Fiscal Policy, Sectoral Balances and Financial Sustainability

Many people, upon hearing “fiscal policy” mentioned in relation to “financial sustainability”, might imagine that it is the government’s financial sustainability that needs to be placed under scrutiny. Given the mass media’s proclivity for pumping out superstition and myth, especially when it comes to macroeconomics, this reaction would be entirely understandable. But, actually, assuming the government is a currency issuer that refrains from borrowing in currencies other than its own, questions of its financial sustainability do not apply. Rather, concerns of financial sustainability properly pertain to the private sector. Whereas a currency-issuing government faces no financial constraint (its only hard constraint is in terms of real resources), the financial reality for private households and firms is completely different. Private debt can very definitely reach financially unsustainable levels. This occurs when growth in income is insufficient to service private debt.

Misguided attempts to restrain government spending on the supposed grounds of financial “affordability” hamper the efforts of indebted private households and firms to remain solvent. A government surplus usually requires, as a matter of accounting, the private sector as a whole to be spending more than its income. The only exception occurs when a country happens to be running a current account surplus so large as to offset the effect of the government surplus. By definition:

This is an accounting identity, which means it always holds true. Many countries run current account deficits. For such countries, the rest of the world (the foreign sector) is in surplus with respect to them (the foreign balance is positive). When the foreign balance is positive, the domestic private balance can only be positive if the government balance is sufficiently negative to more than offset the effect of the foreign surplus. If, instead, the government balance is positive (a surplus), then the domestic private sector’s balance must necessarily be negative (a deficit), with households and businesses in aggregate spending more than their income.

When the domestic private sector spends more than its income, it means one of two things. Either it has drawn down past savings to finance the current private sector deficit, or it has borrowed and taken on additional debt. If this continues for long – with government running surpluses (taxing more than it spends) and the private sector running deficits (spending more than its income) – the likelihood of a significant cohort of households and firms getting into debt stress rises.

For the economy to grow in a financially sustainable way, the private sector should normally be allowed to maintain a financial surplus (spending less than its income). For many countries (the majority with current account deficits), this means government needs to spend more than it taxes under normal circumstances. For a currency-issuing government, this is not a problem. A currency-issuing government spends by issuing its own money. ‘Government money’ can take the form of hard currency (notes and coins) or reserve balances (funds that banks hold in special accounts with the central bank or central banking system). When a currency-issuing government spends, the very act of spending creates government money in the form of reserve balances. Conversely, the government destroys its money (reserve balances) when taxes are paid. For this reason, taxes do not provide the government with money with which to spend. To the contrary, taxation destroys money that the government previously spent into existence. The government has no need of this money once taxes are paid, because it will create new money as necessary, and automatically, as and when it spends. In short, government spending creates reserve balances out of nothing; taxation destroys them. Government spending is the birth of reserve balances; taxation is their death.

When the government spends within the domestic economy, the spending creates income for private-sector recipients (households and businesses) and also creates an equal amount of leakage from the circular flow of income to taxes, saving and imports. The immediate recipients of the government spending will use some of the income to pay tax and can use the rest to save, purchase imports or spend on domestically produced goods and services as desired. The same is true of other businesses and households down the line as each act of spending creates still more income for others, who once again have the choice of saving or spending, once any taxes are paid. No matter what proportion of the new income leaks out to taxes, saving and imports at each link in the chain, the total leakage from the circular flow of income that results from the initial act of government spending will always equal the amount the government initially spent. What varies is the total amount of spending (and hence new income) that is ultimately created as a result of the initial act of government spending. If a high proportion of new income is taxed or saved or used to buy imports on each round of the multiplier process, the total impact on income will be relatively small. The leakage to taxes, saving and imports will be a relatively large fraction of the new income created. Conversely, if only a small fraction of new income is taxed, saved or used to buy imports on each round of the multiplier process, the ultimate impact on income will be relatively large. The leakage to taxes, saving and imports will be a relatively small fraction of the new income created.

