Tuesday, March 27, 2012


This is (as I start writing) intended to be a very short post. I was just browsing through the economics news and found this rather fabulous quote in reference to Spain's shrinking economy:

It is unclear how he can slash the budget deficit from 8.5pc of GDP last year to 5.3pc to meet the compromise target agreed with Brussels after a bruising confrontation.
“It is frankly impossible, given that it would aggravate the recession and this would crush state revenues,” said Jesús Fernández-Villaverde from the University of Pennsylvania.
This is 'fabulous' as it is a very clear illustration of a point I have made several times. It illustrates just how intellectually bankrupt a large swathe of academic economics actually is. I will just start by putting the quote in a usable format:

  • Cutting borrowing will make the recession worse
  • If the recession is worse, then state revenues will be lowered
  • Therefore, if borrowing is cut, state revenues go down
  • If state revenues go down, then payment of existing debt becomes impossible
 What this really means is something like this (this is simplified/basic principle only):

  • I am borrowing 200 units of new debt per year
  • I have to pay 100 units per year from tax revenue to service my existing debt
  • The 200 units create activity in the economy as the borrowed money is used for consumption of goods and services
  • The activity in the economy from the borrowing of 200 units sees 50 units of the borrowed money returned to me in tax revenue from the tax on the consumption of the 200 units
  • If I do not borrow at all, the tax revenue from activity in the economy will only be 50 units
  • If I cut borrowing to 100 units I will only see 25 units of tax returned to me from the 100 units borrowed
  • Cutting my borrowing to 100 units means that I have the 50 units + 25 units of tax revenue from the borrowing
  • If I only receive 75 units I can not pay for my existing debt, which requires 100 units
  • Therefore I will continue borrowing 200 units so that I can pay for my existing debt which gives me the 50 units of no borrowing tax revenue + 50 units of tax revenue from the borrowing and consumption of 200 borrowed units
  • If I do not borrow 200 units I cannot pay my existing debt.
  • If I borrow 200 units, I increase my existing debt.
  • If I cannot pay for my existing debt without borrowing, how will I pay for next years greater debt and greater annual servicing costs?
In short, the process is one in which I borrow 'x' amount for others to consume, and then tax that consumption of the borrowed money in order to return a fraction of the debt to me and pretend that this is revenue, not a fraction of the money borrowed earlier. If I do not do so, I can not support my debt. In short, I need to borrow money in order to make payments on previously borrowed money. In doing so, my debt pile gets bigger, necessitating more borrowing to pay previous borrowing. It is an upwards spiral of debt in order to keep paying existing debt. It is also a downwards spiral into greater and ever less sustainable debt. It is a good method of destroying an economy - unless a choice is made to just not pay the debt.

And this is a solution? Really? 

Note: This is a bit of rushed post, but I hope it all makes sense. If there are any errors in the logic, please feel free to point them out. Also, if (and I apologise in advance if I think it is no better) you can offer an even simpler and clearer explanation, I may use it as a post, with full credit to the author (as anonymous, or by name according to your preferences, so let me know). I really think this is one of the most fundamental examples of just plain odd thinking in economics. As such, getting it as clear and logical as possible would be great. I still feel that my explanation is not quite there, or might not quite hang together.

Update, 30 March 2012: A very good explanation from Carrew below, which integrates the fundamental problem of dishonest politicians.TheFatBigot (I really like this name) also weighs in with some good points about GDP and the underlying foundations of revenue, as does MR. Anonymous has picked up on the rather distorting economy as a medical patient metaphor, and proposes a more apt variant. In the case of Carrew and TheFatBigot, they offer some very good explanation. However, although very good, and somewhat simpler, but I am still looking for the 'killer explanation' that skewers this dangerous economic thinking (something which those less interested in economics might grasp with ease). Further efforts would be welcome.
Update, 2nd April 2012: There are some more good thoughts and explanations below.  An anonymous poster has had a good go at it as well. Perhaps between the various comments and my own explanation, someone can provide a good synthesis that takes the good points from all? As ever, I am impressed with the readership of the blog.

Lemming: Apologies, I found a comment from you which escaped the approval process for some reason. I am not sure how long it sat unpublished, but apologies if it was a long time.


  1. Your argument assumes no change in tax revenue from sources other than government-financed consumption.

    In the case of Spain that might be a fair assumption, but it not necessarily so for all countries in which the government runs a substantial deficit.

    As always we get back to the fact that the value of stuff a country produces (including services it sells to overseas customers) lies behind its true wealth and, therefore, its capacity to generate tax revenues for the government.

    Once stuff is produced by A it is sold and creates a waterfall effect - the wholesale purchaser (B) adds a mark-up to the retailer (C) who adds a mark-up to the consumer. From one item of production A, B and C all have money to spend on other things including tax, but there is a limit to what each item of production adds to economic activity. There is much derivative economic activity when A, B and C spend their profits on goods and services, yet still there is a limit related directly to the value of stuff produced.

    Unless more stuff is produced or more money comes in through selling services overseas, a government running a deficit is necessarily in a downward spiral to insolvency.

