Demand leakages require deficit spending

In a simple economy, with no government and no foreign trade, economic activity (the GDP) can only remain at a stable level if everyone spends all their income.

Why?

Because if they don't spend all their income but instead save some then they deprive other parties of income. These other parties then have to cut down on their purchases. The original sellers will experience a reducing in sales and therefore receive less income. To be succinct: if you represent the entire economy your spending today is your income tomorrow. Cut spending and you cut your income.

Understanding this basic principle is so important that I will illustrate it with an example. Imagine that the economy consist only of two people, one producing food (the food guy) and the other drink (the drink guy). Imagine that they have 1 dollar between them, which is 'the money supply'. To start things off the drinks guy has the dollar and he uses it to purchase food from the food guy, which enable the food guy to use this dollar to purchase drink. With this income the drink guy can once again buy food. This purchasing cycle can continue indefinitely with economic activity at a stable, constant rate.

Now imagine the drinks guy decides he would like a few days off occasionally. This is only possible if he saves some of his income from selling drinks to spend on food on his days off, when he won't receive any income because he won't be selling drinks.

In order to save he decides not to spend his entire 1 dollar income on food. Instead he spends only 75 cents and saves 25 cents. But this means that the food guy only earns 75 cents so he can only buy 75 cents worth of drinks the next day. The drinks guy is disappointed that his sales (and therefore income) have dropped from $1/day to 75p/day but decides to still save 25 cents of this and spends 50 cents on drink. However the next day he finds he only sells 50 cents worth of food (because that is all the drinks guys has received in income). He realises he can't save any of this so now he spends 50 cents. Now he and the drinks guy continue trading but at only half the level - 50 cents/day. Economic activity has dropped by 50% simply because one of the parties has decided save some of his income.

This propensity of individuals and companies to save is a form of demand leakage. Another source of demand leakage is net imports - where some of our spending is diverted outside our economy. Demand leakages WILL cause economic activity to contract unless the missing demand is replaced.

Government tax policies actually promote demand leakage by making contributions to pensions tax deductible. This provides a strong incentive to make pension contributions from your income (i.e. save) instead of spending. Apart from suppressing demand these tax incentives for saving channel huge amounts of money into the financial sector.

There are three possible sources of demand to fill the gap caused by demand leakage.

1. From outside the country - increasing exports to other countries. This is easier said than done. Moreover, not every country can be a net exporter. Not until we find markets on other planets.

2. From credit expansion by bank lending. This has been the main source of demand compensating for demand leakages in the past 4 decades. It has resulting in excessive private sector debt and an asset price bubble, the collapse of which precipitated the current crisis. Now this debt has to be paid off. Clearly credit expansion can no longer be relied on to plug a demand leakage. Instead there is a powerful desire to save which is likely to last until private sector debt are at sustainable levels.

3. From the government sector. Demand leakages can be filled by deficit spending. This is when the government sector spends more into the the economy than it extract through taxes. Spending injects demand and taxation subtracts it. That is why tax cuts are a powerful economic stimulus.

Unless countries are net exporters, like Germany, deficit spending is required just to maintain economic activity at a steady state (i.e. no growth). In the absence of net exports the level of deficit spending needs to match the level of net private savings (savings - investment) just to prevent the economy from shrinking. If a country is net importer the budget deficit needs to equal net imports plus net private sector savings just to prevent a recession.

This is another illustration of how deficit spending is usually essential in an economy, since most economies have demand leakages as the private sector tries to save.

