Tuesday, 29 November 2011

The merits of a debt money system

In my previous post I explained how the Western world's debt money system works.  Currently, in our system, all money is created as debt. Debt precedes savings: it is lent out by financial intermediaries and becomes someone else's savings when it is spent. Therefore, contrary to popular opinion, for someone to have savings it is necessary for someone else to have debt. And because debt (in its widest sense, so including corporate equity) and savings are equally balanced over the economy as a whole, when debt is paid off savings are reduced by an equal amount.

In a debt money system the value judgements so frequently applied to debt and savings are unhelpful and can lead to completely inappropriate courses of action being taken by individuals, corporations and - particularly - by governments and supra-governmental organisations such as the IMF. Popular morality, particularly in the Anglo-Saxon world, has it that debt is a BAD thing and savings are a GOOD thing. These mores may be helpful when teaching fiscal responsibility to teenagers. But they are meaningless when applied to a debt money economy.

In a debt money economy, both debt and savings are necessary. Savings cannot exist without debt, and because of the way fractional reserve banking works, new debt cannot be settled without savings. It is completely circular and, as I noted above, economically balanced.

Socially, however, it is far from balanced. The fact is that most of the savings are held by richer people, and most of the debt is held by poorer people, or by governments on behalf of poorer people.  And as a couple of people pointed out in the comments stream on this post, the imbalance is also inter-generational. Older people tend to have more savings, of all kinds, than younger people do, and conversely younger people tend to have more debt than older people. The commentators on Positive Money's post describe this incorrectly as a wealth transfer from younger to older. It is nothing of the kind: people build up wealth by saving from their lifetime's income, so it is inevitable that people who have lived and worked longer will tend to have more wealth (savings) than younger people. These savings are lent back to younger people to enable them to have things such as cars and - yes - houses that they do not yet have the wealth to be able to afford.This transfer of savings from older to younger, and from richer to poorer, to enable younger and less wealthy people to have a better standard of living than their present wealth would permit is in my view one of the principal benefits of a debt money system. Yes, that debt has to be paid back from future income, and if future income disappoints in relation to the money borrowed then paying back that debt can become very difficult. But as a way of redistributing wealth on a temporary basis it works pretty well.

The opposite of a debt money system is a saved money system. An increasing number of people, including (but not limited to) Positive Money, are calling for changes to the Western debt money system which would amount to transforming it into a saved money system. In a saved money system, money is created through payments, not through debt, so savings precede debt.  And because savings precede debt, it is of course not necessary for debt and savings to balance.  Money stuffed under mattresses or buried in the ground never gets lent to anyone, so debt will tend to be less than savings.

Intuitively a saved money system "feels" better to many people, because it's how they've always thought the money system worked - partly because banking and economic textbooks incorrectly teach that savings precede debt in fractional reserve banking.  And it fits better with the mores I described above: if savings can exceed debt - as they can in a saved money system - then Anglo-Saxon moral judgements about the evils of debt and the wisdom of saving can be applied with impunity.

But there is a huge problem with a saved money system. You see, it discourages lending to all except safe risks - which generally means people who already have wealth, not people who don't but might have in the future. This is because whereas in a debt money system savings don't exist unless there is debt, so there is a tendency for debt to increase, in a saved money system not only do savings precede debt, they can exist without it. In a saved money system lending is entirely optional and hoarding is very, very tempting, and in hard times people can be very reluctant indeed to lend. In a saved money system therefore, debt tends to be much lower than it would be in a debt money system.

Now, I can hear you all saying "but less debt, more savings is a good thing, surely"? No, it isn't. Remember that in a debt money system, the lifetime savings of wealthy (older) people are recycled through their investments back into lending to poorer (younger) people? That redistributive function is much less certain in a saved money system, particularly if money supply is kept tight to control inflation. The result is that instead of poorer (younger) people financing a better standard of living (and the start of saving) through debt, they are likely to have to fund far more of their major purchases from income alone, by "saving up for them". This is particularly the case if the older generation are applying value judgements to savings and debt, so are unwilling to lend to younger people unless they already have good incomes and savings - which sort of defeats the purpose.  In a saved money system therefore I would expect to see levels of evident material poverty, particularly amoung the young, that in a debt money system would be mitigated by the use of debt. The wealth inequality between the richest and the poorest would be on show for all to see. Is this what we really want?