There is a simple formula to calculate the total effect of the government spending. Call the government’s initial amount of spending G. Call the average fraction of income that leaks out to taxes, saving or imports on each round of the multiplier process α. Call the total change in income that results from the entire multiplier process ΔY. In that case, the initial act of government spending causes a multiplied increase in income calculated as:

Call the total amount of leakage to taxes, saving and imports L. This total leakage will amount to:

We can use these two formulas to confirm that the total amount of leakage will equal the initial amount of government spending. To do this, substitute the first expression for ΔY in (1) into the formula for L given by (2):

Example 1. Suppose the government spends $100 and spending recipients, on average, use half of any income they receive to pay taxes, save or purchase imports. In that case:

Example 2. Suppose the amount of government spending is the same ($100) but that spending recipients, on each round of the multiplier process, use on average one-third of their income for paying taxes, saving and buying imports. This time we have:

In both examples, the total leakage matches the initial amount spent by government, as we know must be the case. But because the rate of leakage (called the ‘marginal propensity to leak’) is smaller in the second example than in the first, the change in income is larger. In the second example, the total change in income is ultimately triple the amount initially spent by government, whereas in the first example it is only double. In the first example, the ‘expenditure multiplier’ is 2, because the initial spending of government results in a total change in income that is twice as large. In the second example, the expenditure multiplier is 3. Call the multiplier k. The multiplier can be calculated using the formula:

Now, our main focus in the present discussion concerns the financial sustainability of the domestic private sector. We can consider how the domestic private sector’s financial balance is affected by the government spending an extra $100.

To do so, we need to know a few more details. Suppose that one-half of the total leakage that occurred as income grew went to saving. In that case, saving of the domestic private sector increased by $50, which is one half of the total leakage of $100.

The rest of the leakage will have gone to taxes and imports. Let’s say one quarter of the leakage went to taxes and the other quarter to imports. That would mean the government spending of $100 has been partially offset by an increase in taxes of $25. The government has spent $75 more than it imposed in taxes. This amount goes to the ‘non-government’ (defined as the domestic private sector plus foreign sector) as disposable income.

This constitutes a movement toward or into financial surplus for the ‘non-government’ as a whole of $75. We have already worked out that the domestic private sector used $50 of this for saving. That means the foreign sector received the other $25 as a result of import spending. Overall, then, the domestic private sector has increased its saving by $50 and moved toward or into financial surplus by this amount. Its financial position is stronger than before the government spending took place.

We can relate this outcome to the accounting identity discussed earlier:

As must be the case, the changes to the financial balances of the domestic private sector and the foreign sector are exactly offset by the change in the government balance.

There is another way to arrive at the same conclusion. Reconsider the first example. Notice that half the extra spending (the initial government expenditure of $100) was made by government. In total, income changed by $200, which means that total spending also increased by $200. We know this because total spending equals total income by definition. Every act of spending creates an equal amount of income. Therefore, in example 1, only half the extra spending was private. The other half was by government. Of the extra $100 spent by the domestic private sector, $25 went to imports and so did not add to income for the domestic private sector (but instead added to the income of foreigners). Overall, the domestic private sector increased its spending by $100, whereas its income, which excludes taxes and imports, increased by $150 (equal to the total change in income of $200 minus taxes of $25 minus imports of $25). Since the domestic private sector’s spending increased by $100 and its disposable income (domestic income minus taxes) increased by $150, it has moved toward or into financial surplus by $50, which is the same conclusion we reached in the previous paragraph.

The key point to notice is that when government spends more than it taxes, this adds to private saving and helps the domestic private sector to maintain a financial surplus. This puts the private sector on a more financially secure footing. It has more wriggle room if something goes wrong, such as some people temporarily losing their jobs or the business sector facing a period of falling sales. Accumulated savings from the past can help – up to a point – tide people over until economic activity picks up again.

