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the latest source of comment and analysis from the Institute for Security & Resilience Studies at UCL.


The Myth of Debt

By Mandeep K Bhandal, on 11 March 2013


In a recently published article in the Sunday Herald, ISRS Senior Research Fellow, Chris Cook discusses the global debt problem and the road to recovery. The below article is published with the kind permission of the Sunday Herald.

The Myth of Debt

From the latest cuts to economic forecasts to the Italian elections to the gathering debate about how George Osborne should play this year’s Budget, all discussions about the financial system now lead swiftly back to the world’s sovereign debt problem. It towers over every effort to get back to prosperity, threatening to take decades at best before it can be resolved, very possibly with an almighty crash along the way.

But maybe that is because we are looking at a 21st Century problem in a 20th Century light. My research at University College London’s Institute for Security and Resilience Studies indicates that the answers might lie in modern versions of legal structures and instruments which pre-date the modern financial system and even the Act of Union. But before I explain this ‘Back to the Future’ proposal for recovery, a warning: we’ll need to turn much of the received wisdom that underlies modern economics and politics upside down as we proceed.

Prior to the advent of double-entry book-keeping and the concept of profit and loss in the Middle Ages, accounting typically involved the use of wooden tally sticks. Notches and marks were made on a stick, with two functions. One was as a memorandum tally or receipt evidencing a sale, and the other was as a record of an obligation – a loan tally. In both cases, the tally stick would be split down the middle with the longer portion (the ‘stock’) being given to the counter-party of a transaction and the shorter portion (counter-stock or foil) kept by the originator.

For over 600 years from the early 12th Century and even before, UK sovereigns were accustomed to raising funds to fight wars and for other sovereign expenditure by obtaining money, goods and services from their subjects as an advance on their tax liabilities. The subject would receive a loan tally in exchange, which represented a pre-payment of tax due.

It could be handed back (hence ‘Tax Return’) in lieu of more conventional money at any point in the future when they came to pay their taxes. This is different from a debt, which normally comes with a date on which it must be paid back. And naturally these Medieval taxpayers did not give the sovereign £10’s worth of value in exchange for a £10 prepayment of tax but received a discount for their trouble.  The phrase ‘rate of return’ literally means the rate over time at which the stock could be returned to the issuer, enabling the initial discount to be realised.

In 1694, the Bank of England stepped in. Originally a private company, it was founded to create money backed by its gold holdings that could be exchanged for Treasury pledges over future taxes. In contrast to the old tally stick system, these pledges, known as ‘gilt-edged’ stock, or gilts, came with redemption dates and paid a fixed rate of interest.

These changed characteristics of a fixed date and rate of return made the pledges resemble debts. However, the difference is that these pledges are ownership claims created by an individual over his own income, whereas a debt claim is created by one individual over another individual’s income. The correct analogy is to think of gilt-edged stock as akin to interest-bearing shares or equity bought by investors in UK Incorporated, with a redemption date.

The position today is quite similar, except that the Bank of England is now State owned and the pound sterling is not backed by gold but by faith alone.

The fiscal myth of tax and spend shared by virtually all schools of economics is that tax is first collected and then spent. This has never been the case: the reality, as we have just seen, has always been that government spending has come first and taxation later. The reality is that taxation acts to remove money from circulation and to prevent inflation: it does not fund and never has funded public spending.

The Treasury does not, as we imagine, bank with the central bank in the same way that we maintain a bank account where our interest-bearing bank deposit asset is the bank’s interest-bearing debt liability and vice versa. The central bank creates credit/money on the Treasury’s behalf which it exchanges with the Treasury for gilts or lends to the clearing banks as necessary for them to balance their interest-bearing lending and deposits.

The clearing banks of course have their own power to create money, for the purposes of lending. They are responsible for most new money in the modern system, accounting for about 97% compared to 3% from the Bank of England.

Incidentally they too are the subject of a well peddled myth, which is that deposits are first collected by banks and then spent or lent into circulation on the basis of requiring a certain reserve level of deposits to be maintained. In fact, there is no constraint on UK credit/money creation of reserves: the constraint on modern money creation by private banks is the capital required to cover losses on loans.  Private banks first lend or spend what are essentially ‘lookalikes’ of central bank money, and then fund their dated interest-bearing loans (assets) with dated interest-bearing deposits (liabilities).

