Sunday, 29 May 2011

Vampire City

I was asked some time ago to write a blog explaining how government debt works, who owns it and who pays interest on it.  Well, better folk than me have written on this subject, and I've listed a few of their contributions below.  But the more I look the relationship between the financial sector, the Government and ordinary people, the more I am struck by the way in which the financial sector acts like a sponge, draining real money from the economy and replacing it with debt.  Or perhaps more like a parasite, some kind of giant leech sucking the lifeblood out of Western economies. 

There are two ways in which this happens.  The first was the subject of one of my previous posts, The Great Savings Fallacy.  In this I argue that when people save by placing their money in pensions, long-term savings accounts or bank deposit accounts, most of this money is removed from the economy and is not available for investment. Additionally, much of this money is eligible for tax relief, so there is a net loss of tax income arising directly from savings. So if people follow government's advice and save instead of spending, tax income reduces and the economy shrinks. It's madness. Why does government want them to do this?

The government believes that a strong and vibrant financial sector benefits the UK economy, and therefore wants people to provide funds in the form of savings to financial institutions. Why? Will the loss of tax revenues and investment opportunities be offset by tax revenues from the financial sector and deferred spending and taxation when savers receive their pensions and draw out their money?  I don't think so.

First, let's consider the matter of deferred spending and taxation. Deferred benefits are undermined by inflation, so the value of deferred spending and tax receipts should be discounted by the anticipated inflation rate over the period of the investment.  RPI for the year to April 2010 was 4.6% and ten-year returns on pensions currently around 5.2%.  Pathetic, frankly.  Admittedly, the government's RPI target is quite a bit lower, at 2%, so a more optimistic view could discount at maybe 3%.  So real pension returns might be around 2%. Hardly spectacular, is it?  Evidently, the up-front cost in terms of loss of tax income and investment opportunity won't be recovered by this route. 

Will economic benefit therefore arise solely from taxation receipts from the financial sector? Well, the financial sector employs a lot of people and pays some of them very highly, so the Government clearly benefits from income and NI receipts from these people. Additionally, financial institutions pay corporation tax at the large company rate, and as financial transactions are exempt from VAT they are unable to recover VAT on, for example, purchases of fixed assets. But the real tax income received from these institutions is much less than might be expected.  Much has been made of the low tax rate paid by companies such as Barclays when writing down losses.  But a much bigger issue, which has been extensively written about by Richard Murphy and Nicholas Shaxson among others, is the "hiding" of company profits in offshore jurisdictions to avoid tax.  The headline corporation tax that these companies pay might be 24%.  But if they manage to hide large amounts of their profits in low-tax jurisdictions, the actual rate paid on their total profits is much less. There is some evidence that reducing the corporation tax rate reduces the incentive for large companies to pay accountants to find clever ways of avoiding tax, and reducing corporation tax rates can attract businesses to set up in the UK. Hence the Government's strategy of reducing corporation taxes and offering tax breaks to companies. Some tax is better than no tax, it would seem.

But the opportunity cost of loss of savings from the economy is HUGE - much larger than any potential gain from taxation in the financial sector. Clearly taxation alone is not sufficient to explain the government's belief that savings are essential.  The government, like many people, confuses savings with investment - in fact the terms are used interchangeably.  Now, if savings were actually used to finance investment in the UK economy, this confusion would be immaterial.  But the fact is that savings do not finance investment in the UK economy.  They are traded on the international financial markets, where they simply change from one type of paper money to another without ever being used to finance the production of real goods and services.  A small amount of the profits generated through this money transformation process does go back to the saver in the form of interest, which is eventually taxable.  But the vast majority of those profits go to line the pockets of pension and hedge fund managers. Meanwhile the UK government has to borrow to finance investment programmes.  Who does it borrow from?

When the UK government borrows, it issues government debt securities - known as gilts because the pieces of paper that represent this debt are traditionally edged with gold, or "gilt-edged".  Gilts are traded on the international capital markets, where they are regarded as a virtually risk-free form of saving.  Financial investors looking for a safe place to put their money buy up gilts.  The heaviest purchasers of gilts are pension funds, followed - since the financial crash - by banks. So the people of the UK do indirectly lend to the government  through their pension savings and their investment in UK banks. However, only new issues of government debt actually finance investment. Purchases and sales of gilts on secondary financial markets - which is the way in which gilts are most frequently traded - only benefit traders.

So pension savings, unless they are invested in new debt issues which are held to maturity, don't benefit the UK economy.  What's more, the government actually pays much of the return on pension savings.  It works like this.  People put their savings in pension funds and other such vehicles, which use that money to buy gilts together with private sector securities such as corporate bonds and equities (including bonds and shares issued by banks). The government pays interest on gilts, which provides a small return to the pension saver and a much larger one to pension fund managers....but hang on.  That pension saver is presumably also paying income tax and NI, which the government uses to pay the interest on the government bonds. As an example, yield on ten-year gilts is currently about 3.5% - not great, but certainly better than the average return on a pension investment (note the yield calculation takes the time value of money into account, so there's no need to discount the rate). The pension saver pays no income tax or NI on money invested in pensions.  But because of the difference between the interest rate on gilts (which is in effect paid by the pension saver through the tax on the rest of their income) and the long-term return on pension investments, the pension saver is in effect paying a small amount of tax on the portion of their savings that is invested in gilts - which may be most of the investment (see example here).  The return on those savings is therefore only the difference between the income tax and NI foregone and the notional tax paid. The pension fund might as well have invested in moon cheese.  The saver would have done better to make no pension provision at all, pay tax and NI on ALL their income and spend the remaining money on goods and services that benefit the economy. And the government, overall, has LOST tax income.  The only people who have benefited are the pension fund managers.  In effect, money has been drawn out of people's pockets and into the City. Some comes back as taxation and consumer spending, of course, but most of it is reinvested on the international financial markets or stashed away in Jersey, Isle of Man, Cayman, Switzerland, Bermuda.....