The other way of redistributing wealth between rich and poor is of course tax and benefits. But the older to younger distribution is much less effective here. In fact in most advanced tax systems there are transfers in both directions - from older to younger in the form of state education and benefits aimed at younger people, such as child benefit: and from younger to older in the form of state pension and benefits aimed at older people, such as free bus passes and fuel allowances - not to mention the fact that older people are much heavier users of a national health service than younger ones.  If we moved to a saved money system, to mitigate the evident poverty of younger people intergenerational transfers would have to be skewed considerably in favour of younger people, for example by heavy taxation of equity held in property. And hoarding would have to be systematically discouraged, for example by heavy taxation of investments deemed "unproductive" and enforced contribution to forms of saving considered "socially desirable".  I have seen proposals along these lines, but all of them depend on there being a far more authoritarian and invasive system of government than we currently have. Is that what we really want?

Neither a debt money system nor a saved money system is perfect, and neither can be left to run on its own. In a debt money system left to run on its own, debt generates more debt until eventually the debt levels overwhelm the economy and the population ends up in debt peonage. In a saved system left to run on its own, obscene wealth is juxtaposed with grinding poverty, older people who have done well in life hoard their savings while younger people - and older ones who have been less fortunate - starve.

I see no benefit in changing to a saved money system, and potential for great harm in the level of authoritarianism that would be required to mitigate the wealth/poverty imbalance through taxation and coerced lending. I would rather retain our debt money system, with all its faults, but seek to put in place an effective brake on its tendency to generate more debt, and limits on the lending practices that create this tendency. This to my mind is the function of government.  In recent years governments have been increasingly "hands-off" with regard to the regulation of money creation through lending. This is not freeing the market to do its best - it is abdication of responsibility.

It may be that even with brakes such as tighter lending standards and taxation of bank balance sheet expansion, debt will still get out of hand from time to time. The "debt jubilee" proposal which is doing the rounds at the moment is an idea from early Jewish culture, in which debts were wiped out every seven years and people in debt slavery were able to return to their families. It may be that we, too, need to consider introducing routine writeoff of debt after a certain period of time, or a general wipeout of debt every few years. But we shouldn't be blind to the cost of this. When you wipe out debt, you also wipe out savings. And life being the way it is, you can absolutely guarantee that it won't be the excess savings of the very rich that will be wiped out. It will be the pensions and savings of ordinary people. Steve Keen's idea seems to be that government should step in to protect those savings - but is that really a jubilee, or is it just borrowing from a future generation to protect the current one?

Whatever system of money we have, the real issue is the growing wealth imbalance in our society. And unless we address that, the same problems will return again and again.  The more wealth is concentrated in a very small number of people, the more everyone else has to borrow to have a decent standard of living (in a debt system) or the more poverty-stricken they are (in a saved money system). Changing the money system solves nothing.

Thursday, 24 November 2011

Knowledge and belief

This post is a long overdue response to Richard Murphy's post "I believe in belief", which directly criticises comments I made about another of his posts and makes false and unjustified assertions about my beliefs and my background.

I thought long and hard before writing this post. I don't want to be seen as someone whose aim is to discredit another writer: frankly, life's too short to expend much time on such a fruitless task, and I have far more interesting things to do. But this post touches on some fundamental issues. And that is my real reason for writing this post.

I reproduce here the comments I made on the Liberal Conspiracy blog regarding this post from Richard Murphy:
Can I comment on two quotes: 
Quote number 1:
“A Courageous State is populated by politicians who believe in government. They believe in the power of the office they hold. They believe that office exists for the sake of the public good. They know what that public good is.” 
Quote no. 2, six paragraphs later:
“A Courageous politician knows that there is a great deal that he or she does not know, and knows that despite that they will have to act.”
Conceivably that might mean they don’t actually know what the public good is, but they will act for the sake of it anyway. Or is the idea that politicians MUST know what the public good is, even if they know nothing at all about anything else? I can’t help feeling that logical inconsistencies like this should have been ironed out in the proof-reading process.
I am also a little concerned by the quasi-religious language. Beliefs abound, but on what are they based? Not much, it seems, except your definitions. What exactly qualifies you to define what politicians should believe? 

