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If you’ve been following this blog for some time, you might be wondering why I’ve been talking about cards at all. After all, for nearly 3 years, I’ve been saying that we can understand the economy in terms of what everyone owns, is owed and owes — and that’s all that the cards represent.

The reason is that I want as many people as possible to be able to understand economics. There’s strength in numbers. But economics has a reputation for being difficult to understand, and people are easily put off learning when the ideas sound like they might be difficult, even though people generally understand them quite well already. Owning things, being owed things and owing things are common experiences for most people, but I expect that expressing these ideas in terms of drawing, transferring and discarding playing cards makes it seem far less intimidating, and maybe even seem fun, while still being just as accurate.

So really it’s about psychology rather than saying anything different. I’ve actually bought 3 decks of cards from a printing company, and the next time I get to go on a podcast, I’ll be bringing them along to demonstrate the ideas. I think it would work much better than just showing the normal arrow diagrams — at least until listeners get the point. Playing cards are far more palpable than diagrams with arrows, even though the arrows have some advantages, especially in showing how everyone’s Raw Net Worth1 changes.

In the first article of this series, I described how the actions with playing cards related to the arrow diagrams, but I hadn’t worked out how to create images to show the playing card actions. Over the last few weeks, I’ve worked out a way to do it which is probably good enough, so I’ll finish this article by showing the relationship between the 7 economic actions and the actions of the card game which represent them.

Produce

Consume

Transfer tangible asset

Create debt

Transfer debt asset

Transfer liability

Write off debt

It’s important to remember that all economic activity is composed of these actions. And the effect of any combination of these actions is just the sum of the effects of the individual actions.

It’s hard to overstate just how important this is: in economics speak, there is no fallacy of composition. This is probably the most desirable feature of a model of anything! It means that you can understand the whole just by understanding the simple parts from which it’s composed. I believe this is unique (in economics), profound, and incredibly important, and it’s why I’ve been trying for years to share what I’ve discovered. If you think I’m right, or aren’t sure but think you know someone who you trust to judge it, please do share this blog! Many thanks!

Here, I want to convince you that this analogy is actually powerful enough to describe any society’s economy accurately, not just, say, a traditional western free-market liberal society. All this needs is the idea of “imaginary” players (an idea used in some common card games) to represent corporations, and some extra rules restricting which cards can be picked up, transferred to another player, or discarded.

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Different games, or just variants?

Let’s just consider whether these differences between different societies mean that they are represented by completely different games, or just by variants of the same game.

There are lots of games which can be played with a standard deck of 52 playing cards. Some of these are completely different (e.g. Snap and Bridge). But some are really just variants of each other (e.g. Hearts and Black Maria).

I think it’s more accurate to consider the 3-deck games representing different societies to be variants of each other, rather than different games. The basic structure is always the same:

• There are a number of players,

• They can each hold purple, green and pink cards, and

• They can perform just 3 types of action:

  • drawing a card from a deck,

  • transferring a card to (or accepting a card from) another player, or

  • discarding a card.

There are some restrictions on the actions a player can take which apply everywhere, because of logic or natural laws. For example there are 2 rules which are essential to all games:

1. When one player picks up a green card, another player must pick up a pink card, and vice-versa. And both cards must have the same object drawn on them.

   

2. When one player discards a green card, another player must discard a pink card with the same object drawn on, and vice-versa.

   

This is just to make sure that any debt which is owed to someone must be owed by someone else, and vice-versa. One-sided debts can’t exist. They just don’t make sense.

Other restrictions on a player’s actions reflect laws and customs. For example, there have been societies where only a few people were allowed to have silk clothes. In that case, there would be a rule against the other players obtaining purple cards representing silk clothes.

Sometimes there are actions which are allowed, but only if the players perform other actions at the same time. For example, if a society has a 20% Value Added Tax, then one player (the customer) can transfer a green card representing £1.20 cash to another player (a shopkeeper) in exchange for a purple card representing a loaf of bread, but then the shopkeeper must draw a pink card representing 20p (VAT), and the government player must draw a green card also representing 20p, because the shopkeeper is now required to pay 20p tax to the government.

Let’s look at a couple of variants of the 3-deck card game for different societies.

The “corporations” variant

Some societies allow corporations to exist. Those societies pretend that there are extra people who can own, be owed, and owe things — but these extra people are imaginary, so all their decisions and actions have to be taken by real people on their behalf. To understand how this affects the 3-deck card game, let’s first look at what’s probably a more familiar example.

The game of Blackjack uses a standard 52-card deck. To win, a player has to get a higher score (the sum of their card values) than the dealer, but if they go over 21, they automatically lose. They start with 2 cards, and can ask the dealer for extra cards.

The important point here is that there’s an interesting “split” rule. If the player’s first 2 cards have the same value (e.g. both aces), the player can “split” them. That means that the cards are physically separated, and the dealer adds another new card to each. There are now 2 hands where there was 1, and they’re played independently, as though there’s an extra player. But in reality this extra player is imaginary, and “their” decisions are taken for them by the real player who split their cards.

In the 3-deck game analogy, a corporation is also represented by an extra hand, which is controlled by other real players. There are various types of corporation, such as:

• A limited liability company (e.g. supermarket J Sainsbury plc)

• A government body (e.g. Corporation of London; the UK Government’s Consolidated Fund)

• A foundation or trust (e.g. Ford Foundation; Nuffield Trust)

From the perspective of the card game analogy, these different types of corporation are essentially the same. The difference between them is just about who makes decisions on their behalf, and what restrictions there are on the decisions they can make.

From an economic perspective, the key feature of a corporation is that it has its own assets and liabilities (and balance sheet), which is why there is a hand associated with it in the game analogy.

The corporation is an imaginary “player”, which can’t make decisions of its own. Instead, a group of real people make decisions on its behalf. In principle, the decisions could be voted on by everyone concerned, but that’s often completely unrealistic, and a small group of people are usually appointed as directors, government ministers or trustees to make strategic decisions. They in turn delegate detailed decisions to other people who work for the corporation.

The important point is that the corporation’s hand works in the game analogy just like any other player’s hand. It draws cards, gives cards to other players, receives cards from other players, and discards cards.

The “socialism” variant

As I understand it, the defining property of a socialist society is that the “means of production” (tools, machines, factories, etc.) are owned socially. That has two consequences for the 3-deck card game analogy:

• Separate hands are created to own the means of production.

• Individuals aren’t allowed to buy, or produce for themselves (or for corporations which they exclusively control), the means of production.

That’s pretty much it. The hands containing the purple cards for the means of production could be controlled by regular meetings of citizens, or by regional, national or even global governments. Another possibility is that the employees of the corporation could control it together.

Just like corporations mentioned above, these socially-controlled corporations’ hands work just like any other player’s hand.

Summary

Many economic models make a lot of assumptions about the type of society which they describe. Neoclassical economics assumes that firms try to maximise profits. Marxist economics appears to assume that commodities have an objective value. But I believe that the card game analogy is flexible enough to describe any society without making such assumptions. All it assumes is that:

1. People exist.

2. They can own, be owed and owe things.

3. Corporations can exist. They are like imaginary people: they can own, be owed, and owe things like real people, but their actions have to be controlled by real people.

4. Anything owed by someone is owed to someone else, and vice-versa.

And as always, remember the One Lesson:

I want to be clear — this is a big claim I’m making here. People sometimes compare the real world to a game like Monopoly when trying to make a point about the economy. But games like that are artificial. Players do use money, buy and build houses and hotels, mortgage property, pay taxes, and so on, which are all things which happen in the real world economy. But most economic activity isn’t represented at all in the game, and some of what is represented is inaccurate (e.g. taxes going to the bank).

The card game is different. Every action in the economy which involves changes to what anyone owns, is owed or owes, is directly represented by players picking up, transferring, or discarding cards. It’s an accurate model of the economy.

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There’s a very nice feature, which I didn’t mention in the last article. Each player’s hand (i.e. the cards they’re holding) represents their balance sheet:

• The purple and green cards (what they own and what they’re owed) are their assets, and

• The pink cards (what they owe) are their liabilities.

If they lay out the cards on the table, face up, with the purple and green cards on the left, and the pink cards on the right, that’s basically a standard representation of a balance sheet.

Let’s see a simple example, imagine Bob owns a house, and he’s already paid for a car but not had it delivered yet (so the retailer owes him the car). He still owes the bank £95,000 of his mortgage, and he’s promised to give Alice an apple. In the card game analogy, he’d have a purple card for the house, a green card for the car, a pink card for the £95,000, and another pink card for the apple.

The only thing missing is a direct representation of (Raw) Net Worth1 on the right hand side to make the two sides balance. But that’s not a problem. The information is already there, because you can work it out by adding up all the assets, and taking away all the liabilities. If you wanted to show it directly, you could imagine doing the calculation, and writing it on a completely blank card which you put on the right underneath any of the pink cards.

The great thing about this card game analogy is that it’s accurate, it corresponds directly to what happens in the economy, and it’s easy to visualise. It means that you can use your existing understanding of card games to understand economics.

I’m convinced that a lot of misunderstandings in economics come from analogies which are relatively easy to picture, but aren’t accurate. But comparing the economy with the card game, your intuition will serve you well.

Summary

The card game described more fully in the last article is actually a model of the economy. It’s accurate and, being familiar and easy to understand, should make economics surprisingly intuitive. Next time your assets or liabilities change, try imagining what that would look like in the card game analogy, and let me know in the comments how you got on!

Economics can seem quite overwhelming. There are so many objects of so many different types (houses, cars, bikes, loaves, apples, books, pencils, plates, knives, saws, chisels, lamps, multimeters, factories, roads, banknotes, cheques, credit cards, etc.) and so many events which happen (people making or breaking things, people swapping one thing for another, people taking away goods from shops after putting a small plastic rectangle next to a small box, etc.).

People have been trying for literally thousands of years to understand all this complexity. It’s no good just making a list of all these objects and events, because you’d have no understanding of the connections between one object an another, between one event and another, and between objects and events. Instead you have to look for patterns and ideas which can explain these connections.

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Finding these patterns and ideas is the job of academics: people who have the time to think about it for hours on end. They can come up with a theory of how all the complexity and variety in the world can be explained by a small number of underlying ideas. Ideas like needs, desires, products, debts, trade, and so on.

But even if their theory is right1, the ideas are often very abstract, and not always easy for non-experts to understand. If you talk to the average person about Gross Domestic Product, for example, their eyes will probably instantly glaze over. Maybe it’s bound to happen that some important ideas can’t be fully understood by the public, but it can be dangerous for these ideas to be completely controlled by a small group of people, especially when the effects of making bad (or corrupt) decisions can have a huge effect on everyone’s life.

So it’s important for specialists to communicate the ideas to the public in a way they can easily understand, and that’s what I’m trying to do with this blog. One of the most useful tools for communicating abstract ideas is the analogy. If you can find something which is based on similar ideas, but which people are already familiar with, the subject can become widely understood.

The analogy has to be good though. A bad analogy can mislead people, and perhaps encourage them to make bad decisions. An honest communicator must be very careful not to do this.

Card games as an analogy for the economy

I’ve recently thought of an analogy for the economy which I’m convinced is very helpful, honest, and familiar: card games. Here’s the basic idea.

A group of players sits around a table. In the middle of the table are a selection of coloured pens, and 3 decks of cards: one purple, one green, and one pink.

• A purple card represents a product (what someone owns).

• A green card represents a debt asset (what someone is owed).

• A pink card represents a liability (what someone owes).

The front of each card shows what the player holding the card owns, is owed, or owes. Since there are so many different types of thing which people could own, be owed or owe, the fronts of the cards are blank at first, and players can use the pens to draw or write on them when they draw2 a card from one of the decks.

Players play by:

• drawing cards from the decks,

• transferring cards between players, or

• discarding cards to a pile in the middle of the table.

Below I describe what these actions represent. And for each, I also show the corresponding arrow diagram which I’ve been using since I started this blog.

Purple deck

Production

Picking up a card from the purple deck represents producing a product3. The player uses the pens to draw on it what they just produced. They now own something which nobody owned before.

Transfer product

Transferring a purple card to another player (in any way) represents a transfer of ownership of the product to the player who now has the card. This can happen for any of several reasons:

• The owner decides to.

• The rules of the game force the owner to transfer it. Or,

• Another player steals the card from the owner when they aren’t watching.

Consumption

Discarding a purple card represents consuming a product. What they previously owned is no longer owned by anyone.

Green and pink decks

New debt

Picking up a card from the green deck represents being owed something extra, which nobody owed before. This can only happen if another player picks up a card from the pink deck at the same time — and both players have to draw exactly the same picture on their cards. The player who picks up a pink card now owes something extra. Two players picking up the corresponding green and pink cards represents creating a new debt. The player with the new green card is the new creditor, and the player with the new pink card is the new debtor.

