Why Government Deficits Are Good

We’re all familiar with the expression ‘money doesn’t grow on trees’. Politicians often use it when they want to justify cuts to public services. And it is, of course, true. Money really doesn’t grow on trees. What is more rarely discussed, though, in relation to how public services may be financed, is just where money does come from. I would like to offer a brief account of where money comes from.

Money is created when people borrow it from banks. Suppose I want a mortgage to buy a house. I go to a bank and ask to borrow £100 000. The bank looks at my income, at the value of the house I want to buy, at my credit history and so forth, and then agrees to lend me the money. At that point, the bank credits my current account, which may be with the same bank or with another financial institution, with £100 000 and at the same time opens a new account in my name which has a balance of -£100 000. This second account is the mortage which I must, over time, repay. The £100 000 which is deposited in my current account is new money which can then be used to pay for things. I can arrange for it to be transferred to the account of the seller of the house, in exchange for the house. The seller of the house can then use that money to buy goods and services. This is how money is created. It is created by being borrowed from banks.

This might seem strange. I think many of us intuitively feel that banks play an intermediary role between savers and borrowers, and that the banks lend out to borrowers money that has been previously deposited in the banks by savers. I think we feel that this must be the case because in our everyday lives we cannot lend something that we don’t have. Whether it’s money or sugar, we can only lend something to someone else if we have first acquired it ourselves. Banks, though, are different. Banks are licensed to create money by lending it. I realise that this is a startling idea, but if you still doubt it I’d ask you to consider, then, just where, if it doesn’t come into existence by banks lending it, money does come from (remember, it doesn’t grow on trees).

Money comes into existence when people borrow it from banks. Every time someone borrows money from a bank one account in that person’s name is credited and another account, also in that person’s name, is debited. That person may then use the money in the account that has a positive balance to buy things. Let’s look again at the example in which I borrow £100 000 to buy a house.

The bank agrees to make me the loan. It credits my current account with £100 000, and opens a new account in my name with a balance of -£100 000. I then transfer the £100 000 from my current account to the current account of the seller of the house. Now, I owe £100 000 to the bank and the seller of the house has £100 000 that they can spend on other stuff. I no longer have £100 000 credit in my current account but I still have -£100 000 in my mortgage account. The £100 000 credit is now in the account of the seller of the house, and from there it may be transferred to the accounts of shops and restaurants and garages where the seller of the house uses it to purchase goods and services.

All money is like this. If someone has an account with a positive balance it is because that same person, or someone else, has another account with a negative balance. Accounts with a positive balance are only possible because of other accounts with a negative balance. If positive balances in some accounts rise, then negative balances in other accounts must also rise. A simple way to think of it is like this.

savings (positive balances) – debts (negative balances) = 0

Let’s write this as

S – D = 0

Now, of course, some people like to save. That is, they maintain accounts with a positive balance, and they add to that positive balance. I think we can easily see that doing this is only possible if there are others who are accumulating debt. If S rises, then D must also rise, since S – D = 0.

We can distinguish, though, between two types of debt. There is private sector debt, and there is government debt. Let’s call these PD (private sector debt, the debt of individuals and firms) and GD (government debt). Now,

S – (PD + GD) = 0

I think it is clear from this that any reduction in government debt will necessarily entail either a rise in private sector debt or a fall in savings, and also that if the level of savings rises then either the level of private sector debt, or the level of government debt (or both) must rise. Sadly, when politicians bemoan the level of government debt, journalists do not typically ask them whether they would prefer to see the level of savings fall, or the level of private debt to rise. If government debt falls then either the level of savings in the economy must fall, or the level of private sector debt must rise. Every time a politician says they want to cut the deficit they should be asked whether they want to stop the level of savings from rising, or if they want to see the level of private sector debt rise.

The only direct way that goverments could prevent the level of savings from rising would be by confiscating savings. I think it’s safe to say that this option is politically unpalatable, especially amongst exactly those conservative politicians who insist most strongly on the need to cut the deficit.

The alternative, in periods during which the level of savings is rising, would be to allow the level of private debt to rise. High levels of private debt, though, are extremely dangerous, as we saw in 2007. As a person’s debt grows they begin to worry more and more about whether they will ever be able to repay it, and the lenders also worry more and more about whether they will ever get their money back. Either way, people spend less, either because they want to reduce their debts or because others will no longer lend them money to spend. This is how recessions happen. Consumers wish to reduce their debt, or are forced to reduce their debt, so they stop spending so much. By doing this, though, they succeed only in putting each other out of work. When consumers reduce their spending employers lay off staff, since it’s no longer profitable for them to continue to employ so many staff. When staff are laid off their ability to spend money on goods and services is reduced further, which leads to employers laying off more staff still, and so on. The economist Irving Fisher put this well when he said,

‘the more debtors pay, the more they owe.’

As people seek to reduce their debts they reduce each other’s income, which serves only to increase their debts.

Government debt, though, is different, at least in the case of the government of a country with its own central bank and its own currency. Remember, money is created when banks lend it. If it were absolutely necessary, a central bank could create more money by lending money to itself (in fact, this is how central banks finance quantitative easing). This means that the government of a country with its own central bank could never be in a position where it was unable to repay its debts. It would always be able to borrow money from its own central bank with which to repay its creditors. I am not recommending that governments actually do this to finance their spending but the fact that they could do it if it were necessary means that lenders need not worry about governments being unable to repay in the way that they worry about private borrowers being unable to repay. High levels of government debt will not lead to recession in the way that high levels of private sector debt will lead to recession.

The upshot is this. Since S – (PD + GD) = 0, if S rises then either PD or GD must rise. As long as people want to save the only way of preventing S from rising is for government to somehow prevent people from saving. If PD rises to the point where lenders begin to worry about whether they will get their money back then the economy goes into recession. The only remaining option appears to be to allow GD to rise. Rising GD is the government deficit. Rising levels of government debt are much, much less dangerous than rising levels of private sector debt, for the reasons I’ve outlined above. Unless the government has a workable plan to stop the level of savings from rising then the only alternative to rising private sector debt is rising government debt. During periods in which people want to increase their savings governments can do one of three things.

a) limit how much people can save

b) allow the level of private debt to rise

or

c) allow the level of government debt to rise

Next time you hear a politician say that they want to eliminate the deficit (i.e. stop government debt from rising) please ask them which of a) or b) they prefer. Do they want to stop people from saving money, or do they want people to accumulate unsustainable levels of debt? Eliminating the government deficit necessarily entails doing at least one of those two things.