Putting most money creation into the hands of organisations whose raison d’etre is to make money from lending (and more recently, from speculation) is behind much of what has gone wrong with the financial system. As with all historic bubbles, the profit motive drove excessive credit creation. Bank lending departments were abetted by everyone from bank lobbyists persuading the authorities to allow dangerously low capital ratios to trading departments devising increasingly complex instruments for shifting loans off bank balance sheets to make more and more lending possible.

From out of these observations, I reach two conclusions. First, the clearing banks cannot be trusted to freely create the credit which is modern money.  If money is to be created by a middleman or intermediary then it should be the Central Bank or the Treasury: the question is, how and by whom such State credit issuance and allocation should be professionally managed and accountably supervised.

For instance in Hong Kong, there is no central bank. The Hong Kong Monetary Authority supervises the issuance of virtual currency and physical bank notes by three commercial banks including HSBC. The Hong Kong dollar is kept pegged to the US dollar between upper and lower rates which are defended by a currency board mechanism, putting strict limits on the amount of money that the commercial banks can create.

The idea of direct Treasury creation of money should not seem alien, by the way. During the First World War, UK Treasury notes known as Bradburys were temporarily issued as money to surmount a shortage of credit. In the US to this day, there remain a small amount of US Treasury Notes (greenbacks) in circulation which are worth exactly the same as the Federal Reserve Bank dollar notes which replaced them.

My second conclusion is that we must revisit the concept of the National Debt itself and recognise it for the National Equity it is in reality. We have only saddled ourselves with this debt delusion because we have forgotten what the true relationship actually is between public spending and taxation.

All existing UK gilt-edged stock could be consolidated as happened before with Goschen’s Conversion in 1888 which created the single class of undated Consolidated Stock (‘Consols’) which remain to this day.  We could again create a single class of undated stock and the absence of dated ‘debt’ obligations would drastically reduce the UK’s funding costs to the rate of return paid in respect of this ‘National Equity’.

In fact, one could argue that the creation of £375 billion of quantitative easing (QE) reserves – upon which the Bank of England pays interest at 0.5% pa – has partially achieved such a Consolidation by the back door.  These reserves of fiat money created and used by the Bank of England to buy  and hold gilts are assets which are functionally equivalent to gilts, since both are created as claims over future tax income, just like the broken tally sticks from days long forgotten.

Such a centralised re-architecture by the UK government of the national balance sheet is admittedly difficult to foresee at present. But once you dispel the myth of the national debt, it creates a space for discussion of more practical solutions now emerging as a result of technological innovation. With the prospect of a Scottish Treasury emerging in the near future, this is worth serious consideration.


Panel: Open Capital

In Mathematics there is +1, -1 and 0; in Physics, positive, negative and neutral. But in Economics we see only conflicting absolutes of equity and debt; freehold and leasehold; public and private. The long forgotten prepay instrument which enabled UK sovereigns to fund themselves through tax prepayments opens up new neutral asset classes which I refer to as ‘Open Capital’.

Prepay instruments enable not only direct ‘Peer to Peer’ credit, but also direct ‘Peer to Asset’ investment in productive assets without Treasury or banking middlemen.

I’ll illustrate this by outlining a couple of prototypes under development. One involves a housing authority that is building new flats in a project financed by a bank on the basis that their construction loan will be refinanced by the local council once the block is complete. This way the bank gets repaid quickly and the council avoids taking the construction risk.

This model will get the flats built, but means that the money is tied up in the project for years while the housing authority repays the council. The concept of Open Capital ‘rental prepay’, is that once the flats are let, investors will buy (say) 40 or 50 years of rental units at a discount. For the sake of argument, it could be 22 million £1.00 units of index-linked rentals sold at a price of £15m to investors.

Long-term funding for the project becomes equity not debt, albeit not equity as we know it. The refinancing releases what is essentially a revolving pool of public credit to be reinvested in other projects. The Open Capital model is particularly well suited to affordable housing because  the absence of compound interest and debt repayment drastically cuts funding costs and means a more reasonable rental may be charged.  Since an affordable rental is by definition more likely to be paid; the risk of non-payment is lower; and this greater certainty justifies a lower rate of return.

