The myth of default

Paul Krugman and Larry Summers are two mainstream economists, from the neoclassical school, who are arguing strongly for governments to maintain spending and avoid tax increases rather than cut deficits. In this they are absolutely correct.

Unfortunately they are not getting much traction. The main reason for this is that their reasoning has one gigantic hole in it which makes it unconvincing. The key question is what happens when the deficit and debts gets so large that markets take fright and refuse to 'lend' to the government except at very high interest rates? People have seen what has happened in Ireland, Greece, Portugal, Italy and Spain and they worry that unless their government cuts the deficit the same think could happen in their country. Many commentators warn of the same issue. They warn that 'the bond vigilantes' will suddenly turn on spendthrift governments, demanding very high interest rates which make debts much harder to bear.

There is a simple, reassuring answer to this concern. It can't happen in countries that, unlike the Eurozone, have their own currencies, borrow in that currency, and have floating exchange rates. This includes the UK, USA, Japan etc. These countries have no real need to 'fund' their expenditure as they can create money in unlimited amounts. Anyone who says otherwise is wrong. Of course there are risks associated with excessive money creation, namely inflation and devaluation of the said currency. However there is essentially no risk of default.

Because Krugman and Summers have the conventional mistaken view that governments need to borrow to fund deficits they are unable to make the clear argument that deficit spending when there is deficient demand is absolutely without risk. Instead they make woolly, unconvincing arguments about how government spending will kick start growth which will increase tax revenues enabling government debt to be paid back. This strategy sounds pretty risky to most people, like doubling down when gambling. When things are bad people don't want to take risks. What is needed is an explanation which demonstrates that deficit spending when there is deficient demand carries no risk. It is austerity that is incredibly reckless.