An open letter to Brussels

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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 Q1Mon­ey 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

Graph for Europe takes a battering for Brussels' stability and growth delusions

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.