Public Deficits and the Monetary Expansion Mechanism

Article written in collaboration with Tomás Mamede

Public deficits, which arise when governments spend more money than they collect in taxes, are often seen as mere fiscal imbalances. However, these deficits are the backbone of a sophisticated financial system that incentivizes the creation of money out of nothing.

This mechanism involves a symbiosis between governments, commercial banks, and central banks, such as the European Central Bank (ECB) and the U.S. Federal Reserve (FED), which transform public deficits into fuel for monetary expansion, often at the expense of the loss of purchasing power for those who save and hold that currency.

This article explores the money-creation process and compares how it operates in the European economic area and in the United States of America, while criticizing the fiat monetary system and presenting Bitcoin as a counterforce to this system.

The Deficit-Driven Cycle of Money Creation

When a European government runs deficits, it must seek external financing, typically by issuing treasury bills and sovereign bonds. Larger deficits amplify the need for financing, putting pressure on the financial system to put more money into circulation. Errors in government management—whether due to poor and inefficient allocation of resources, unproductive spending, or bad policies—increase these deficits. Thus, without real productivity gains—that is, without producing more value with the same resources—deficits continue to grow exponentially, which increases the need to increase state debt or “print” more money.

Commercial banks are the main buyers of these treasury bills and government bonds for two main reasons. First, because they earn interest on the spreads, i.e., they make money by lending to the state. Secondly, these sovereign assets are considered extremely safe and liquid, allowing banks to use them as collateral with the ECB. And they are safe because they are backed by the state’s promise that, as a last resort, more money will be created to pay back the loan. This allows commercial banks to leverage these debt securities, transforming public debt into a tool to generate liquidity and provide near-immediate credit support.

In practice, banks buy sovereign debt securities and immediately pledge them to the ECB as collateral. In return, they receive newly created digital euros. Thus, the ECB lends euros directly against public debt, converting the deficit into liquidity for the financial system. That’s why debt doesn’t pay taxes — this is how money is created and introduced into the financial system.

Central banks in the Eurozone operate with a leverage ratio between 10:1 and 30:1. In practice, this means that for every €1 of equity, banks are allowed to hold between €10 and €30, largely financed through debt and customer deposits. Before the 2008 crisis, banks were allowed to operate with even higher leverage, which proved unsustainable.

To keep this money-creation machine running, the ECB is responsible for determining monetary policy, which includes setting the main refinancing rate (the rate at which commercial banks can obtain liquidity from the ECB), the deposit facility rate (which remunerates money parked at the ECB), and the marginal lending facility rate (which acts as a penalty for last-resort borrowing). These rates condition the cost of money creation in this system.

Euribor (Euro Interbank Offered Rate) results from the average interest rates at which a group of large European commercial banks are willing to lend money to each other on the interbank market for different maturities (1 week, 3 months, 6 months, 12 months). The ECB indirectly influences Euribor through its key policy rates (main refinancing rate, deposit facility rate, and marginal lending facility rate). These rates determine the cost of money in the financial system, thus shaping the conditions under which commercial banks lend to each other.

Thus, Euribor is not a rate set directly by the ECB, but its monetary policies create the conditions that shape that value. Euribor is crucial because it serves as a reference for millions of credit contracts in Europe—from mortgages to business credit lines. When Euribor rises, loan payments increase; when it falls, the financial burden on households and companies eases.

In this way, the ECB allows banks to multiply the credit they issue and profit from it through the difference between the rate at which the ECB lends them money and the rate at which they lend to customers. This is a fantastic system for governments and banks, but not very friendly to those who work and save. Governments obtain perpetual financing, banks profit, and the ECB maintains short-term stability in the financial system.

However, this ongoing monetary expansion continues to dilute the purchasing power of those who save and keep bank deposits in euros. Furthermore, it fosters a spendthrift and irresponsible mentality among governments, who see the ECB as a safety net against failure, encouraging persistent deficits. Only real productivity can counter this; otherwise, it manifests as inflation.

FED vs. ECB: Treasury Bonds and Interest Rate Control

In both the U.S. and Europe, treasury securities are the foundation of the financial system, acting as safe assets, interest rate benchmarks, and tools for monetary policy decisions. In the U.S., variable-rate mortgages and business loans are indexed to SOFR (Secured Overnight Financing Rate), which reflects liquidity conditions for using treasury securities in monetary operations. It plays a similar role to EURIBOR in Europe.

In the U.S., the FED controls interest rates directly. To lower them, it buys treasury securities on the secondary market, pushing prices up and yields down. To raise interest rates, it sells treasury securities and halts reinvestment of maturing debt, pushing prices down and yields up. This dynamic sets SOFR, which in turn influences loan payments for businesses and households.