In response, Murphy claims that my questions arise from my supposed belief in neoliberalism, which he seems to regard as more of a philosophy, or even a religion, than an economic theory. Here are two of  his descriptions of me from this post:
This commentator’s observation is based upon that neoliberal thinking that presumes us automatons without, for example, belief systems.... 
....as this commentator shows, for those schooled in neoliberalism that whole exercise of normal human thinking and decision making has been utterly undermined by the false philosophy they follow.....
What concerns me is the manner in which Murphy presents his beliefs - about me, in this case, though he tends to do this generally anyway - as gospel truth. He has no evidence for these assertions. He is making a statement of faith.

Now, I don't have a problem with people making statements of faith, where there are no facts to be found. Humans need beliefs - it is how we attempt to make sense of a world we don't understand. But when facts are available, it is quite wrong to make assertions without checking those facts.  And it is not only wrong, it is immoral to make assertions about another person that are not supported by anything they have said and done and are clearly intended to discredit.

Murphy knows NOTHING about what I believe. Nothing at all.  All he knows is that I do not agree with him on the best course of action in relation to the problems in banking and finance and the future direction of economics in this country. He knows nothing at all about my background, my training or my personal beliefs. But because of our disagreement he BELIEVES that I hold "neoliberal" views - despite the many, many statements that I have made that undermine that belief. He BELIEVES that I regard humans as automatons who make decisions entirely on the basis of facts and knowledge, without any need for belief systems. And he BELIEVES that I have no other belief system.

Nothing could be further from the truth. I am not "schooled in neoliberalism".  Yes, I did some economics as part of my MBA, and have voluntarily studied more since. But I read material from across the range of economic thinking, from left to right, Marx to Friedman, Keynes to Hayek, Adam Smith to modern MMT theorists (whom I rather like). And where I stand on economic and political matters is my own creation. I am the "cat that walked by himself". Many, many people have said that I am "hard to place" on the left-right political spectrum: my understanding of banking and finance, and my opposition to economic solutions that involve spending yet more government money, suggest right-wing tendencies, but my social views are decidedly lefty. I have been called both "hard-right" and "far left" by various people.

But even more important, I am not "without beliefs". Far from it, actually. What underpins everything I do and everything I say is my Christian faith. Indeed the reason why I started writing about banking and finance earlier this year was that I felt I was being called to do so. And it was absolutely against my wishes. When I left banking, I believed I would never return - that after years of holding my family together by doing well-paid jobs that left me no time for my family and no energy for singing, I was finally being given the chance to follow my heart and use the voice (and, it turned out, the teaching gift) that I have been given, both to keep my family and to benefit others. I still hope that I am not being asked to return - that my involvement will be limited to standing on the sidelines and chucking grenades. But my Lord has the last word, and my faith requires obedience. When he calls me to do something, I must do it. So if he makes it clear that I must give up all I have gained and return to the job that tore me apart, then that is what I will do.

So Murphy's notion that I think belief systems are unnecessary is so far removed from the truth that it is laughable.  My whole life is driven by my Christian beliefs.  I get it wrong, of course - because I am human. I say things I shouldn't, and I do things I shouldn't. When I get it wrong (which is pretty much every day) I am called to account for that and I have to repent, apologise and if possible make amends.

And further to this....if my own life is driven by my belief system, how could I possibly criticise others for acting according to their beliefs? That was not the point of my comments at all. My concerns are twofold:
  • that politicians acting on faith alone, and refusing to acknowledge facts that, if considered, would suggest an alternative course of action, are dangerous; 
  • that people who think they have the right to define what other people, especially those in public life, should believe, are also dangerous
Murphy's response does not address either of these points. Distressingly, if he had actually taken the trouble to address my concerns instead of trying to discredit me by imputing to me beliefs I don't hold, he might actually have agreed with me on the first, at least. After all, ideological adherence to an austerity agenda despite overwhelming evidence that this is driving economies into recession, is a large part of what is already terrribly wrong in the Eurozone and is rapidly going wrong in the UK.