  2. Their argument makes a lot more sense in that they see government stimulus more as a defibrillator. With a huge shock, the economy will become self-reliant again. Krugman especially makes this much more explicit when he argues that the long term US gov financial picture will be much better if we borrow more now.

    I do not view government borrowing as a defibrillator, but as life support. The patient will die the moment it stops.

  3. It's just the 'debt to GDP' magical thinking. When you stop borrowing and start repaying, this ratio goes worse.

  4. To me, the problems we’re living through could be viewed as being very simple.

    Governments have income which is variable depending on the economy of the country. Call this A. A strong economy with lots of activity means that over time A will be increasing in value. A weak economy where there is little activity means A will be decreasing in value.

    Governments have expenditure and can choose how much to spend and where. Call this B. Except that they have some fixed costs in the form of repayments for previous loans. Call this C. So the total for a balanced expenditure budget should be (B+C)

    In a balanced budget (B+C) should never be greater than A. Except that to win favour with voters politicians have convinced themselves that B doesn’t have much relationship at all with A. So they make commitments and promises which are not based on the income which they will have. If A=100, then so should (B+C) =100. Unless you’re a politician.

    A, however, depends upon activity in the economy. What is happening is that to try and raise A as high as possible extra taxes are being levied. But the impact of these taxes is to reduce the activity in the economy and thus this becomes at some point a self-defeating exercise. So A might only be 95 or perhaps 90 if the economic activity isn’t happening.

    B in the meantime is continuing to grow, partly because of promises and contracts entered into years ago (PFI anybody? Government pensions & ageing population?) Although the government is introducing austerity measures to try and limit their spending on B it seems that the reduction in spending on B is causing a more severe contraction of economic activity, thus reducing income A. There is something bizarre about spending (B) to create income (A), but that’s the way the world works.

    Remember C? That pesky repayment of debt which the Government has to do? That has to have interest paid on it so C is in effect over time a constantly rising number.

    So if C is constantly rising due to loan interest, and that loan interest is fixed and rising faster than the growth in the economy then B must always be being squeezed. Except it’s not because Politicians are borrowing ever more to supplement their income of A. Lets’ call this D (for debt!).

    So our balanced budget (as politicians see it) is A+D = B+C. In this way, the can of debt repayments C can keep on being kicked down the road for ever. Except that the only way of doing this is to keep on adding more D to the weakening A, and as C is continuing to rise the government has to try to reduce B ever more. Except they can’t because reducing B causes a sharper reduction in A. And so, eventually it all comes to a very sudden crashing halt.

    Have I got it right?

  5. Best I can come up with is this:

    Once deficit spending becomes the norm in an economy, a democratic government loses control of its finances. Full stop.
    If it tries to cut the deficit year by year, activity falls, revenue falls and welfare payments rise - so the deficit rises.
    If it maintains the deficit year on year, debt rises so repayments rise - so the deficit rises.
    If it deliberately increases the deficit year by year, it doesn't generate real extra activity (because the economy is already over-inflated) but – duh – the deficit rises.
    If it defaults on its debt, it can't borrow so it has to cut the deficit at once, but this doesn't work because activity falls, revenue falls and welfare payments rise - so the deficit rises.
    If it prints money to fund the deficit, it doesn't generate real extra activity (because the economy is already over-inflated) but just shifts purchasing power from households and companies to itself. So activity falls, revenue falls – and the deficit rises.
    The only way out is if export-led growth allows the government to cut its deficit. But this is outside the government's control because it depends on external demand. (Devaluation helps, but not hugely. This is because it increases the cost of imported inputs.)
    The best the government can do in terms of macro-economics is switch its spend from consumption to investment (or shift taxes from investment to consumption), in the hope of cutting production costs and/or increasing quality so that there's more chance of export-led growth or of displacing imports. But that works best if the rest of the world isn't trying to do the same thing at the same time....

  6. carrew,
    excellent comment

  7. What Carrew has said is pretty much on the mark, though here's the kicker, economies that can print their own money can in effect short circuit D through the back door by having their own national bank buy up their own debt, often done at below market interest (if any).

    D becomes borrowing AND printing of money which is used in the process of soaking up debt (which usually is seen as a taxation on pensions and savings via inflation). Interestingly a few ideas concerning the whole money printing approach such as having the bank buy up shedloads of govt debt and then simply writing it all off, this might be the way out of dealing with B and C longer term, though who knows what that would do to the markets (I imagine the currency of the country involved would turn into a new Zimbabwe dollar).

    Horribly confusing stuff.

  8. Cynicus,

    The economy is a bathtub ..........

    the water in the bathtub is the 'money' in circulation in the economy and reflects the cash and credit in circulation. Imagine the level of water in the bath reflects the size of the economy measured in £. If the water level rises the economy is growing if the water level falls, then the economy is contracting.

    This bath though, is a bit different. It has a number of taps allowing money into the bath and a number of plugholes allowing money to drain out of the bath.

    The taps allowing money into the 'bathtub' are private credit (i.e. mortgages), company credit(corporate loans), export revenues and inward investment + probably some others.

