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
