This post was originally posted here and included an image of a Bank of England letter which had been presented and discussed on X. The post is reproduced here without the image due a copyright infringement claim that was made by the owner of the image and which resulted in the original version of this post being suspended.
An
apparent statement by the Bank of England made in a personal
correspondence and referring to the role of money creation in government
spending recently came to my attention.
The statement is purportedly a response to a question on whether the UK
government finances its spending by money creation, taxation or
borrowing. It is partly reproduced below and includes a few statements
that are roughly consistent with mainstream depictions of government
finances as being dependent on revenues from taxation and the issuance
of bonds.
"The
government finances its expenditure through a combination of current
tax revenues and the issuance of government bonds (’gilts’), which it
sells to investors via the Debt Management Office (DMO). Neither the act
of taxation nor the issuance of government bonds directly affects the
overall amount of money in the economy. In that sense, the money the
government spends is coming from existing money in circulation.
The
Bank of England can create and destroy central bank reserves (‘base
money’), which is how for example it conducts ‘Quantitative Easing’
(QE). But the Bank of England has operational independence from the
government, and QE decisions, and all other monetary policy decisions,
are made solely for the purpose of achieving the Bank of England’s remit
of price stability - e.g. low and stable inflation - and not for the
purposes of financing government spending. For example, those reserves
are exchanged with private investors for government bonds, and the
transactions take place in secondary markets - the government or the DMO
are not involved.
In principal governments or their central
banks, can create certain types of money, which could be used to pay for
government expenditure. But in practice, this has tended to be
associated with high inflation and other adverse economic consequences.
Which is why many countries, including the UK, have strong institutional
arrangements to prevent this from happening - such as an independent
central bank tasked with an inflation target."
Parsing the language
The main crux of the Bank's statement is the question around the nature of government tax and spend, etc. But it is worth highlighting a few other things first. In the 3rd and 4th paragraphs the Bank refers to the importance of "operational independence from the government" and appears to infer that this has direct relevance for the role of the Bank as the government's banker. This would be incorrect, as the operational independence extends only to "monetary policy" under the Bank of England Act 1998, whereas the Bank's relation to government tax and spend ("fiscal") activities is governed by a different Act of Parliament, as we will see. It is possible that the motivation for these paragraphs is a concern at the Bank that Quantitative Easing (QE) is perceived as being undertaken for the benefit of the government's finances rather than for monetary policy purposes. In that narrow context, those paragraphs are reasonably factual, except in implying that QE was undertaken independently of the government (QE is indemnified by HM Treasury, and requires authorisation from the Chancellor of the Exchequer). But questions around the government's banking arrangements generalise beyond QE so this is not really relevant for the wider question of government financing.
Focussing on
that, the first thing to state is that there are at least two
ambiguities that can alter the intepretation of the Bank's words, and
these can be exploited (either with good-intentions or more cynically)
to draw a particular conclusion. The first is that it is unclear what
the Bank means by "money" when it states that "neither the act of taxation nor the issuance of government bonds directly affects the overall amount of money in the economy".
Does the Bank mean central bank ("base") money, commercial bank money,
or maybe even something else. It is not clear, and one can imagine
scenarios where the statement is either true or false.
For example, if the Bank is referring to commercial bank deposits, then it would be true that the issuance of government bonds does not change the amount in the economy, in the first instance at least. This is because primary bond issuance is to banking intermediaries (Gilt-Edged Market Makers, or GEMMs) which, together with the government, bank with the Bank of England. As such, these bond sales transact using central bank money only and there is no effect on levels of "money" understood in the form of commercial bank deposits. Since the bonds are often sold on immediately to third-party, non-bank customers of the GEMMs, commercial bank money is certainly reduced if we consider that step to be in scope.
There is also a change in the amount of central bank money when the bond is sold to the GEMM. It might be argued that there is no change in overall central bank money because an amount has simply been transferred from a commercial bank reserve account to the government's public deposit account. It is not clear if this is the intended meaning of the Bank's comments, but it is incorrect for reasons that will be spelled out later. A much simpler refutation is that government held public deposits are not considered to be part of the formal money supply, and therefore the stock of central bank money has technically reduced even if something remains in the government's account. This is a semantic or definitional argument and not one that needs to be depended on, but it does, again, help to widen the range of possible interpretations of the Bank of England's statement.