Transfer debt asset

Transferring a green card to another player represents transfer of a debt asset. The debt is still owed by the same player as before (the one with the corresponding pink card), but it is now owed to the new holder of the card instead of the previous holder. Just like with purple cards, green cards can be transferred voluntarily, by force, or through theft.

Transfer liability

Transferring a pink card to another player represents transfer of a liability. The debt is still owed to the same player as before (the one with the corresponding green card), but it is now owed by the new holder of the card instead of the previous holder. Normally the new debtor has to agree to accept the pink card, since it makes them worse off, but it’s possible that one player could sneak one of their own pink cards into another player’s hand.

Notice that the arrow below is in the opposite direction to the transfer of the card. This is because gaining a liability makes Alice worse off, and losing a liability make Bob better off.

Write off debt

Discarding a green card represents no longer being owed what’s shown on the card. This can only happen if another player discards a4 corresponding pink card, meaning they no longer owe the debt. Two players discarding corresponding green and pink cards represents writing off a debt.

Other rules

There isn’t enough information above to say how the game is played. You can imagine lots of different games which could be played with these 3 decks of cards, just like there are lots of games which can be played with a standard deck of 52 playing cards. But the rules above apply to all games.

There are other rules which always apply, because of how the world is. For example, there’s only a certain amount of gold in the world, so if people already have purple cards for all the gold which exists, it’s not possible for someone else to draw a card representing producing more gold5. And there are other physical constraints e.g. you can’t produce 1kg of charcoal, without consuming at least 2.5kg of wood.

Societies can also have laws and conventions which limit how players can play. For example, income taxes mean that employees have to give some of their green cards to a government player.

We’ll look at some specific games in future articles.

Summary

A card game using 3 decks of cards is a very helpful analogy: card games are easy to understand, and that understanding translates directly to understanding economics. If someone makes a claim about economics which seems dubious, always test it by imagining how the card game would look. (In my experience, they’re usually drawing a green and a pink card, but pretending that the pink card doesn’t exist).

The One Lesson has an answer, which most economists probably won’t entirely like, but I expect that some of them really won’t like the answer.

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Method

We need to decide what it means for an economy with money to be “essentially” barter. It can’t be that any scenario involving money leaves the real economy (goods and services) exactly as it would be if there were no money. There are obvious counterexamples. For example, Alice buying a book from a bookshop in my very first Substack article:

In the real economy (purple and/or white arrows only), the only change is the transfer of the book from the bookshop to Alice. This wouldn’t normally happen in a barter economy, because it would mean the bookshop had donated the book to Alice.

The reason this isn’t the same as barter is that we’re not comparing like with like. Alice has lost £10 and the shop has gained £10. To see whether a monetary economy is equivalent to barter, we need to see what actions are left over when everyone ends up with the same money they started with.

Examples where money returns to where it started

Two people

Consider this interaction from the article on Bastiat’s broken window fallacy. After a vandal has broken the baker’s window and thrown the glazier’s birthday cake in the bin, the baker buys a replacement window from the glazier for £50 cash, and the glazier buys a replacement cake from the baker for £50 cash.

Unlike in the last scenario, everyone ends up with the same amount of money which they started with. So how have everyone’s assets and liabilities changed? Hopefully it’s clear that the transfers of money cancel each other out, which means that the only changes are the transfer of the window and the transfer of the cake.

Effectively, the glazier and the baker have swapped a window for a birthday cake. It’s the same result as a barter transaction.

What about if there are more than 2 people involved?

Multiple people

Let’s look at a scenario based on the first article in the money and banking series.

Each person has something, but wants what the next person along has. Suppose Alice also has £10. She can buy the book from Bob for £10. He can then buy the cake from Charlotte for £10. She can buy the DVD from Dom for £10. And he can buy the amber from Alice for £10.

First, just look at the financial economy (green/pink arrows).

• In transaction 1, Alice loses £10, and in transaction 4, she regains £10.

• Each of the others first gains £10, and then loses £10.

So everyone ends up with exactly the same money as they started with.

Now look at the real economy (purple/white arrows).

• Alice has lost some amber, but gained a book.

• Bob has lost a book, but gained a cake.

• Charlotte has lost a cake, but gained a DVD.

• Dom has lost a DVD, but gained some amber.

Once again, the result is simply like barter, as though the 4 people had met, stood in a circle, and passed on what they have to the person on their right, while receiving what they want from the person on their left.

It seems pretty clear that if money (or any other debt asset) is simply being transferred around, and ends up back where it started, the only changes that are left are actions from the real economy. That is, the result is the same as if the people involved had met and bartered their goods and services.

What about when money is actually created in the scenario?

Money creation

As we’ve seen, most money today is created simply by banks creating a new debt. It exists for some time and then is eventually destroyed when the holder writes it off (usually in exchange for the bank either (i) writing off the holder’s loan debt to it, or (ii) giving the holder cash).

So how can we compare like with like, when the scenario involves money creation? The answer is that we need to look at what has changed once the money has been destroyed again.

Here’s a simple example, where Alice borrows £10,000 from a bank, and uses it to buy a car.

She then works for an employer for 6 months, earning £10,000 which she uses to repay the loan2.

First follow the actions for the loan:

• Created in transaction 1.

• Written off in transaction 4.

The asset and liability created in transaction 1 are both destroyed in transaction 4, leaving no trace on anyone’s balance sheet.

Now follow the actions for the new money (the “deposit”):

• Created in transaction 1.

• Transferred from Alice to etc. in transaction 2.

• Transferred from etc. to Alice in transaction 3.

• Written off in transaction 4.

This is only slightly more complicated. The asset and liability are created in transaction 1, then the asset is transferred twice before the debt is written off in transaction 4, again leaving no trace on anyone’s balance sheet.

So all that remains is the following:

Alice has exchanged her work for the car. The money simply allowed her to obtain the car before she did the work which paid for it. While it wasn’t a single transaction, the result is still that Alice has swapped her work for the car.

The effect of a debt on balance sheets

Remember that any debt is first created, then both the asset and liability sides of the debt can be passed along a chain of creditors and debtors respectively, and eventually the final creditor agrees that the final debtor no longer owes the debt.

It’s important to understand that every one of these actions can be, and most often is, part of a transaction involving other actions, as we saw in the example of Alice buying a car or working for money.

The effect of a loop of actions like this on anyone’s assets and liabilities is nothing:

• Each creditor first gains an asset and then loses it.

• Each debtor first gains a liability and then loses it.

So the only changes to anyone’s balance sheet following a scenario in which a debt is created and subsequently written off are the actions which don’t relate to this debt.

This is true for all debts. And this includes all modern money.

What this means is that, once a debt has finally been written off, the only effects which remain are from the actions relating to the real economy — and to other debts. But since this observation applies to all of those debts too, ultimately the entire economy reduces to actions in the real economy:

• Production

• Transfers of goods

• Consumption

• Provision of services (which can be thought of as the simultaneous production, transfer and consumption of an immaterial product).

There’s a constant process of unimaginable numbers of debts being created and later written off, so there is never realistically going to be a time when there are no debts outstanding, with all previous economic activity amounting to barter. But each debt outstanding at any point in time is just in the process of moving towards its effects being cancelled out. Each creation of a debt moves the economy further from a pure barter outcome, but it’s on the way to being written off, which will move the economy just as far back towards a pure barter outcome.

In the next article, we’ll see what happens if a debt remains outstanding forever.

Summary

Ultimately, the effects of any debt (which doesn’t remain outstanding forever) are undone, leaving no effect on the economy. The only lasting effects are from the real economy of goods and services.

Money is a veil over barter.

I’ve reached a new milestone of 200 subscribers (and over 300 followers)! In celebration, I’ve actually lit the candles on the cake this time.

Thank you to each one of you!

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For anyone new, if you haven’t checked out the pinned post yet, I’d highly recommend it. It’s less than 20 minutes’ reading (according to Substack!), and it’ll make the other articles much easier to understand. In particular, it shows how thinking in terms of everyone’s “Raw Net Worth” (what they own + what they’re owed - what they owe) makes economics as easy to understand as barter1. Then your intuition will be a good guide to some extremely controversial questions in economics. The pinned post also has a link to a topic index, where I’ve grouped all of the articles I’ve written over nearly 3 years into categories: money and banking, macroeconomics, double-entry bookkeeping, and more.

Also, I’d be very interested to hear from you in the comments about your background, how you came across this blog, any feedback you have, and whether there are any topics you’re interested in me covering. Otherwise, I have a few ideas in mind:

1. At some point, I’ll do the second half of the UK Exchequer series.

2. Illustrating Perry Mehrling’s “Economics of Money and Banking” lectures.

3. The economics of Minecraft.

Thanks again for reading, and remember the One Lesson!

Then you turn on the tap long enough to put in another 10 litres of water.

Can you drain out the same 10 litres of water which you just put in?

You can certainly drain out 10 litres of water. But is it the same 10 litres? And does it actually matter?

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How banks pay employees

The reason I’m bringing this up is that I’ve been trying to understand how people I’ve been debating against think. A question which has come up a few times is whether banks create money when they pay an employee’s wages.

I’d say the answer’s clear. Yes, a bank (usually) pays an employee simply by increasing the balance in the employee’s bank account. The bank is creating a new debt (which it calls a “deposit”), owed to the employee:

As we can see from the arrow, the bank’s Raw Net Worth1 (RNW) ↓ (it owes more) and the recipient’s RNW ↑ (they’re owed more).

I don’t know why anyone would find this controversial. Everyone surely must agree that a bank could pay an employee by handing over some of its cash, and that the employee could then deposit that cash back at the same bank, like this:

There are 3 actions:

1. (Transaction 1) The bank transfers £2,000 cash to the employee (“transfer debt asset” action).

2. (Transaction 2, action 1) The employee transfers £2,000 cash to the bank (“transfer debt asset” action).

3. (Transaction 2, action 2) The bank creates a £2,000 deposit for the employee (“create debt” action).

So cash is transferred from the bank to the employee and back again, and the bank creates a “deposit” for the employee. If the bank and the employee are happy to skip the there-and-back-again cash transfer (actions 1 and 2), why not have the bank simply create the deposit? The result is exactly the same.

But many economists believe that banks only create money when they lend, and most seem to be extremely resistant to having this idea challenged by examples like this. I don’t know why. (If anyone has any suggestions for possible reasons, please leave them in the comments).

One idea which I’ve heard several times is that a bank doesn’t pay employees by creating new money, but by spending some of its earlier revenue. (“Revenue” is often used interchangeably with “income”). Do you see where I’m going with this article?

Flow → flow? Or flow → stock → flow?

Economist Michael Kalecki apparently quipped that “economics is the science of confusing stocks with flows”.

• A stock is a value which exists at a point in time e.g. the amount of water in a bath.

• A flow is a change in a stock over a period of time. An increase in a stock is an inflow e.g. water running into a bath. A decrease in a stock is an outflow e.g. water draining from a bath.

RNW is a stock. Revenue is an inflow of RNW. Expenses, like wage payments, are an outflow of RNW.

To say that wages are paid from revenues is like saying that the water going down the drain comes from the tap, as though the outflow is directly connected to the inflow. This isn’t too bad a simplification if the total outflows are always exactly equal to the total inflows, but that’s assuming a very unrealistic equilibrium. In reality, outflows are rarely equal to inflows, and the difference between them causes the amount of water in the bath (or the bank’s RNW2) to increase or decrease.

Thinking of the bank as being like the bath, we can say that revenue adds to its stock of RNW. (This often involves destroying existing deposits). And its expenses, like wages, decrease its stock of RNW. (This generally creates new deposits). This seems to me to directly represent what actually happens3. Different sources of revenue (as well as injections of capital) flow into the bank, where they are pooled. And different expenditures flow out of this pool. All of this activity is happening at different times, meaning that the bank’s RNW is constantly increasing or decreasing.

In conclusion, I think it’s most accurate to say that a bank pays an employee simply by creating money: the bank creates a new “deposit” debt (by increasing the balance in the employee’s account), which transfers some of its stock of RNW to the employee. The source (or rather the many and varied sources) of its RNW (and what effect that had on the stock of money) really doesn’t matter when we’re just thinking about what happens when the employee is paid.

It’s not really about the money anyway

Sometimes this sort of argument seems a little futile, because the One Lesson argues that the quantity of money is actually far less important than most people think. It’s RNW which really matters. Creating more money is easy, as we’ve seen many times: a bank can just swap new debts with a borrower. What’s difficult to increase is RNW — to do that, someone has to produce more than they consume in the process.

But I think the discussion needs to be had because so many economists believe that money represents purchasing power. By encouraging economists to understand exactly when money is created, and when it’s destroyed — and importantly, that these are just transfers of RNW — I hope they’ll eventually recognise that RNW is purchasing power, and therefore that Jean-Baptiste Say was right. I’m firmly convinced that a stable and prosperous civilisation depends on this.

