Where does money come from daddy?

The question my 5-year old daughter asked me recently after which I replied, “money doesn’t grow on trees you know”.

It got me thinking about all the COVID-19 support initiatives provided by governments across the world.  How are they funding these support initiatives, and perhaps more importantly, how will it be repaid?  I glanced through my old economics textbooks not only to develop my own understanding, but crucially give Robyn a more robust answer than ‘it’s inside the pot of gold at the end of a rainbow’.

How is money created?

In short, money comes from the central banks across the world.  They can create money in two ways: - (1) printing it; and/or (2) buying bonds in the treasury market.  When central banks buy bonds, they usually buy their own country’s treasury bonds and their purchases are made from banks that own bonds.  The banks then lend the bond receipt out through mortgages, business loans and overdrafts with the money now entering the economy.

So how do the governments create their own money?  

The main source of their money is through (1) taxpayers’ receipts (income tax and business taxes); and (2) borrowing from investors on the bond market.  The government issues a bond and pays a monthly coupon to the buyer.  A bond is essentially an ‘IOU’, which is typically bought by pension funds, insurance firms and investment banks as it is viewed a low risk investment.

Given the speed at which the UK Government needed money to fund their financial support initiatives they temporarily borrowed direct from the central bank through the 'Ways and Means' facility (an overdraft facility made available for exceptional circumstances which dates back to the 17th century).  This meant that the government did not flood the bond market with too much debt and part compensated for the reduction in taxpayers’ receipts as employees were furloughed with a payment of business taxes deferred.

By selling bonds and borrowing from the central bank the UK Government received the money it needed to fund (or ‘spend’) the support initiatives.  This ‘cash’ was transferred directly into business owners’ bank accounts through grants or the furlough scheme.  Official statistics record that total UK Government borrowing exceeded £2 trillion in July 2020 for the first time ever.  Whilst it is normal for governments to borrow, the UK Government borrowed an extra £200 billion since the beginning of lockdown which is an 11% increase on the total borrowings inside only 5 months.

It is important to highlight that not all the financial support initiatives require government spending.  The UK Government provided guarantees to lenders to encourage them to lend to businesses adversely impacted by COVID-19.  The guarantees are designed to give banks additional comfort when considering lending proposals. This is not government spending, but in effect government underwriting.  No capital spend is required to underwrite the guarantees; however, capital spend would be required if a guarantee is called should a borrower default and any supporting collateral be insufficient to repay their debts. 

How will a government repay its debts?

Traditional bank debt is typically repaid from a borrowers’ cash flows or sales of assets.  The challenge for the UK Government is that their income, taxpayers’ receipts, has reduced significantly meaning their cash flow isn’t what it was pre COVID-19.  Taxpayers’ receipts will only improve when (1) employees are back to work generating income tax and making national insurance contributions; and (2) businesses start transacting at higher levels thus creating business taxes.  This means that further borrowing, through bond issues, is likely to continue in the short to medium term.

You may even see the government consider selling other assets or perhaps arranging sale & leaseback deals on government owned buildings to release capital. Keep an eye out for No.10 being listed on eBay.

Whatever happens with the central banks and governments across the world, Robyn and I will continue to check rainbows in search of that pot of gold.