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Wrong for a different reason

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Alexandria Ocasio-Cortez – A well-meaning but not particularly bright left-leaning US politician – made a stir earlier this week by wearing a figure-hugging dress emblazoned with the slogan “Tax the Rich” to the prestigious 2021 Met Gala.  Since the slogan was clearly political, it wasn’t long before the various political tribes took to social media to pass judgement. 

“Hypocrisy!” was the charge made by the libertarian right.  As Amanda L Gordon at Bloomberg explains:

“The message itself wasn’t surprising — Ocasio-Cortez has been one of the biggest supporters of raising taxes on the rich to help pay for more social services and narrowing the massive wealth gap between America’s rich and poor. But the latest setting in which AOC — as she is known — chose to express it drew attention.

“The annual event at New York’s Metropolitan Museum of Art is the haunt of celebrities, designers, billionaires and various other members of the jet set that are willing to pay $35,000 a pop for the privilege to attend.”

But, the left ask, “where better to demand that the rich pay their fair share of taxes than in a gathering of the rich themselves?”  According to Hannah Selinger at the Independent, for example:

“The truth is, women have always used clothing — the most accessible medium — to express their politics. One might say that such choices in the everyday sphere have been more subtle. Ocasio-Cortez’s dress, of course, was anything but. And that was entirely appropriate for the space in which the statement was made.”

Ocasio-Cortez has also clarified that she did not pay $35,000 to attend and that the dress was borrowed for the evening:

“The time is now for childcare, healthcare, and climate action for all. Tax the Rich.

“And yes, BEFORE anybody starts wilding out – NYC elected officials are regularly invited to and attend the Met due to our responsibilities in overseeing our city’s cultural institutions that serve the public. I was one of several in attendance. Dress is borrowed.”

So much for yet another of those irritating teacup storms which infest social media these days.  The only saving grace being that by the end of the week we will have forgotten all about it.  Nevertheless, Ocasio-Cortez is dangerously – though very likely unconsciously – wrong for an entirely different reason… one where the libertarian right are more often correct than the left.

The ”tax the rich” message is something of a mantra among left-leaning politicians on both sides of the Atlantic – the British Labour Party were calling for the same in response to the Tory hike in National Insurance earlier in the week.  But the mantra serves to perpetuate the magic money tree version of currency creation in which governments – like households – “cannot borrow more than they earn.”  In this version, currency appears through some unknown process – hence the magic money tree – so that before a government can spend it, it must first obtain it via taxation.

This though, is not how currency is created.  There isn’t a magic money tree, there is a central bank and – in the UK – around 50 licenced commercial banks which, between them, create all of the currency in existence.  By convention – but not by necessity – governments begin the process by borrowing currency into existence by issuing bonds and auctioning them to the licenced banks, who use them as interest-earning investment vehicles or sell them to the central bank in exchange for a special currency called central bank reserves which banks use to settle accounts with one another.

Given the high volume of transactions made in an average day, we could be forgiven for imagining that billions of pounds’ worth of central bank reserves would be moving between the banks to settle accounts.  But since there are a limited number of banks and since customers and retailers are evenly distributed between them, when totalled up via a process called “multi-lateral net settlement,” the amounts that each bank must transfer are relatively small.

It is this which allows banks to create another form of currency – bank credit – in vastly greater volumes than the total central bank reserves.  In the modern world, this is the primary form of currency that households and businesses depend upon.  But it comes with a very big sting in the tail – every unit of bank credit was created with interest attached when banks made loans.

It is this bank-created currency that economist J. K. Galbraith was referring to when he famously remarked:

“The process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent.”

The common sense – and entirely wrong – understanding of how banks make loans is based on the myth of transferring funds between prudent savers and impatient borrowers.  What is usually described is the process by which a building society or a credit union operates.  Savers deposit money in exchange for a small amount of interest.  Borrowers take money out but agree to pay a much higher rate of interest.  The building society pays for its administrative overheads out of the difference between the respective interest payments.

Banks don’t work like this though.  When a bank makes a loan, no money leaves anyone else’s account.  Instead, the signed loan agreement is entered on the bank’s balance sheet as an asset and entirely new currency, spirited into existence at the stroke of a keyboard, is deposited into the borrower’s account and entered onto the bank’s balance sheet as a liability.

In theory, some fraction of the bank’s central bank reserves ought to limit the total mount of bank credit which can be spirited into existence.  In reality – and especially since the introduction of quantitative easing – only a collapse of the entire banking and financial system sets the limit to how much currency can be borrowed into existence.

There is an obvious question here: where does the interest come from?  There is nowhere near enough cash in circulation to cover it.  And only banks have access to central bank reserves.  And so, the only place that the interest can come from is from bank credit itself.  But that is impossible.  If we were to somehow stop time today and add up all of the outstanding debt, including the interest, there would not be enough currency in circulation to pay it back.  And so, the only place it can come from is the future – we must – collectively – borrow ever more currency into existence if we are to prevent the entire financial economy from crashing.

Now, perhaps, you can glimpse why we have had unlimited quantitative easing and ever lower interest rates since 2008.  But that is just the start of our problems, because debt-based, interest-bearing currency must interact with the real economy.  Banks lend to businesses and individuals whose incomes will grow over the term of the loan.  But growth in the real world means using ever more energy to process ever more resources to produce the goods and services from which businesses and individuals derive their incomes.  As I explain in my book, The Root of all Evil:

“Growth itself is the necessary outcome of the need to pay back interest on all of the currency that we collectively borrow into existence. As we have seen, in practice, this means exploiting people and raping the planet’s resources and energy in order to keep producing secondary wealth so that even more money can be borrowed into existence in the future. We do not need the latest phone or car or washing machine. Indeed, we do not even need to own any of the goods we use – and there is good reason to believe that an economy based around rental would be far more environmentally friendly. It is solely the requirement that we pay compound interest on our money supply that keeps this sorry state of affairs going.”

The rich who Ms Ocasio-Cortez would like to tax – and who, incidentally, write the tax laws in the first place – are the beneficiaries of the modern, debt based and interest-bearing currency system.  And far from being the starting point of the system, the taxes we all pay are the end point.  They are what gives those bonds that the government issues at the beginning their perceived value.  Because, unlike a household, a government can borrow against the taxes of future generations.  That is, our taxes are the interest earned by the banks on government bonds.

By focusing on the taxes – or lack thereof – levied on the rich, activists and politicians like Ms Ocasio-Cortez divert attention away from the reality of currency creation and perpetuate the myth that governments can only spend if they can raise taxes.  As we enter a world in which energy and resource constraints make further economy-level growth impossible, perpetuating the myth prevents us responding appropriately to the process of unplanned de-growth.

And there are – if only we could be honest about how currency is created – some alternatives.  Not least because there is nothing to prevent central banks from, say, creating new currency to invest in research and development into such things as alternative energy sources, sustainable agriculture or conservation projects.  Governments have chosen on our behalf only to allow new currency to be provided to allow voracious corporations to complete the process of depleting our energy and destroying our habitat so that – and possibly not that far into the future – none of us will survive.  And they will continue to get away with so long as politicians and activists perpetuate the myth that public spending begins with taxation.

As you made it to the end…

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