So long as economic growth is fueled, to a significant degree, by the government committing to spend more than it taxes, the process is consistent with households and firms maintaining a financial surplus. This improves their chances of keeping their debt under control. The domestic private sector can spend less than its income, accumulating the difference through saving.

In contrast, a growth process reliant on the private sector spending more than its income is obviously not conducive to financial sustainability. To illustrate this, consider a scenario in which it is the private sector stepping up its spending by $100 rather than the government. Call this extra amount of private spending A and suppose that it is not financed out of income but, instead, involves either drawing down past savings or borrowing from the commercial banking system.

Just as with government spending, this extra spending – which is a form of ‘autonomous spending’, because it is financed independently of income – will start off a multiplier process. The $100 of extra private spending will go to others as income. They will then use the income to pay taxes, save and purchase imports. To the extent the income is spent, it goes to others who face the same options. And so on. The ultimate change in income is calculated much the same way as in the case of government spending that we have already considered:

The total amount of leakage to taxes, saving and imports is once again:

And, as before, it is true that the total leakage will equal the initial amount of autonomous spending. To confirm this, substitute the expression for ΔY in (4) into (2):

If half of all new income leaks out to taxes, saving and imports, the ultimate change in income is:

The total leakage is:

Suppose, as in earlier examples, that one-quarter of the leakage goes to taxes and another quarter to imports. The remaining half is saved by the domestic private sector. The initial increase in autonomous private spending will push the government balance toward or into surplus by $25, equal to the extra tax payments. It will also push the foreign sector toward or into surplus by $25, equal to the extra imports. In contrast, the private sector will have spent an extra $200 (equal to the total change in income) but must pay $25 in taxes and allocates $25 to the purchase of imports. As a result, disposable income of the domestic private sector, which excludes taxes and imports, has increased by $150 (equal to the total change in income of $200 minus taxes of $25 minus imports of $25), whereas private spending has increased by $200. The private sector has moved toward or into deficit by $50. Even though it has increased saving by $50, this is more than offset by the increase in autonomous private spending of $100, which is a form of dissaving (meaning negative saving). In terms of the accounting identity, we have:

If the domestic private sector was initially in balance – spending an amount equal to its income – it will now be in financial deficit, spending more than its income. If this continues for long, the private sector’s financial position will become more precarious over time, and the economy more susceptible to a financial crash.

Possible Further Reading

The first two posts below are not directly related to the above discussion, but provide some background information for readers who may be fairly new to macroeconomics. They are at an elementary level.

Short & Simple 4 – Total Spending Equals Total Income

Short & Simple 5 – Uses of Household Income

This next post is similar in difficulty to the present one, and on the same topic:

Budget Deficits and Net Private Saving

These next two posts are at about the first-year university level. The first gives a fuller explanation of the expenditure multiplier and the multiplier process. The second relates these multiplier effects to the sectoral balances, by which is meant the financial balances of the domestic private sector, government and foreign sector (in other words, the accounting identity we considered in the present post).

Planned Investment/Saving and Keynesian Causation

Introduction to the Sectoral Financial Balances Model

This final post is the one that relates most closely to the present post, but it assumes quite a bit more knowledge. It is at about the intermediate undergraduate level:

Government Spending and Financially Sustainable Growth


7 thoughts on “Fiscal Policy, Sectoral Balances and Financial Sustainability

  1. Hmmm – I haven’t been incorrigible on heteconomist for awhile, so this thread is as good a place as any.

    I read Norman Doidge’s ‘The Brain That Changes Itself’ and ‘The Brain’s Way of Healing’ recently – can recommend them to anyone interested in case studies and healing techniques, beyond the pharmaceutical industry push to drug everything in sight. Of particular interest to me was the paradigm shift – from viewing consciousness, and the sense of self, as being some sort of exudation of the brain – as now elevated to resident in the brain waves. (If you see someone following you down the street with a big magnet, they may be trying to steal your identity 🙂 ). In some of the case studies, the self was able to use the mind, to switch epigenetic switches in genes off and on, or map brain functions to other parts of the ‘plastic brain’ (hatha yoga). Of course this idea that the self is resident in the brain waves is a working hypothesis.

