FROM the latest cuts to the economic forecasts to the Italian elections to the gathering debate about how George Osborne should play this year's Budget, all discussions about the financial system now lead swiftly back to the world's sovereign debt problem.

It towers over every effort to get back to prosperity, threatening to take decades at best before it can be resolved, very possibly with an almighty crash along the way.

But maybe that is because we are looking at a 21st-century problem in a 20th-century light. My research at University College London indicates that the answers might lie in modern versions of legal structures and instruments which pre-date the modern financial system and even the incorporating Union of England and Scotland in 1707. But before I explain this "back to the future" proposal for recovery, a warning: we'll need to turn much of the received wisdom that underlies modern economics and politics upside down as we proceed.

1: loans, taxes and tally sticks

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

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

It could be handed back (hence "tax return") in lieu of more conventional money at any point in the future when they came to pay their taxes. Naturally these medieval taxpayers did not give the sovereign £10 worth of value in exchange for a £10 prepayment but received a discount for their trouble. The phrase "rate of return" literally means the rate over time at which the stock could be returned to the issuer, enabling the initial discount to be realised.


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

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

3: THE myth of tax and spend

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

The fiscal myth of tax and spend shared by virtually all schools of economics is that tax is first collected and then spent. This has never been the case: the reality, as we have just seen, has always been that government spending has come first and taxation later.

The central bank creates credit, or money, on the Treasury's behalf which it exchanges with the Treasury for gilts, or lends to the clearing banks as necessary for them to balance their interest-bearing lending and deposits. Taxation acts to remove money from circulation and to prevent inflation: it does not fund and never has funded public spending.

4: printing money

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

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

Putting most money creation into the hands of organisations whose raison d'etre is to make money from lending (and more recently, from speculation) is behind much of what has gone wrong with the financial system. As with all historic bubbles, the profit motive drove excessive credit creation.

Bank lending departments were abetted by everyone from bank lobbyists persuading the authorities to allow dangerously low capital ratios to trading departments devising increasingly complex instruments for shifting loans off bank balance sheets to make more and more lending possible.

5: Conclusions

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

The question is, how and by whom such state credit issuance and allocation should be professionally managed and accountably supervised. For instance, in Hong Kong, there is no central bank. The Hong Kong Monetary Authority supervises the issuance of virtual currency and physical bank notes by three commercial banks including HSBC.

The Hong Kong dollar is kept pegged to the US dollar between upper and lower rates which are defended by a currency-board mechanism, putting strict limits on the amount of money the commercial banks can create.

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

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

All existing UK gilt-edged stock could be consolidated into a single class of undated stock as happened before with Chancellor George Goschen's conversion in 1888, which created the single class of undated consolidated stock ("consols") that remains to this day. The absence of dated "debt" obligations would drastically reduce the UK's funding costs to the rate of return paid in respect of this "national equity" because there would be no need to pay back each gilt as it reached its redemption date.

In fact, one could argue that the creation of £375 billion of quantitative easing (QE) reserves – upon which the Bank of England pays interest at 0.5% pa – has partially achieved such a consolidation by the back door.

These reserves of "fiat money", created and used by the Bank of England to buy and hold gilts, are assets which are functionally equivalent to gilts, since both are created as claims over future tax income, just like the broken tally sticks from days long forgotten.

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