The other ambiguity is the period over which "financing" is considered. It is absolutely true that, under current institutional arrangements, taxation and borrowing (as well as spending) do not change the quantity of central bank reserves held in the banking sector when considered over the accounting period of a business day. This is because current policy is defined to ensure such an outcome, though this is by no means necessary. The Bank can certainly state that tax and borrowing don't change the quantity of money in the economy, and as long as they are referring to (1) central bank money and (2) an accounting period greater than one day, the statement would be correct most of the time and under current government policy (the effect of spending, taxation and bond trading on levels of commercial bank money is more ambiguous). However, this obscures the possibility of the Bank creating (and destroying) money on behalf of the government during each business day (and occasionally overnight), which is actually the claim made in the Accounting Model. So if the Bank's statement is indeed a refutation of the Accounting Model, then it must be interpretted as meaning that the Bank explicitly denies providing intraday credit to the government.
The Sterling Monetary Framework and intraday credit
It is worth taking a step back at this point and considering the role of intraday credit in the UK payments system. Under the terms of the Sterling Monetary Framework (SMF) which is managed by the Bank of England, participant banks have access to intraday credit. This functions analogously to an overdraft on their reserve settlement accounts and helps to ensure payments are settled smoothly and in a timely fashion, increasing the stability and resilience of the system.
In order to protect the Bank against credit risk, advances of central bank money are provided "against a defined set of high-quality, highly-liquid collateral transferred by way of full title transfer to the Bank". When we consult the list of eligible collateral for intraday credit we learn that it refers to government securities (i.e. gilts, Treasury bills and other UK government debt). In other words, UK government securities are instruments in the monetary system with sufficient creditworthiness for the Bank agree to issue its own liabilities in exchange. Essentially, they are the wholesale "money" that a financial institution needs in order to "buy" central bank money.
In this context, we can ask why would the Bank not provide intraday liquidity to the government? It is not prohibited by law, as is sometimes purported. The government is the most significant single agent in the economy in terms of payment volumes so why would it be desirable for the stabilisation of the payments system to extend this facility to commercial banks but not to the government? It becomes even more nonsensical when the only entity banking with the central bank that cannot access intraday credit is the creator of the collateral that is required from everyone else! We can also mention the fact that the government owns the Bank that extends this facility and provides capital injections and indemnities to support it, just to hammer home the absurdity of the proposition.
The Bank's more detailed description of the system
As
it happens, the Bank of England has itself described in great detail
how government spending and taxation through each day alter the balances
of central bank money held within the banking system. From The Management of Money Day by Day (Bank of England
Quarterly Bulletin Q1, 1963) for example:
"Transactions by the Exchequer or by the Banking Department (including the issue and payment of bank notes) will generally result in a credit or debit to the account of a bank or a discount house at the Head Office of the Bank of England: and these are the main transactions that cause a change in the total of Bankers' balances"
So government financial activity is realised in debits and credits to the reserve accounts of banks (though they weren't termed "reserves" then). But aren't these just transfers to or from the stock of central bank deposits in the government's own account? Not according to Exchequer and Central Government Finance (Bank of England Quarterly Bulletin, Q1, 1966):
"... the U.K. Government have virtually no cash balances to draw on,
nor do they build up temporary surpluses, seasonal or otherwise, on a
bank account for use when required… Any excess of government payments
over receipts is matched by an increase in the amount of government debt
held outside the central government; and any excess of receipts over
payments by a reduction of such debt."
Nor in The role of the Bank of England in the Money Market (Bank of England Quarterly Bulletin Q1, 1982):
“There is in the United Kingdom a highly centralised banking
mechanism for central government receipts and payments: the Bank of
England acts as the main banker to the Government... The Government does
not hold balances, other than working amounts, with other banks. This
centralised system provides the Bank with an up-to-date picture of much
of the Government's financial position, and enables it to minimise
government balances by employing any surplus cash to reduce the amount
of official debt outstanding”
“A
government’s budgetary policy will have a neutral impact on the
creation of high-powered money, if the government the government is able
to offset the combined
liquidity-creating impact of its budget deficit ... by issuing new debt
to the non-state sector.”
with the additional money created being able to be subsequently drained by issuing bonds.
