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 billion2All 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.