Silent ECB intervention

A curious thing has been happening in the Eurozone, first noticed by Warren Mosler. Despite massive amount of money leaving Greek and Spanish banks in the past 3-4 weeks no bank has had liquidity problems and these Government have made all their payments on time and in full. The likely explanation for this is  that the European Central Bank (ECB) is providing effectively unlimited liquidity to the national central banks, governments and commercial banks. In other words the ECB is acting as lender of last resort. What is striking is that this has been happening on the quiet. There have been no announcements. This is a huge shift in policy since it means the ECB is now injecting net financial assets into the  Eurozone. This means that the Eurozone solvency crisis described in my previous post is being countered by ECB intervention. The fact that there has been no objection to this from Germany suggest that there has been a dramatic change of view. Presumably because when they recognised that they faced two equally unacceptable options they decided to relent and allow the ECB to stretch its rules. It is interesting that they have decided to keep quiet about this policy change. Instead Merkel et al have been making the same noises about Greece sticking to its commitments and the need for fiscal integration before Eurobonds can be considered. There may be a careful political game going on where noises are being made to reassure the German public that their money is not going to be squandered through fiscal transfers, whilst the ECB is being allowed to use its money creating powers to fully support the Eurozone. AT LAST!

Provided this is allowed to continue we can all breathe a sigh of relief. Financial armageddon will be avoided.

Mosler dates this change to an intervention approximately 5 weeks ago when Trichet, the outgoing ECB head, floated the notion of ECB-backed fiscal authority.

Germany seems trapped.....but there is a way out

Germany faces an awful choice. It has done everything by the book. It's citizens work hard, accept modest wage increases, and avoid excessive debt. It's government likewise limits its borrowing. It is highly competitive and is a world-class exporter. But now everything is going pear-shaped and they can see no way out. One by one Eurozone governments are going bust, requiring bailouts or threatening to default. Germany has tried to solve the problem by agreeing to lend money to these countries provided that they implement austerity measures and 'structural reform'. But this approach has not worked. Wherever implemented it has aggravated the debt problem. Now that Spain has succumbed and required a (disguised) bailout, Italy is next, and then the game will be up, as its huge debts will take Germany down with it. Everyone is clamouring for Germany to put all its financial and economic might behind the entire Eurozone. But that would mean placing German citizen's hard one savings at risk - something that they are understandably reluctant to do. Yet if they don't help and countries default, the resulting financial contagion could destroy the Euro and the EU. Germany is deeply committed to the EU and is desperate to prevent this happening. It certainly does not want to be blamed for destroying the EU.

Looked at this way, which is the perspective of most Germans, there seems to be no way out. But there is. What is required is for Germany to understand what the real problem is. When they do the solution will be obvious.

There has been much discussion about the need for fiscal and banking union to solve the problem. In short it is argued that a monetary union such as the Eurozone can only work if the Eurozone developed a structure similar to the USA. I would argue that this is not only unrealistic, at least within a time scale needed to prevent collapse of the Eurozone, it would NOT solve the key problem which underlies the current crisis. Conversely, addressing this problem will both resolve the crisis and provide the time needed to move towards full integration.

So what is this problem? Essentially, it is that the Eurozone is becoming insolvent, if it is not so already. This process is accelerating and has reached the stage that it is irreversible unless there is massive intervention by the ECB to inject net financial assets into the banking system through support of deficit spending, something which is blocked by Eurozone rules.

The problem arose because of a serious flaw in the design of the Eurozone. Its critical feature is that it is forbidden for the ECB to act in a way that enables increases in the money supply through deficit spending. As a result the only mechanism by which the money supply can grow is through credit creation by commercial banks. This was OK during the boom years because banks created money (too) freely, supported by (and resulting in) asset price inflation in several Eurozone countries. As noted in previous posts, the problem with growth fuelled by commercial bank lending is that it is accompanied by ever-increasing debt since all new money is matched by an equal amount of associated debt. Under this system economic growth across the Eurozone REQUIRES increasing private sector debt

The rules meant that, even with economic growth, it is impossible for the Eurozone as a whole to accumulate net financial assets. Some within the Eurozone can accumulate net assets but only if others become more indebted. Individual and businesses can accumulate profits but only if others borrow more to provide the source of these profits. Similarly countries that are net exporters within the Eurozone can stay in the black, but only at the expense of the net importer countries.

