Brunswick on Nostr: In times of economic downturn, governments often engage in deficit spending and ...

In times of economic downturn, governments often engage in deficit spending and increase their deficits. The fundamental reason for this action is what would happen if they did not: a collapse in economic activity driven by a contraction in credit, leading to a deflationary spiral.

It is commonly said that defaults on loans cause a deflationary spiral. While defaults contribute to such a spiral, they are not the primary cause. The true cause is the collapse of credit, which refers to people's ability to take out loans. When a large number of individuals start defaulting on their loans, this doesn’t directly lead to deflation. In fact, defaults can create inflationary pressures because the debt that is supposed to be serviced starts to erode, disrupting the balance of deflationary and inflationary forces in the economy.

Credit issuance is a powerful inflationary force. As long as people are able to pay their loans, the economy maintains a balance between inflationary and deflationary pressures. However, when defaults occur because people lose their jobs and can no longer service their loans, the deflationary effect of repaying loans is undermined. At the same time, banks begin to reduce their lending, fearing increased defaults, which triggers a much stronger deflationary pressure than merely paying off loans.

When banks cease issuing new debt, the economy contracts because credit availability is restricted. This restriction is driven by the deteriorating economic conditions, which reduce people's creditworthiness. The resulting credit contraction is not just a decision by banks, but also a reflection of a broader economic environment where people’s ability to earn money and, therefore, their ability to take on and service debt, is reduced.

Even in a stable economy, a certain amount of credit is consumed regularly, and banks are typically willing to issue debt against this credit because it costs them nothing as long as the loans are being serviced. However, when defaults increase, inflationary pressure mounts because the economy is no longer balanced by the repayment of loans. If banks ignored creditworthiness and issued indefinite loans—where repayments could be delayed indefinitely—this would cause massive inflation and eventually erode the value of money entirely, making it worthless.

The legal enforcement of loan repayment is what gives credit-based money its value. People's promise to repay is the cornerstone of this system. During an economic downturn, governments step in with deficit spending to create opportunities, provide liquidity, and stimulate the economy through the issuance of debt. By doing so, they are essentially injecting credit into the economy, which helps maintain the balance of inflation and deflation by ensuring that people can continue to pay their loans and participate in the credit system.

This government borrowing and spending act as a buffer against deflationary pressures. As the government issues debt, it effectively transfers credit to the population, enabling the continuation of economic activity. However, this also creates inflation, as money flows through the economy, and this inflation is difficult to reverse without a deflationary event.

In a debt-based economy, deflation is primarily caused by a contraction in credit rather than a scarcity of the monetary instrument itself. In contrast, if the economy operated with a fixed supply of money, the value of that money would be tied directly to the real economy. Deflation could increase the value of money in such a system. But in a debt-based economy, where money is largely created through credit, the constriction of credit is the true deflationary force.

Thus, deficit spending by the government during downturns is a critical tool to prevent the collapse of credit and avoid a downward spiral in economic activity.