But the most worrying part of all of this is that he has completely misunderstood my second point. Instead of answering my question "what qualifies you to define what politicians should believe?", he redefines it as questioning his "right to believe in belief". I have no problem with Murphy believing in belief, if that's what he wants to believe in, though it sounds a tad tautological to me: personally I'd rather believe in God, but there you go. And I defend absolutely a politician's right to believe in whatever they want to, even Murphy's ideas if that's what floats their boat: they are human just as I am, and as I said above, humans need beliefs. But I reject absolutely the notion that Murphy has the right to define what politicians SHOULD believe. No-one, absolutely no-one has the right to tell someone else what they should believe. That way lies the Inquisition:  repression, persecution and genocide....it has happened so many, many times before. Freedom of belief is one of the great blessings of our Western society, and a rare thing in our world even now. We must guard against the desire - that we all have - to suppress dissent and force others to adopt our worldview.

Sunday, 20 November 2011

The other side of debt

This post is sparked by the debate that there has been in the last few days around Positive Money's proposals for reform of the monetary system in the UK. You can read their proposals here.  I'm not in this post aiming to debunk Positive Money's ideas so much as to clarify for people's benefit the nature of our debt money system and how fractional reserve banking works in practice. If more people understood how things REALLY work (rather than what the textbooks say) we would be better able to have a sensible debate about how we want it to work in future.

The matter I want to address in this post is relationship between debt and savings. Positive Money correctly describe the way bank lending works, but they ignore the impact on savings, and therefore tell only half the story. And in the course of the debate it became apparent that there are many people who simply don't understand the relationship between debt and savings. Yet the relationship between debt and savings is fundamental to our monetary system. The other side of debt is savings.  For every debt there are equivalent savings, so across the monetary system as a whole debt and savings are equal

Now before someone screams at me that it's obvious that there's more debt than savings, innit, because bank lending far exceeds bank deposits, let me define what I mean by debt and savings.

Debt is deferred payment for goods or services desired now, or in economics-speak,  "consumption brought forward".   For example, you need a new car, now, but you haven't saved up enough money to pay for it outright. So you borrow the money.  You are prepared to pay more for the car than the current price, because you benefit from being able to use the car now and defer part of the payment until later. You therefore pay your lender interest on that borrowing. The total cost to you of that car is not the amount you pay to your dealer, it is the loan principal plus all the interest payments over the course of the loan, discounted by the rate of inflation over the period of the loan, minus any deposit you pay now from your own savings.

There are many different forms of bank lending.  From an economic point of view, though, the major difference is between committed and uncommitted lending.  In committed lending, such as a bank loan, the money is legally committed to you at the time the agreement is signed and cannot subsequently be withdrawn without notice. In uncommitted lending, such as an overdraft, a credit facility is granted to you which you MAY use, but the undrawn portion of the facility can be withdrawn at any time without notice. I've generalised here considerably, and legal eagles out there will no doubt say I've simplified far too much - bank lending agreements are far more complex and the distinction between committed and uncommitted lending is not always clear. But it will do as a general principle. 

Banks aren't the only source of debt. Issuing bonds is a form of debt financing for large corporations and governments. Any individual or financial institution that purchases and holds bonds is in effect lending to the issuers of those bonds.  I'm not in this post going to address how bond issuance and trading works, but corporate and government bonds make up a significant part of global debt. And they are important to ordinary people: anyone with a private or corporate pension almost certainly has significant holdings of government and blue-chip corporate debt.

Savings are deferred spending (deferred consumption). You don't need to spend all of your wages this month (lucky you), so you put some of it in the bank. Or you choose not to spend all of your wages in order to put money aside for spending at a later date - for example, when you are too old to work.  You want to put your money somewhere that will earn you a return on your deferred spending, partly to compensate for the erosion of the value of those savings by inflation, and partly because by choosing not to spend that money now you are forgoing the pleasure you might receive from, for example, having a fantastic holiday.

