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In a previous post, we defined “sound money” as the practice of Governments to balance their budget over the business cycle.

Understanding why sound money principles lead to recession and depression requires an understanding of “sector balances.”

In a nutshell, the budget balances of the Government, domestic private sector and foreign sector will net to zero.  If we assume a balanced trade account (imports=exports) then the government surplus will exactly equal the private sector deficit.  Conversely, a government deficit will exactly equal the private sector surplus  (I had demonstrated this in the post linked to above, so you can go there and see it for yourself).

Once we have this, we can understand that when the Government runs consistent surpluses, the private sector will be in jeopardy.

Let’s say, for example, the Government runs a surplus of $200 billion for 3 straight years, and that the trade balance is neutral (imports=exports).  If this is the case, the private sector will have spent $600 billion more than they earned over the same period.  In order to keep up their spending, the private sector will be forced to either spend down existing savings or increase their borrowings by the same amount.

For reference, the last time the US ran consistent surpluses prior to the late 1990′s was the late 1920′s, just before the Great Depression.

This is why Governments very rarely run surpluses, why they never pay off the National Debt –the one time the US did this, in 1835, a particularly nasty depression resulted–and why attempting to run down deficits during a downturn in private credit creation, such as now, is a recipe for disaster.




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