Why We Need Government Deficits

We’ve seen in the last few weeks that money is created when banks make loans, so increasing the money supply in line with productivity is only possible with ever-increasing private debt, which is simply not sustainable, and hence our economy is prone to cycles of boom and bust.

So clearly, we need a way to create new money that is not based on private debt – money that will not be destroyed when private debt is repaid.

One option would be to give the banks the right simply to create new money out of nothing that isn’t linked to debt, and spend it as they wish.  Okay, hands up who wants to give the banks that power?

There are various other alternatives.  As mentioned last week, new money could be paid directly to citizens (‘helicopter money’).  An administratively simpler system than direct payments would be to distribute the money through the current tax and welfare system.  Effectively, a portion of Government spending would be funded with newly created money, enabling tax cuts.  You can see here  that what you are doing is funding a Government deficit.  And hence another option is simply to fund a portion of Government expenditure out of newly created money.  The benefit of this is that you can ensure that new money is spent on investment (in the case of Government expenditure, through infrastructure projects, which is what is proposed with ‘People’s Quantitative Easing’, also mentioned briefly last week).

But at the end of the day, whether you say you are funding ‘helicopter money’, tax cuts or Government spending (infrastructure or otherwise) makes no difference from an accounting point of view.  The creation of the new money would be a liability of the Central Bank, part of the public sector.  Even if all the new money is given out as grants to the private sector (effectively ‘helicopter money’ for private businesses), the giving of that grant would be public expenditure in the national accounts, so this would still be funded by a Government deficit.

Needless to say, if I was to get into the technical accounting detail of how these options could work it would take weeks of posts.  I’m dying to explain how Quantitative Easing was sort of like this but also different (and why it failed abysmally) but that in itself would take a couple of posts.  And in fact, worrying about what to spend the money on is a pointless distraction – right now we already have a deficit, we would just need to fund a portion of this through new money instead of selling bonds.

All we need to focus on for now is the essential principle:

Increasing productivity requires an increasing money supply if we are to avoid deflation.  In our current system, new money is only created as private debt, which drives up the private debt to GDP ratio.  Empirical evidence tells us that all crashes have been preceded by high private debt ratios.  We therefore need a monetary system that has an alternative way to create new money – and the only option is through a Government deficit.

Government deficits are essential to our economic health, and all the clamour over them in public discourse is completely misguided (so you can add this to my earlier post explaining why ‘Magic Money Tree’ is such an ignorant phrase).

Over the last 2 weeks I’ve emphasised that I’m not interested in simplistic ‘solutions’.  But what is clear is that one element of a functional monetary system, that serves an economy that provides enough for everyone, would be a level of Government deficit funded through newly created money.

This proposition is likely to raise howls of protest, both for ideological reasons, and because the notion that a deficit is a bad thing is so ingrained in people’s thinking that they will struggle to grasp this new idea.  But it is based solely on the logic of the sequence of ideas presented in this blog, and summarised above.  If you don’t think it can possibly be right that Governments actually need to run deficits then go back through the blog and find the logical errors.  Don’t just spout that I must be wrong because “everyone knows” that Government deficits are bad!

And in terms of the logic of this, I need to be very clear.  I am saying that, to avoid deflation, it is necessary for the money supply to increase if productivity is increasing, in a way that does not require spiralling private debt (as the current system does).  Therefore, the amount of new money to be created is based purely on a calculation of the quantity of new money needed in the economy.  This calculation is entirely separate from any consideration by the Government of how much they want to spend.  Indeed, one can imagine a system in which the monetary authority grants the Government new money to spend, but if the Government wants to spend even more than the sum of its tax revenues and this new money it can still borrow the difference.  (Government bonds play an interesting and critical role in financial markets and monetary policy, but discussing that will have to wait for another time.)

So I am not saying, in any way, that all Government deficits should be funded by new money up to whatever amount the Government wants to spend.

What I’ve said implies that an institution (for example, the Monetary Policy Committee of the Bank of England) needs to decide how much new money needs to be created each year, and where this needs to be spent, keeping a close eye on levels of private debt, investment, productivity, and the balance of payments.  And there could be times, for example when the economy is at full capacity and inflation is rising, when it would be necessary to have a Government surplus to reduce the money supply and cool down the economy.

Will they get this calculation right?  Almost certainly not.  Indeed, no economy is run on this basis, so no-one in the world can claim to know how to do this.  The first time this is attempted there are likely to be multiple unforeseen problems and it could take generations to learn how to do this effectively.

But we need to learn how to do this, as a society.  Everything you see in the media railing against deficits is wrong.  All the politicians, journalists and economists getting in a frenzy about government deficits simply do not understand how the monetary system works.

But equally, most of those seeking to justify government deficits are just as clueless.  It’s not that they understand that deficits (within very definite limits) are necessary to a healthy economic system, they just don’t want to see the loss of jobs and public services.

Let’s be absolutely clear – it is not merely Government spending that is necessary, it’s not just a Government deficit this is required, it’s a deficit funded with newly created money.  Funding deficits by selling Government bonds, as happens currently, does not fulfill this purpose because it does not involve the creation of new money.  The vast majority of those arguing for deficits (or against austerity) don’t understand this systemic need for Government deficits, because they don’t understand our monetary system, and therefore are not making the compelling case for them.  I find this even more infuriating than those who argue for a  Government surplus.  (If we ever achieved a surplus this would actually choke the economy and ramp up private debt even further, hastening the next crash.  But in any case, in the current economic climate we will never achieve a surplus – the more cuts Government makes, the more it chokes the economy causing tax revenues to fall, leading to a continued deficit.)

What is needed is a clear-headed understanding of how the monetary system works and how it serves as the lifeblood of the economy.  If we want to create an economy that provides enough for everyone we have to learn to study economic phenomena scientifically, free from political bias.  The need for Government deficits is really a minor point in creating such an economy, but pointing it out with such emphasis is to show you how warped economic thinking becomes when it is mired in political dogma.

As Keynes famously wrote in the introduction to his ‘General Theory’:

The ideas which are here expressed are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify … into every corner of our minds.

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