There are many forms of saving. Bank deposit accounts (including current accounts) are one form. Others are pensions, ISAs, long-term savings plans (endowments), shares and bonds, gold and other precious metals, art, wine and property. The last of these - property - is particularly important because a high proportion of the UK's population have their savings principally tied up in the house they live in. Even if they have a mortgage, the difference between the present value of the house and the amount outstanding on the mortgage - their "equity" - is their savings.  When house prices rise, existing home owners benefit because their savings increase. Conversely, new buyers have to take on more debt.  The increase in debt among new home owners balances the increased savings of existing home owners. 

Overall, the people of the UK now have far more savings outside bank deposit accounts than they have in them. That's why, if you only look at banks, it looks as if there is far more debt than savings. But when you take into account other forms of saving - including tax, which is government savings (tax extinguishes government debt obligations, which is equivalent to saving), and bank and corporate retained earnings, which are the savings of shareholders - it becomes evident that globally, debt=savings.  That is why it is very wrong, and very dangerous, to suggest (as some have done) that debt is made of "imaginary money" which can simply be wiped out cost-free. No it isn't, and it can't. Wipe out debt, and you also wipe out savings.

Financial intermediation is the process by which borrowers obtain from savers the money they need to buy things. Or alternatively, the process by which savers obtain from borrowers the interest they need to maintain the value of their savings over time and compensate them for not spending that money themselves. Banks and other financial institutions act as financial intermediaries, lending to borrowers at interest and paying interest to savers. They make money by paying less to savers than they charge to borrowers - that is known as the "spread".  And they accept and manage the risks inherent in lending to borrowers over a long period of time while allowing savers to remove their funds if they wish.
The money supply is the total amount of various types of money in circulation.  "Money" in this case pretty much means anything that will be accepted by somebody as payment for a product or service.  "Base money" is notes & coins plus bank reserve balances at the Bank of England (more on this later). "Broad money" is all other versions of money, including balances in bank deposit accounts and various types of commercial paper.   


Fractional reserve banking
"Fractional reserve banking" is the process by which banks intermediate between borrowers and savers.  It is commonly believed that banks "lend out" deposits.  Banking and economic textbooks are full of descriptions of banks lending and re-lending fractions of deposits.  Sadly those textbooks are wrong in one important respect: they assume that deposits precede lending. No, they don't. 

What actually happens, as I've explained previously, is that banks lend, and then look for reserves to settle the drawdown of that lending. The accounting entries for a new bank loan for £10,000 are as follows:

Customer loan account:       £10,000 DR                  
Customer deposit account: £10,000 CR           

The loan account debit represents the customer's DEBT, which is the bank's ASSET.
The balancing customer deposit account credit is the actual money advanced by the bank, which is the bank's LIABILITY. It is usually a credit to a demand deposit account such as a current account, and can be drawn in cash or paid out by bank transfer or cheque in the same way as any other deposit. It is not possible to distinguish in any meaningful way between a deposit created from a bank loan and a deposit made by the customer.

Demand deposit account balances form part of bank reserves  - not capital. This distinction is important, as I describe here. Bank reserves are required to settle deposit withdrawals, including loan settlement, but they are not referenced at the time the loan is granted.  And demand deposit balances are included in the measures of "broad money" supply in the economy. So the creation of a new deposit without drawing on underlying reserves has the effect of increasing the amount of money in circulation - as Positive Money correctly claim. Therefore, in my example above, when these accounting entries are made "broad money" increases by the amount of the deposit. 

That new deposit behaves in all respects like any other sort of deposit. You can draw it in cash or you can pay your car dealer by bank transfer or cheque. If you draw cash the bank must physically have cash to pay you – as with any other deposit withdrawal. Banks estimate their cash requirements on a daily basis based on withdrawal patterns across their customer base. Sometimes they do run out, of course. I’m sure you have all experienced trying to get money out of an ATM over a bank holiday weekend. And most banks require notice of large cash withdrawals.

If you pay your car dealer by bank transfer or cheque then no cash is involved. The accounting entries are as follows:


Your bank:

Customer deposit (current) account       £10,000 DR
Interbank settlement account                   £10,000CR
Car dealer's bank:
Interbank settlement account                   £10,000 DR
Car dealer's deposit (current) account   £10,000CR

BoE reserve account entries:

Your bank                                                  £10,000DR
Car dealer's bank                                    £10,000CR

Your money advance has now become your car dealer's deposit. In the process your bank has drawn on its reserve account at the Bank of England (sort of like its current account) and is now running an overdraft. Conversely, your car dealer's bank now has excess reserves at the Bank of England.