Two of the articles cited above (The Management of Money Day by Day, The role of the Bank of England in the Money Market) feature a detailing of the "operational arithmetic" with which monetary conditions would be assessed by the Bank of England daily. Government net flows implicitly represent additions or subtractions of reserves to or from “banker’s balances” and this forms part of the context for judging the necessity and scale of any offsetting operations or accounting adjustments.
In The Treasury Bill (Bank of England Quarterly Bulletin Q3, 1964), the Bank goes a step further and explains that it is precisely because government spending injects new money to the system that sales of securities are guaranteed:
"There is a difference, important in any analysis of holdings, between those whose decision to increase or decrease their holdings of Bills is quite autonomous - such as the overseas holders, and domestic holders apart from banks - and the banking system (the banks and the discount houses), whose aggregate holding is initially determined in part by forces beyond their control... with no cash balance to speak of, the Exchequer's needs have to be met from day to day. As the system works, the banks and discount houses between them find themselves inevitably holding the residual amount of Bills necessary to bring into balance the Exchequer's cash position - and the market's.... The banking system fills this gap, however big it may be; but not by any conscious decisions each day to buy the particular amount of government securities needed to produce a balance. Rather it is a reflex action of the system. Government payments that are not financed by government income, or by borrowing from outside the banking system, give rise at once to surplus cash in the banks… The banks cannot prevent the system working in this way, except by holding on to the surplus cash; this would be unlikely, however, because it would deprive them of earnings."
This system was summarised in a 2000 Parliamentary Select Committee Inquiry
which acknowledged that the government's "short-term cash transactions"
affect the quantity of liquidity in the banking system whilst
explaining that the issuance of securities was undertaken for monetary
policy purposes:
“... the Bank's money market operations are geared towards delivering the Monetary Policy Committee's decisions on the level of short-term interest rates, whilst offsetting the effect of the Government's short-term interest cash transactions with the banking system. If the Government's short-term cash transactions do not of themselves create a daily shortage in the money markets, then the Bank creates a shortage by draining liquidity through the sale of Treasury bills. Hence, although Treasury bills are a government debt instrument, the Bank's monetary considerations determine the level of the weekly tender. Having created the shortage, the Bank is in a position to relieve it by lending money to the market at its chosen interest rates. The Bank, acting as the banker for the government, provides the market with sufficient funds to cover its daily cash needs, such that any variation in expenditure or revenue not met by longer term debt instruments, results in a change in the level of the Government's Ways and Means borrowing from the Bank.”
It seems emphatically true, if we are to believe the Bank of England and Parliament, that the government is able to inject new central bank money into the banking system during the day through spending, despite maintaining no appreciable balances.
What does stand out is that the Bank of England used to write about this subject regularly and in detail through the latter half of the 20th century and now apparently does not. We can ask ourselves why that might be the case but, regardless, there is no evidence that the system is substantively different today. Indeed, there is evidence that it remains as described despite institutional changes such as Bank of England independence, the establishment of the Debt Management Office (DMO; both 1998), and the establishment of Government Banking Service (GBS; 2006).
What we know about the system today
The legislation that governs government spending is the Exchequer and Audit Departments Act 1866 which predates the Quarterly Bulletin articles cited above by a whole century. The passage of a few decades is therefore no reason to infer change. The Bank of England Act 1998 has no relevance on the provisions of the 1866 Act since it merely confers operational independence for "monetary policy". In any case, the spending mechanisms stipulated in the 1866 Act (on which more later) were reaffirmed afterwards by the Government Resources and Accounts Act 2000 which updated the archaic language but not the substance.
The establishment of the DMO in 1998 was made in order to transfer responsibility for government cash and debt management away from the Bank. This essentially delegated a part of monetary policy operations to a subsidiary of HM Treasury. As stated in the consultation at the time, no changes to debt management strategy were intended. Equally:
“the Government has no plans to change the Exchequer's system of bank accounts at the Bank of England. Hence, it is envisaged that the Bank of England will remain the Government's banker”.
