A short guide to why there isn’t a useful Magic Money Tree

Simon Carr at the Oldie, among others, seems mystified as to why we can have quantitative easing – which appears to be a magic money tree – and yet not a magic money tree to pay for everything that John McDonnell wants to buy to bribe the electorate. Another way of putting this question is, well then, why won’t Corbynomics, or Peoples’ Quantitative Easing (to use Richard Murphy’s name for this) work then?

One answer being that Richard Murphy is a retired accountant from Wandsworth not an economist. That seems to be insufficient reasoning to some even though McDonnell himself has been distinctly less than complimentary about Murphy’s economic knowledge.

Another possible answer is that this is important so you’d better go find out Carr. After all, as you say, an election could hinge upon this and in a democracy it’s the voters who have to get up to speed on this stuff. It’s our job to understand who is lying to us and who is not. You know, we’re the citizenry making the decision and all that.

At which point, the economics of this in baby steps.

The Magic Money Tree is the idea that the government can just print lots of money and then go and spend it. There’s no financial constraint upon government that is. They don’t have to worry about taxes to fund buying lots of lovely things for us voters. They just get the Bank of England to print more and then everything, but everything, can just be paid for. This is also the central claim of Modern Monetary Theory.

It’s correct. Government can do this. Many governments have done this. Henry VIII did it in Britain. OK, he did it in a slightly different way but it was indeed the same thing, he debased the silver coinage. Which is indeed the same thing, add 50% copper to the silver and you’ve twice as much money which government can then spend. His children spent much of their reigns trying to deal with the effects.

The effect being inflation of course. More money around did not increase the number of things around which could be bought. More shillings and the same number of things just meant that each thing cost more shillings. Inflation in short.

(Interlude – do note that central banks do increase the amount of money around each year. But they only increase it by the amount of more things there are around as well. A growing economy needs more money in exactly the same way that as a restaurant gets busier it needs more plates to put the food upon. But that growth in money should be at the speed the economy is growing itself, no faster)

At around and about the same time Spain also did much the same thing. All that gold and sliver from Latin America flowed into Spain. Spain didn’t have any more land, sheep, people, or anything else as a result, just more gold and silver. Thus prices rose in relation to that more abundant gold and silver. This inflation flowed across Europe.

Other historical episodes include the Weimar inflation, the Hungarian Pengo and in more recent times Zimbabwe – where they kept printing money until the last run of hundred trillion $ bills weren’t worth enough to buy the ink for the next run – and Venezuela.

Government can therefore just print money and go and spend it. This has an effect. Inflation.

Another name for this in the technical jargon is monetisation of fiscal policy. There’s a reason why it’s banned (yes, banned) under the eurozone rules. For we’ve a number of countries and governments all of which share the same currency. Any one of them could print more euros and go and spend them. This would be great for that specific country. They’d get to spend lots without having to tax. But the inflation would be carried by all the countries in the currency bloc, not just the one doing the printing. The incentive therefore would be for everyone to do as much as they could before anyone else did.

This is what actually happened after the break up of the Soviet Union. Each new country had a printing press which produced entirely legal rubles. So they all printed masses and whoo!, didn’t they all have inflation?

So, just printing more money leads to inflation. The more money printed the more the inflation is.

The Modern Monetary Theory answer to this is taxes. If you print lots of money to spend and then spend it then you can tax that extra money back. Which indeed you can. And look what happens then.

You’ve a high spending government which is taxing lots. The end result here is just Old Labour again, high taxes, high spending. More of the economy flows through government and we’re not anywhere different from when Healey was squeaking pips.

The basic idea just isn’t new. The results are predictable – and the way politics works no one will ever tax enough to stop the inflation. Spending is fun, taxing not so much. Which is why it always has led to inflation on a roaring scale.

So what about this quantitative easing then? This is just the same isn’t it? The Bank of England has just invented money and gone out and spent it, hasn’t it?

Yes, but with three little caveats.

The first is that we wanted to create inflation, which we did, so that’s good.

The second is that the BoE didn’t spend it, it’s just sloshing around the markets instead.

The third is that it’s reversible. And if we don’t reverse it then the inflation will come in a roar.

Baby steps, baby steps……but we have several different kinds of money. Various names, base and wide money, or the jargon of M0, M1, M4 and so on, or low powered and high powered, or if you prefer actual money and then credit. M4 is credit, wide money, low powered money, largely, M0 is base, high powered or even just money money.

You’ll have seen the claim around that 95% of all money is just created by the banks when they make a loan. Sorta, ish-ish, true. 95% of credit, or wide money, or low powered money, is created by the banks. 100% of narrow, high powered, money is created by the Bank of England.