Banks have to balance their Bank of England reserve accounts at the end of each day.  If they have a negative balance (more money drawn than received) they borrow from other banks which have credit balances, or as a last resort directly from the central bank.  It isn’t possible for a bank to run an overdraft overnight on their reserve accounts. They have to borrow the money from somewhere, and they pay interest on those loans. 

Your bank could of course borrow your deposit back from your car dealer's bank to clear its reserve overdraft. It's sort of circular. And it gets even more circular if you and your car dealer bank at the same bank and you pay him by bank transfer, which clears during the day.  In this case there is no impact on interbank settlement or BoE reserve accounts. Your loan is in effect funded by its own deposit. But the bank still pays interest on that funding - even current accounts attract interest, pitiful though it is. 

The example I have given above is of a committed loan, of course. In uncommitted lending no deposit is created and the liability remains off balance sheet until it is drawn. On drawdown settlement funding applies as I have described. Whether or not drawdown of uncommitted facilities increases the money supply is a matter of debate: personally I think it does, because a new deposit is created in the recipient's bank for the amount of the drawdown. 

I hope I have shown through the example above how lending creates new money that then inflates savings as well. Overall, household debt has increased by £10,000, small business savings have increased by £10,000, and broad money supply has increased by £10,000.  But to argue, as some have done, that banks don't need to borrow to settle loans because they can invent the money, is simply wrong. 

Reserve and capital constraints on lending
Since banks lend in advance of obtaining reserves for settlement, it's not in any way meaningful to regard bank lending as constrained by the availability of reserves.  And because of the money creation involved in lending, there is NEVER a shortage of reserves for settlement provided banks are willing to lend to each other.  If for any reason banks become unwilling to lend to each other - as we are seeing at the moment in the Eurozone - central banks provide settlement funding ("liquidity") at penalty rates.  

Under the present system bank lending is capital constrained, not reserve constrained. How much credit a bank can create is governed by the ratio of shareholders’ funds and retained earnings (money it DOESN’T OWE TO ANYONE, which is its capital base) to what we call “risk weighted assets”, which are a way of valuing loans by their risk. Each new loan drains an amount of capital proportionate to its risk weighted amount. Banks can only lend within their capital ratios. In the run up to the 2007 crash the capital ratios were much lower than they are now and were widely ignored anyway. Now capital requirements are much higher, which limits lending, and hopefully regulators are being tougher about enforcing them. The problem with this is of course that calculating risk weightings is a bit of a black art, and risk classifications can be intrinsically wrong: e.g. sovereign debt is weighted at zero, which means banks can lend unlimited amounts to governments because their debt is assumed to be risk free – but we all know that’s not true, don’t we? So regulators are trying to move towards constraining leverage as well, which is the ratio of capital to deposits. As each loan creates an equal deposit, forcing banks to restrict their leverage would also have the effect of limiting lending.


Positive Money would like to change this, of course. In effect their proposal is to introduce reserve constraints on lending: they want banks to obtain reserves in advance of lending and only lend up to the limit of those reserves. They also want to force all banks to obtain reserves only from term deposits or from central bank liquidity: current accounts would be excluded, and banks would not be allowed to lend to each other. The MPC would be tasked with making sure the Bank of England created enough money to fund lending without increasing inflation. I know the MPC has a reputation for wizardry, but how on earth they are supposed to forecast lending needs versus inflationary pressures without resorting to clairvoyance is beyond me. 


Conversely, the Independent Commission on Banking (ICB)'s proposal for bank reform envisages significantly increasing capital requirements, particularly for systemically-important banks with retail operations.  The ICB (correctly, in my view) rejected Positive Money's proposals for bank reform on the grounds that they would be unnecessarily restrictive of credit.  Instead, they proposed capital ratios for large banks that would go beyond the levels recommended by the Basel committee.  Predictably, the banks have objected to the amount of capital they are being required to raise, on the grounds that it would hinder economic recovery.


