IN last week’s Scottish Banking & Finance Group (SBFG) article we discussed the function of taxation as an important means for managing the economy by removing currency from circulation in order to manage the risks of inflation once the economy is at full capacity and there is full employment.

Tax also has an important role in shaping the kind of society we live in and reducing harmful economic activities, products and forms of consumption.

Taxation is not the only important tool for managing the economy. Government borrowing also has a vital role to play. It is commonly thought government borrowing is needed to cover the financial shortfall created by fiscal “deficits” – when tax revenue is less than government spending.

However, this understanding of “borrowing” is misplaced because a government with its own currency and central bank can always provide all the money that is needed.

But if governments can create all the money they need why do they borrow?

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When a government “borrows” it is using an alternative method to taxation which removes from circulation some of the currency, which it has previously created. When it “borrows” the government is providing a safe means of saving for households, businesses and financial institutions (such as banks, pension funds and insurance companies). The government pays a rate of interest on the money it takes out of circulation.

The most common form of government borrowing is by issuing “government bonds” and these are bought in large quantities by banks, pension funds and other financial institutions. They make up an important part of banks’ assets, which they need in order to be able to lend.

There are also other important kinds of bonds – these are issued for special purposes and are known as “hypothecated bonds”. The best known of this type of bond are the “War Bonds” issued during the Second World War.

These WW2 war bonds were not issued in order to pay for the war effort – they were not launched until the war was well under way. They were issued because all the resources of the economy were allocated to the war effort. There was full employment and people had plenty of money to spend.

The problem was that there were limited things to spend it on. Food was rationed and production of consumer goods had been cut back heavily. The bonds were issued to encourage people to save and to reduce their spending on things that were in short supply. The objectives were to combat inflation, reduce black markets for goods which were in short supply and to discourage imports of goods not necessary for the war effort.

These special bonds will be important in an independent Scotland if we decide it is necessary to allocate a large proportion of our available human and physical resources to building all the new infrastructure, manufacturing capability and types of goods that we will need in order to make the transition to a zero-carbon world.

This will be as big an undertaking as fighting a war, and with full employment and well-paid jobs people will have money to spend while it is likely that there will be fewer consumer goods to spend it on. Encouraging savings will be necessary.

Government borrowing in order to encourage saving is also important because if citizens have savings, they are better able to manage unexpected shocks which may affect them individually but may also have an impact across the whole of the economy – the coronavirus pandemic is a good example of a system shock. If everyone has savings they are more self-reliant and able to deal with the unexpected. We are all familiar with the motto “saving for a rainy day”.

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All societies need to make provision for unexpected events – we call it “insurance”. Government “borrowing” means that reserves of money are maintained at all levels of society, which allows individuals, households, businesses and financial institutions to plan and manage their finances.

These reserves are the bedrock of banking, whether it be private commercial banks or mutuals such as credit unions and savings banks. They are the bedrock for pension funds, which are the collective savings of citizens for retirement. They are the bedrock of insurance companies who manage reserves in order to be able to respond to events which cause damage and loss to individuals, households and businesses.

By “borrowing”, governments can manage the risks of inflation, control the level of demand for imports and create the reserves of savings needed across society to make it more resilient to shocks.

Together, taxation and borrowing are two essential controls which enable a government to manage the economy. Just as an aeroplane cannot be flown safely with just one set of controls, nor by pre-setting the controls in advance, managing the economy requires judgement, skill and flexibility to steer a way through ever-changing conditions.