Summary

Many economists seem to think of economic activity only in terms of flows. But it’s much clearer to understand exactly what’s happening when you also consider stocks: inflows tend to increase a stock, and outflows tend to run it down. The net effect depends on whether the inflow or outflow is greater (which may be constantly changing over time).

In the One Lesson, the main flows are the economic actions, and the main stocks are each person’s Raw Net Worth (composed of their assets and liabilities).

It’s fine to say informally that someone is spending their income. But it’s clearer to recognise that their RNW sits between their income and their spending, like a bath sits between the inflow from the tap and the outflow from the drain.

As in previous articles about the BTW study, I’ll be cross-referencing it by putting section numbers in square brackets.

This last article on government spending is based on section [5.6], which discusses the “Contingencies Fund” (CCF)1, which section [3.1.3] tells us is used “for urgent payments in excess of quantities already authorised by Parliament”. It allows the government to spend more than Parliament has authorised2, by drawing on the Consolidated Fund (CF) and repaying “within the same or following financial year out of subsequently authorised expenditure”.

The most important thing is to notice how each party’s raw net worth (RNW) changes at each stage, by looking at the arrows pointing towards them (RNW↑) and away from them (RNW↓). In particular, notice how in most steps, nobody’s RNW is actually changing overall.

Unfortunately, like some of the longer articles earlier in this series, this won’t fit in an email, so please follow the link (click on the article title) to see the whole article.

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Basics of Exchequer Spending (ctd) [5]

The Contingencies Fund and Covid-19 [5.6]

This section mentions that the CCF was multiplied by a factor of 25 (from 2% of the previous year’s approved expenditure to 50%) in 2020 when the government decided to declare Covid-19 as a pandemic and introduce major restrictions on economic and social activity. This was an increase from ~£10 billion to ~£266 billion. “As of September 2020, […] £121 billion had been advanced to government departments […] of which £90 billion was ‘repaid’ following formal Parliamentary authorisation”.

In this scenario, the Department for Work and Pensions (DWP) essentially borrows £50 from the CCF, which in turn obtains it from the CF.

It continues with DWP spending the £50, and then the government receiving £50 from some other source3 . Finally, Parliament approves the expenditure which has already occurred, and CCF is repaid.

Step 1 — CCF advance to DWP

DWP, realising it needs to make a payment which hasn’t been authorised by Parliament, obtains CCF’s promise to provide money for it to spend, and promises to repay it later.

This is the same pattern as borrowing from a bank: there are two “New Debt” actions, each party promising to pay the other £50 in future.

Step 2 — DWP receives GBS deposit

DWP can’t spend a debt owed by the CCF: as we’ve seen before, it needs a deposit at GBS.

In step 2a, CCF obtains a deposit at GBS, which in turn receives CF’s promise to pay. And CCF promises to repay CF. This is very similar to a department receiving a deposit for authorised spending. But unlike allocation of authorised spending for a government department, the expectation here is that CCF actually will repay CF.

This is a transfer of £50 of RNW around a loop: CF→GBS→CCF→CF.

In step 2b, CCF transfers £50 to the DWP account at GBS, fulfilling its earlier promise.

This is just like a transfer between accounts at the same bank, as we saw in section [4.1], but in addition DWP writes off CCF’s debt, since it’s now kept its promise. So this is a transfer of £50 of RNW around a loop: CCF→GBS→DWP→CCF.

Step 3 — balance sheet

Step 3 in the BTW study just shows balance sheets of the different actors at this stage.

Step 4 — DWP spending

As we’ve seen in earlier articles, for DWP to spend its deposit, GBS needs public deposits at the Bank of England (BoE), which it obtains from the CF. If CF doesn’t have any already in its account at the BoE, it can borrow from the BoE, which creates new public deposits.

Step 4a shows the CF transferring £50 from its account at the BoE to GBS’s account. GBS writes off the debt from CF, now that CF has kept its promise.

As we’ve seen before, there are several inconsistencies in the BTW study between the balance sheets and the journals. The journals generally assume there is already money in the CF’s account at the BoE, but the balance sheets start with the account being empty. Here, I’ll follow the journals, as it’s simpler. (We’ve already seen several examples where the CF draws on its overdraft facility with the BoE because it doesn’t have enough in its account, so there’s no need to add that complication here).

This is a common settlement pattern: CF transfers £50 to GBS indirectly (via the BoE), and in exchange, GBS writes off the £50 debt from CF. It’s a transfer of £50 of RNW around a loop: CF→BoE→GBS→CF.

Step 4b shows DWP making a £50 payment.

In fact this journal in the BTW study doesn’t include rows for the recipient’s bank (HSBC) or the recipient (Alice). This would be the same as step 2 of section [5.4], and the following extra entries would appear:

(HSBC Assets): Reserves +50
(HSBC Liabilities): Deposit for Alice +50
(Alice Assets): Deposit at HSBC +50

The arrow diagram below includes these extra entries (the green tip of the arrow from BoE to HSBC, and the pink-to-green arrow from HSBC to Alice).

This is a chain of transfers of £50 of RNW: CF→DWP→GBS→BoE→HSBC→Alice. CF’s RNW↓ by £50, while Alice’s RNW↑ by £50.

Step 5 — government cash inflow

Here, the BTW study refers to an inflow of £50 cash to the CF, without going into the details. It suggests that this could be from cash management (issuing a new government bill), but since we haven’t seen that yet4, let’s assume for simplicity that it actually comes from HSBC incurring and immediately paying a tax5.

The BTW study’s journal doesn’t actually show rows for the source of the money. In the simplified example here, it is just HSBC, and the following entry would appear in the journal:

(HSBC Assets): Reserves -50

Again the arrow diagram below the journal includes this extra entry (the green base of the arrow from HSBC to BoE).

This is a chain of transfers of £50 of RNW: HSBC→BoE→CF. HSBC’s RNW↓ by £50, while CF’s RNW↑ by £50.

Step 6 — balance sheet

Step 6 in the BTW study just shows balance sheets of the different actors at this stage.

Step 7 — funding (for past spending)

At this stage, Parliament votes to approve the spending which has already occurred.6 The result is similar to the normal supply funding which we’ve seen before.

This is a transfer of £50 of RNW around a loop: CF→GBS→DWP→CF.

Step 8 — DWP repays CCF

Now that DWP has a £50 deposit at GBS again, it uses it to repay CCF, which writes off DWP’s debt to it in exchange.

This is a transfer of £50 of RNW around a loop: DWP→GBS→CCF→DWP.

Step 9 — CCF repays CF

Finally, CCF uses its balance at GBS to repay CF.

This is a transfer of £50 of RNW around a loop: CCF→GBS→CF→CCF.

Overview

As we’ve seen throughout this series on government spending, almost all activity in this scenario involves debts which just transfer RNW around a loop. The only steps which actually change anyone’s RNW are:

• Step 4b (CF’s RNW↓ £50, Alice’s RNW↑ £50).

• Step 5 (HSBC’s RNW↓ £50, CF’s RNW↑ £50).

There were 27 actions in the complete scenario. But some of the “new debt” actions (pink-to-green arrows) are undone by corresponding “write off debt” actions (green-to-pink arrows). What’s left over after these cancellations?

Just this:

Alice has been paid £50 by DWP (which is in turn compensated by CF). HSBC has been taxed £50, which is sent to CF. So the only change remaining is a new £50 deposit debt from HSBC to Alice!

It’s always interesting to look at what changes remain after a new debt has finally been written off.

Summary

The (Civil) Contingencies Fund (CCF) allows the government to make urgent payments which haven’t been authorised in advance by Parliament. Traditionally this is for modest amounts (up to 2% of the budget).

The CCF borrows from the Consolidated Fund (CF), receiving a deposit in the Government Banking Service (GBS). It lends this to a department which can then spend it. Once this spending has been retroactively authorised by Parliament, all the borrowing is repaid, and the situation returns to how it would have been if the spending had been authorised in advance in the normal way.

It’s a short article based on section [5.5], which describes the “Ways and Means (W&M) Account”. It’s basically where the government has a long-term overdraft facility with the Bank of England (BoE), for times when it’s spent more than the money coming in from tax payments and borrowing.

This section of the BTW study shows that the BoE is actually composed of two legal entities: the Issue Department, and the Banking Department.

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

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Basics of Exchequer Spending (ctd) [5]

The Ways and Means Account [5.5]

In the last article, the government spent £5 without receiving any money from tax revenue or borrowing. It did this by drawing on an overdraft facility at the BoE. Following the end-of-day sweep, the £5 overdraft was in the National Loans Fund’s (NLF) account at the BoE.

This section shows a transaction in which the overdraft is transferred to the Ways and Means (W&M) account, which is actually held with the Issue Department of the BoE — the part which issues banknotes. (Every interaction with the BoE which we’ve seen in earlier articles has been with the Banking Department). This involves a set of transfers around a loop between the NLF, the Issue Department and the Banking Department.

As we’ve seen before, there are several inconsistencies in the BTW study between the balance sheets and the journals. Here, the journal shows an increase in the assets of the NLF’s account, but the balance sheet shows a decrease in its liabilities. In this article, I’ll be following what the balance sheets say: the journal below shows the changes made to match the balance sheets.

There are 3 actions:

1. The NLF owes a new £5 debt to the Issue Department (in the Ways and Means account).

2. The Issue Department transfers some gilts1 to the Banking Department.

3. The Banking Department writes off the NLF’s £5 debt to it.

The journal shows £5 “worth” of gilts being transferred from the Issue Department to the Banking Department. That doesn’t necessarily mean a government IOU for £5, because the prices of gilts can rise and fall, for reasons which I won’t go into here. Since the “current market price” is not what RNW represents, I’ll simply show this as “gilts” without specifying exactly what face value of gilts is transferred. The transfer of gilts is still zero-sum: the Banking Department’s RNW↑ by exactly as much as the Issue Department’s RNW↓.

The NLF had a short-term £5 overdraft with the Banking Department (i.e. it owed the Banking Department £5), but now has a long-term £5 overdraft (or a £5 increase in it) with the Issue Department. The Issue Department, with its new debt asset, compensates the Banking Department for having to write off the original debt by transferring some gilts to it.2

The W&M Account in practice

This is my own observation, not part of the BTW study, but from my reading of the NLF accounts for 2023-24, the “Other Debt” owed by the NLF to the Issue Department (see P44) was £371m. It’s not clear whether this is only the W&M account, but it appears that the W&M account is included; if so, £371m is the most it could be. And compared to annual government spending, it’s a tiny fraction: < 0.1%.

Summary

The Ways and Means (W&M) account is a place where any debts owed by the government to the Bank of England (BoE) are accumulated when there isn’t enough income from taxes or private sector borrowing to cover its spending. By moving the balance from the main National Loans Fund (NLF) account to this long-term overdraft account, the main account can be kept clear of accumulated historical debts.

While in theory an unlimited overdraft balance could be kept in the W&M account, it seems that, in practice, the government avoids using it for any substantial sums.

This article illustrates section [5.4], which combines everything we’ve seen so far on government spending:

• Supply funding

• Cash allocation

• Spending

• End-of-day sweep1

We’ve been through all these steps in earlier articles, so I won’t labour the details. Instead, I’d like you to focus on two things:

1. How much everyone’s raw net worth2 changes in each step, and in the scenario as a whole. (Arrows pointing towards someone show their RNW↑ and arrows pointing away from them show their RNW↓). Notice how few of the steps involve anyone’s RNW changing.

2. How government spending means that the National Loans Fund (NLF) is left with a negative balance at the Bank of England (BoE) after the end-of-day sweep3, but the Consolidated Fund (CF) writes it an IOU to compensate, so it’s actually the CF whose RNW↓ over the whole scenario.

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

Unfortunately this article’s too long to fit in an email, so please follow the link (click on the article title) to see the whole article.

As we’ve seen before, there are several inconsistencies in the BTW study between the balance sheets and the journals. The journals assume there is always money in the CF’s account at the BoE, but the balance sheets start with an empty account. In this article, I’ll be following what the balance sheets say, because we’re thinking about how the government could spend even without receiving taxes or issuing bonds.

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Basics of Exchequer Spending (ctd) [5]

The simplest model of Exchequer spending [5.4]

Step 1 — supply funding, cash issuance

In step 1a,

• CF promises to make £50 available to the Government Banking Service (GBS) for settling payments.

• GBS creates a £50 deposit for the Department for Work and Pensions (DWP).

• DWP promises to pay the £50 to CF if for some reason it doesn’t end up spending it for the approved purpose.

This is the usual transfer of RNW around a loop: CF→GBS→DWP→CF.

In step 1b, “cash issuance”:

• GBS draws down £10 of the £50 of supply funding from CF, in the expectation of DWP spending it in the near future.

• CF obtains this £10 by borrowing it from the BoE because it didn’t have any to start with.