The Bank of England creates notes and coins, that M0, (yes, it gets more complex but baby steps). Then we all go and use it, spend it, save, it, stick it in banks, borrow it, lend it, all sorts of things, and the net result of all of this is that wide money measure, M4. The difference between the two is the money multiplier or, in the jargon, V, the velocity of circulation (yes, I know but look, baby steps).

This difference is significant. Before QE the UK’s M0 was of the order of £50 billion. M4 was a couple of £trillion. Not the right numbers but about right, in magnitude at least.

After QE M0 is about £450 billion, M4 is still a couple of trillion.

Note that inflation is determined by M4, not M0. M4 hasn’t grown which is why we’ve not got massive inflation as a result of QE. So, why haven’t we?

Because our entire problem was that V, that velocity of circulation, or the amount of stuff that we did with the money the BoE was creating, fell massively as a result of the financial crisis. This is the central economic analysis of what happened by the way, which is why all the central banks did go and do this QE. And if that V falls, and we’ve the same amount of M0 around, then M4 will fall – and that’s the opposite of inflation, that’s deflation. What happened in the 1930s turning a nasty recession into the Great Depression (yes,that is now the standard analysis, Milton Friedman was right here). So, we print lots of M0, that’s the BoE inventing money in the basement, and we don’t get inflation. which is what actually happened. Great.

But what happens when V recovers? When we all start to borrow and save and move money around like we used to? That old relationship between M0 and M4 will revive and thus M4 will soar (we’ve 10x as much M0 as we used to) and so will inflation.

Which is where the difference between QE and magic money tree is. The BoE quite deliberately did not spend that new money into the real economy. It was used to buy bonds, mostly Treasuries. This lowered interest rates, a little bit, which is nice. But the big thing is that when (OK, if) we get back to normal now we can reverse things. We can sell those bonds, collect that money we created earlier, feed it back into the computers in the basement and cancel it. We thus bring down M0 but not M4 (recall, we think our multiplier between these two is recovering) and thus have we avoided deflation for a time but without creating inflation for the long term. Note that the Federal Reserve, just last week, announced the schedule it will use to do this. There is no mystery to what I am saying, this really is how this system works.

Magic money would be spent into that real economy. We cannot get it back again when inflation starts to arrive. Well, we can, but only at the price of extortionate tax levels. Which, as above, means that using the magic money tree to really spend just means higher taxes a la Old Labour. Not so magic, hunh?

At which point, the difference between quantitative easing and the magic money tree. QE is temporary, reversible, and is a tactic of last resort to prevent deflation and thus a depression. It works but it must, at some point, be reversed. If it isn’t reversed it will cause significant inflation. Two and three digits a year sort of inflation.

The magic money tree is permanent spending of the same invented money, it is not temporary – the effects are permanent – and it is not reversible without stinging tax rates. It is also known as the monetisation of fiscal policy, or the monetisation of spending. And it has everywhere and everywhen been a disaster from the point of view of subsequent inflation. Not inflation of a couple of percent here and there either, but of two and three digits a year sort of inflation.

That is, the effects of just making more money are the same either way, in the end at least. But QE can be reversed to stop it, the magic money tree cannot.

For the end effect of the magic money tree see the Hungarian Pengo.

And now to British politics. John McDonnell’s going to stop spending all that newly invented money to stop the inflation that’s going to arrive in 18 months time. Isn’t he?

34 comments on “A short guide to why there isn’t a useful Magic Money Tree

  1. Other point: the usual sort of taxes aren’t designed to curb inflation and don’t do a very good job of it. Putting up taxes on high earners, for example, likely does very little to inflation (given their propensity to save rather than spend). Hence, whilst the MMT people never get into this, the likely result of their proposals is heavy taxes on low/middle earners.

  2. The money supply doesn’t need to grow just because output grows. Prices can fall if money supply remains constant; as the demand for money increase people will exchange more goods for each unit of money. Since we won’t run out of decimal places in accounting ledgers I don’t see much problem with a fixed money supply and falling prices (due to output growth). I appreciate holders of nominal debt would be unhappy with this.

  3. That is, by definition, deflation, which as a matter of the general price level we think is a bad idea. We love deflation of individual items of course, $20 landfill android is just great compared to a $1,000 iPhone, but not of the general price level for precisely that debt reason.

  4. Not all “we” think deflation due to fixed money supply is a bad thing, see Mises. Real price decreases due to increases in output/efficiency gives clear market signals. Buggering about with the money supply just adds a veil of confusion between market participants, no doubt much to the delight of politicians and rent seekers.

