Eureka - How the Bank of England could fix the system for good

I think this may be it. The solution....

Here's what needs to happen.

1) The Bank of England should introduce a modest financial transaction tax on all sterling-denominated electronic transactions

2) The money raised by the tax should be used in two ways

• To progressively buy back the entire stock of gilts that are not already held by the Bank of England (£1214 billion)
• To provide the UK government with enough funds to cover the public sector borrowing requirement

That's it. Simple.

Let's see how this might work. Suppose that the Bank of England were to set the rate of the financial transaction tax at 0.05%. To calculate how much revenue would be generated, we would need to know the volume of sterling-denominated transactions. This is actually not trivial. I have estimated UK transactions at over £2 quadrillion a year in 2014. However, a substantial proportion of those transactions are certainly in other currencies, especially the dollar and euro. I'll assume that the volume denominated in sterling is about 25% of the total - i.e. £500 trillion a year. With the tax set at 0.05% this would generate around £250 billion a year.

The Government is currently expecting to have to find roughly £100 billion to cover the public sector borrowing requirement, but this is supposed to drop over the next few years. So lets assume that there will be at least £40 billion per quarter for the buy-back program. At that rate, it would be possible for the Bank of England to buy back the entire stock of gilts by about 2022.  The following graph (modified from the one I published earlier this week), shows how this could happen.

In the graph I have simply assumed that the Bank of England buys up the stock of gilts uniformly, until in 2022, there are no gilts left in the hands of the financial markets.  From that point on, the 4.4% of GDP that UK taxpayers have been forking out every year to pay interest on government debt since 1694 would be history. But of course, the precise sequence of buy-backs could be done in another order if needed. It might be a good idea for the Bank of England to buy back gilts preferentially from particular players. For example, if we conside the £1214 billion currently in circulation outside the Bank of England, £24.9 billion (2.1%) are currently in the form of gilts held by households. Allowing these "households" to cash in their gilts first might be particularly useful, because those households are more likely to  spend their cash in the economy that other players. The same argument applies in the case of Public Corporations, Local Government and Private Non-Financial Companies which together hold about £3.5 billion in gilts. But this is a mere 0.3% of the total.

Most of the gilts are currently in the hands of Insurance Companies and Pension Funds (£468.3 billon), Foreign Investors (£333.4 billion), Other Financial Institutions (£159.7 billion), Monetary Financial Insitutions (i.e. Banks, £157.9 billion), and Foreign Central Banks (£66.3). Frankly, for me, I don't think that any of them deserves special treatment.

There are a number of points about this potential solution that merit attention.

First, the Financial Sector, which holds 97.7% of all the £1214 billion currently owed by UK taxpayers, should be happy. Over the next few years, they will receive exactly the same amount that they contribted in the first place, so surely they will be in no position to complain. I note that this freshly minted Bank of England cash can be spent on anything - including bankers bonusses if they want.

Second, the standard complaint that Central Bank Money creation leads to inflation falls flat on this occasion. Since the money used by the central bank to buy the gilts has been removed from circulation by the Financial Transaction Tax, there is strictly no way that this procedure could produce inflation.

Thirdly, this procedure will produce a massive reduction in the the amount of money that needs to be paid out in interest payments. In the last 20 years, UK taxpayers have handed over £653.6 billion in interest payments on public sector debt. That's over £10,000 for every man, woman and child in the country.  This money will be saved in future, and could be spent on more useful things, including health, education, housing, renewable energy, transport and so forth.

Finally, it should be noted that the mechanism doesn't require anything too radical (apart from the introduction of a Financial Transaction Tax). The fact is that we are already used to the idea that Central Banks buy back government bonds on the secondary markets. It's precisely what the Federal Reserve, the ECB and the Bank of England have been doing for some years now. The only real difference is that here I am proposing that they don't just buy back some modest proportion of the bonds. Instead, they simply have to bite the bullet and buy up the whole lot. 

But there are a number of other somewhat more indirect benefits of such a scheme.

Firstly, by showing that the sky doesn't actually fall in when you introduce a financial transaction tax, the path will be cleared for a radical reform of the tax system. You may well be aware that for over four years I have been arguing that it should be possible to replace the vast majority of taxes by a universal flat rate transaction tax. Once it is clear that the UK government can indeed use an FTT to raise money, there would be nothing to stop it going on to scrap other taxes. As I have argued, Income Tax, which raised £163.2 billion last year, could be replaced by an FTT of well under 0.1%.  Likewise, VAT, which raised £111 billion, could also be replaced by an FTT well under 0.1%, as could Corporation Tax, which raised a relatively modest £42.3 billion. Getting rid of these antiquated taxes would be a really good move.

Second, if the scheme works, it should also become clear to everyone that, in fact, Central Banks can perfectly well inject money into the economy directly. In the current scheme, I was careful to avoid the standard complaint that Central Bank money creation could lead to hyper-inflation by ensuring that the exact same quantity of money would be removed at the same time. But it will rapidly become clear that there is actually nothing to stop the Central Bank buying up a larger quantity of gilts than can be purchased directly with the revenue generated by the FTT.

Third, once the gilts have all been reabsorbed, and the interest payments brought to an end, the FTT would still be in place, and the Bank of England would still be able to raise revenue. At this point, this money could be given directly to the UK government to finance public sector spending, including spending on pensions, health, education and so forth. 

Finally, don't tell anyone in the Banking sector, but the fact is that this scheme would actually break the entire basis on which the entire current financial system is built. Instead of being perpetually in debt to a Commercial Banking system that lends the government money that it creates  out of thin air, and then sits back an collects the interest, the UK's democratically elected government would finally be able to break free of the stranglehold of the banks. The Government of  the 1%, by the 1% and for the 1% would cease.