My second example of Peer to Asset investment concerns energy saving schemes. Suppose  investors are concerned about inflation and believe that natural gas will hold or increase its value relative to sterling.  investors may buy units in a fund at the market price of gas in £/therm each of which equates to ownership of a standard number of therms of gas.

This fund would then invest in energy-saving projects and households or communities would take on a ‘gas loan’ obligation to buy back therm units from the fund at the gas market price. Suppose one was a community combined heat and power generator, where instead of heat going up the chimney of a power station, we are going to use it to heat people’s homes. Now suppose this halved the number of therms of gas that each household used per month, from 120 to 60. They would pay the supplier for 60 therms and would buy back the 60 saved therms from the fund thereby reducing their gas loan by 60 therms.

Instead of receiving a sterling loan, the generator is funded by a gas loan based on future consumption, though an electricity loan is equally viable The investor makes money if the price of the power goes up, and loses if it goes down.

Unlike the UK Government’s Green Deal, which is lending money for household energy saving projects, this idea lacks two disadvantages that some believe will make that scheme unworkable. It does not involve compound interest and there is less risk of the savings being undermined by people simply turning up the heating, because unless they save gas, they end up with higher bills during the repayment period.



4 Responses to “The Myth of Debt”

  • 1
    Melanie Giles wrote on 25 March 2013:

    FROM this article I understand two things. First, the clearing banks cannot be trusted to freely create the credit which is modern money. If money is to be created by a middleman or intermediary then it should be either the central bank or the Treasury itself.

  • 2
    Gravity watch online wrote on 7 February 2014:

    Hello, I read your blogs daily. Your humoristic style is witty, keep up the good work!

  • 3
    Ralph Musgrave wrote on 28 December 2014:

    “…I reach two conclusions. First, the clearing banks cannot be trusted to freely create the credit which is modern money. If money is to be created by a middleman or intermediary then it should be the Central Bank or the Treasury…”

    Quite right. Exactly what Irving Fisher and the “Chicago economists” concluded in the 1930s. In Fisher’s own words, “We could leave the banks free . . . to lend money as they please, provided we no longer allowed them to manufacture the money which they lend”.

    Fisher’s basic idea (full reserve or 100% reserve banking) was subsequently supported by Milton Friedman in his book “A Program for Monetary Stability” (Ch3), and even more recently by Prof Richard Werner, Positive Money and many others.

    “..the question is, how and by whom such State credit issuance and allocation should be professionally managed and accountably supervised.”. Positive Money and Richard Werner worked that all out here (around p.10):


  • 4
    John Picken wrote on 13 May 2015:

    Can I post this rant in reply and say thank you for your article:
    A level economics
    Comments (rant by) John Picken May 2015
    Thanks for the article Mandeep.

    It would have been regarded as a particularly well written summary of A level economics when I did mine in 1964.

    It raises several issues:
    What is the role of Government
    How do you control the money supply
    What are the issues around money supply.

    The role of Government includes to manage the money supply, invest for the future, protect citizens, even out economic inequalities over time; mitigating boom and bust, protecting employment and wealth distribution while more addressing more immediate inequalities / deficiencies within the system (partly moral judgements or philosophy, partly sociology – another pair of unpopular subjects. Why let rational thinking get in the way of wealth redistribution?).
    Control of money supply

    Was formerly done by linking paper to gold. This was broken since more money was needed to enable a growing economy. Money supply became a balancing act: promote and enable growth via investment (broadly provides a long term investment return along with immediate issues of employment, tax generation, other social priorities etc.). However too much supply produces inflation. Small inflation seems broadly to support a growing economy. In particular it enables evening out or re-balancing the price of items in the market which become out of balance. An example today would be house price in relation to wages.

    An interesting example comes from the United States civil war when, I understand, the North financed their war effort simply by printing “Greenback” dollars, still in circulation but a large portion of money supply in 1860. Rather than produce inflation the economy grew to need the money supply so there was no significant inflation. Quantitative easing anyone? Was it investment for little return which needed to be achieved in other ways, and of course still needs those structural financial market changes.