HM Treasury officials also stated at the time:
“The
Bank of England is still the government's banker and that is across
legislation very extensively and, indeed, there is no intention to
change that. We have to have a relationship with them and that will be a
daily relationship in the way in which we manage the end of day
business to square off all of the accounts... Essentially reflecting the
role of the Bank as government banker means we have the Consolidated
Funds and National Loans accounts and many other funds at the Bank....
The move of cash management does not change that relationship at all”.
The only substantive cash management change would be a policy preference against the routine daily use of the Ways and Means account.
The establishment of Government Banking Service in 2006 similarly represented a transfer of functions from the Office of HM Paymaster General to HMRC, though the general banking model and accounts would remain (and in fact be extended to cover HMRC and National Savings and Investments).
As in earlier times, we know that the account from which spending presently arises starts every day with balance of zero at the Bank of England. This is because such a feature is mandated in the National Loans Act 1968 and described in each of the Annual Accounts published for the Consolidated Fund.
"The
CF finishes every day with a nil balance on its bank account because
any surpluses or deficits are offset by transfers to or from the NLF"
This is consistent with the earlier descriptions of a government minimising balances and repurchasing it's own debt, and means that balances are never accumulated overnight for subsequent spending. It can be emphasised that the National Loans Act 1968 anticipates either a deficit or a surplus on the Consolidated Fund each night before the zeroing is enacted. It is not possible to achieve a deficit position on this account without intraday credit being advanced.
We
also know that, although the Consolidated Fund is the target of tax
revenue from HMRC and borrowing revenue from the DMO (the latter via the
National Loans Fund), these receipts are transferred at the end of the business day. For example, HMRC has stated:
"HMRC holds a range of bank accounts that are used to transact HMRC’s daily business activity including banking of revenue receipts. During the day balances are transferred from the lower level accounts to HMRC’s General Account held at the Bank of England. The number of intraday movements varies depending on the account and the balance of receipts in the account. HMRC’s end of day process ensures all available net balances are transferred to the HMRC General Account."
So revenue is only guranteed to be moved from the commercial banking sector to HMRC's account at the Bank of England by the end of the business day. Transfer into the Consolidated Fund occurs subsequenly. Equally, the DMO:
"As regards the operation of the Debt Management Account (DMA), this account directly links to the National Loans Fund (NLF) in that there is an end of day transfer between the two accounts such that the NLF is cleared to zero by a transfer to or from the DMA depending on whether the NLF is in surplus or deficit."
So
proceeds from securities trading are only transferred from the Debt
Management Account to the National Loans Fund - whereupon they are
reconciled with the Consolidated Fund's balance - at the end of each
day.
As such, all spending is made from the Consolidated Fund during the day when it has a zero or negative balance, and it follows that all spending is advanced using intraday credit. Revenues that arrive at the close of business simply serve to extinguish that credit retrospectively. This is the actual sense in which taxation and borrowing do change the amount of central bank money in the economy: the receipts are being transferred to an account which is already overdrawn and therefore (at least partly) simply cancel against that negative balance. Whereas the Bank of England's balance sheet expanded earlier in the day with government spending, it contracts at the end of the day with transfer of receipts. This is straightforward money creation and destruction. None of this should be controversial given the role of intraday credit in the monetary system administered by the Bank. The same thing happens with the private sector flows crossing the balance sheets of all of the commercial banks.
The other thing we know about in the current system is that the Ways and Means account still remains at the disposal of HM Treasury. This is because it is described in the annual reports published by the DMO as an option for dealing with an end of day deficit.
"The DMA is held at the Bank of England and a positive end-of-day balance must be maintained at all times; it cannot be overdrawn. Automatic transfers from the government Ways and Means (II) account at the Bank of England would offset any negative end-of-day balances, though it is an objective to minimise such transfers"
So the Ways and Means account is available to be used, and indeed occasionally is, such as on 13th December 2021. Again, though, just the possibility of
the Ways and Means account being used indicates that spending has
already been settled by the Bank by issuing new central money.
