Economics,  Markets and economy,  Modern Monetary Theory

Why government deficits are a good thing

Every dollar the Australian government spends is a dollar that goes into someone’s pocket and contributes to economic activity. The government’s red ink is our black ink, so the larger the government’s deficit the better off the economy is, and vice versa.

That is, of course, the opposite of what we’ve been told all our lives as ‘responsible’ governments strive to ‘balance the budget’ to demonstrate their fiscal prudence.

If you think about it, every dollar in the economy has to have come from the government, since it’s the only institution that can legally create the currency.

The money comes from the government and has to go into either the household sector, the corporate sector, or the foreign sector, there’s literally nowhere else for it to go. So it follows that every dollar issued by the government has a matching balance in one of those three sectors.

Chart 1 shows that relationship in the US since 1952 (note, the household and corporate sectors are combined as the ‘domestic private sector’):

Another way of looking at it is to imagine the economy is like a bathtub. The water is the government spending money, and the water accumulates to represent economic activity. As long as the plug is in, the water/money grows. If you pull the plug out, which is the equivalent of the government taxing back the money it’s injected, the water/money drops, and the economy shrinks.

To extend the bathtub analogy a bit more, if the water keeps pouring in too quickly until it overflows, the economy no longer has the resources to back that level of spending and that’s when you get inflation. We don’t want the bath to overflow.

So every government deficit is good for somebody on the other side of that spending, the questions are, who is benefiting and what’s the purpose of the spending? For instance, spending $1.2 trillion on a bunch of tax cuts that mainly benefit the wealthy, as the Trump administration did, is hardly a good use of a deficit, but spending to fix crumbling infrastructure or provide free childcare so parents can work if they want to, is a far more productive use of resources.

When a government runs a budget surplus, it’s sucking money out of the economy, meaning the only way for the economy to grow is by the private sector making up for the reduction of government money in the system by running down its savings and borrowing money.

Here in Australia, the Howard government was lauded for running budget surpluses, so how did the economy grow so strongly over that period? In short, there was a credit boom. Household savings rates fell from 4% to -1%, and credit growth averaged around 12%, peaking as high as 16% in 2005. The result was household debt increased from around $200 billion to $900 billion, representing an almighty credit impulse to offset the lack of government spending.

However, MMT identified ages ago that relying on households to borrow in order to stimulate the economy will only work for so long, because eventually borrowing capacity maxes out and you’re left with the situation we had prior to COVID, where interest rates were the lowest they’d been in years, but credit growth was also the lowest since they started tracking it in 1977. Economists call it ‘pushing on a string’.

Why has borrowing jumped again? Because the government pumped the equivalent of 15% of GDP into the economy in the form of COVID support packages like JobKeeper. That massive bout of fiscal spending, reflected in a huge government budget deficit, ignited the economy and we saw the likes of Gerry Harvey describe the retail environment as the best in his 60 years as a retailer. The government’s red ink became his black ink.

MMT does not argue for permanent government deficits, sometimes a surplus may be called for to temper an overheating economy. What it does argue though, is that deficits are not, of themselves, a bad thing.

If you’d like to learn more, you should have a listen to Professor Stephanie Kelton’s recent Ted Talk, or read her book, The Deficit Myth.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

Subscribe and Never Miss a Post!
Enter your email address and click on the Get Instant Access button.
We hate spam. Your email address will not be sold or shared with anyone else.