There is no doubt that bank reform is necessary. There is also no doubt that it will be painful, not only for banks themselves but also for their customers, both borrowers and savers. Savers are receiving rubbish returns on their investments. Borrowers are finding it hard to get credit and are facing rising interest rates and charges. Whichever alternative is adopted - reserve-constrained lending, as Positive Money would like, or increased capital constraint, as the ICB proposes - the result will be that lending becomes more expensive and more difficult to obtain.  The days of cheap and easy credit are gone - for now. 

Monday, 7 November 2011

Austerity and the Eurozone

There has been much discussion recently about the austerity measures being imposed on Greece, Italy and others in the Eurozone in the interests of returning their budgets to balance and implementing much needed structural reforms. The question is not whether these measures are necessary, but whether in the current economic situation they are achievable.

Firstly, some basic economics.

If a country runs a trade surplus it is a net exporter of goods & services and an equivalent net importer of capital. Conversely, if a country runs a trade deficit it is a net importer of goods & services and an equivalent net exporter of capital.

If a country runs a fiscal surplus it means that the government's income is greater than its spending. Conversely, if a country runs a fiscal deficit it means that government spending is greater than its income.

There is of course a relationship between trade surplus(deficit) and fiscal surplus(deficit). If the domestic private sector is balanced (neither spending overall nor saving overall), then a country with a trade surplus will also have a fiscal surplus, and a country with a trade deficit will also have a fiscal deficit. If the private sector is spending overall, then a country with a trade deficit may still have a fiscal surplus due to indirect taxation increases. Conversely, if the private sector is saving overall (or paying off debt), a country with a trade surplus may still have a fiscal deficit because of reduced tax income. The most poisonous mixture is a country with trade and fiscal deficits where the private sector is net saving, which makes for an economy dangerously close to recession. British readers will recognise this as the UK's problem....which I shall return to in another post.

The trade flows between countries net to zero. So within an economic area, such as the Eurozone, a trade surplus in one country must be balanced by trade deficits in one or more other countries. Everyone wants net exports, but not everyone can have them. Which is why the "exports are good, imports are bad" view that is so prevalent at the moment is economically nonsense.

Countries usually issue debt to cover their deficits, so the longer a country runs a fiscal deficit the deeper in debt it will be. If attempts are made to cut a fiscal deficit without also reducing the trade deficit, either by increasing exports or cutting imports, the deficit is in effect transferred to the private sector who are forced either to use existing savings or borrow to pay for goods and services previously paid for by government. If the private sector has no savings (or is unwilling to use them) and is unwilling or unable to borrow, then cutting a fiscal deficit without export growth causes recession. I hope this is clear.

How does all this stuff about trade and fiscal surpluses and deficits apply to the Eurozone?

Germany  has a large trade surplus with its Eurozone partners. As Gavyn Davies points out, the excess of its exports to Eurozone countries over its imports from them just about balances the trade deficits of Greece, Italy, Portugal and Spain combined. These countries all have excessive public debt, and all except Italy have fiscal deficits - and Italy has only achieved primary balance this year. Basically, the four of them have imported from Germany more than they have exported to it, and they have funded those purchases by borrowing from, among others, German banks. Germany has therefore benefited from the debts taken on by those countries, not only because of the income generated by the exports themselves, but also because of the interest paid by those countries to German banks. It is fair to say therefore that Germany's trade surplus with the Eurozone is funded by the excessive debts taken on by those four countries, and that its fiscal surplus arises from taxes paid on income from exports and lending to those countries.

In the Eurozone, like everywhere else in the Western world, the private sector is already highly indebted and unwilling or unable to take on more debt. For deficit countries to reduce their fiscal deficits, therefore, their trade deficits must also reduce. One of the major issues that these countries face is that the locked exchange rate within the Eurozone makes their exports uncompetitive compared to Germany's. Making their exports competitive requires massive reduction in the cost of production, particularly labour costs, which is politically immensely difficult to do. It is highly unlikely therefore that their trade deficits will reduce due to increased exports. But if Germany's Eurozone trading partners reduce their trade deficits by cutting imports - which is already happening - then its trade surplus can’t possibly be sustained. Germany’s economy is heavily reliant on exports to the Eurozone. Balanced budget measures in other Eurocountries will therefore force the German economy to shrink unless it increases its exports outside the Eurozone. It is in fact doing this, but whether it can increase external exports enough to compensate for declining Eurozone exports is questionable.  And this does of course undermine the whole purpose of the European Union, which was to promote trade between European countries.

