Why public sector deficits are prudent and surpluses are reckless

Those of us who approve of prudent financial behaviour are naturally inclined to think that it is prudent for governments to reduce their budget deficit and even run surpluses to pay of the 'national debt'.

However this is wrong, tragically wrong.

It is wrong because it misunderstands the crucial difference between the currency-issuing authority, that is the government, and everyone else who are currency users. [Note that Eurozone governments are currency users and this post does not apply to them]

Currency-issuers have a very different role from currency-users because they control, through spending and taxation, the amount of private saving that is possible in an economy. By extracting less in taxes than they spend into the economy (i.e. by running a deficit) a currency-issuing government allows the collective private sector to behave in a prudent manner and accumulate savings. Conversely, when such a government extracts all that it spends (i.e. balances its budget), or extracts MORE than it spends (run a budget surplus), it forces the collective private sector to borrow, and this can result in dangerous increases in private debt, insolvency and economic collapse. It is an under-appreciated fact that all of the 6 depressions in the past 220 years of American history were immediately preceded by several years of budget surpluses, as 'prudent' Governments tried to pay down the national debt. Conversely, multi-year budget surpluses have always been immediately followed by depressions.

The point is that when currency-issuing governments behave 'prudently' and pay off their 'debt' the collective private sector is forced to increase its aggregate debt, and this may be highly imprudent. Requiring a currency-issuing government to balance it budget means that the central bank issues no new currency to support demand and growth. Instead it can only encourage private borrowing. For the economy to grow this borrowing must increase relentlessly, until it eventually becomes unsustainable, as happened in 2007/8.

Only once we understand the essentially different role of currency-issuing authorities (which need to expand the money supply in line with real economic output) and currency-USING authorities, which must only spend what they can earn, will we be able to combine economic growth with sustainable levels of private sector debt.