Another way of describing credit creation is that banks create money and equal amounts of debt. The money accumulates in the net exporter countries while the importers retain the debt. Such a system cannot continue for ever. Eventually the debts will become too great. And this has come to pass.

So what is to be done? The core of the problem is that a system which relies exclusively on commercial bank lending is vulnerable to financial collapse. As soon as growth stall and and confidence drops people stop borrowing and start saving and paying down their debts. This cause a drop in the money supply and demand and asset prices (which back up much of the debt). This leads to a recession which leads to further drops in confidence and reductions in spending and asset prices. A downward spiral continues until there is complete collapse. Even if those with the money step in to stand behind the debts of the indebted the problem is not solved. The entire system becomes insolvent.

It is critical to understand that what is happening is contraction of the money supply. Bank-created loans are paid paid off the money is eliminated. Economic activity, which depends on money, is thereby reduced. The only way to break this downward spiral is to introduce counter this contraction by introducing net financial assets into the economy through increases in government spending and/or decreases in taxes. In other words government must spend more into the economy than they extract through taxes - the essence of deficit spending. This must be supported by the ECB either through provision of debt free money to government's, or through them purchasing government bonds.

This will restore demand and thus growth and reduce unemployment. Most importantly, it will finally allow the aggregate private sector to save and pay off its huge debts. Everyone will be better off and the Euro would be saved.

Germany will see the drawback of this approach as being two fold. First the risk of inflation if money creation is excessive. Second, the moral hazard of providing both profligate governments with 'free money'. Regarding inflation I would argue that the risk is minimal and it would not be difficult to reduce any inflation by simply reversing the policy and tightening monetary policy. Regarding moral hazard I would argue that the approach that should be used is for the ECB to provide debt free money to Eurozone countries on a per capita basis. That would mean that everyone benefits to the same extent.

Importantly this will enable Germans to keep their hard earned savings while preserving the EU.

I believe that Germans (and other Eurozone citizens) would embrace this solution if it was offered to them. The tragedy is that it is not even being offered to them. ECB-supported deficit spending is not even on the agenda. That reflects the dreadful state of macroeconomic theory, for which academic economist are largely to blame.

Guardian letter

The Guardian printed a letter today that I wrote in response to Larry Elliot's comment yesterday. It is disappointing that the chief economics editor of a liberal newspaper is spouting the nonsense that the underlying problem is international current account imbalances and that the solution is improving competitiveness in importer countries to enable them to become net exporters. Firstly, it is impossible for all countries to become net exporters unless we discover another planet with willing importers. Trying to do so will lead to trade competition between countries in which some countries can only benefit at the expense of others. It becomes a zero sum game which increases conflict and reduces cooperation. Secondly, it misses the real problem which is excessive private sector debt. This was the inevitable consequence of us relying for the past 40+ years on increases in commercial bank lending to provide our money supply and gradually removing all control on credit creation. That resulted, as it always will, in asset price bubbles which always burst, eventually. This is exactly what caused the Great Depression. The solution to this problem is crystal clear. The private sector must be allowed to reduce its debts. Instead what policymakers are trying desperately to do is get them to renew their borrowing spree. This is utterly ridiculous and cannot succeed. The private sector are not idiots. The ONLY way for the aggregate private sector to save is for the public sector to spend more into the economy than it takes back out through taxes. That is a straightforward accounting reality as the private sector and public sector balances MUST add up to zero. In other words we NEED deficit spending. This is what allowed robust recovery following the Great Depression. Provided this is supported by central banks this can continue indefinitely. There is no risk of default. The only limiting factor is inflation but this is readily controlled by reducing the deficit or switching to a surplus and/or increasing the base interest rate.

How do banks create money?

One of the root causes of the global financial crisis is that mainstream economists do not understand how banks work. Like most people they believe that banks act as convenient financial intermediaries, receiving deposits from savers and lending this money onto others. While this seems intuitively sensible it is wrong. When banks extend credit they simply increase the borrowers current account balance by the loan amount. They do not "get" this money from anywhere. It is literally created out of thin air. Instead of deposits being required for loans, loans actually create bank deposits.