    I’m not denying there wouldn’t be some structural changes and economic uncertainty and individual winners and losers (much like Brexit) but I’m of the belief that changing the money supply is a net bad (especially as it helps inflationary political policies).

  5. Tim, is there not a good argument for some inflation – maybe 10%? Savers are forced to invest. Long term debt is eroded. Businesses are pressured to move faster, which stokes growth. Why are we targeting 2% (i.e. almost nothing), surely this is making the economy lethargic and leaving trillions dumped in bank savings accounts?

  6. It is indeed a trade off. That little bit of grease, a tad of inflation, which makes declining real prices acceptable where they occur, as against entirely mashing over price signals with high inflation. 2% is adjudged to be about the best compromise. It’s not theoretically correct but might well be pragmatically so. Note the “might well” there.

  7. There’s a guy in Ely going blue in the face and pounding his keyboard to explain that, candidly, you are wrong and your time is up on this blog

  8. Wriggling Tim has now moved to position that the Magic Money Tree exists, is controlled by the commercial banks making ” loans” but is likely to be inflationary.(When I was saying this a few months ago, I received a barrage of abuse on here ,precious little showing any wit.)
    The monetary reform system Keynes plagiarised, that of Silvio Gesell ( whom he acknowledges in his “General Theory…”) dealt with the velocity of money issue by speeding up the circulation of its notes by cancelling their value completely if you didn’t stick stamps on them by certain dates: people couldn’t wait to spend them and pass them on to avoid paying this stamp “tax” on bank notes, generally called demurrage. Gesellian schemes were successful in Worgl and Swanenkirchen in the Tyrol during the previous Depression and a small voluntary scheme operates there now.
    Gesell saw that money should be prevented from pouring into land price inflation and proposed Land Value Taxes and ultimately, land nationalisation.
    Unfortunately monetary reformers in the UK backed the Establishment dullard Keynes who thought that a little mild inflation from time to time would do the trick.

  9. Tim – the other bad point about deflation is the discouragement of spending (both big-ticket consumption and investment); assuming that it’s not desperately urgent, why would I bother to buy a new widget-making machine when it’ll be cheaper next month?

  10. His latest piece on PFI is hilarious from start to finish. He doesn’t seem to understand that the entities that build things tend to be different from the entities who manage and maintain them. The risk is more in the build. Once a road, hospital, train line is built, the running costs become predictable. Little risk, but a small consistent reward. Rather like gilts. So we should issue gilts to buy these quasi gilts off Vinci, John Laing, 3I? Why?

  11. @DBC REED

    “When I was saying this a few months ago, I received a barrage of abuse on here ,precious little showing any wit”

    Can we think of reasons why that was the case?

  12. yes and no – depends on the stickiness of pricing (or at least your perception of it; most companies tend to estimate that that can hold pricing better than they actually do) and how much is being spent from cash reserves

  13. that the Magic Money Tree exists, is controlled by the commercial banks making ” loans”

    Confusing your M0 and M4?

    Commercial banks making loans is not MMT, it’s credit.

    saying this a few months ago, I received a barrage of abuse on here


  14. Woergl, population 13311
    Swanenkirchen appears not to exist but there is a Schwanenkirchen in the district of Hengersberg, total population 7476. Why can’t foreigners learn how to spell as good as eddicated folks like DBCR?

    So an experiment was conducted in the smallest test tube possible and it worked. Yo, Bros! Let’s crank it out over the entire planet!

    Serial Bore makes Snippa seem like Einstein. And folks, he keeps trotting out the same discredited examples so let’s ensure he gets reminded of their utter inconsequentiality.

  15. “The BoE quite deliberately did not spend that new money into the real economy. It was used to buy bonds, mostly Treasuries.”

    I disagree with this point. The BoE didn’t spend QE in the real economy, but the Government certainly did spend its borrowings there. The effect of QE was to allow the Government to borrow as much money as it needed to borrow to keeping public spending at the levels they had been prior to the Crash, and stop there being a massive societal catastrophe. In the absence of QE it would have been considerably harder (and more expensive) for the UK government to issue the billions of ££ worth of gilts they needed to, indeed they could have hit a bond strike at any time and a massive crisis of confidence. So the QE money did end up in the real economy, because the government spent the money it borrowed, that it may not have been able to borrow in the absence of QE.

    As it happens that wasn’t a problem inflation-wise, as broad money was falling through the floor, but the money did affect the real economy, probably stopped it going into a deflationary death spiral if truth be told.