    We have now increased the money supply via banks and private debt – try your visa card. Where government “should” use debt, or pre-paid taxation, for long term investment, public good, much private debt is frivolous. In the historical past most private debt was for investment. Now it is for frivolous short term spend with no long term value therefore inflationary as the money supply is then surplus as the goods serve no long term purpose. (or transferred to property which since there is only a limited supply is an inflation in price, not value. This also represents a transfer of wealth from many to a few – with the illusion for some that they are better of because of the increased property price whereas the only ones better of are the few who were paid the surplus price and exit the market). Hence most private debt is inflationary without benefit. It has been used to grow the economy in a non productive way, in the sense of no long term benefit. Remove the private debt stimulus and the economy collapses. The inflation has been limited because a large amount of this new money has been salted away by foreign nations, notably China and the very rich. Also the inevitable crash has been postponed by effectively continuing the “South See Bubble” of the current lending in the banking system. However it will come home eventually. So do we want to manage these issues or accept the crash and burn when it happens?

    Inflation or devaluation is inevitable as the ratio of investment, tangible product/services to growth in money supply has been out of balance for so long; the change is inevitable as the supply of private debt eventually collapses.

    Also this is linked to the decline in Community Capital; deteriorating roads, schools, hospitals, public housing, infrastructure, education etc. financed by previous governance debt / deferred taxation. The decline in value e.g. roads, the sale of public goods e.g. rail, royal mail, B.T. etc. sale of public property etc. all below value. The transfer of value has been used to fund private debt, increase money supply and transfer wealth from all to a few.

    The short term solution to the current situation requires:
    control and pulling back of private debt and privatised money supply i.e. banking and credit, with transition provision to cover the worst of the social problems which will ensue
    Control of banks and lending; links to above

    Steady but controlled inflation to allow a rebalancing of price: some prices stay still (e.g. land houses) while wages increase. So inflation may need to wait a year or two while the structural changes needed to change supply are made. These should be quick.

    Changes in tax subsidy currently given for a whole range of items: e.g. empty property, many tax allowances, subsidy for forestry, exemption for death duties, artificial charities, overseas holding companies and many I have no idea about.

    Changes in planning and related taxation: recognising limited supply, freeing resources and change of use with appropriate public benefit from changes I.e. Taxation on land use and value.
    Land value taxation a particularly effective tool to consider
    Public i.e. Government investment and government control of money supply largely via alternating spend and taxation: investment on infrastructure (long term: e.g. roads, rail, broadband, research, education, housing) to create immediate jobs and more general employment. This should have been the focus of quantitative easing.
    Social justice changes in structure which promote wealth distribution, social cohesion and especially employment. Why? Because a socially just society is healthier for all ALL within it. Otherwise change will come even if it takes a few generations. The longer it waits the more drastic it is likely to be – like a pressure cooker: Libya is a prime example, Iraq, and of course much of the Middle East is brewing. Postpone the revolution without creating replacement institutions and you create chaos: Ghana, Nigeria, Belgian Congo. We did slightly better in India. China seems to be trying hard. The next major social justice issues will be around refugees, population movements and climate change. These are only just getting under way. But all are linked.

    Again it is best as a Government guided process. That needs strength, moral courage and vision (knowledge, imagination and skill). All seem particularly lacking just now. Evolution or revolution: we make a choice but one thing is certain: change is inevitable.

    And of course your examples of project spends highlight the difference between PPI investment and public investment from future taxes. PPI is absolutely nuts. It is another way of transferring wealth from all to a few.

    Where did the economists go to school; or why did they believe the rubbish, what was in it for them?
    This is all A level economics from 1960s. My economics teacher was a bright cookie, making simple what others found complex. Even with my resentment of school I knew it at the time. I have come to greatly respect him.

    Where have people been? I may be wrong, something major I do not understand. Yes bits certainly but overall I don’t think so. I am pig-headed believing I am right and have said all of this since mid 1980s when Thatcher emphasised the difference between price and value and as private debt grew. Price, the pound became god and values should be used and not get in the way. Even “good traditional” conservative values.

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