Is David Cameron the most dangerous prime minister we have ever had?

David Cameron never tires of lecturing us on the dangers of debt. We have all borrowed too much. Banks are over-leveraged. And of course his favourite, that the government deficit and resulting growing government debt are unsustainable and must be slashed. It sounds convincing to most. But it dangerously confuses two very different types of debt, public sector debt and private debt, and in doing so it advocates policies that are incoherent and dangerous.

A few simple facts.

1. In order for the economy to grow there needs to be an increase in the money supply.
2. There are two basic ways of introducing money into an economy. The first is by governments spending more into the economy than they extract through taxes, i.e. by deficit spending. The second is by commercial bank lending. When banks make loans they create new money. This money is always associated with a matching debt.
3. In the past few decades mainstream economic opinion has held that deficit spending is a bad thing and that government should strive to balance their budgets over the economic cycle. As a result the monetary growth required for economic growth has been almost entirely the result of commercial bank lending. In the UK almost all (97%) money is commercial bank money which is matched, of course, by the same amount of debt.
4. These policies mean that economic growth REQUIRES ever-increasing debt. Indeed private debt levels have grown relentlessly in the past 30 years, assisted by progressive loosening of banking regulation and credit controls. Debt was at historically unprecedented levels, in excess of 300% of GDP, before the global financial crisis.

This growing private debt was pretty much ignored at the time by economists, central bankers and politicians. In retrospect we now appreciate that continued growth of private debt as a proportion of GDP was and is unsustainable, and that the collapse of the asset price bubble that supported it was the primary cause of the global financial crisis. Attempts by the private sector to reduce their debts is the primary reason for the sluggish growth we are experiencing. The main focus of policymakers at present is to persuade the private sector to start borrowing once again using 'monetary policy'. Hence the focus on measures to keep interest rates low. Quantitative easing is one of these policies. Central banks create money to purchase debt instruments, thereby making them cheaper and effectively reducing the cost of borrowing.

However a policy response confined to restarting private borrowing seems illogical. In the best case scenario commercial bank lending will resume growing, and private debt will reach even higher levels, returning us eventually to the situation that caused the current crisis, excessive private sector debt and an over-leveraged banking sector.

So why do policymakers focus on using monetary policy to engineer a recovery? Primarily because they do not consider the other method of money creation, deficit spending, to be an option. Why not? There are three main reasons given to justify avoiding deficit spending. All three are easily dismissed.

1. High levels of government debt are unsustainable because the market will charge ever higher interest rate to lend governments money, which would lead to even greater debt and eventually possible default. Politicians point to Greece as a lesson in point. This is completely wrong. Eurozone countries are currency users who have no power to create money. Like you and I they have to raise it or borrow it to spend it. Most countries, including the UK, issue their own currencies. This means that they can never be forced to default on any debts in their own currencies. The central banks can always simply issue money to repay this debt. Bond traders know this, which is why bond yields in these countries (e.g. USA, UK, and Japan) are so low despite high debts and deficits. To use the threat of the bond market to scare voters into accepting cuts in government spending reveals remarkable ignorance or frank dishonesty.
2. The second, more sophisticated, reason given for 'cutting the deficit' is that government borrowing reduces private investment by competing with ('crowding-out') private borrowing, thereby increasing interest rates. There is no evidence to support this. Furthermore, central banks can always intervene to keep interest rate low.
3. The third reason given is that deficit spending will lead to inflation. This is a potential concern but is easily monitored and avoided. As long as unemployment is high and there are high levels of spare capacity in the economy deficit spending is unlikely to lead to inflation. Inflation is a result of demand exceeding supply. When the problem we face is weak demand it seems perverse to worry about inflation.

Not only are government deficits mostly harmless, they are actually essential, especially under the current circumstances. An understanding of sectoral balances explains why. The key concept to grasp is that the government sector and the non-government sector balances always have to add up to zero - this is an accounting identity. Thus for the non-government sector to save more REQUIRES the government sector to run a budget deficit. Conversely, if the government reduces its deficit or runs a surplus the non-government sector is FORCED to increase its borrowing and go further into debt. This is probably why all six periods in the past 200 years in which the US government ran multi-year surpluses were followed by depressions. By running surpluses these governments unwittingly bankrupted the private sector! Cameron and his fellow deficit hawks would happily do the same, in the name of 'sound fiscal policy'. That is why they are so dangerous.