I’ve modified the journal for step 1b below to match the balance sheets. Instead of CF writing off £10 already in its account at the BoE (CF A↓, BoE L↓), it instead promises to pay the BoE £10 later (CF L↑, BoE A↑).

This is another transfer of RNW around a loop: CF→BoE→GBS→CF.

Step 2 — DWP spending

The BTW study slightly simplifies how it shows the DWP’s payment to Alice at this point, by missing out the temporary step of GBS first promising to pay HSBC (Alice’s bank), and settling it later. Step 2 shows the transfer between accounts at the BoE as happening immediately.

Steps 2a and 2b are combined below, since they’re logically a single transaction.

This is a chain of transfers of RNW: CF→DWP→GBS→BoE→HSBC→Alice. CF’s RNW↓ by £5, while Alice’s RNW↑ by £5.

Step 3 — balance sheets

Step 3 of the BTW study just shows everyone’s balance sheet at this intermediate stage.

Step 4 — end of day sweep

In step 4a, GBS lends its remaining £5 to the NLF overnight.

This is another transfer of RNW around a loop: GBS→BoE→NLF→GBS.

In step 4b, the CF’s debt to the BoE is transferred to the NLF. But the BTW study explains that the CF has to compensate the NLF by writing it an IOU (“Funding”) directly.4

I’ve modified the journal for step 4b below to match the balance sheets. Instead of CF gaining £10 of assets in its account at the BoE (CF A↑, BoE L↑), here the BoE agrees that CF no longer owes the £10 debt from earlier (CF L↓, BoE A↓). Also, since the NLF only has £5 in its account (transferred from GBS), it can’t lose £10 of assets from this account. Instead, it loses the £5 asset and also gains a new £5 liability.

Despite the transfer of £10 from NLF to BoE being split into two different actions, this is still just another transfer of RNW around a loop: NLF→BoE→CF→NLF.

Steps 1-4

As with other scenarios, several of the actions undo all or part of previous actions. Here’s what’s left over when we look at the scenario as a whole:

If you’re wondering what’s happening in the middle of the group of boxes on the left (NLF, DWP, GBS and CF), there’s a £10 transfer from CF to NLF (“funding”), and a £45 transfer from GBS to DWP (“deposit”). I’ve just separated the arrows to stop them overlapping each other.

Go through the boxes, one at a time, and check the total of the arrows pointing towards them and the total of the arrows pointing away from them. For example, there is one arrow pointing towards NLF (£10 from CF), and two arrows pointing away from it (£5 to GBS and £5 to BoE, so the total is also £10). See which boxes have different totals for the arrows pointing towards and away from them.

You should find that the only ones whose RNW changes are CF (↓£5) and Alice (↑£5). In other words, from the perspective of RNW, all that’s happened is that CF has transferred £5 of its RNW to Alice.

Summary

If the government doesn’t have money in its account, the Consolidated Fund (CF) can simply borrow from the Bank of England (BoE) and the government can spend that. At the end of the day, CF’s liability to the BoE is transferred to the National Loans Fund (NLF), but CF is ultimately responsible for it: it writes a corresponding IOU to the NLF.

Government spending involves a lot of accounting activity. There are good reasons for this, notably so that it can keep track of how much spending has been approved by Parliament, and how much of that still hasn’t been spent. But when we look just at how everyone’s RNW changes, almost all of this activity doesn’t have any effect, and the spending itself is simply a transfer of some of the CF’s RNW to the recipient, just like we’d expect from our intuition.

In this article, we’ll see the same payment, but using a faster CHAPS transfer, which works in a slightly different way. But, as we’ll see, the outcome is the same.

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

If you don’t have time to read the whole thing, I recommend just looking at the arrow diagrams, and especially noting whose RNW changes at each stage2.

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Basics of Exchequer Spending (ctd) [5]

Payments of out the Exchequer (ctd) [5.3]

CHAPS Payments [5.3.2]

The BTW study tells us that CHAPS payments can’t be settled directly from the Exchequer. Instead, they are settled from the reserve account of the bank which provides the banking services to the GBS (NatWest at the time of the study), which receives a transfer from the GBS’s Paymaster General (PMG) Drawing account to compensate it.

In essence, the difference between this and a BACS payment (as we saw in the last article) is that the transfers from the PMG Drawing account to the recipient’s bank’s reserve account are indirect (via NatWest), rather than direct.

Let’s take a look at the detail from the journals.

This scenario starts in the same place as the BACS scenario from section [5.3.1], where the following has already happened:

• The CF has provided GBS with £20 of supply funding3 ,

• GBS has given the Department for Work and Pensions (DWP) a £20 deposit, and

• For now, DWP has promised to pay the £20 back to the CF if it doesn’t end up spending it for the authorised purpose. (The CF gradually writes off this last IOU as the department makes the authorised payments).

And, like the BACS scenario, the aim is for DWP to pay £5 to Alice, who banks with HSBC.

Step 1 — cash allocation

This is the same as step 2 of the BACS payment, so what follows is almost a repeat of that.

GBS will need something in the PMG Drawing account to transfer to HSBC to actually settle the payment. In step 1, as we saw in step 2 of section [5.1], the CF transfers some of the balance in its account at the BoE (borrowing it from the BoE if it doesn’t have enough).

Once again, there’s an inconsistency in the BTW study at this point. The balance sheets in steps 0 and 4 imply that the CF has essentially used an overdraft facility at the BoE i.e. its liabilities increase, while the journal below shows the CF’s assets decrease, as though it started with a positive balance (perhaps from tax receipts). But the effect is essentially the same: the CF’s RNW↓ and the BoE’s RNW↑. The arrow diagram below follows what the journal shows.

There are 3 economic actions. Two for the transfer of £10 from the CF to GBS’s PMG Drawing account (via the BoE), and one for GBS writing off £10 of the CF’s “supply funding” debt, since the CF has now kept its promise.

You can think of this as the CF settling £10 of the £20 “supply funding” debt — the promise it made to the GBS earlier.

Notice that, as with all settlement, nobody’s RNW has a net change: each party’s RNW both decreases and increases by £10. So this is not economically significant.

Step 2 — payment to Alice

Step 2 is split into two parts in the BTW study, but I’m combining them here, since it should be a familiar pattern of actions by now:

• DWP transfers £5 to Alice (indirectly, via GBS, NatWest and HSBC).

• CF writes off £5 of the debt owed to it by DWP4.

There are 5 actions which form a chain of transfers: CF → DWP → GBS → NatWest → HSBC → Alice.

The difference compared to a BACS payment is just that GBS promises to pay NatWest, and NatWest promises to pay HSBC, rather than GBS promising to pay HSBC directly.

Step 3 — settlement

The final part of the scenario is settlement of the two inter-bank debts. Step 3a shows the settlement of the debt from NatWest to HSBC, and step 3b shows the settlement of the debt from GBS to NatWest. This should be very familiar by now.

First step 3a:

This is the usual 3 actions for bank settlement. NatWest transfers reserves to HSBC (via the BoE). And in exchange HSBC agrees that NatWest no longer owes the debt.

As always, when settlement involves paying what was owed, there’s no net change to anyone’s RNW. Each party’s RNW both increases by £5 and decreases by £5.

Now step 3b:

This is the same 3-action structure as step 3a. The payment is made from GBS to NatWest indirectly via the BoE, and NatWest agrees that GBS no longer owes the debt.

The only difference is that the arrow from GBS to BoE is labelled “deposit”, because government balances at the BoE are known as “public deposits” rather than “reserves”. I’m not aware of any practical difference between public deposits and reserves — I believe they’re just categorised differently.

Again, being settlement, RNW is just transferred around a loop, so there’s no net change to anyone’s RNW.

Steps 1-4

Unsurprisingly, given the similarity to the BACS payment from the previous article, all of this activity amounts to the same thing. In almost every case, there’s no net change to any party’s RNW in the transactions. The only exceptions are CF and Alice in step 2, where CF’s RNW↓ £5 and Alice’s RNW↑ £5. In other words, the whole scenario simplifies to a transfer of £5 of the CF’s RNW to Alice:

Summary

The only significant difference between a BACS payment and a CHAPS payment is that the transfer from the Government Banking Service (GBS) to the recipient has an extra link in the chain: the provider of the GBS services (NatWest at the time of the BTW study) receives payment from GBS, and makes a payment to the recipient’s bank, instead of GBS paying the recipient’s bank directly.

When we look at just the changes to everyone’s Raw Net Worth (RNW), we see that government spending for a CHAPS payment is as simple as for a BACS payment: the Consolidated Fund (CF) transfers £5 to the recipient.

In this article, we’ll finally see some actual government spending. The previous articles have all been preparation for understanding how this works. We’ll see that there are a lot of accounting entries, but that when we look at the changes to every party’s raw net worth1, government spending couldn’t be simpler.

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

If you don’t have time to read the whole thing, I recommend just looking at the arrow diagrams.

Unfortunately, like some of the earlier articles in this series, this one is too long for Substack to send in full as an email, so please follow the link (click on the article title) to see the whole article.

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Basics of Exchequer Spending (ctd) [5]

Payments of out the Exchequer [5.3]

There are three common means of making payments in the UK banking system: BACS, CHAPS and Faster Payments. A BACS payment takes 3 days to complete, similar to a cheque, while CHAPS is practically instantaneous2.

The BTW study says that BACS is the government’s preferred way to make payments, for reasons which I won’t go into here. In this article, we’ll see a BACS payment, and next time we’ll see a CHAPS payment.

BACS Payments [5.3.1]

As I mentioned in an earlier article, the Government Banking Service (GBS) acts like a bank for government departments. Its Paymaster General (PMG) Drawing account acts like a normal bank’s reserve account with the Bank of England. A payment from a government department to a recipient should look very familiar if you followed the earlier articles on banking in this series.

Before the BACS scenario of this section starts, the first step from an earlier article (see step 1 here) has already taken place:

• The CF has provided GBS with £20 of supply funding3 ,

• GBS has given the Department for Work and Pensions (DWP) a £20 deposit, and

• For now, DWP has promised to pay the £20 back to the CF if it doesn’t end up spending it for the authorised purpose. (We’ll see that the CF gradually writes off this last IOU as the department makes the authorised payments).

In this scenario, the DWP makes a £5 BACS payment to Alice (called “Recipient” in the journals). The way it works is that:

1. GBS draws on £10 of its £20 supply funding from the CF4;

2. DWP gives up £5 of its deposits with GBS;

3. Alice gains £5 of deposits from her bank, HSBC;

4. GBS promises to pay HSBC, and settles this later; and

5. CF writes off £5 of the debt owed to it by DWP5.

In the BTW study, the increase in Alice’s account at HSBC is split between step 1a (HSBC’s L↑) and step 3 (Alice’s A↑). In this article, I’m putting both parts into step 1a, because it seems far clearer to have both sides of the action (both halves of the same arrow) in the same step.

Step 1 — DWP pays Alice £5

Step 1a is the decrease in DWP’s deposits with GBS and the increase of Alice’s deposits with HSBC. Step 1b shows GBS promising to settle with HSBC later. Together, this works just like the transfer from Alice to Charlotte in section [4.2] (see here).

Since this should be very familiar already, they’re combined into a single action diagram below.

Notice that, even though this is now the third article about chapter 5 of the BTW study, this is the very first diagram in which anyone’s RNW changes. (DWP’s RNW↓ and Alice’s RNW↑). Until this point, RNW was only being transferred around a loop. This is the first significant economic activity of government spending. DWP is transferring £5 of its RNW to Alice indirectly, via GBS and HSBC.

Notice too that the structure of the diagram is exactly the same as section [4.2] step 1 (see below), where Alice (banking with HSBC) paid Charlotte (banking with Lloyds):

• The payer loses a deposit with their “bank”

• The recipient gains a deposit with their bank

• The payer’s “bank” promises to pay the recipient’s bank.

Comparing the two diagrams, we can see that GBS is performing the same role as a private sector bank.

Step 2 — cash allocation

So far, GBS has only promised to pay HSBC. It will need something in the PMG Drawing account to transfer to HSBC to actually make the payment. In step 2, as we saw in step 2 of section [5.1], the CF transfers some of the balance in its account at the BoE (borrowing it from the BoE if it doesn’t have enough).

Once again, there’s an inconsistency in the BTW study at this point. The balance sheets in steps 0 and 5 imply that the CF has essentially used an overdraft facility at the BoE i.e. its liabilities increase, while the journal below shows the CF’s assets decrease, as though it started with a positive balance (perhaps from tax receipts). But the effect is essentially the same: the CF’s RNW↓ and the BoE’s RNW↑. The arrow diagram below follows what the journal shows.

There are 3 economic actions. Two for the transfer of £10 from the CF to GBS’s PMG Drawing account (via the BoE), and one for GBS writing off £10 of the CF’s “supply funding” debt, since the CF has now kept its promise.

You can think of this as the CF settling £10 of the £20 “supply funding” debt — the promise it made to the GBS earlier.