    Similarly there are a number of plugholes - payback of previous loans, payback of interest, import costs and outward investment. All effectively taking money out of the 'bathtub'

    There is then a special overflow from the bathtub which feeds a header tank, which feeds money back into the bath. As you can probably guess this special header tank is Government spending. In effect it takes money from the economy via taxation and then simply 'reinvests' it back into the same economy. The higher the level of money in the bathtub, then greater the 'overflow' back to the Government header tank.

    But this header tank, has another input in terms of Government borrowing, which simply increases to make up any shortfall should the 'overflow' from the bathtub starts to fall.

    .... a picture would sum this up much more easily.

    So, back to the real world. When creation of credit is squeezed, or confidence falls then the inflow of credit money into the bathtub reduces and the 'money' level in the bathtub falls. The economy heads into recession.

    At this point, Governments start squealing as they simply fail to get the taxation receipts needed. Of course, they can cut spending accordingly and continue to see the water level in the bathtub fall, or they can increase their borrowing to try and keep the bathtub topped up in the hope that they can offset the credit crunch and lack of confidence until such time as private credit growth starts again.

    Now a special point about the credit interest plughole on this bathtub. Obviously the size of this plughole varies with interest rates. Higher the interest rate then bigger the plughole, i.e. a greater flow of money out of the bathtub. This mimics the effect that increasing interest rates takes more money out of the economy but also subdues the amount of credit being created and helps to control the level of 'money' in our bathtub economy.

    Similarly, the greater the amount of credit money in the bathtub then bigger the credit interest plughole becomes, drawing ever more money out of the bathtub economy.

    The exchange rate will also affect the size of the plughole.

    The thing that becomes obvious is that whilst ever interest is paid on credit money, then the bathtub will always be losing more money than is pouring into the bathtub. Thus the bath tub needs a continually increasing flow of credit to keep the level of money in the bathtub at the same level. The only option to offset this effect is for export revenues to exceed the outflow due to import costs ..... needless to say, this doesn't happen in the UK !

    So back to the opening point. Increasing borrowing just makes the plughole bigger and no matter what you do, the bathtub just keeps emptying. The economy will simply continue to go down the drain unless you start earning money by getting your exports going and reducing your imports.

    In this country we have successfully filled our bathtub by creating the best part of £4-5 Trillion of credit.

    Best Regards,


    1. The water going out of the bath(interest) is recycled back in to the bath.

    2. Possibly, but not necessarily. It all depends who the interest is paid to. If it is paid back to say, a foreign fund such as the Saudi's then it may end up truly getting drained from the bathtub.

      They may choose to 'reinvest' back in the UK or they may invest in Brazil for example. The thing that no one can put their finger on is the flows of capital around the world, as it constantly changing due to all sorts of short term gambles, on currencies, stock markets, bond markets etc.

      For example the last credit crunch was caused by bad gambles on US based CDO's which then led to increases in interest rates on loans made to British banks.... and so it then ripples down the food chain, so to speak.

      The 'rich' folk (whoever they are) who get the interest, may or may not reinvest it back into the UK. Whether they do so depends on circumstances all over the world and we cannot assume that interest always gets reinvested back into the UK.

  9. Hobbes:

    It is all very confusing.

    Currently the BoE is buying up gov. bonds in order to hold the price up and so keep the interest rate down. I wonder what would happen if the BoE, as buyer of last resort, did stop buying/

    Where would the true(r)market price and interest rates lie?

    I also see this action as a permanent act of monetizing the government debt, although I doubt the BoE will admit it. To what level would the economy have to improve to enable/encourage private buyers of UK debt to 1. take up all the new debt and 2. buy up the debt on the balance sheet of the BoE?

    That is a shed load of debt to be sold into probably a very reluctant market, particularly as it would herald monetary tightening, with accompanying increasing interest rates, driving down the price of gov. bonds.

    I believe that this experiment will be regarded as a permanent arrangement so that gov. deficits can be maintained or, as forecast, INCREASED in the UK by 40% over the next four years.

    I expect that private buyers will by sufficient debt to meet their needs and the rest will be sucked up by the BoE to prevent interest rates rising and a disastrous "failed" auction.

    Actually I believe this could be a positive thing, as a percentage of the government expenditure is then effectively injected into the economy as "debt free money", enabling the humongous accumulated debts in the private sector to be paid off.

  10. Today's Telegraph includes this http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/9189398/Europe-and-the-Law-of-Sticky-Wages-technical.html. It suggests to me that government econonomic policies are not about the economy at all, but are about trying to maintain social order by keeping the money going round.

    Government thinking in the UK is notoriously short term, their primary concerns are getting through the week & winning the next election: so long as the money keeps going round (in the manner so eloquently described above by TheFatBigot, Carrew and Yorkie) the population the majority of the population is well behaved and HMG doesn't care.

    Most people don't understand the underlying economics since there is next to nothing readily available to explain it to them with CE's clarity. Those who do understand are hanging on in quiet desperation. The government of the day gets through the week and when eventually it loses an election the opposition party gets left with the mess.

  11. Think of money in terms of production. If you spend all the money from future`s production(over consumption), then nothing will be produced in the future.


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