This is the third post in a series in which I describe how a family would operate if it was similar to a modern economy, with the parents as government (and central bank) and the children and grandchildren as the private sector. Hopefully it will be self-evident from the first two posts in this series that in order for the amount of trade between children (and their descendants) to increase the number of circulating coupons needs to increase as well. In other words economic growth requires growth in the number of coupons (i.e. money) in circulation. The question is how to provide these coupons in the required amounts?
There are two ways of accommodating this need for more coupons. One way is for parents to provided additional coupons by spending more than they remove through taxation - i.e. deficit spending. The second way is for children acting as banks to make loans. In the former case the coupons are debt free and no interest is paid on them. In the latter case all the new money is accompanied by a debt and there is a requirement to pay interest. In other words the coupons are rented from children acting as private banks, with the interest payment being equivalent to rent.
IT MAKES SENSE TO CREATE MONEY IN TWO WAYS: DEFICIT SPENDING AND PRIVATE CREDIT CREATION
Looked at this way it is not obvious why creating coupons by deficit spending is necessarily worse than allowing them to be created through lending. Indeed it is better in some ways as it avoids excessive debt and the corresponding growth in the number of children who make their living as rent-seekers (who grow wealthy at the expense of other children by renting them they coupons they need for economic activity). There is a risk of inflation if deficit spending is excessive but there is no reason why this cannot be contained by the parents simply by reducing the number of coupons created or increasing the number removed through taxation.
It would seem sensible to use both mechanisms of coupon creation together, and in moderation. Deficit spending to gradually increase the amount of debt free coupons, with strict controls to prevent inflation. Bank lending to provide the flexibility needed for productive investment wherever the opportunity arises, with strict controls on the overall level of debt so that it remains at sustainable levels.
THE IDEOLOGY BEHIND BALANCED BUDGETS
Given the above why has it become conventional wisdom that in the real economy money creation by deficit spending is entirely bad whereas money creation by credit creation is good?
As far as I can tell the reason is largely ideological and deeply cynical. It is based on the notion that governments and the general public cannot be trusted with the knowledge that government spending is not constrained by revenues. It is feared that once they realise this they will not be able to resist the temptation to spend ever more and tax ever less, even this results in inflation. So in order to maintain political pressure to moderate spending it is better if parents (politicians) and children (voters) believe that deficit spending is dangerous. This is achieved by maintaining the myth that parents need to get the coupons that they spend by taxation and borrow the difference from the children. Once this is believed then it is relatively easy to convince children that it is bad for parents to deficit spend just as it is bad for the children themselves to live beyond their means. It is also possible to persuade them that the parents are forced to cut the deficit by fear of not being able to borrow coupons in future except at very high rates, which the children would have to pay through higher taxes. Which could result in default and economic collapse.
If you have followed my explanation of how things actually work you will see this is a plainly ridiculous falsehood. Since the parents (governments and central banks) create coupons (money) they can never run out of it. They have no need to borrow it but if they do, to comply with self-imposed accounting rules, they can keep the interest rate at whatever level they want. Deficit spending provides the children with more coupons which accommodates increase economic activity and enables them to accumulate savings. It is particularly needed if children are trying to reduce excessive debt levels. This is because as they pay their debts this eliminates bank-created coupons from the economy. Exactly the same common sense applies to the real economy.
Whatever merit there were was maintaining the myth of the need for governments to finance their spending and 'balance their budget', I think experience over the past 5 years has demonstrated that this approach is neither prudent nor sustainable. It was was indirectly responsible for excessive credit creation because it forced central banks to make borrowing money ever cheaper as they had no other means of stimulating growth. It also required ever looser financial controls on borrowing to accommodate ever higher debt levels. The end result was an asset price bubble and a relentless, unsustainable growth in private sector debt relative to income, until the bubble burst in 2007.
Unfortunately entire generations of our leaders and the public at large have been so heavily brainwashed for so long that they do not understand how our monetary system really operates, don't really understand why there was a financial crisis, and have no clue as to how to restore economic growth. This will be one of those example of where thinking changes with funerals as the old guard simply cannot change their world view.
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