Some critics of fiscal stimulus claim that by running large budget deficits, governments risk creating unsustainable levels of public debt and a burden on future generations. In reality, budget deficits create no such debt burden for societies whose governments are monopoly issuers of flexible exchange-rate fiat currencies. The debt of these governments will never become unsustainable unless for some inexplicable reason they decide to borrow foreign currency rather than their own fiat money.
In fact, as was discussed in Fiat Money and its Social Significance, there is no financial need for these governments to borrow at all in order to fund their deficit spending. The reason, in practice, that they do issue debt to match their deficit spending is to meet voluntarily imposed legislative requirements that are in place for operational or political reasons – none of which are indispensable – but not financial reasons.
Not all governments are so fortunate. The Spanish and Greek governments, for instance, don’t have the same policy freedom because they have committed themselves to operating under a common currency, relinquishing the right to issue their own currencies as they see fit. National governments who maintain a fixed or pegged exchange rate similarly give up some policy freedom. Lower levels of government, such as local or state governments, also lack such freedom because they are mere users of the currency, as opposed to issuers of it. However, for the governments of the U.S., U.K., Japan and many other countries, there is plenty of scope to pursue as much deficit spending as is necessary to facilitate economic recovery.
None of this is to suggest that debt is without consequences. But the debt that is problematic is private debt, not public debt. Unlike the government, private households and firms really do need to fund their spending. A household can’t simply credit its bank account on whim; nor can a private firm. When private debt can’t be paid, economic crises can occur, as recent events have made clear.
At a time of deep private indebtedness, a key question is how governments can assist the private sector in its attempts to pay off debt. Until this is achieved, the expenditure of households and firms will be severely constrained, hampering economic recovery.
It may not be apparent from perusing mainstream newspapers or watching the evening news, but the private sector’s capacity to save and pay off debt is inextricably linked to the government’s use of fiscal policy. Attempts to slash budget deficits will actually work against private-sector efforts to get debt under control. By directly subtracting from demand, fiscal contraction will have a negative impact on output, employment, income and therefore private saving, frustrating private-sector attempts to pay off debt.
The following accounting identity shows an aggregate relationship that must hold by definition for a closed economy, such as the global economy as a whole:
(G – T) = (S – I)
In this identity, G is government expenditure, T is tax revenue, S is private saving and I is gross private investment.
The left-hand side of the identity, G – T, is the budget deficit. The right-hand side, S – I, is referred to as net private saving or the private sector balance.
Net private saving is the amount by which disposable income exceeds private spending. This can be seen by noting that S = Y – C, where Y is disposable income and C is private consumption expenditure, which implies S – I = Y – (C + I). When the private sector, in aggregate, spends less than its income, it is said to be in surplus. When it spends more than its income, it is in deficit.
The identity can therefore be restated as:
Budget Deficit = Net Private Saving
This shows that, in a closed economy, the net saving of the private sector matches the budget deficit dollar for dollar. A larger budget deficit means higher net private saving. A reduction in the budget deficit implies lower net private saving.
This relationship makes sense considering that government expenditure involves crediting private bank accounts whereas taxing involves debiting private bank accounts. If the government spends more and taxes less, there is a net increase in private bank deposits held by households and firms, and a corresponding increase in bank reserves, held in special accounts with the central bank. Some households and firms may use the extra funds to buy government bonds, which will result in some bank reserves being converted into bonds. Either way, there is an increase in net financial assets (which comprise currency, bank reserves and government securities). If, on the contrary, governments try to cut spending and raise taxes, as they are beginning to do in a misguided attempt to reduce government debt, private saving will be squeezed.
For open economies (i.e. individual trading nations), the analysis can be extended to include external sources of revenue and expenditure. There are now three sectors: the government, domestic private and external sectors. The accounting identity becomes:
(G – T) = (S – I) – NX
Here, NX denotes net exports (exports minus imports). In words, we have:
Budget Deficit = Net Private Saving – Net Exports
If we rearrange this expression, it becomes clear that there are now two possible sources of domestic private saving:
Budget Deficit + Net Exports = Net Private Saving
If domestic citizens sell more goods and services to foreigners than they buy in return, export revenue will exceed import spending and there will be a build up of financial assets. So, in an open economy, private net saving can come either from government deficit expenditure or net exports.
In many countries, though, including the US, net exports are typically negative, which means the external sector subtracts from net private saving. This leaves the budget deficit as the only source of net private saving. For trade deficit countries such as the US, in other words, it is impossible for the private sector to net save unless the government runs a budget deficit.
Despite this elementary principle, governments around the world, including the governments of trade-deficit economies, seem intent on slashing their budget deficits. This strategy is bound to fail if the aim is to enable sustainable economic recovery. The fact that private households and firms desire to net save, in aggregate, means that private sources of demand are currently weak. By engaging in fiscal contraction at the same time, governments will only succeed in further subtracting from demand, resulting in lower output and employment. With both private and public domestic demand weak, this leaves exports as the only remaining source of demand. However, not all countries can export their way out of trouble. One county’s exports is another's imports. At the global level, net exports cancel out to zero. Not every country can have a trade surplus.
Viewed in this light, the current trend towards austerity policies looks more like a class-war strategy of the elites than a legitimate approach to reviving global demand and output. By giving primacy to export performance, the task is presented as one of reducing wages to improve international competitiveness. But wage reductions in one country can be countered by wage reductions in other countries. The end result is no alteration in each country’s competitiveness but a redistribution of income from wages to profits. This is the real motive for austerity. Greek workers are right to resist this policy agenda.
Even in normal times when the global economy is not in crisis, the accounting identity presented above makes clear that if there is a private-sector desire to net save in a trade-deficit economy, there must, by necessity, be a budget deficit. Budget deficits are the normal requirement, not some aberration.
This point sheds light on the massive accumulation of private debt that occurred in the run up to the global financial crisis. In the US, a series of budget surpluses were run under the Clinton and Bush II administrations prior to the war-related deficits under Bush II. These policies occurred alongside an unsustainable buildup of private debt. By definition, with governments running surpluses, the private sector had to be net dissaving. Combine that with a lack of effective financial regulation and widening income inequality, and the impetus for private households and firms to borrow was very strong.
This approach to economic growth, based on fiscal austerity and an ever increasing build up of private debt, is clearly unsustainable. It hits its limit when private debt becomes so high relative to income that some households and firms can no longer service their debt. Unlike a fiat-currency issuing government, private households and firms are financially constrained. If an increasing number of them can’t meet their obligations, bankruptcies mount and a crisis ensues.
The unsustainability of budget surpluses is borne out by history. As Randall Wray has recently pointed out in an article, The Federal Budget Is Not Like a Household Budget, the US government has attempted to string together successive budget surpluses seven times in its history, and on the first six of these occasions, the attempt was directly followed by a depression. Whether it is about to happen for the seventh time will be revealed over the next few years.
There are really only two effective ways to address the private sector’s current need to reduce debt. One method would be to arrange for an orderly write down or cancellation of debts. This would free up private income for expenditure, providing an impetus for private production. Alternatively, and in keeping with the national accounting considerations discussed above, the government can use sustained deficit expenditure to maintain demand, income and, with it, private saving. Once private firms and households have saved sufficiently to bring their debt under control, they will be in a stronger position to undertake expenditures that add to demand and income. At this point, tax revenue will revive, endogenously reducing the budget deficit.
Recommended reading on this topic
The following links are to Bill Mitchell’s blog, which I cannot recommend highly enough. The links give much more detail on concepts touched on only briefly in this post.