  16. A small thought experiment – if John McDonnell is Chancellor and tells the BoE to start a QE program of £100bn year, and simultaneously starts issuing additional £100bn of gilts every year, and spending the proceeds, is that QE money hitting the real economy?

  17. A growing economy needs more money in exactly the same way that as a restaurant gets busier it needs more plates to put the food upon.

    Does it? We could just let money become more valuable, as I sneeze in threes has said. Might this deflation be useful as an automatic passive countercyclical policy?

    The third is that it’s reversible. And if we don’t reverse it then the inflation will come in a roar.

    Inflation has already come in with a roar in asset prices and the increase in debt levels.

    and the way politics works no one will ever tax enough to stop the inflation.

    For similar reasons, the central banks will not reverse QE if it means bursting the bubbles they’ve created in asset prices.

    But what happens when V recovers? When we all start to borrow and save and move money around like we used to?

    i.e. when we go back to the levels of the debt fueled bubble years of the early-mid 2000s?

    Tim, is there not a good argument for some inflation – maybe 10%? Savers are forced to invest. Long term debt is eroded.

    pintofale: You consider 10% a year to be “some” inflation?! Forced to invest (or presumably forced to spend)? The mindset of the central planner – no consideration of the freedom of the individual to spend their own money or wealth on what they want, when they want. Instead people are just considered to be cogs in a collectivist system, to spend/invest more or less this year as determined by some committee of the supposedly great and good. This is little different to the Keynesian nonsense of paying someone to dig a hole so you can pay someone else to fill it in – the focus is only on the quantity of transactions, never on the usefulness or quality of them.

    leaving trillions dumped in bank savings accounts

    I bet the people and government of e.g. Puerto Rico wish they had more money in savings at the moment, available for immediate spending. Money in savings, or even money held in cash or in a full reserve banking system, is never a waste.

    Tim – the other bad point about deflation is the discouragement of spending (both big-ticket consumption and investment); assuming that it’s not desperately urgent, why would I bother to buy a new widget-making machine when it’ll be cheaper next month?

    Flatcap Army: It depends upon how much better the new widget-making machine is compared to your existing, still functioning widget-making machine. Deflation has worked well for us in the IT industry for example.

    In our lifetimes we have seen some of the greatest advances in technology and business processes, and thus productivity, in human history, yet we have as official policy that prices on average should get more expensive every year. We consider our countries and societies to be getting richer, yet we have ever higher levels of debt and an ever growing section of our population dependent on welfare of some sort. Our basic economic policies don’t seem to be working well IMHO.

  18. But what happens when V recovers? When we all start to borrow and save and move money around like we used to?

    I don’t understand this bit. Where is the evidence that V collapsed because people didn’t borrow and save as much as they used to, and merited a tenfold increase in base money? The housing market is still bonkers, consumer spending hasn’t crashed, people still borrow to buy cars, etc. I don’t see where the drop off in borrowing and saving occurred.

    So who did it, when and why?

  19. Rob, have you tried http://www.bankofengland.co.uk/publications/Pages/fsr/2009/fsr25.aspx ?

    Growth collapsed…
    In late 2008, the global economy abruptly fell into a severe
    downturn. All the major developed economies entered
    recession, with the International Monetary Fund (IMF)
    estimating that world GDP fell at an annualised rate of around
    6% in the fourth quarter of 2008. Although a downturn had
    been anticipated, its severity was much greater than had
    previously been expected: in October 2008 the IMF expected
    world GDP to grow by 3% in 2009, but by its April 2009
    Report it forecast a decline of 1.3% (Chart 1.1). The severe
    contraction of output was associated with sharp rises in
    unemployment (Chart 1.2). In the United States,
    unemployment increased almost twice as quickly as its
    previous peak growth rate. And in the United Kingdom,
    unemployment rose at its fastest rate since 1981, putting
    pressure on banks’ household-loan portfolios.
    …and property prices fell sharply…
    Against a backdrop of sharply contracting activity, both
    commercial and residential property prices continued to fall
    sharply in a number of countries. By March 2009, residential
    property prices in the United States had fallen by around 30%
    from their peak according to the Case-Shiller 10-City index,
    the largest nominal fall on record. In the United Kingdom,
    property prices had fallen further than in the early 1990s
    recession, with residential and commercial property prices
    down 20% and 41% respectively from their 2007 peaks
    (Chart 1.3).
    …causing a sharp pickup in household loan arrears…
    As unemployment increased, debt servicing became more of a
    concern for some households. UK personal insolvencies and
    bankruptcies rose to historic highs. In the United States, the
    personal insolvency rate rose to 0.5% in 2009 Q1, around 50% higher than in mid-2007.

