Does deficit spending increase national debt?

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A national economy, with a sovereign currency, is big money system. Unlike a household the independent inputs and outputs are not income and expenditure. The input to a national economy is currency that is introduced into the system through public spending. The output is the money that leaves to go abroad, as a trade deficit, currency that is saved by the private sector (households and business) and money that is removed from the system through taxation.

The diagram below illustrates this system for the UK in 2016. The government spent £745 billion1All data is approximate and values are indicative. Data was drawn from www.ukspending.co.uk into the economy on things like health, education, welfare and pensions and defence etc. It removed £680 billion in tax (income tax, corporation tax, VAT etc).

We are net importer, so our trade deficit was approximately £87 billion. In other words this currency left the domestic economy.

To balance this, private sector savings had to reduce to by $22 billion to meet the shortfall. For many individuals this means increased private debt. In other words £22 billion was introduced into the economy from the private sector. The private sector was using reserves or borrowing to deal with a private sector deficit created by government economic policy.

This model is the idea of former University of Cambridge economics professor and government adviser, Wynne Godley. Godley proposed that all surpluses had to match all deficits in the economy. This an accounting fact and not an economic theory.

A government with a sovereign currency does not borrow to spend . It simply credits the accounts of health trusts, local governments and welfare recipients.

Then, it is important to understand how the national debt arises.

Government bonds or gilts are used to reduce excess reserves accumulated in private sector saving accounts in commercial banks. This is necessary to maintain interest rates. If savings are too large then interest rates, as a result of supply and demand, will have to reduce. In order to stop them going negative the government has to reduce the amount of saving by exchanging currency reserves for bonds.

The private sector and its investors, in times of economic certainty prefer to limit risk. Government bonds are one of the least risky investments even though returns might be low. When the government cuts spending, like the Conservative-led government in the UK since 2010, demand reduces and private debt increases. Investing in business or development becomes risky, there is uncertainty that there will be sufficient demand to make the business sustainable. Currency that has gone overseas in trade or that has been accumulated in the domestic private sector ends up in banks and it is necessary for the government to exchange these for bonds, i.e. to increase the national debt.

This explains why, even when we cut spending, the national debt does not reduce and can even increase (see chart below). In fact, taking Wynne Godley’s approach demonstrates that the normal operating condition of a healthy economy is with a public sector deficit.

The period from 2010 shows a decrease in the deficit yet the national debt increased. It also happened 2004 to 2007 and 1993 to 1996. National debt is as much dependent on economic confidence as it is on public sector deficit.

Reference

8 thoughts on “Does deficit spending increase national debt?

  1. Nigel Hargreaves

    An excellent post, Steven. The only thing I would amend is “Tax Revenue” in your diagram. Tax is not a revenue. I would want to use “Tax appropriation, but it’s clumsy. What about just “Tax receipts”.

    Of course the so-called national debt is not a debt at all, it is a savings scheme, which I am sure you understand.

    Nit-picking, “least riskiest” should be “least risky”.

    Reply
    1. Steven Watson Post author

      Agree with all of this. Thank you. Have amended my English. My aim is to explain to those who have not thought about it how debt and deficit works – so forgive some of the clumsiness. But I am grateful for you supporting the fact that my overall explanation is accurate.

      Reply
          1. Iain Crawford

            Hi Steve,
            Nice article – one question.
            How is the interest generated on Bank created money represented in this model?
            As I understand it Bank created money gets created via fractional-reserve bank loans then over time is nominally destroyed as the loans are paid back. However the money used to pay the interest in the loans presumably has to be created by government in the long run.
            Does this mean it is part of the “Private Sector Savings” in the first diagram.

  2. Nigel Hargreaves

    Ian,

    I might be able to answer your question if I could understand what you are asking. I’ll initially try anyway using some assumptions. I am also not sure how far ahead you are with your knowledge of the Modern Monetary System, so forgive me if I might sound patronising.

    Are you asking about Central Bank-created money or Commercial Bank? I am assuming the former.

    If so, the money is not created by fractional reserve loans (nor is it for the latter for that matter). It is created ex-nihilo (ie out of thin air, although I dislike that term). There is, really, a box missing from the diagram in the form of the Central Bank which is, in MMT, treated as a part of the consolidated government sector. So the Treasury instructs the CB to credit the reserve account of the High Street Bank (HSB to avoid confusion) at which the target of its spending holds a current account. This increases the reserves of the HSB so it is able to credit the target’s current account with whatever the amount is.

    Exactly the same thing happens with an interest payment. The holder of a governmet security is entitled to a “coupon” payment at a certain date, and the government instructs the CB to credit the reserve account of the HSB at which the security holder has a current account. Again, the money is created ex-nihilo.

    Alongside this, the government looks at how much it has spent over a period and how much it has received in taxation and other fees and, purely as a matter of established procedure, it issues further securities to cover the difference between income and expenditure, assuming there is a deficit. To be slightly more accurate, it does this in advance so that there is a permanent “buffer”. It doesn’t actually have to in a fiat monetary system, but it has always done so since the Gold Standard, and it isn’t a bad rule of thumb anyway in order to stabilise interest rates.

    So the payment of interest happens in exactly the same way as the payment for goods or sevices, and the fugure appears on the Whole of Government Account resport. For 2015, for example, it was £83.6bn nett after adding a provision for pension scheme liabilities and deducting invesment income. It is not, however, included in the figures used for calculating the government fiscal deficit. Don’t ask me what figures are and are not – it’s a black art which I am trying to get to the bottom of.

    Does that help? Again I apologise if I am trying to teach granddad etc.

    Steven, please feel free to contradict me, this is your blog after all.

    Reply
    1. Iain

      Hi Nigel,
      Many thanks for your informative reply.
      I am still in the initial stages of “grocking” MMT so your comments about Central Bank CBs are helpful.
      I was actually referring to commercial banks HSBs with my first question but from your answer it looks like the CBs are actually creating the money loaned by the HSBs – Is that correct or did I miss something?
      I am still unclear as to how the interest paid on HSB loans is accounted for in Steve’s first diagram.

      Reply
      1. Nigel Hargreaves

        First of all you need to understand how loans are actually created by HSBs, and you may be surprised to hear that it is not done by fractional reserve. It would be impossible for me to describe how it works in a few short sentences, but the gist is that when a bank makes a loan it adds the borrower’s promise to pay to its balance sheet – that is it is an asset of the bank – and then it creates an equal liability to the bank – that is the ability of the borrower to withdraw the funds. So effectively you are borrowing from yourself – or your future earnings. The banking system merely facilitates this process. There is a very good paper from the Bank of England that describes it, Working Paper No 259, which you can find on the BoE’s website.

        The creation of the interest the borrower pays happens in much the same way, but you would need to understand how the entire monetary system works to understand that. Believe me I have been studying it for well over two years now and I still get lots of things wrong.

        As a start off, if you want to get to have a better view, I would strongly recommend you read “Modern Money Theory” by L. Randall Wray which is available from the British Library or it costs about twenty pounds from Amazon. You will then see that you can never look at one small aspect such as where interest comes from without considering the entire monetary system – one thing interreacts with another. That is known as a complex system in mathematics.

        Reply

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