Have I made sense so far? Pour yourself a stiff drink. The worst is yet to come.

Here's the second way in which the financial sector sucks money from the economy. To explain this I need to talk about the way in which fractional reserve banking creates new money.

When a bank lends to a customer, it doesn't have to have physically available the money it is lending at the time the loan is granted.  It only has to have physical funds for settlement when the loan is drawn down, and it can of course borrow these funds from other banks. Readers of my blog The foundation of short selling will recognise this as a short selling strategy - you sell something you don't physically have and cover settlement by borrowing.  Bank lending in the 21st century is the largest short selling scheme in the world.

When a bank loan is sold short and not physically settled, the accounting entries for it create new money.  This is because banks lend using deposits as collateral.  When a loan account is created, the bank also creates a matching deposit for the amount of the loan - usually by making an electronic entry for the amount of the loan in the customer's current account. This entry enables the customer to draw down the loan.  However, the bank then uses this deposit (which it has created by lending, not by actually receiving a customer deposit) as collateral against other lending.  The effect is that the amount of "money" in the economy as a whole is inflated.  The problem, as I'm sure you have realised, is that this money is not real.  It is not the product of real economic activity but a consequence of the way in which bank loans are recorded. When the bank loan is paid back, the deposit disappears as well and the economy shrinks by the amount of the loan.

So how does this activity suck money out of the economy? The problem, of course, is the physical settlement of loans. The idea behind bank lending was originallly that banks accepted real customer deposits and lent that money out in the form of bank loans - this is known as financial intermediation. But when banks create loans out of thin air ("credit creation") those loans have to be funded too, even though the banks don't have  real deposits to support them. As long as banks can borrow from each other, and especially from the investment banking sector, which tends to be savings-rich, there is no problem funding these loans.  This, of course, is the real reason why government is so keen for people to save. Investment banks, pension funds and other such financial institutions need a good supply of funds, because they provide liquidity to the interbank lending markets. Highly liquid interbank lending markets are essential to support bank lending.

But if the interbank lending markets dry up, banks turn to central banks for support - i.e. to government. This is what happened after the failure of Lehmann Brothers in 2008. The banks stopped lending to each other and instead tapped central bank reserves for funds. These funds were (and still are)  provided by taxpayers.  Billions of pounds, dollars and euros were pumped into the banks to support their loan settlements.  The banks are not able to pay this money back because the money never existed in the first place.  The deposits they used as collateral weren't real.  But the money provided to them by taxpayers was real money, generated by tax income from real economic activity. So the banks have sucked real money out of the economy and replaced it with huge amounts of sovereign debt.  All major Western economies now have debt problems as a result of the massive collapse of bank lending in the last four years.  In effect, the imaginary deposits have now been replaced with real ones by government, leaving government with debt.

Now, just to recap - who buys government debt? Financial institutions do....pension funds, hedge funds and banks. Yes, that's right - banks. The government borrows from banks in order to replace the (real) money they provide to banks to replace the (imaginary) money that banks create through bank lending.  The more money banks lend, the more goverment has to provide to support them and the more it therefore has to borrow from them. At present the government is actively encouraging banks to buy gilts so that they have a buffer of risk-free liquid assets that they can use to fund depositors' withdrawals without having to tap central bank reserves.   But the government pays interest on the money it borrows from banks.  So taxpayers pay interest to banks both directly on bank loans and indirectly through their taxes.

And the final straw is.....too much government debt, and financial institutions start to get worried. Well, any sensible parasite would be concerned if its host looked a bit worn. After all, the survival of the parasite depends on a healthy host.  So supra-government institutions such as the IMF, whose sole purpose is to ensure the survival of the international financial system, insist that governments inflict austerity measures on their citizens to reduce government debt levels.  Debt levels that are sky-high not because governments have overspent, but because banks have conjured into existence far more money than has been produced through real economic activity and have then dumped that difference on government.  And governments so far have preferred to cut the wages, benefits and living standards of their own people to the bone rather than face down the financial institutions who have sucked them dry.

Welcome to Vampire City.


Further reading:
Pub Philosopher:           State debt - a giant PFI scheme                
Sturdyblog:                   To whom do we owe this money, exactly? 
                                    THE ANSWER (To whom do we owe this money, exactly?)
Stumbling & Mumbling: Against the rally against debt


  1. This is certainly clear which neither means that I understand it, certainly not that I could repeat or translate it, nor question it. Where is it controversial - in the sense that it could be argued? Or would anyone attempting such an analysis have to agree?

    Thanks for setting it out. I'm only commenting so you have some feedback for such a worthwhile piece of work and in order that others may begin to debate...

  2. I agree with Jeffrey...why isn't government, as taxpayer representatives, dropping bombs on the vampires?