    I also read in a Quanta Magazine article the discovery that if you take a lump of matter and transpose it to energy, there is a surplus of energy over and above the energy resident in the matter. This confounds the physicists and although they don’t mention it, to me it also means that all of the laws of nature resident in matter, are transposed to an unknown realm of an ‘energy surplus’. Same realm where the self is hypothesised to reside.

    So, from there I start thinking about how when this self emerges in the world embodied in a human personality, that personality is conditioned by the world. And how someone, probably in the Upanishads, stated without any reservation, that everything you see in front of your eyes is Illusion. (By Illusion – they meant ‘not what it seems’). Then you begin to ponder how human personalities act and react with each other on this planet; the whole thing of countries, pomp, avarice, and power – and you begin to understand why Kabir laughed a lot; because it was either that or cry. Kabir knew the essence of the self – this knowledge was called Raj Vidya; the king of all knowledges. You can speculate why.

    And the whole thing of ‘we live in interesting times’ passes through the mind. And how mind binds people, hand and head, but not the heart.

  2. Thanks for the recommendation, jr..

    I’ve been missing in action too lately, but incorrigibility will win out sooner or later.

  3. As I have been saying, read Meher Baba’s God Speaks for a conceptual model of the scheme of things purportedly based on comprehensive experience. It is the most succinct, comprehensive, and authoritative account of which I am aware and this is my field of specialization. It was given in English, so no translation issues, although many Sanskrit words from Vedanta and Arabic and Persian words from Sufism for technical terms that don’t have exact parallels in English.There is a glossary too.

    This is a library of books by and about Meher Baba. Scroll down to God Speaks, in two parts to download or read online.

  4. I’ve been working on a WordPress website; I don’t know if I’ll get it up and running towards the end of the year; I have registered a domain name. Am starting from base; learning WordPress security took a while, and am just starting to outline the content. Am not worried about SEO – the internet version of word of mouth will do.

    The idea is to create a website solely dedicated to human experience. So, nothing about concepts, politics, economics, religion, or events. Simply human experience: – any time, any Age, any one. And the kind of experience that lifts a person up; makes them more aware and appreciative of life, and fills their heart with gratitude. It could be in the personality life or it could be deeper. It could be your own or someone else – am thinking of some of the experiences that Krishnmurti wrote down here; but there are many others. It could have had a profound and immediate effect on the life or gentle and universal like the sun rising and spreading its warm glow. It could have risen from the ashes of disaster or descended from a heaven within. If you are a human being and you have had an experience that opened up your eyes and heart in some way; that enabled you to fall deeper in love with life and touched your sovereign humanity – that qualifies. I want people to understand how human experience reaches far beyond thought, and the ‘I’. Far beyond national borders, and everyday life – although it is expressed in everyday life. How precious is a human being. How unique, how miraculous is each. We have forgotten how to see and celebrate, admire, a human being.

    How we are something more than a societal robot. How to extract the most from our seventy laps around the Sun and preserve our dignity, and experience the peace, the clarity people feel, when they connect to themselves. Instead of trying only, to screw an experience out of the world.

    So the website, I contemplate, will have three main themes: – EXPERIENCE; then INSIGHT gained from the experience; then EXPRESSION – how the experience and insight has been, or is expressed in life.

    My role I guess, will be to act as a gatekeeper and I will record my own experience. So the site will be vulnerable to the accuracy of my BS detector. But genuine human experience is recognised by the heart, and the heart is within us all. It is, who we are.

