Private sector debt is the problem

I find it puzzling that discussions on debt invariably focus on government debt. However a casual glance at the data shows that government debt was not particularly high before the financial crisis, except in Japan. What was very high was NON-government (i.e. private sector) debt.

Private sector debt has risen dramatically since World War II, as shown in the following data from the USA. In contrast, government debt has actually fallen.

The figures for the UK and most other developed countries are similar. Falling or stable government debt and rapidly rising private sector debt.

It is widely accepted now that the global financial crisis was the result of a bursting asset price bubble, which had been inflated by excessive credit creation by banks.

Given this analysis, what is needed is that the private sector deleverage (pay off their debt) by borrowing less and saving more.

Since the money for saving by the private sector can only come from the public sector (there is no other source of money), deleveraging REQUIRES the public sector to run a deficit i.e. spend more into the economy than they collect back through taxes.

This is what has been happening since October 2008, and is the primary reason for the large government deficits across the developed world. To repeat, these government deficits are REQUIRED in order for the private sector to pay off its excessive debts.

Unfortunately the knee-jerk response to rising public sector deficits has been to sound the alarm and advocate cuts in in spending and increases in taxes. These deficit hawks argue that deficits must be reduced or the government could find itself unable to finance its spending. What is happening in the Eurozone is cited as evidence to support this view.

There are several errors in this thinking.

The first error is the notion that governments with sovereign currencies and floating exchange rates need to raise money through taxes in order to spend it. This has not been the case since 1971 when the gold standard was abandoned. Since then governments with their own sovereign currency have had no need to finance their own spending. They spend by marking up numbers in bank accounts. Admittedly they do still give the appearance of 'financing' spending, by removing through taxes much of what they added by spending and appearing to 'balance the books'. However this is a self-imposed accounting exercise designed to restrain government spending by coupling it with taxation, which is seldom popular.

The second error is to assume that if the amount 'raised' through taxes is less than the amount spent then the difference has to be borrowed from the 'markets'. Clearly if the government spends by simply adding numbers to spreadsheets it has no fundamental need to borrow money. Once again this is a self-imposed rule designed to provide 'discipline' on governments. Government bonds are really just savings accounts for the private sector. Government debt equals private sector savings. Increases in government debt represent an increase in private sector net financial assets. When the private sector is so heavily indebted it is surely a good thing for them to accumulate savings in the form of government debt.

The final error is to assume that if the private sector don't want to purchase government bonds it will increase the costs of financing and the government could default on it debts. This is clearly absurd. How can a government with a sovereign currency with the ability to create its currency ever run out of its own money? That is like saying that a cricket scorer can run out of points, or a pocket calculator can run out of numbers. 

Events in Europe have confused many because they seem to reinforce the view that government debts can result in default. However countries in the Eurozone do not have their own sovereign currency. It is only the ECB which has the power to create debt-free money. Eurozone countries and their central banks have signed away this privilege, permanently. They are thus at the mercy of the markets. In contrast most countries still have their own currencies which they control and issue. They can never therefore be forced to default on debts in their own currency.