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