How the Economic Machine Works Part 5

Key Concepts

• Deleveraging: A process where borrowers reduce their debt.
• Budget Deficit: When government spending exceeds its revenue.
• Wealth Redistribution: Shifting wealth from one group to another.
• Inflationary: Tending to cause inflation (a general increase in prices and fall in the purchasing value of money).
• Stimulative: Tending to encourage economic activity.
• Financial Assets: Assets that derive their value from a contractual claim, such as bank deposits, bonds, and stocks.
• Government Bonds: Debt securities issued by a government to raise money.

Impact of Deleveraging on Central Government Finances

During a deleveraging period, lower incomes and reduced employment lead to a decrease in tax revenue for the central government. Simultaneously, the government faces increased spending demands due to rising unemployment, as many individuals lack sufficient savings and require financial support. To counteract the economic downturn, governments often implement stimulus plans, further increasing their expenditures. This combination of reduced revenue and increased spending results in significant budget deficits.

Funding Government Deficits and Wealth Redistribution

To finance these deficits, governments must either raise taxes or borrow money. Given falling incomes and high unemployment, the primary source for increased tax revenue becomes the wealthy, as wealth is concentrated among a small percentage of the population. This leads to a redistribution of wealth from the affluent ("haves") to those less fortunate ("have-nots").

Social and Political Consequences of Deleveraging

The economic hardship and wealth redistribution can foster resentment. The "haves," facing economic decline, falling asset prices, and higher taxes, may resent the "have-nots." Prolonged depression can escalate into social disorder and increased tensions, not only within countries but also between debtor and creditor nations. Historically, such conditions have led to extreme political changes, as seen in the 1930s with the rise of Hitler, war in Europe, and the Great Depression in the United States.

The Role of the Central Bank and Money Printing

In desperate times, with credit scarce and people lacking sufficient money, the central bank's ability to print money becomes crucial. After lowering interest rates to near zero, central banks are compelled to print money. This action, unlike spending cuts or debt reduction, is inflationary and stimulative. The central bank creates new money and uses it to purchase financial assets and government bonds. This was observed in the US during the Great Depression and again in 2008 when the Federal Reserve printed over $2 trillion. Other central banks globally also engaged in significant money printing.

Cooperation Between Central Bank and Central Government

By purchasing financial assets, the central bank helps to inflate asset prices, which can improve creditworthiness for asset owners. However, the central bank can only acquire financial assets, not goods and services. The central government, conversely, can purchase goods and services and directly inject money into the economy through stimulus programs and unemployment benefits, but it cannot print money. Therefore, for effective economic stimulation, the central bank and the central government must cooperate. The central bank's purchase of government bonds effectively lends money to the government, enabling it to run deficits and increase spending. This process boosts people's incomes but also increases government debt.

Balancing Deflationary and Inflationary Forces

The described scenario leads to a reduction in the economy's total debt burden. However, this is a precarious situation. Policymakers must carefully balance the deflationary aspects of deleveraging (like debt reduction) with the inflationary aspects (like money printing) to maintain economic stability. A correct balance can lead to a "beautiful deleveraging."