Currently the issue of trade imbalances is being ignored by the Eurozone leadership, especially Germany's Merkel, and the insistance on fiscal austerity in deficit countries is not balanced by a requirement for fiscal loosening in surplus countries. They don’t seem to understand that since within a currency union the usual monetary tools such as interest rates and exchange rates can't be used to control trade flows, fiscal policy must substitute for these ON BOTH SIDES.

So why is the Eurozone leadership, against all sound economic advice, so wedded to the idea that austerity measures alone will achieve balanced budgets and growth in deficit countries without compensatory fiscal loosening in the surplus countries and redistribution of surpluses to the deficit countries?

Value judgements about government financing - deficit = "bad", surplus = "good" - skew government decision-making in favour of spending restriction that may not be the most appropriate course of action in the economic circumstances. So in the Eurozone, deficit countries ("bad", profligate) must reduce their spending and make structural reforms, but surplus countries ("good", prudent) are models of fiscal rectitude so need make no changes.

These value judgements are completely unhelpful. "Good" and "bad" depend on your point of view. Someone who is a thrifty net saver is likely to regard saving as "prudent" and spending as "profligate".  Someone who has a less frugal lifestyle and spends instead of saving may well regard saving as "selfish", if it means others go without, and spending as "generous". Neither has any right to regard their viewpoint as better than the other, or to attempt to impose their values on others. But that is what is happening in the Eurozone. People in the countries that have net saved regard their way of doing things as  "right" and don't see why they should pay to support countries who have spent instead of saving. They can't see that their saving has only been possible because of the debt-financed spending of the deficit countries. And conversely, people in the countries that have net spent don't see why they should pay to bail out the irresponsible lenders who have financed their spending, and why Germany shouldn't give back some of the money it has earned from its exports and lending.  The result is that the dominant country, Germany, tries to impose austerity on countries who won't accept it and who adopt all manner of underhand ways of avoiding having to implement it. It's a standoff.

Now, some people believe that austerity-induced recessions are good because they "clear out" malinvestment and force structural reform. To some extent that is true. But the Eurozone is a special case. Austerity-induced recession only works as a reform strategy if the country concerned has control of interest and exchange rates, so that it can manipulate these to encourage business growth and exports. The Eurozone countries have no such control, and no politician who valued his job would seriously try to impose the wage cuts really required to restore competitiveness.  Austerity-induced recession therefore cannot possibly be the brief painful clearout it is meant to be, because growth will be strangled at birth by counterproductive monetary policy and insufficient demand for exports. Without fiscal support from the surplus countries, the recession facing the deficit countries in the Eurozone will last for decades - if the people of those countries allow it to go on so long.

Which brings me to my final point. Structural reforms are indeed desperately needed in the deficit countries, but for the Euro to survive, structural reforms are needed in the surplus countries too. Germany and other countries in fiscal surplus need to relax their fiscal discipline to encourage domestic spending so that smaller Eurozone countries such as Greece have a fighting chance of exporting to them. And surplus countries must commit to reinvesting their trade surpluses within the Eurozone instead of outside it. To be fair, Sarkozy did comment that countries in fiscal surplus need to consume more, and the G20 communique contains a commitment to do something to increase demand in surplus countries. So maybe light is beginning to dawn. But it may be too late to save the Eurozone.

Unless the imbalances between Eurozone countries are addressed, the deep recession in Greece will spread to other countries too, eventually including Germany. It is already beginning to. And once recession takes hold in the entire Eurozone, people will start to see that their lives and their futures are being sacrificed on the altar of a political dream that is rapidly becoming a nightmare - and they will take action. We are already seeing political unrest in Greece, Spain and Portugal. As recession deepens, this unrest will worsen and may be violently repressed - a fertile ground for actual revolt and even war.

Is preserving the Euro in its current form really worth wrecking the lives of an entire generation of Europeans, and risking the end of over 60 years of peace in Western Europe? I think not.