Step 3 — GBS settles debt to HSBC

So far, the GBS has only promised to pay £5 to HSBC later. At a point later in the day, GBS actually settles its debt by making a transfer between their accounts at the BoE. In exchange, HSBC agrees that GBS no longer owes the debt.

Note that the step 3 journal in the BTW study shows Alice gaining a deposit at HSBC, but in this article that’s been moved to step 1a above, to be with the other entry for the same economic action.

This is another settlement with 3 economic actions. Two for the transfer of £5 from the GBS PMG Drawing account to HSBC (via the BoE), and one for HSBC writing off GBS’s promise to settle the debt resulting from DWP’s earlier £5 payment to Alice.

Step 4 — CF writes off £5 of DWP debt

As mentioned above, before the start of this scenario, DWP had promised to pay its allocated £20 back to the CF if it didn’t end up spending it for the authorised purpose. But now that the DWP has spent £5 of it, the CF writes off £5 of that debt owed to it by the DWP.

This is just a single economic action:

Again, this isn’t RNW being transferred around a circle, so you could say it’s economically significant. But with it being a transfer within government, it’s much less significant than step 1, which was a transfer of RNW from the government (specifically the DWP) to Alice.

Steps 1-4

If we combine all the steps, two actions cancel each other out: GBS promising to pay HSBC £5 (in step 1) and HSBC writing off that debt when it has been settled (in step 3). Also, the transfer of £10 from BoE to GBS (in step 2) is partially offset by a transfer of £5 from GBS to BoE (in step 3). This leaves the following diagram, which might seem complicated at first:

But even though the exact assets and liabilities have changed for each party, if you look at only the total change to their RNW, you’ll see that almost all are unchanged6:

DWP: + £5 - £5 = 0
GBS: + £5 + £5 - £10 = 0
BoE: + £10 - £5 - £5 = 0
HSBC: + £5 - £5 = 0

Only CF’s and Alice’s RNWs have changed:

CF: + £10 - £5 - £10 = - £5
Alice: + £5

In other words, when we’re only looking at changes to RNW, without considering the specific assets and liabilities which make it up, government spending simplifies to this:

The blue arrow represents a transfer of RNW without being specific about how that transfer takes place. From the point of view of RNW, government spending is nothing more complicated than a transfer of RNW from the CF to the recipient.

Summary

In previous articles, we’ve seen the preparation work done to enable a government department to spend. Here, we’ve seen that the spending is just like a bank transfer within the private sector. The Government Banking Service (GBS) acts like a bank for the government department, and its Paymaster General (PMG) Drawing account is equivalent to a bank’s reserve account at the Bank of England (BoE).

When a government department makes an authorised payment, that reduces the amount which it owes back to the Consolidated Fund (CF) for any authorised spending which hasn’t taken place.

While the combination of preparation work and payment may seem complicated when we look at all of the changes to each party’s assets and liabilities, it’s just made up of smaller steps which make sense in their own right. And additionally, if we simply look at the changes to everyone’s raw net worth (RNW), most of the changes cancel each other out, and government spending is simply a transfer of RNW from the CF to the recipient. It couldn’t be simpler.

Here we’ll look at how the government’s accounts are tidied up at the end of each day, and restored the following morning. This tidying is known as the “end of day sweep”, and is why people often say (misleadingly?) that the CF’s balance is reset to zero every day.

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

If you don’t have time to read the whole thing, I recommend just looking at the arrow diagrams to see how the sweep works.

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Basics of Exchequer Spending (ctd) [5]

End of Day Accounting [5.2]

As we’ve seen, the Paymaster General (PMG) Drawing account works like the GBS’s equivalent of a bank’s reserve account with the Bank of England (BoE). It holds enough “public deposits” for the payments which government departments expect to make in the short term. The CF also has an account with the BoE, which could have a positive or negative balance.

At the end of each day, these balances are “swept” into the National Loans Fund (NLF). According to the BTW study:

The purpose of this sweep is to collect all balances of central bank money across the Exchequer into a single balance so that these can be reconciled with any claims by the Bank of England on the central funds (due to issuances).

The PMG balance is lent to the NLF overnight, where it’s considered a deposit, and it’s restored by a withdrawal in the morning. It’s as though the NLF is acting as a bank for the GBS.

This scenario, showing the end of day sweep, continues the one from the previous article, where the Department for Work and Pensions (DWP) first received a £20 deposit at the GBS, for which the GBS received £20 of “supply funding” from the CF. After this, the GBS exchanged £10 of this supply funding for £10 of public deposits at the BoE1. It’s this £10 of public deposits which is swept into the NLF.

Step 4 — End of day

Step 4 is split into 2 parts. Step 4a shows the sweep from the PMG Drawing account into the NLF. Step 4b is the sweep of the CF account to the NLF.

Here’s the journal for the sweep from the PMG Drawing account:

There are 3 actions: two for a transfer of public deposits from the GBS to the NLF (via the BoE), and one for a promise by the NLF to repay the GBS the following day.

1. GBS→BoE {£10 (deposit)}: Write off debt.
   [GBS] A↓
   [BoE] L↓

2. BoE→NLF {£10 (deposit)}: New debt.
   [BoE] L↑
   [NLF] A↑

3. NLF→GBS {£10 (NLF deposit)}: New debt.
   [NLF] L↑
   [GBS] A↑

Notice that £10 is just going round a loop again. Each party both loses and gains £10 of raw net worth2 (RNW). According to the BTW study, the typical amount actually transferred from the PMG Drawing account in the end of day sweep is about £25 billion.

In step 4b, there’s another sweep — this time from the CF.

In the last article, there was an inconsistency in the BTW study between what the journal said and what the balance sheets before and after implied. The same is true here: the balance sheets in steps 3 and 5 imply that the CF’s liabilities decrease during this sweep, but the journal in step 4b shows that its assets increase. Unlike last time, I’ll show a diagram which matches the balance sheets. The reason is that the text in section [5.4] makes it clear that the aim of the sweep is to leave the CF with a zero balance at the BoE, and an increase to assets or liabilities is always moving away from zero. In practice, what really matters is that the CF’s balance with the BoE is transferred to the NLF, whether that balance was positive or negative.

The NLF is writing off the £10 public deposit asset at the BoE which it received from the GBS in step 4a, and the BoE is writing off its £10 asset owed to it by the CF in step 23.

1. NLF→BoE {£10 (deposit)}: Write off debt.
   [NLF] A↓
   [BoE] L↓

2. BoE→CF {£10}: Write off debt.
   [BoE] A↓
   [CF] L↓

3. CF→NLF {£10 (Funding)}: New debt.
   [CF] L↑
   [NLF] A↑

In this step, the NLF has transferred £10 to the CF (via the BoE). In exchange, the CF writes a new IOU (“Funding”) for £10 to the NLF.

In this particular scenario, both the NLF and the CF end up with a zero balance at the BoE. But this is just a special case, where their balances before the CF sweep happen to be equal and opposite. In general, the CF is always left with a zero balance, but the NLF isn’t.

Other sweeps

The BTW study tells us that the idea of the overnight sweep is to reconcile the Exchequer with the Bank of England by accumulating everything in a single place, and that there are other accounts at the BoE in government which are also swept into the NLF in the same way.

Note that the DWP account with the GBS is internal to government, and isn’t involved in the sweep. Only accounts held by the government at the BoE are swept into the NLF. The government departments themselves don’t need to be concerned with the sweep at all. As far as they are concerned, they have the same balance with the GBS as before.

Step 5 — balance sheet

In the BTW study, step 5 is just showing everyone’s balance sheet at this point. This series is only showing the changes to balance sheets, so let’s move on to step 6.

Step 6 — Start of day

At the start of the following day, the GBS “withdraws” its deposit at the NLF. If the NLF doesn’t have enough in its BoE account to transfer to the GBS, it obtains it from the CF (which borrows it from the BoE if necessary). In this case, the NLF’s balance is zero, and the GBS is withdrawing £10, so the NLF requests £10 from the CF.

Again, the balance sheets and the journals are inconsistent. Since the CF starts with a zero balance, I’ve adjusted the journal below to show the CF gaining a £10 liability (as implied by the balance sheets), rather than losing a £10 asset which it doesn’t currently have.

There are 4 actions here, transferring £10 of RNW around a loop:

• The CF writes a new £10 IOU to the BoE,

• The BoE creates a new £10 public deposit for the GBS (in the PMG Drawing account),

• The GBS writes off its deposit at the NLF, and

• The NLF writes off £10 of “Funding” from the CF.

1. NLF→CF {£10 (funding)}: Write off debt.
   [GBS] A↓
   [CF] L↓

2. CF→BoE {£10}: New debt.
   [CF] L↑
   [BoE] A↑

3. BoE→GBS {£10 (deposit)}: New debt.
   [BoE] L↑
   [GBS] A↑

4. GBS→NLF {£10 (NLF deposit)}: Write off debt.
   [GBS] A↓
   [NLF] L↓

No changes to RNW

We still haven’t seen anything in chapter 5 where anyone’s RNW has changed. It’s all been transfers around a loop. As I said in the last article, that implies to me that nothing economically significant has happened yet. The various new debts which have been recorded in the accounts of the government and the BoE are showing what can be expected to occur in the short and medium term.

Summary

At the end of each day, balances in the several government accounts with the Bank of England, notably the Government Banking Service’s PMG Drawing account, are “swept” into the National Loans Fund, leaving them with zero balance at the BoE, but a deposit at the NLF. In this way, the NLF acts as a bank for the other parts of government. The Consolidated Fund’s balance is also swept into the NLF. This means that there is just a single account held by the government at the BoE which has a non-zero balance at the end of the day, which makes clear the position of the government with respect to the BoE.

In the morning, the PMG Drawing account balance at the BoE is restored by withdrawing its deposit from the NLF, which can call on the help of the CF if needed.

The sweep doesn’t affect individual government departments, whose account balances are with the GBS, and are left unchanged.

All of what we’ve seen so far in the government’s accounting is transfers of RNW around a loop, so nothing of economic significance has occurred yet. (We’ll see some actual changes in RNW in the next article when the DWP actually starts spending).

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

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Basics of Exchequer Spending [5]

According to the glossary in the BTW study, “The Exchequer” means:

Central government’s central financing arrangements, based on the Consolidated Fund and National Loans Fund, and managed by HM Treasury and the Bank of England.

The Consolidated Fund (CF) and the National Loans Fund (NLF) are two separate entities, each with its own assets and liabilities. We’ll see how they work over the coming weeks. As a starting point, it’s helpful to think of the CF as the part of government associated with spending and taxation, and the NLF as the part associated with the national debt.

The other main entity involved in government spending is the Government Banking Service (GBS). It acts like a bank for government departments, which have accounts with it1. But unlike for banks, the GBS’s equivalent of a bank’s reserve account — the Paymaster General (PMG) Drawing account — is almost entirely used for transfers out. Transfers in come from the CF, not from banks.

The basic process for government spending is a little involved. Every year, each government department requests authorisation from Parliament to spend particular amounts for particular purposes. If approved, the department is given a deposit2 in an account at the GBS, and it can spend this as needed, in a process which looks similar to the inter-bank transfers which we saw in chapter [4].

I’ll mention here that government balances in accounts at the BoE are referred to as “public deposits”, rather than “reserves”. It appears to me that the difference is just how they are categorised for reports.

If this introduction seems at all confusing, it should all become clear with the example scenarios.

Issues from the Consolidated Fund [5.1]

In this scenario, we imagine that the Department for Work and Pensions (DWP) has requested Parliament’s approval for its planned spending of £203. Once this has been authorised, the DWP is first allocated a £20 deposit at the GBS. At this stage, the GBS hasn’t received any public deposits in the PMG Drawing account — instead it just has the CF’s promise (called “supply funding”4) to increase the balance when it’s actually needed. The BTW study says that:

Such issues are typically made daily and are intended only to cover the forecasted short-term expenditure of particular departments and thereby reduce the need for unnecessary cash balances.

An issue like this is shown in step 2, at the point where the DWP will be making a £10 payment soon. The GBS calls on a part of its supply funding from the CF to top up the PMG Drawing account, in readiness to make the transfer.

Step 1 — “vote funding”

This is where the DWP receives the £20 deposit in its account with the GBS. There is actually a loop of transfers, because the CF promises (“supply funding”) to make a transfer to the GBS’s PMG Drawing account on request (so that GBS can settle payments made by the DWP), and the DWP promises to pay back the CF if for some reason it ends up not spending the money for the purposes which were authorised5. (As we’ll see in future, this debt from the DWP to the CF is gradually written off as it makes its authorised payments).

There are 3 actions, with £20 being transferred around a loop.