Finally, we know the spending mechanisms which are defined in the 1866 Act still govern issuances from the Consolidated Fund. Sections 13 and 15 of that Act specify that Bank of England is to issue money on order of HM Treasury for any spending that has been by authorised by Parliament. The Bank of England has no discretion in this matter, there is no balance of available funds to be checked.
We can stress at this point that this spending mechanism is defined in law and is therefore incontrovertible. Spending will inevitably cause the "creation of high powered money" and result in a counterpart liability of the government to the Bank. The need to clear this deficit position at the end of the day, or over any other time frame, is, however, a matter of policy only, and any such position persisting overnight results in new money backed on the Bank's balance sheet by a Ways and Means balance by default. This is the legal and logical base case for characterising the government's arrangements for expenditure. Any additional activity, such as reflexive trading in securities, falls into the category of discretionary policy.
Does any of this matter?
We can see that the government has two categories of overdraft available to it: the intraday version, and the overnight version. The latter is simply the formalisation of the former in what is known as the Ways and Means account. In both cases newly issued money in the banking sector is the corollary.
The statement made by the Bank of England, that "neither the act of taxation nor the issuance of government bonds directly affects the overall amount of money in the economy" is correct (allowing for ambiguities) when considering the overnight case, most of the time, and under current policy. It is not consistent with intraday conditions or other possible policy options available to government.
This might seem an insignificant distinction. If the government does create money during the day but it is all destroyed by the end of the day, then isn't it basically equivalent to taxes and borrowing funding the spending? The daily flows certainly resemble that kind of system at a glance, and maybe for certain purposes that is a useful and pragmatic characterisation. But this is like saying that a characterisation of the sun as revolving around the Earth is reasonable working model. Yes, it is - if you're only concerned with whether the sun will rise tomorrow. But if you want to send a probe to Mercury, you'll find that that model misses some of the subtleties of the system that have turned out to be of interest and importance.
In the case of the government's financial flows, the subtlety of intraday credit is incredibly pertinent when considering the constraints that the government operates under. In particular, the sequence of spending first and taxation and borrowing coming afterwards completely changes the reality of what limits government's activities.
For example, we are sometimes told that the government can run out of money and won't be able to honour it's spending commitments. This implies that spending is constrained by available revenue, and might be described technically as liquidity risk. Well, now that we know that expenditure is legally secured for all spending authorised by Parliament, and is not contingent on any end of day requirements, we can dismiss this constraint as a fiction. The government cannot run out of money through spending because the spending process creates money.
A special case of the above risk is default risk, where failure to repay principal or interest on debt might be a concern. Again, this can't happen, for all the reasons stated above. Repayment of debt happens via the same money creation mechanisms as above, from the National Loans Fund with recourse to the Consolidated Fund by virtue of the 1968 and 1866 Acts mentioned above. Again, this is not dependent on any end of day stipulations.
Another risk is market risk, where the government might fail to sell it's securities to a hostile market or be forced to pay exorbitant interest rates. This is commonly known as the bond vigilante argument. But again, the intraday dynamics show that this is not a concern. The main reason is explained in the quote from the Bank of England from 1964 cited above. Since the spending has injected new money into the system, the banking system already holds excess money and it is this money that is reflexively used to buy the bonds that the government - under current policy - wants to sell. All the government hasto offer is a rate marginally greater than the rate the banks are receiving in these excess reserve deposits, which is why short term government debt is priced close to the prevailing Bank policy interest rate. Under exceptional circumstances, the government additionally has the option to not deal with the market at all. Sales of bonds are a policy choice only, they are not an economic, financial, or legal requirement. The government is never forced into trades that might be considered unfavourable, as the Ways and Means account is always available. This option was exercised in the early days of the COVID-19 pandemic although the facility was not ultimately used.
So it really matters that the government issues money when it spends and only seeks to reconcile that spending with revenue activities later. The fact that bonds are sold, and that the quantities of spending and revenue fall into line by the end of the day, is a pure matter of policy and design, and not a binding constraint.
The statements by the Bank regarding the impact of tax and borrowing on the supply of money are not incorrect if one squints a bit and narrows the context suitably. But when applied to different contexts, questions or timescales, they are seen to be contradicted by the many sources described above - including many of the Bank's own publications.
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