with the old stories, then we are stuck with the old (and present) consequences. Money continues to be extracted by the rich. The rest of us, and our public services, have less and less with which to produce the real wealth that will sustain the quality of our lives.
A Flow economy is the answer to that, and the Flow Story describes what that looks like. Money is the rain that falls on the vegetable patch: not too much, not too little, but in the right place at the right time to give productive growth its best possible chance. And what is left over finds its way back into the atmosphere, to fall again and stimulate growth elsewhere at another time.