An open letter to Brussels

The Euro­pean Sta­bil­ity and Growth Pact is based on the prin­ci­ple that sta­bil­ity and growth are enhanced when gov­ern­ment deficits are either min­imised or elim­i­nated. I want you to dis­pas­sion­ately con­sider an argu­ment that reaches a dif­fer­ent con­clu­sion. It may sound like some­thing you have heard before from oth­ers and already dis­missed. But bear with me.

When con­sid­ered from a strictly mon­e­tary point of view, an econ­omy can be regarded as hav­ing five major sec­tors: house­holds, firms, the gov­ern­ment, the banks, and the exter­nal sec­tor. To focus on money flows, I will diverge from main­stream eco­nomic the­ory by treat­ing house­holds as con­sist­ing exclu­sively of work­ers, while I will com­bine firms and their own­ers into the firm sec­tor, and do like­wise with banks and their own­ers. I also treat the cen­tral bank as part of the gov­ern­ment sec­tor, and I ignore cap­i­tal and income flows between nations in this sim­ple exposition.

Nei­ther house­holds nor firms can pro­duce money, while the other three sec­tors are poten­tial sources of money. As is now well known (though this fact is still con­tested by aca­d­e­mic econ­o­mists), banks cre­ate money by mak­ing loans:

When­ever a bank makes a loan, it simul­ta­ne­ously cre­ates a match­ing deposit in the borrower’s bank account, thereby cre­at­ing new money. (Bank of Eng­land Quar­terly Report 2014 Q1, Money cre­ation in the mod­ern econ­omy.)

Gov­ern­ments can also cre­ate money by run­ning a deficit (if it is financed by the cen­tral bank, or by bonds sold to banks in return for excess reserves). Money can also be cre­ated by run­ning a bal­ance of pay­ments sur­plus (which in this sim­ple expo­si­tion is exclu­sively a bal­ance of trade surplus).

In order to sim­plify my argu­ment, I will assume that

• Gov­ern­ment spend­ing goes exclu­sively to firms;
  
• Taxes are paid exclu­sively by firms;
  
• Only firms bor­row money from banks;
  
• Banks charge inter­est on loans but do not pay inter­est on deposits;
  
• Only firms trade with the exter­nal sec­tor, sell­ing goods as exports and buy­ing goods as imports;
  
• Ini­tially, the exter­nal sec­tor is in bal­ance so that exports equal imports; and
  
• Ini­tially, the gov­ern­ment sec­tor is in bal­ance so that gov­ern­ment spend­ing equals taxation
  

These assump­tions lead to the pat­tern of mon­e­tary flows shown in Table 1.

Table 1: Basic mon­e­tary flows

Click here to read the rest of this post.