    Sharp falls in residential property prices reduced the value of
    many mortgagors’ collateral. The estimated incidence of
    negative equity had increased to between 7% and 11% of
    UK mortgagors by 2009 Q1, restricting their access to credit,
    including via mortgage equity withdrawal, and contributing to
    increases in mortgage arrears.(1) UK mortgage arrears more
    than doubled in the year to 2009 Q1, but remained well below
    their peak levels in the early 1990s.(2) The marked
    deterioration in the economy led to expectations of a further
    rise in mortgage arrears, as discussed in Box 1.
    …and in corporate sector financial pressure.
    As growth fell, corporate default rates picked up sharply.
    Globally, default rates were forecast by Moody’s to rise
    significantly for speculative-grade firms. In the
    United Kingdom, total corporate insolvencies increased by
    over 50% in 2009 Q1 compared with a year earlier.
    Refinancing became more difficult; contacts of the Bank’s
    regional Agents reported sharp increases in fees and spreads on
    the renewal or extension of existing facilities. Consistent with
    that, measures of default risk — such as corporate bond
    spreads — increased by much more in the near term than
    further ahead (Chart 1.4).

  20. Tightening credit availability contributed to a marked
    slowdown in lending growth in the major economies. In the
    United States lending began to fall. Lending also slowed
    sharply in the euro area, Japan and in the United Kingdom.
    Growth in mortgage lending by major UK banks fell to its
    lowest rate over the past decade. The stock of unsecured
    lending shrank for the first time. And lending to UK companies
    also slowed sharply (Chart 1.14), partly reflecting a withdrawal
    of foreign lending as cross-border capital flows reversed (see
    Box 2). To plug the lending shortfall, firms became more
    reliant on bond markets. But while investment-grade bond
    issuance increased, speculative-grade issuance remained weak

  21. The velocity of money isn’t real is it? Its not something in its own right. Its a ratio of two other factors, which are the things that change, V doesn’t change on its own and then create changes in the the other two things. V drops if broad money drops relative to narrow money. Or vice versa. There is no knob on the economy control panel that says V on it, while there is a knob for base money and for broad money. You can do things to make more or less money, but you can’t change V without changing one of the ratio pair first.

    As far as I can see its a pointless concept.

  22. “DBCReed

    Has it ever occurred to you to examine WHY you might be receiving so much abuse?”

    I know this. It’s because he is a tedious cunt.

  23. The problem with deflation is probably more psychological than practical. If deflation was running at 4% per year, would you be willing to accept a 2% cut in nominal wage? It would actually be real increase. But, imagine going home to the wife and crowing, “I got a 1% wage decrease this year. Let’s celebrate!”

  24. “Did lending dry up? Why quibble over terminology?”

    Yes lending dried up, for the very obvious reason the banks were bust and had made huge amounts of bad loans, so weren’t likely to be making any more for a while. Thats what happened. Why bother creating this thing called ‘Velocity of Money’ and pretending its a thing in its own right when it isn’t? Banks stopped lending, period. Calling that a drop in V doesn’t actually help anyone does it, so why bother?

  25. Very good overall! But this one little part is simply wrong:

    “A growing economy needs more money in exactly the same way that as a restaurant gets busier it needs more plates to put the food upon”

    A growing economy does not “need” more money as the ratio of goods and services to money increases. Rather, the price of goods and services could just fall instead.

    I think what you mean to say is that big debtors (particularly governments) *prefer* that more money be added to the system so that they can simply pay back debts with cheaper currency.

    This is a preference of some groups, namely, debtors. It is not a “need”.

    On average, savers, workers, lenders, some investors and most non-debtors tend to prefer the falling prices and increased purchasing power.

    Using gold or another relatively difficult-to-produce commodity as money of course, has a built-in way to address this and keep nominal prices stable. As demand for money goes up, people are incentivized to create more.

    When they (almost inevitably) make a bit too much, they start to get less than would be desirable in return for their efforts and are incentivized to stop.

    In the past, it may have been desirable to increase *credit* in a local area if the purchasing power of a hard commodity was so high as to be impractical to use in minor day-to-day exchange. And using credit may still be practical for short-term exchanges in the current day, to be settled later in real money.

    But “money” and “credit” are simply not the same thing. Money is what is used to pay back a credit. Paying back a credit with a credit does not extinguish a debt. It just sustains credit, or more commonly, *expands* credit, assuming that there is a positive rate of interest.

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