1. CF→GBS {£20 (Supply Funding)}: New debt.
   [CF] L↑
   [GBS] A↑

2. GBS→DWP {£20}: New debt.
   [GBS] L↑
   [DWP] A↑

3. DWP→CF {£20}: New debt.
   [DWP] L↑
   [CF] A↑

Step 2 — cash allocation

At this point, £10 is expected to be paid by the DWP soon, and so the GBS needs £10 in the PMG Drawing account, ready to settle the payment.

This step works a bit like a bank withdrawal. The CF had promised (“supply funding”) to pay the GBS £20, and GBS now wants £10 of this, so it gives up £10 of its supply funding in exchange for £10 of public deposits in its PMG Drawing account. The CF obtains the £10 from the BoE.

There’s actually an inconsistency in the BTW study at this point. The text (and the balance sheet in step 3) describes the CF essentially using an overdraft facility at the BoE i.e. its liabilities increase, while the journal below shows the CF’s assets decrease, as though it started with a positive balance (perhaps from tax receipts). But the effect is essentially the same: the CF’s raw net worth6↓ and the BoE’s RNW↑. In the diagram, I follow what the journal shows.

Again there are 3 actions, this time transferring £10 around a loop.

1. GBS→CF {£10 (Supply Funding)}: Write off debt.
   [GBS] A↓
   [CF] L↓

2. CF→BoE {£10 (public deposit)}: Write off debt.
   [CF] A↓
   [BoE] L↓

3. BoE→GBS {£10 (public deposit)}: New debt.
   [BoE] L↑
   [GBS] A↑

GBS has swapped £10 of supply funding from the CF for £10 of public deposits at the BoE.

Notice how nobody’s RNW has changed in the scenario so far. In each step, each party has been involved in 2 actions: one making its RNW↑ and one making its RNW↓ by exactly the same amount. That implies to me that nothing economically significant has happened yet. The various new debts which have been recorded in the accounts of the government and the BoE show what can be expected to occur in the short and medium term.

Summary

In this article, we’ve looked at the preparations made for a government department to be able to spend:

1. Each year, the department asks Parliament’s authorisation to spend for particular purposes in that year.

2. If approved, the department is allocated a deposit at the GBS, backed by “supply funding” from the CF — its promise to provide public deposits later.

3. When the actual spending is imminent, the GBS draws on its supply funding to receive public deposits in the PMG Drawing account at the BoE, which will be used to settle the department’s payments when they actually occur. The public deposits come from a transfer from the CF, which may involve the CF using its overdraft facility at the BoE — much like a bank does when it doesn’t have enough in its account to settle an inter-bank payment.

In the next article, we’ll look at the “sweeping process” which occurs at the end of each day.

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

Again, unfortunately this won’t fit in an email, so please follow the link (click on the article title) to see the whole article.

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A simple model of the UK banking system (ctd) [4]

Intraday credit [4.4]

In version 2 of scenario [4.1], we saw how Alice (“Customer 1”) could make a £5 payment to Bob (“Customer 2”) even if she didn’t have £5 in her HSBC account, as long as HSBC allowed her to use an overdraft facility.

In this scenario, we’ll see something similar happening at the next level up, where Lloyds doesn’t have enough reserves to make a settlement payment to HSBC, but is able to make the payment by using a short-term overdraft facility offered by the Bank of England. Lloyds starts with £5 of reserves, but this isn’t enough to settle the debt which results from Charlotte paying £10 to Alice.

Step1 — Charlotte pays Alice

To start with, Charlotte at Lloyds pays £10 to Alice at HSBC, in the normal way we’ve seen in earlier scenarios.

Charlotte has £10 in her Lloyds account, so she has enough to make the payment.

This step is the usual 3 actions, as we’ve seen several times already. At this stage, Lloyds has only promised to pay HSBC later.

1. Charlotte→Lloyds {£10 (deposit)}: Write off debt.
   [Charlotte] A↓
   [Lloyds] L↓

2. Lloyds→HSBC {£10}: New debt.
   [Lloyds] L↑
   [HSBC] A↑

3. HSBC→Alice {£10 (deposit)}: New debt.
   [HSBC] L↑
   [Alice] A↑

Step 2 — Settlement

Since Lloyds doesn’t have enough reserves at the BoE to transfer to HSBC, it must instead borrow from the BoE, similarly to how, in scenario [4.1] (version 2), Alice borrowed from HSBC to pay Bob when she didn’t have enough deposits to pay him.

There’s actually a numerical error in the BTW study at this point1. Step 2a shows Lloyds borrowing £10 from the BoE, but the initial balance sheet in step 0 showed that Lloyds actually started with £5 of reserves, which means it only needs to borrow £5 from the BoE to be able to pay £10 to HSBC. So that’s what I’ll show here. Future steps in the BTW study assume that this is what happened at this point.

The BTW study notes that Lloyds must pledge collateral (some of its assets, typically gilts i.e. government bonds) as security for the loan. That is, if it fails to repay the BoE later, the BoE can take possession of them. However, this doesn’t affect the journals, unless Lloyds actually fails to repay the BoE. (We’ll see an example of this later on).

There are 2 actions: the BoE creates new reserves for Lloyds, and Lloyds promises to pay the BoE later — the normal actions for lending.

1. BoE→Lloyds {£5 (reserves)}: New debt.
   [BoE] L↑
   [Lloyds] A↑

2. Lloyds→BoE {£5}: New debt.
   [Lloyds] L↑
   [BoE] A↑

With the £5 of new reserves together with the £5 Lloyds started with, Lloyds can settle its £10 debt to HSBC.

Rather than showing a transfer of a debt asset (reserves) from Lloyds to HSBC, the journals represent it as a write off of Lloyds’s reserves at the BoE and the creation of new reserves for HSBC at the BoE. These are effectively the same thing: BoE ends up with its total reserve liabilities unchanged, Lloyds ends up with £10 fewer reserve assets, and HSBC ends up with £10 more reserve assets. The other side of the transaction — HSBC’s write off of the debt, agreeing that Lloyds no longer owes it — is shown exactly as before.

1. Lloyds→BoE {£10 (reserves)}: Write off debt.
   [Lloyds] A↓
   [BoE] L↓

2. BoE→HSBC {£10 (reserves)}: New debt.
   [BoE] L↑
   [HSBC] A↑

3. HSBC→Lloyds {£10}: Write off debt.
   [HSBC] A↓
   [Lloyds] L↓

As always, settlement doesn’t change anyone’s raw net worth2. Each party both gains £10 (arrow pointing towards them) and loses £10 (arrow pointing away from them). It’s just the composition of assets and liabilities which has changed.

If we combine both parts of step 2, we get the following diagram for the settlement of step 1:

Notice what’s going on between Lloyds and the BoE here:

1. Lloyds started with £5 of reserves,

2. It borrowed an extra £5 of reserves (promising to repay later), and

3. It then wrote off £10 of reserves.

Obtaining £5 of new reserves followed by writing off £5 of reserves cancel each out, which leaves just the two actions we see in the diagram: the promise to repay £5 (pink-to-green arrow) and the write off of the £5 of reserves which Lloyds started with (green-to-pink arrow).

This looks similar to step 2b by itself. The only difference is that half of the transfer from Lloyds to the BoE is Lloyds creating a new £5 debt instead of writing off an extra £5 of existing reserves as shown in step 2b.

Step 3 — balance sheet

In the BTW study, step 3 is just showing everyone’s balance sheet at this point. This series is only showing the changes to balance sheets, so let’s move on to step 4.

Step 4 — Lloyds borrows from another bank to settle debt to BoE

The BTW study tells us that Lloyds is apparently expected to settle its £5 debt to the BoE by the end of the day. If it doesn’t receive an inflow of reserves from another bank in the meantime3, it has to find another source.

A common way to do this is for Lloyds to borrow from another bank. In the BTW study’s example, it borrows from HSBC itself (which has a surplus due to the settlement of the payment from Charlotte to Alice). Step 4a shows this borrowing.

HSBC transfers £5 of reserves to Lloyds (again shown as an indirect transfer via the BoE), and in exchange, Lloyds promises to pay HSBC £5 the following day (plus interest, which the BTW study doesn’t show4).

1. HSBC→BoE {£5 (reserves)}: Write off debt.
   [HSBC] A↓
   [BoE] L↓

2. BoE→Lloyds {£5 (reserves)}: New debt.
   [BoE] L↑
   [Lloyds] A↑

3. Lloyds→HSBC {£5}: New debt.
   [Lloyds] L↑
   [HSBC] A↑

Apart from the minimal interest charged (not shown), again nobody’s RNW changes. HSBC is swapping £5 of reserves now for a promise to pay £5 later.

The final step in this scenario is Lloyds repaying its loan to the BoE.

This is the usual diagram for repayment. Each party writes off the other’s debt to it, undoing the original lending (step 2a).

1. Lloyds→BoE {£5 (reserves)}: Write off debt.
   [Lloyds] A↓
   [BoE] L↓

2. BoE→Lloyds {£5}: Write off debt.
   [BoE] A↓
   [Lloyds] L↓

The write off by Lloyds of £5 of reserves undoes the creation of £5 of reserves for it by the BoE in step 4a. So the complete step 4 looks very similar to step 4a:

Steps 1-4

The complete scenario may seem a little strange. Here’s the summary:

1. [Step 1] Charlotte pays Alice, requiring Lloyds to promise to pay HSBC in future.

2. [Step 2] Lloyds borrows from the BoE to pay its debt to HSBC.

3. [Step 4] Lloyds borrows from HSBC to pay its debt to the BoE.

What’s the point of steps 2 and 4, when they seem to cancel each other out? I’d say it’s that step 2 could occur before the end of day, when there’s still a chance that Lloyds will receive a payment from another bank later in the day, which would allow it to settle its debt to the BoE at end of day without having to borrow from another bank. The original debt from Lloyds to HSBC is an integral part of the bank clearing system, and must be settled the same day, while the debt from borrowing in step 4 is the result of commercial overnight lending between the banks, in which HSBC has no obligation to be involved, and for which Lloyds must pay interest.

The other curious point about this scenario is that a debt between banks is left outstanding at the end of the day. Maybe the following day, Lloyds will gain more reserves than it loses, allowing it to settle the debt to HSBC. Or perhaps it will “roll over” the loan with HSBC’s permission, paying another day’s interest. Or it could even borrow from a third bank in order to pay its debt to HSBC, and hope to settle with that bank the day after. As long as there isn’t a continuous outflow of reserves for one bank, this is a satisfactory arrangement for everyone.

Alternative scenario — Lloyds uses gilts to repay BoE

Instead of borrowing from HSBC to repay the BoE, Lloyds could actually simply surrender the gilts which were collateral for the loan in step 2. The BTW study shows a step 4 for this alternative scenario. Step 4b (alt) also shows the BoE deciding to sell the gilts to another bank (in this case HSBC).

Step 4 (alt) — Lloyds surrenders gilts

Lloyds transfers some of its gilt assets to the Bank of England, instead of repaying the loan using reserves.

The journal shows £5 “worth” of gilts being transferred to the BoE. That doesn’t necessarily mean a government IOU for £5, because the prices of gilts can rise and fall, for reasons which I won’t go into here. Since the “current market price” is not what RNW represents, I’ll simply show this as “gilts” without specifying exactly what face value of gilts is transferred.

1. Lloyds→BoE {gilts}: Transfer debt asset.
   [Lloyds] A↓
   [BoE] A↑

2. BoE→Lloyds {£5}: Write off debt.
   [BoE] A↓
   [Lloyds] L↓

In the alternative scenario’s step 4b, the BoE sells the gilts to HSBC, which may prefer to have them than the reserves it received from Lloyds in step 2b.

Again, this is gilts with a “current market price” of £5. The face value is likely to be different.

1. HSBC→BoE {£5 (reserves)}: Write off debt.
   [HSBC] A↓
   [BoE] L↓

2. BoE→HSBC {gilts}: Transfer debt asset.
   [BoE] A↓
   [HSBC] A↑

The complete alternative step 4 is just transfers round a circle, as are so many steps of these scenarios:

HSBC gives up the extra reserves. The BoE writes off Lloyds’s debt to it. And Lloyds transfers gilts to HSBC.

Steps 1-4 (alt)

Unlike the complete main scenario, the complete alternative scenario leaves no debts outstanding between the banks (other than the BoE, which still has reserve liabilities to HSBC):

Essentially, the main difference from normal bank settlement is that Lloyds transferred £5 “worth” of gilts instead of £5 of reserves for part of the amount (with the consent of HSBC).

Summary

A bank may not always have enough reserves to settle its obligations resulting from inter-bank transfers. It can obtain very short-term loans from the Bank of England to be able to make the transfers, but if it isn’t able to repay before the end of day, it needs to obtain reserves from a separate source, such as borrowing from another bank. Alternatively it can surrender the collateral from its BoE loan instead of repaying.

This is the end of the chapter on banking in the BTW study. It’s an important foundation for the study of the government’s own accounting, which we’ll start looking at in the next article.