In Europe, the ECB controls interest rates indirectly, since the central bank is not allowed to buy sovereign debt on the primary market. In fact, the ECB operates through refinancing, accepting euro-denominated sovereign debt as collateral. These operations influence the interbank rates from which Euribor emerges. In times of crisis or emergency, such as the 2012 crisis or during the COVID-19 pandemic, exceptional programs are created that allow for secondary-market purchases of debt, in a manner similar to the FED.

Productive Financing

Despite criticisms of banks, their business model can be highly beneficial to society when the credit issued is used to finance infrastructure or projects that create real value. Indeed, innovative companies invest in new products, services, and technologies, while infrastructure projects such as roads, bridges, and energy and telecommunications systems strengthen countries’ economic life. Meanwhile, education and research expand human capital and increase capacity for long-term growth.

In these cases, credit does not merely finance spending and public deficits but generates sustainable growth and collective wealth. For example, a new road built with borrowed capital is not just debt. In reality, it shortens distances, has the potential to increase trade, and transforms local communities.

Thus, the distinction is clear: credit applied to productive projects can generate real value and contribute to national progress, whereas bad credit results in higher deficits, inflation, and societal stagnation. When banks allocate capital wisely, they can become a driving force for the evolution of the societies they serve.

Strong Currencies vs. Weak Currencies: The Impact of Deficits

In the case of strong currencies, such as the Euro or the Dollar, deficits create structural incentives for low interest rates, since banks buy debt and use that debt as collateral with the ECB or the FED to generate cheap liquidity in the form of newly created digital money. Thus, in Europe and the U.S., the impact of inflation is mitigated because these currencies circulate globally, spreading the cost of money printing across multiple countries.

In the case of weak fiat currencies, such as the Argentine Peso or the Brazilian Real, the process works the other way around. Since global markets distrust these countries’ sovereign debt and do not view it as a safe-haven asset, governments pay high interest rates to attract buyers. Therefore, in an attempt to keep capital in the country, governments seek to maintain high interest rates.

Fiat Money: Distorted Value and Illusion of Control

In a free market, nothing has inherent value. All value is subjective and depends on who assigns it. Fiat money imposes an objective nominal value on things that at times does not align with reality, leading to distorted market perceptions. In a stable monetary system, relative values remain consistent and reflect genuine economic signals for the market to absorb. However, fiat money introduces instability through unlimited monetary expansion and artificial interest rate manipulation.

Several critics argue that central banks’ control over Euribor or SOFR is illusory. It is true that there are tools to influence interest rates, but the decision chain is heavily influenced by the interests of specific groups. In fact, the shareholders of the ECB and its constituent banks trace back to private entities that prioritize profits over economic stability. Moreover, many decisions made in these centralized institutions have consequences that are sometimes difficult to predict.

When forecasts fail, wars and external events are blamed for the discrepancies, and deficits align incentives to lower rates. Amid all this, governments continue to be financed, banks profit from spreads, and central banks maintain their power. At its core, the fiat financial system fosters deficits which, in turn, create incentives to inflate the currency—ultimately penalizing workers who save in that currency.

Bitcoin: An Alternative to the Flaws of the Fiat System

Bitcoin emerges as a revolutionary alternative that removes the fiat system’s incentives to manipulate money. Unlike fiat currency, the supply of bitcoins is fixed, as it is mathematically guaranteed that there will never be more than 21 million bitcoins. This prevents the arbitrary expansion of the money supply in the economy and realigns the world with free-market principles in which value is subjective. Furthermore, the monetary incentive for wars is mitigated, as governments cannot simply create more money out of thin air to finance their conflicts and deficits.

In the ideal fiat world, banks would lend the newly created digital money only to be applied to productive assets, so that the economy could grow to absorb the monetary expansion. But reality is far from this ideal. Meanwhile, Bitcoin creates an economy where value is dictated by the market and distortions are minimal. As a borderless and decentralized asset, Bitcoin challenges the central banks’ illusory abstractions and can offer true scarcity and stability.

Conclusion

Public deficits are not isolated fiscal problems but catalysts for monetary expansion through the dynamics between governments and central banks. Although the FED and the ECB differ slightly in how they operate, both perpetuate debt cycles that favor short-term stability at the expense of long-term value preservation. The distortion of value, the illusion of control, and the favoritism of certain elites expose the system’s vulnerabilities. However, Bitcoin represents a paradigm shift that can help neutralize these incentives and promote a fairer monetary reality.