This can be a difficult concept to grasp so here is an analogy to help explain it. Imagine that the landlord at your local pub allows you to buy drinks and food on credit, i.e. run up a tab. Now imagine that he extends credit to you before you spend it. To do this he tells you that you have £10 to spend in his pub which you have to repay at a future date. This is equivalent to having £10 in your 'account' with him. Imagine that he allows you to use this credit to pay £5 to another of his customers, who also has a tab or 'account'. To make the payment the landlord decreases your 'account' by £5 and increase the other customer's 'account' by the same amount. Of course the £10 loan has to be paid eventually but meanwhile you are able to use the credit that this loan created as money. The landlord is now acting like a bank. Indeed, anyone can make these types of arrangements and so act as a bank of sort. All that is needed is a reliable and mutually acceptable way of keeping track of these debt obligations or IOUs, which usually achieved by recording them in writing. There is evidence that these obligations or IOUs were the first form of money and recording them was one of the first uses of writing.

The main difference between all of us and a bank is that the £10 of credit that banks create when making a loan can be spent almost anywhere and converted into cash, whereas the £10 credit that the landlord extends to you can only be spent in the pub or transferred to another person to spend in the same pub. Why is bank money accepted everywhere? The short answer is possession of a banking license. The long answer requires an explanation of the payment clearing system that only licensed banks can use. If you spend money loaned to you and thus created by a bank the money is transferred through this payment system. All licensed banks have accounts at the central bank called reserve accounts. Payments between parties are settled by transfers between these reserve accounts. For example, if I use my debit card to pay for a meal at a restaurant the money is transferred as follows. My bank reduces my current account balance by the amount of the payment. It simultaneously transfers the same amount from its account at the reserve bank to the restaurant's bank's reserve bank account. The restaurant's bank then increases the amount in the restaurant's bank account, less any charges.

Instead of making a transfer between reserve bank accounts for every individual payment the Bank of England keeps a record of all gross transactions between all banks over a 24 hr period and only transfers the net amounts. Transfer between any two banks will occur in both directions and will mostly cancel each other out. It is only necessary to transfer the difference between these amounts - the net amount - between the two bank reserve accounts, which will be a tiny fraction of the gross transactions.

Central banks can create reserves in unlimited amounts and so can and will always ensure that interbank payments will clear. They will also convert bank reserves into cash. This enables customers to convert the money created by banks into cash.

In summary, the central bank provides a clearance system which ensures that bank money can be used to make any payment and convertible into cash.

So when banks make a loan to you they create spendable money out of nothing. In return you acquire a debt of the same value, which you have to pay interest on.

Almost all new money is created this way. At the moment 97% of the money supply in the UK is this kind of bank money. As a result, increases in the supply of money are accompanied by equivalent increases in the amount of debt, on which interest is paid. In effect, we rent our money supply from commercial banks.

Importantly, banks have few constraints on how much new money they can create by extending loans. The main factor that determines whether they extend a loan is whether the person that they are lending the money to can pay back them back and meet the interest payments. That is why they prefer to make loans towards the purchase of an asset such as a house, which can be held as security in case the borrower defaults. Even this limit can be removed if banks can sell the loan onto someone else. This is known as debt securitisation.

Most economists unfamiliar with the intricate details of the payments system think that central banks control the amount of bank lending by, for example, changing the amount of reserves held by banks and/or by requiring banks to holding a minimum amount of reserves that is a certain fraction of their deposits. The reality is that most central banks either do not have this requirement (eg Canada) or allow commercial banks to increase their reserves after they have created the new deposits, by borrowing either from other banks who have surplus reserves or from the central bank itself. Banks create money first and acquire the necessary reserves later, and these reserves are always available. At worst they have to be borrowed from the central bank at the base rate set by central banks.