In the meantime, if you’ve found this article interesting or informative, please click the ‘like’ button, and if you have any questions or comments, please leave them below: I’d be very interested to hear them. Thanks!

As always, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

Again, unfortunately this won’t fit in an email, so please follow the link (click on the article title) to see the whole article.

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A simple model of the UK banking system (ctd) [4]

Net payment settlement [4.3]

In the last article, we looked at an inter-bank payment, where HSBC at first just promised to pay Lloyds later, and at the end of the day actually settled this debt by transferring reserves to the Lloyds account at the BoE.

But now suppose that a customer of Lloyds makes a payment to a customer of HSBC on the same day. What we’ll see is that only the difference (the net amount) needs to be settled, and the remainder of the debts just cancel each other out.

As before, Alice (“Customer 1”) and Bob (“Customer 2”) both bank with HSBC, and Charlotte (“Customer 3”) banks with Lloyds. In this scenario, Alice first pays Charlotte £5. Later on (but before the banks have settled) Charlotte pays Bob £5, and then also pays Alice £5.

Since there are so many steps to this scenario, I’m combining the two substeps for each inter-bank payment (part ‘a’ being the change to customers’ deposits, and part ‘b’ being the promise of the payer’s bank to pay the payee’s bank later).1

Step1 — Alice pays Charlotte

This is actually exactly the same as for scenario [4.2].

So, as before, step 1 consists of 3 actions (hence 3 arrows):

1. Alice→HSBC {£5 (deposit)}: Write off debt.
   [Alice] A↓
   [HSBC] L↓

2. HSBC→Lloyds {£5}: New debt.
   [HSBC] L↑
   [Lloyds] A↑

3. Lloyds→Charlotte {£5 (deposit)}: New debt.
   [Lloyds] L↑
   [Charlotte] A↑

Step 2 — Charlotte pays Bob

Charlotte pays £5 to Bob.

This works exactly the same way as step 1, except in the opposite direction. Here are the 3 actions:

1. Charlotte→Lloyds {£5 (deposit)}: Write off debt.
   [Charlotte] A↓
   [Lloyds] L↓

2. Lloyds→HSBC {£5}: New debt.
   [Lloyds] L↑
   [HSBC] A↑

3. HSBC→Bob {£5 (deposit)}: New debt.
   [HSBC] L↑
   [Bob] A↑

Step 3 — Charlotte pays Alice

Charlotte pays Alice £5.

This is just like step 2. Here are the 3 actions:

1. Charlotte→Lloyds {£5 (deposit)}: Write off debt.
   [Charlotte] A↓
   [Lloyds] L↓

2. Lloyds→HSBC {£5}: New debt.
   [Lloyds] L↑
   [HSBC] A↑

3. HSBC→Alice {£5 (deposit)}: New debt.
   [HSBC] L↑
   [Alice] A↑

Step 4 — balance sheet

In the BTW study, step 4 is just showing everyone’s balance sheet at this point. This series is only showing the changes to balance sheets, so let’s move on to step 5.

Step 5 — bank settlement

At end of day, as before, HSBC and Lloyds need to settle their debts to each other. HSBC has promised to pay Lloyds £5 (step 1), and Lloyds has promised to pay HSBC £10 (steps 2 and 3). There’s no point in HSBC transferring £5 of reserves to Lloyds, only for Lloyds to transfer it back again plus another £5. Instead, the smaller debt (in this case £5) is subtracted from both banks’ debts to the other (“netting off”), and then only the remaining £5 needs to be settled by a transfer of reserves.

Step 5a shows this netting off.

This is a transaction consisting of 2 actions:

1. Lloyds→HSBC {£5}: Write off debt.
   [Lloyds] A↓
   [HSBC] L↓

2. HSBC→Lloyds {£5}: Write off debt.
   [HSBC] A↓
   [Lloyds] L↓

Steps 5b and 5c are the settlement of Lloyds’s remaining £5 debt to HSBC, and works just like we saw in section [4.2] where there was no netting. I’ve combined steps: 5b (where Lloyds transfers £5 of reserves to HSBC), and step 5c (where HSBC agrees that the debt is no longer owed).

The two actions are:

1. Lloyds→HSBC {£5 (reserves)}: Transfer debt asset.
   [Lloyds] A↓
   [HSBC] A↑

2. HSBC→Lloyds {£5}: Write off debt.
   [Lloyds] A↓
   [HSBC] L↓

The whole settlement process, step 5, is like this:

HSBC agrees that Lloyds no longer owes it £10 in exchange for (1) Lloyds agreeing that HSBC no longer owes it £5, and (2) Lloyds transferring £5 of reserves to HSBC.

Steps 1-5

If we combine the whole scenario from step 1 to step 5, missing out any of the actions which cancel each other out, we’re simply left with this:

Unfortunately, because Alice’s payment to Charlotte was completely cancelled by Charlotte’s later payment to Alice, this example is essentially the same as scenario [4.2], and doesn’t clearly show the effect of netting, so I’ll add another example.

Additional netting scenario

This scenario is the same as that in section [4.3], except that instead of Charlotte paying £5 to Bob and £5 to Alice, she pays £10 to Bob.

Step 1 — Alice pays Charlotte £5

This is exactly as [4.3] step 1 above.

Step 2 — Charlotte pays Bob £10

This is like [4.3] step 2 above, except that £10 is transferred instead of £5.

Step 3 — Settlement

Settlement between HSBC and Lloyds is the same as in [4.3] step 5.

Steps 1-3 combined

When all 3 steps are combined, we get a more interesting picture than the previous complete scenario from section [4.3].

Like the previous scenario [4.3], this shows that even though there were £15 of payments between banks, only £5 of reserves actually had to be transferred. But what this example shows a little more clearly is that most of what HSBC was doing was only modifying its own internal accounts: decreasing Alice’s account balance by £5 and increasing Bob’s account balance by £10. The only economic interaction it needed with other banks was receiving the transfer of reserves from Lloyds to compensate for the difference.

Summary

When payments are made between accounts at different banks, there’s a process of “netting off” where the bank which owes more to the other pays the difference, and the remaining debts are simply cancelled, since they are equal and opposite. This means that banks typically don’t need to match deposits at 100% of reserves — or even anywhere near that level. (Of course, they still need enough assets to remain solvent, otherwise the deposits are promises which they can’t keep. But some of these assets can be ones which it’s difficult to sell quickly, such as loans or buildings).

There’s still another scenario in the chapter on banking! I’ll deal with that next time, and then move on to the chapter on government spending.

As I mentioned in part 1, I’ll be cross-referencing the BTW study by putting section numbers in square brackets.

For each journal1 from the BTW study, I first show exactly the same information in an intuitive action diagram (with one arrow per action), which is the main point of this series. To help to interpret it, this is followed by a detailed description of each action in the diagram — but again this is exactly the same information.

So without further ado, it’s time to start illustrating the journals for the study’s banking scenarios, using the arrow notation for economic actions.

Unfortunately, this won’t fit in an email, so please follow the link (click on the article title) to see the whole article.

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A simple model of the UK banking system [4]

The simplest bank payment [4.1]

This scenario is a payment of £5 from one customer of HSBC to another.

There are actually 2 versions of the scenario. In the first, Alice (“Customer 1”) starts with at least £5 in her bank account before she makes the payment to Bob (“Customer 2”). In the second, she starts with a zero balance, and needs to call on an overdraft facility to make the payment.

Version 1: Payment from existing balance

HSBC simply decreases Alice’s account balance by £5, and increases Bob’s account balance by £5. This is a single action:

1. Alice→Bob {£5 (deposit)}: Transfer debt asset.
   [Alice] A↓
   [Bob] A↑

Version 2: Payment by using overdraft

By using the overdraft facility, Alice owes a new debt to HSBC. So there are 2 actions here:

1. Alice→HSBC {£5 (loan)}: New debt.
   [Alice] L↑
   [HSBC] A↑

2. HSBC→Bob {£5 (deposit)}: New debt.
   [HSBC] L↑
   [Bob] A↑

You can think of this as Alice paying Bob indirectly:

1. Alice pays HSBC £5…

2. to pay Bob £5.

A simple interbank payment [4.2]

Here, Alice is making a £5 payment to Charlotte (“Customer 3”), but this time there’s a complication: Charlotte banks with a different bank (Lloyds). In this scenario, Alice does have enough in her account to make the payment.

There are multiple steps to this scenario. (See the top-left of the journal tables for the step number).

Step 1 — Payment

Step 1a shows Alice losing £5 of deposits, and Charlotte gaining £5 of deposits.

There are 2 actions (and hence 2 arrows) here. Something is missing, and it’s immediately clear what that is from the action diagram:

1. Alice→HSBC {£5 (deposit)}: Write off debt.
   [Alice] A↓
   [HSBC] L↓

2. HSBC→Charlotte {£5 (deposit)}: New debt.
   [Lloyds] L↑
   [Charlotte] A↑

Alice is paying HSBC, and Lloyds is paying Charlotte, but that unreasonably leaves HSBC better off and Lloyds worse off. There also needs to be a £5 transfer from HSBC to Lloyds, which is step 1b:

This is a single economic action:

3. HSBC→Lloyds {£5}: New debt.
   [HSBC] L↑
   [Lloyds] A↑

At this stage, this is just a promise by HSBC to pay Lloyds later (e.g. at the end of the day). But this promise to pay Lloyds £5 at a later time immediately decreases HSBC’s raw net worth2 (RNW) by £5, and increases Lloyds’s RNW by £5.

If we combine the 2 diagrams, we can see how Alice is paying Charlotte indirectly — via HSBC and Lloyds.

As far as Alice is concerned, she’s just transferred £5 to Charlotte. Most of the time, she doesn’t need to know that Charlotte has her account with a different bank, or that there is work going on behind the scenes in the banking system to make this happen.

Step 2 — Bank settlement

At a later time (maybe the end of the day), HSBC actually transfers £5 of its reserves (from its account at the BoE) to Lloyds.

Since HSBC and Lloyds both have accounts with the same bank (the BoE), this is just like how Alice paid Bob above. HSBC instructs the BoE to transfer reserves from the HSBC account to the Lloyds account.

1. HSBC→Lloyds {£5 (reserves)}: Transfer debt asset.
   [HSBC] A↓
   [Lloyds] A↑

But settling a debt isn’t just a single action. It’s a transaction, because in exchange, the creditor agrees that the debt is no longer owed. Here’s this other half of the transaction:

Lloyds agrees that HSBC no longer owes the debt.

2. Lloyds→HSBC {£5}: Write off debt.
   [Lloyds] A↓
   [HSBC] L↓

Again, we can combine the 2 diagrams, to see the whole transaction.

As you can see, settling a debt doesn’t involve a net transfer of RNW, because that transfer had already happened as soon as HSBC promised to pay Lloyds. The baseline assumption, when the debt was originally created, was that the promise would be kept, so when the promise is actually kept, it’s not a change from what was expected.3

Let’s finish with the whole scenario, right from the beginning.

This looks very similar to the scenario for just stage 1. The only difference is that instead of HSBC promising to pay Lloyds later, in this full scenario, HSBC has actually paid Lloyds by transferring reserves at the BoE from the HSBC account to the Lloyds account. When the reserves were transferred, HSBC’s promise to pay was written off by Lloyds, which cancelled out the original debt creation, as though the debt had never existed.

Summary

Paying someone who has an account at the same bank, when there’s enough in your account to pay, is simply a transfer of “deposit” debt assets.

If you don’t have enough in your account to make a payment, the bank might agree to let the payment go ahead anyway, as long as you promise to pay the bank later (and perhaps also pay interest or a fee).

Paying someone at another bank is indirect. You give up some of the deposits in your account; your bank promises to pay reserves to the other bank (which it later settles); and that other bank creates new deposits for the person you’re paying. The banking system hides the details of how this works from customers, and makes it look as though everyone is a customer of “one big bank”, as economist Perry Mehrling puts it.

This is only about half of the BTW study’s chapter on banking! I’ll continue in the next article.

If you’ve ever wondered how the financial side of government works, there’s an excellent study of the UK Government’s accounting (“An Accounting Model of the UK Exchequer”), written in 2020 by Andrew Berkeley, Richard Tye and Neil Wilson. I found it extremely informative. You can read it here. It describes the interactions of different government institutions both with each other, and with the rest of the economy: the banking system, suppliers, lenders and taxpayers.1

The core of the BTW2 study consists of accounts for various scenarios in these categories:

• Banking, payments, and clearing

• Government spending

• Cash management and debt management (“government borrowing”)

• Taxation

The aim of this new series is to illustrate these scenarios using the economic action (arrow) notation, which I’ve used throughout this blog for the last 2 years. I believe, and hope I can persuade you, that this arrow notation can provide clarity and intuition not just about government and other accounts, but about economics more generally.