    So, I hope I can get it off the ground and that there are people out there who will make it something refreshing, put a little bit of themselves into it – and so make it different to the angst and gnashing of teeth that goes on most everywhere else. There is so much negativity and fear in the world. Have to have some good music, prose, humour and video too. A place you can enjoy! A place for storytellers! – from the heart; from their OWN experience. There is nothing more powerful in this world than the self in a human being.

  5. Sounds great, jr. Look forward to seeing the blog develop. You, of course, retain all rights to anything you’ve already posted here. No release forms necessary. 🙂 🙂

    Tom, I have been intending to re-read parts of God Speaks and get to other parts that I haven’t yet read. Thanks for bringing it to our attention. It is fascinating and also challenging to comprehend for someone of my limited background.

  6. Right. For those on conversant with the history of philosophy or perennial wisdom, the conceptual model is a bit thick. I’ll try and simply it with an outline of basic assumptions.

    The fundamental assumption is that reality is one and indivisible. Diversity appears because the one indivisible reality can be experienced differently.

    Meher Baba’s model is based on simplifying possible experience into ten types.

    1, Beyond beyond state, which is beyond conception and imagination and therefore beyond predication. Nothing meaningful can be said about it without falling into a different type. It is the primordial experience, which is compared analogously to the ordinary human state of deep sleep.

    2. Beyond state, which is being fully conscious of reality as one, indivisible, eternal and infinite. It is compared analogously with the ordinary human state of being awake.

    3. The Divine Dream of Universal Mind, in which is reality appears as apparently finite and limited, diverse and changing, bounded by time and space. This state is analogous to the ordinary human state of dreaming. It is the state in which the one indivisible reality plays the roles of creation, preservation and dissolution.

    States 4, 5 6 and 7 are modifications of state 3. The first three states are states of experience of the one indivisible reality of itself prior to the collapse of infinity to a finite point.

    4. Individuality. Infinity collapses to a finite point. This is the introduction of limitation into the experience of the the one indivisible reality of itself. The ocean without shores experiences itself as drop or bubble of a wave moving and changing in space and time.

    5. Evolution. The individual “drop” gains different experiences as it identifies with different forms in an evolutionary patter that culminates in the human form with fully develop and functioning gross, subtle and mental “bodies” or sheaths. At this point, the one indivisible becomes capable of realizing its true nature as unlimited.

    6. Reincarnation in the human form. The reason that the one indivisible reality doesn’t ordinarily realize its true nature on attaining the human form in the process of evolution is that the mental body (mind-stuff) is veiled by the many impressions that remain from previous experience. These impressions must be resolved through a series of reincarnations in the human form.

    7. Involution. When the impressions are sufficiently resolved, the veils are thinned and one enters the spiritual path through the planes of the subtle and mental “worlds.” There are essentially three ways of traversing the path, either through “the heavens,” consciously through the planes and blindfolded from experiences of the path.

    8. Realization. When the impression of action are finally and fully resolved the individual realizes one’s true nature as I Am, also expressed as I am That, and I am He. This is called liberation.

    9. A few individuals have the destiny of regaining consciousness of limitation along with infinite consciousness and live this state until they drop the body.

    10. Perfection. A very few individuals have the destiny of not only regaining consciousness of limitation along with infinite consciousness and living this state but also using absolute knowledge and power in the divine dream as part of the “management.” This includes those that go through the process of evolution, reincarnation and involution, and also that aspect of the one indivisible reality that manifests in human form periodically without going through that process.

    In outline, this is the range of possible experience.

    God Speaks provides some interesting details of the levels of potential experience purportedly reported by that aspect of the one indivisible reality that manifests in human form from time to time.

    “Whenever righteousness (dharma) declines and unrighteousness (adharma) increases, O Arjun, I manifest myself. To protect the virtuous, to destroy the wicked, and to reestablish righteousness I take birth age (yuga) upon age.” — Krishna, Bhagavad Gita, 4:7-8

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