There is another constraint on lending which is called the Capital Adequacy Ratio (CAR). This is a requirement for the banks to ensure that their assets (e.g. loans) exceed their liabilities (e.g. bank deposits) by a certain minimum margin. However, the CAR does not act as a restraint as long as banks make a profit. If the CAR is 5% then retained profits of £5 billion enable a bank to make £95 billion of new loans.

In conclusion, commercial banks create almost all new money, through credit creation. We rent our money supply from banks. This explains why economic growth has been been accompanied by huge, unsustainable increases in private sector debt and asset price bubbles, why the global financial crisis was inevitable, why the recovery has been so weak, and what needs to be done to restore growth and reduce private sector debt. The failure of mainstream economists to understand the role of banks explains their failure to predict the GFC, and their inability to come up with effective solutions.

Guess what? Fairy tales don't come true.

The penny finally seems to be dropping amongst the right that the miracle they were hoping for in their fairytale view of the economy is not going to happen.

Recall that they justified government austerity on the basis this would encourage the private sector to start borrowing and spending again. Those who pointed out that the government deficit was a direct result of the private sector trying to pay down their enormous debts were ignored and accused of being irresponsible. Really? When the private sector diverts its income from spending to saving demand drops and the economy goes into recession. This automatically reduces tax revenues and increases government spending on unemployment benefits. This increases the deficit. In fact the deficit is essential because it is a simple accounting fact that the aggregated private sector can only save if the government runs a deficit. If the government tries to cut the deficit at this stage it prevents the private sector from saving by reducing their income. When your income goes down you have to choose between cutting your spending or increasing your borrowing. The miracle that the conservatives seem to expect is for the aggregated private sector to increase their borrowing when their income is dropping. Are they seriously expecting individuals and companies to take on more loans when their income is dropping? Don't they realise that this would be idiotically irresponsible? Nevertheless they press ahead trying to persuade us all to recklessly increase our debts back to the record levels that preceded and caused the global financial crisis.

There is some evidence that they are thinking about trying what those who understand economic reality have been pleading for. For the government to use its unique ability create money to enable the private sector to reduce its debts whilst maintaining spending. This will enable growth and saving.

The problem is how do they increase the deficit now without admitting they were wrong about austerity in the first place. The answer seems to be that they will claim that the because of austerity the government now has the credibility to borrow at a super low rate and they will use this money responsibly for investment in infrastructure etc. This is nonsense of course. The reason UK government bond rates are low is because the market knows that a currency-issuing government can never go broke. For example the Bank of England can and will simply create money to purchase the bonds, keeping the interest rates at any interest rate that they choose.

While I am grateful for the change of heart I am wary of this type of 'investment'. When government embark on big spending plans money tends to be wasted. Worse it get diverted to private companies adept at lobbying. It is called crony capitalism. Surely Conservatives of all people should prefer that the free market determines where this injection of money is spent?

The best way to do this is to cut taxes, especially regressive taxes like VAT. That would immediately inject demand into the economy and automatically ensure that growth occurs in areas where demand is greatest. They should also immediately put on hold any cuts in spending on valuable public services like education and health. Any increases in spending should be gradual and should aim at maximising the productive capacity of the economy and minimising environmental damage. Common sense really.

Coping with an ageing population

A common reason given by those opposed to deficit spending is that we need to save up funds now for when the ratio of retirees to workers increases, as populations age. Otherwise retirees will be a burden on the young.

There is a very serious flaw in this idea. The real problem with an increase in the retiree/worker ratio is that workers will need to be much more productive. A smaller number of people will have to provide all the goods and services for the same size population. Of course it would also help if people could extend their working lives. Money saved now will not help address these problems when they arise. Instead it will just mean that there will be higher inflation since there will be more money available to spend but fewer goods and services to buy. In order to increase future productivity and possibly extend our working lives it is important to spend money NOW in ways that increase future productive capacity. That means better education and healthcare, more research and more investment in infrastructure etc etc. Instead we are foolishly cutting spending in all these areas to save money to spend in future. But money can be created at the stroke of a computer key. Infrastructure, technology, intellectual capital, and a productive workforce take many years to produce. Those deficit hawks claiming to be sensible and thrifty are instead being foolish and reckless.