Here’s an example. In section 4.1, the BTW study uses the following table to represent a £5 payment from Alice (“Customer 1”) to Bob (“Customer 2”), who both bank with HSBC, when Alice needs to use an overdraft facility to make the payment:

The table shows 4 changes to the parties’ assets and liabilities. Pairs of related entries are linked by cross-references in the descriptions.

Now here’s exactly the same information using arrows to represent economic actions:

The pink-to-green arrow from Alice to HSBC represents the increase in Alice’s liabilities and the increase in HSBC’s assets. The pink-to-green arrow from HSBC to Bob represents the increase in HSBC’s liabilities and the increase in Bob’s assets. In an important sense, £5 is being transferred from Alice to HSBC, and £5 is being transferred from HSBC to Bob.

Economic actions, and arrow notation

If you’ve been reading this blog for a while, this should seem very familiar, and you can skip to the next section (“Five key institutions”). If not, then read on…

An economic action is an instantaneous event which changes (one or) two people’s assets and/or liabilities in a consistent way. For example, when Alice gains a liability, someone else (in this case HSBC) must simultaneously gain a corresponding asset (or, less commonly, lose that same liability). Those two journal entries are the same action (“New debt”) seen from two different parties’ perspectives: Alice (the new debtor) and HSBC (the new creditor). Analysis of economic activity into actions makes clear exactly which journal entries are inherently related in this way, and which are less-closely related by being part of the same transaction.

To see why an action is represented by an arrow, we need to understand the fundamental idea of this blog, “Raw Net Worth” (RNW). It’s:

• what someone owns + what they’re owed - what they owe, or in other words

• assets - liabilities

Most actions are zero-sum for RNW. In the action diagrams, an arrow points:

• away from the person whose RNW↓, and

• towards the person whose RNW↑

The colour of the end of the arrow nearest to a person represents whether they are gaining/losing:

• a tangible asset (purple),

• a debt asset (green), or

• a liability (pink).

There are exactly 7 types of action:

All economic activity can be divided into these 7 actions — even services. The first 4 types of action are the building blocks of the financial economy, and the final 3 are the building blocks of the real economy.

Five key institutions

To finish this introductory article, I’ll summarise the BTW study’s description of the most important institutions which it discusses. If you haven’t read the study, this should give you enough information to understand the diagrams in the subsequent articles of this series.

When I’m referring to a specific part of the BTW study, I’ll put the original’s section number in square brackets e.g. “H M Treasury [2.1]” to help you refer to that section for more details.

H M Treasury [2.1]

This is the UK Government’s economic and finance ministry. It manages government spending and taxation, and records the government’s accounts.

Parliament [2.2]

This is the legislature (the institution which creates laws). It also decides how much the government is allowed to spend, and for what purposes. Each year, the government submits its spending requests, and Parliament decides which of those requests it will authorise.

Parliament also decides which taxes will be levied.

Bank of England (BoE) [2.4]

This is the UK’s central bank. It holds an account for each of the major private UK banks, as well as a number of accounts for the UK Government.

The UK Government has several accounts at the BoE. The main ones are:

1. The Consolidated Fund (CF) account [3.1.1]. This is the main government account.

2. The National Loans Fund (NLF) account [3.1.2]. This was originally in place to keep track of government borrowing, but seems to have become less important since the introduction of the DMO (see below).

3. The Debt Management Account (DMA) [3.2]. This is managed by the Debt Management Office (separate from H M Treasury), which is responsible for government borrowing (and repaying).

4. The “Paymaster General” (PMG) Drawing account [3.3]. When a government department has been authorised to spend, transfers (up to the authorised limit) can be made from the CF account to this account for the department to spend. When a payment is actually made, it comes from this account instead of directly from the CF account. (Apparently, this is a simplification of the real accounts, but good enough to understand the idea).

5. The HMRC General account [3.3]. This is where tax receipts are first held.

Debt Management Office (DMO) [2.5]

Before 1998, the Bank of England was responsible for managing the operations of government borrowing. The DMO was created to transfer the responsibility to within the UK Government itself, around the time that the BoE was given the responsibility for setting interest rates.

H M Treasury predicts its cash requirements at different times of the year, and notifies the DMO, which meets these targets by organising the sale of “gilts” and bills. These are both essentially IOUs — promises to repay. Bills are for short-term borrowing (repaid within months), while gilts are longer-term (repaid years or even decades later).

Government Banking Service (GBS) [3.3]

This acts like a bank for government departments. When Parliament has authorised a department to spend, the department’s account balance at GBS is increased accordingly. The department can then draw down from its account into more specialised accounts (of which there are apparently over 2,000). These other accounts are actually operated by a chosen supplier — NatWest at the time of the study’s writing.

If I’ve understood this correctly, NatWest runs these accounts as though they were normal NatWest accounts, except that when an inter-bank payment is made from one of these accounts, a transfer is made to the receiving bank from the government’s PMG account instead of from NatWest’s own account at the BoE.

Summary

This was an introduction to a series of articles which will discuss UK government finances and their accounting, based on a 2020 study by Berkeley, Tye and Wilson, but representing the scenarios using economic action (arrow) diagrams instead of the study’s text-based journals. I hope this will give both readers of this blog and people familiar with the BTW study some useful insights and intuition about government finance and economics more generally.

Part 2 of the series will look at the banking system.

Edits

2025-09-14

1. It’s NatWest, not Barclays, which manages the government spending accounts of the GBS. Barclays manages accounts for tax receipts.

2. Transfers from the CF account to the PMG account don’t happen immediately on spending authorisation, but only when “drawn down” as needed.

2025-09-20

Thanks to Andrew Berkeley for these corrections!

1. While the DMO is responsible for the details of which gilts and bills to issue, and when, it’s H M Treasury which tells it what the cash requirements will be at different times of the year.

2. Added the HMRC General account to the list of main government accounts at the BoE. (In fact there are two accounts reflecting the previous separation of the Inland Revenue, and Customs and Excise, but they are treated as a single account in the BTW study).

In part 1, we looked at the changes in Bob’s assets and liabilities over his lifetime:

• He started with no assets or liabilities.

• Over his life he gained various assets and liabilities.

• He lost some, probably most, of these over his life. (He couldn’t lose any assets or liabilities which he hadn’t previously gained because he didn’t have them!).

• After his death, the probate process cleared up his remaining assets and liabilities, so that he had none left.

Here in part 2, we’ll look at the effect on the raw net worth1 of everyone else i.e. the group of people consisting of everybody other than Bob who has ever lived or ever will live. (I’ll call this group “etc.”). Since Bob ended up exactly where he started, we’re comparing like with like.

Bob’s “economic lifetime”

It’s useful to have a term for the period from the beginning of Bob’s life to the end of the probate process. I’ll call it his economic lifetime.

Always remember that every asset or liability which gets added to Bob’s balance sheet over his economic lifetime is eventually removed, one way or another. So for each asset and each liability, let’s look at:

1. The action which adds it, and

2. The action which removes it.

Then we can work out the combined effect of these actions on the RNW of the “etc.” group.

Debt Assets

Let’s start with a debt asset which Bob acquires at some point. He could be owed anything, but let’s say it’s £100. There are exactly two ways for Bob to gain this debt asset, and both involve someone else e.g. Alice. Either she:

1. Loses that debt asset (“transfer debt asset” action), or

2. Gains a £100 liability (“create debt” action), equal to the asset Bob gained.

Either way, Bob’s RNW ↑ by £100, and the “etc.” group’s RNW ↓ by £100.

Now, how does Bob lose the debt asset? Let’s assume that at this point, the person with the corresponding liability is Charlotte. Bearing that in mind, there are exactly two ways:

1. Someone other than Charlotte gains the debt asset (“transfer debt asset” action), or

2. Charlotte loses the liability (“write off debt” action).

Either way, Bob’s RNW ↓ by £100, and the “etc.” group’s RNW ↑ by £100.

So over the two actions together, Bob’s RNW is unchanged, and so is the “etc.” group’s. For example, here’s one of the 4 possible combinations:

Liabilities

That was straightforward. And so is gaining and losing a liability, as we’ll see. Suppose Bob gains a liability for a particular type of car. There are exactly two ways that could happen. Someone else (e.g. Alice) either:

1. Loses that liability (“transfer liability” action), or

2. Gains a debt asset for the car (“create debt” action), equal to the liability which Bob gained.

(If you aren’t yet familiar with the arrow notation, you might think that the first arrow is pointing in the wrong direction because Bob’s gaining the liability and Alice is losing it, but it is correct. The arrows always point from the person whose RNW ↓ and to the person whose RNW ↑).

Either way, Bob’s RNW ↓ by the car, and the “etc.” group’s RNW ↑ by the car.

Now, how does Bob lose the liability? Assume that at this point, the person with the corresponding debt asset is Charlotte.

1. Someone other than Charlotte gains the liability (“transfer liability” action), or

2. Charlotte loses the debt asset (“write off debt” action).

Either way, Bob’s RNW ↑ by the car, and the “etc.” group’s RNW ↓ by the car.

Again, over the two actions together, Bob’s RNW is unchanged, and so is the “etc.” group’s. Here’s one of the 4 possible combinations:

Is it all this simple? Not so fast!

Tangible assets

Suppose Bob at some point gains an apple, which is a tangible asset. There are exactly two ways for Bob to gain it. Either:

1. Someone else (e.g. Alice) loses that apple (“transfer tangible asset” action), or

2. He produces it himself (“produce” action).

Either way, Bob’s RNW ↑ by an apple. And in the first case, the “etc.” group’s RNW ↓ by an apple. But in the second case, the “etc.” group’s RNW doesn’t change! This is completely different from what happens with debt assets.

Now, how does Bob lose the tangible asset? Again, there are exactly two ways:

1. Someone else (e.g. Alice) gains the apple (“transfer tangible asset” action), or

2. Bob consumes it (“consume” action).

Either way, Bob’s RNW ↓ by an apple. And in the first case, the “etc.” group’s RNW ↑ by an apple. But again in the second case, the “etc.” group’s RNW doesn’t change! This is also completely different from what happens with debt assets.

Over the two actions together, Bob’s RNW is always unchanged, but the “etc.” group’s RNW changes in a more complicated way:

1. If Bob received the apple from someone, and later gave it to someone, the “etc.” group’s RNW is unchanged.

2. If Bob produced the apple himself and consumed it himself, the “etc.” group’s RNW is also unchanged.

3. If Bob produced the apple himself, but then transferred it to someone else, the “etc.” group’s RNW ↑ by an apple.

4. If Bob received the apple from someone, and consumed it himself, the “etc.” group’s RNW ↓ by an apple.

We can summarise all 4 possibilities like this:

The “etc.” group’s RNW ↑ by an apple if Bob produced it, and the group’s RNW ↓ by an apple if Bob consumed it. (If Bob did both, the increase and decrease cancel each other out).

Total

Every single one of Bob’s assets and liabilities over his economic lifetime fits one of the 3 patterns above:

• A debt asset has no effect on the “etc.” group’s RNW

• A liability has no effect on the “etc.” group’s RNW

• A tangible asset increases the “etc.” group’s RNW if Bob produced it, and/or decreases the “etc.” group’s RNW if Bob consumed it

We can summarise all this by saying that:

Over Bob’s lifetime, his economic activity increases the “etc.” group’s RNW by:

• everything he ever produced

• minus everything he ever consumed.

If he produced more than he consumed, everyone else’s combined RNW ↑ by the difference, and if he consumed more than he produced, everyone else’s combined RNW ↓ by the difference.

And that’s the simple answer to the question of what the economic effect of one person is on the rest of the world.

Other considerations

Human and social capital

We’ve looked at the economic effect of one person’s economic lifetime on the rest of the world. And that’s economic effect in a very specific sense: changes to what they own, what they’re owed and what they owe.

Some will argue that human and social capital (people’s skills in production as individuals, and as a group) are part of economics too — and rightly so. What if Bob had taught people how to cook better apple pies, or he’d organised his community so that they became better at working together to meet their needs? These definitely do have an important effect on economics.

But there’s no problem here. The effects are already included in the One Lesson’s model: the economic actions which happen after this will just be different from what they would have been otherwise. For example, there will be more “produce amazing apple pie tangible asset” actions, and fewer “produce mediocre apple pie tangible asset” actions. The effects of the actions, whatever those actions are, will still be as described by the model: the RNW of the producer will increase by what they produce.

Net consumers

We must remember that people are so much more than just their economic activity, and we shouldn’t value their life solely on what they contribute economically to the rest of the world. But it’s still important to understand that aspect. If someone is a net consumer over their life, someone else has to make up the difference. A society can’t ignore this fact. A political decision (informed by accurate economics, and taking incentives into account) is needed for how much this involves others being compelled to make up the difference, and how much is purely voluntary.

Summary

The difference between what Bob consumes and what he produces over his life is the difference between what the rest of the world produces and what it gets to consume.

Most people would probably think this is common sense, but hopefully this proves it to the economists!