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.

The problem is private sector debt

The current focus of commentators, economists and politicians on public sector deficits and debt is completely inappropriate. In fact it shows that they do not really understand the global financial crisis, and have not absorbed the clear lesson from the Great Depression.

The figure shown below is from Steve Keen's excellent Debtwatch website. If one looks at private sector (individuals, households and businesses) and public sector (government, state and cities) debt over the past century it is fairly obvious that the Great Depression and the Global Financial Crisis were immediately preceded by exceptionally high levels of private debt.
This is no coincidence. In both cases excessive credit creation by banks, supported by the resulting increases in asset prices (stocks and property) were directly responsible for the increase in private debt. Banks became highly leveraged as a result. When the asset price bubbles popped and prices dropped many banks, with thin capital cushions, became insolvent, precipitating banking crises. Banking crises and the accompanying credit contraction resulted in contractions in economic activity. This resulted in falls in tax revenues and increases in government spending on unemployment benefits and bank bailouts. As a result public sector debt levels rise, while private sector debt begins to fall.

Now it is a simple, but much ignored, accounting reality that the aggregated private sector can only reduce its debts if the public sector runs a deficit and increases its debts. The decrease in private sector debt following the Great Depression was thus accompanied by increases in Public Sector debt. Similarly the decrease in private debt we are now seeing has been accompanied by an increase in government debt. This is both normal and necessary. To argue for cuts in budget deficits makes no sense when the private sector is overburdened with debt and needs to deleverage.

Those arguing for cuts now on the basis that 'you can't solve a debt problem with more debt' have also forgotten that following the Great Depression exactly the same mistaken arguments lead governments to impose austerity then, with predictably disastrous results. Growth collapsed again and unemployment remained stubbornly high. It was only when deficit spending was renewed with vigour that recovery began. This became politically possible because the Second World War marginalised the deficit hawks. As one would expect deficit spending enabled the private sector to fully deleverage by the end of the war. Growth was restored and public sector debts dropped gradually as a proportion of GDP.

Unfortunately the lesson of the Great Depression were forgotten, and we returned to policies which encourage growth in private sector debt. Mainstream economists did not consider mounting private sector debts as a cause for concern, and they still don't acknowledge that this was a problem! Instead they focus their efforts on trying to get bank lending (and thus private sector debt) to return to its pre-crisis upward trajectory by running very loose monetary policies, lowering the cost of borrowing to their lowest levels in history. At the same time they voice loud concerns about government deficits and debt. 

I have argued in previous posts that this is seriously mistaken. To rely on bank credit creation to provide the monetary expansion needed to fund growth in demand is to require that the private sector to become increasingly indebted. Not only is all newly-created money matched by debt. The requirement to pay interest on the debt ensures that more borrowing is needed just to meet these payments. To prevent the private sector become over-indebted I have argued there should always be deficit spending. Deficit spending  is when governments spend more money into the economy than they extracted through taxes. This injects debt-free money into the economy, enabling the aggregate private sector to avoid excessive accumulation of debt.

Who will blink first?

There is a nerve-racking game of brinkmanship in the Eurozone. Spain's banks are insolvent. The Spanish government is determined not to pour money into them because that would hugely increase their budget deficit and debt. Spain would then be forced to seek a bailout from other Euro countries, who would require vicious cuts in spending and increases in taxes as a condition of the bailout. The end result would be the same economic misery and political turmoil in Spain as we seeing in Greece, with a real risk of violence and civil war. On the other hand, if the banks are not recapitalized there will probably be a bank panic, which could spread widely and do huge damage to all Euro countries and beyond. We are asking Spain to put a gun to their head and pull the trigger. Not surprisingly they are refusing. We urgently need a plan B.