Government Deficits and Net Private Saving

The present is a time of deep private indebtedness. A key question for macroeconomic policy is how this debt burden can be alleviated. Until excessive private debt is cleared away, the expenditure of households and firms will be severely constrained, hampering economic recovery. One approach would be to conduct an orderly write down or cancellation of a substantial part of private debt. Another method would involve government making appropriate use of fiscal policy by engaging in substantial and concerted net spending (government spending in excess of tax revenue) to sustain overall demand and income until the private sector can sustainably revive its own level of activity. A currency-issuing government always has the financial capacity to conduct net spending of this kind. This post focuses on a key positive effect of the second policy approach, but ideally a combination of the two approaches would be employed.

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 government deficits actually work against private-sector efforts to get debt under control. By directly subtracting from demand, fiscal contraction has 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 government’s fiscal deficit or government balance. 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 (income, Y, minus tax revenue, T) exceeds private spending. This can be seen by noting that S = (Y – T) – C, where C is private consumption expenditure, which in turn implies S – I = (Y – T) – (C + I). When the private sector, in aggregate, spends less than its disposable 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:

Fiscal Deficit = Net Private Saving

or, equivalently,

Government Deficit = Private Sector Surplus

This shows that, in a closed economy, the net saving (or financial surplus) of the private sector matches the government’s fiscal deficit dollar for dollar. A larger fiscal deficit means higher net private saving. A reduction in the fiscal 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 an increase in bank reserves, held in special accounts with the central bank, and a corresponding increase in private bank deposits held by households and firms. 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 major sectors: the government, domestic private and external sectors. The accounting identity becomes:

(G – T) = (S – I) – (X – M)

Here, X – M denotes net exports (exports minus imports). In words, we have:

Fiscal Deficit = Net Private Saving – Net Exports

If we rearrange this expression, it becomes clear that there are now two possible sources of net private saving:

Fiscal Deficit + Net Exports = Net Private Saving

If domestic businesses sell more goods and services to foreigners than domestic businesses and households buy from overseas, export revenue will exceed import spending and there will be a build up of private-domestic 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 fiscal 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 fiscal deficit.

Again, this is not a problem for a currency-issuing government. Public debt creates no financial difficulty for a currency issuer provided its debt is denominated in the issuer’s own currency. It is private debt that can be problematic. Households and businesses can go bankrupt. Currency-issuing governments cannot.

Despite this elementary principle, governments around the world, including the governments of trade-deficit economies, seem intent on slashing their 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.

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 government deficit. Government 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 fiscal 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 build up 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 a critical cohort of households and businesses can no longer service the debt. These bankruptcies impact on the incomes of others, due to falling demand for goods and services, resulting in still further bankruptcies and potentially a generalized crisis.

The unsustainability of government 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 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 in the coming years.

To sum up, 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 net 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 fiscal 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.

Deficit Spending 101 – Part 1

Deficit Spending 101 – Part 2

Deficit Spending 101 – Part 3


18 thoughts on “Government Deficits and Net Private Saving

  1. Under current circumstances, these are the most important equations in economics. Sadly, neither the President, nor any member of Congress, nor the vast majority of old-line economists, nor any member of the media seems aware of them, much less understands them.

    Rodger Malcolm Mitchell

  2. “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.”

    I love it! The government can pay its bills by printing money. Zimbabwe here we come.

    If you want to retain any credibility, don’t write stuff like that. You readers may not understand that you are proposing to pay the government bills with a printing press. Other folks will see through your folly and laugh.

  3. Frank, please take the time to educate yourself on MMT. “Zimbabwe” and “Weimar” simply show ignorance of MMT. Don’t you think that MMT economists have considered and met such objections?

  4. I don’t like the assumption that all surplus is taken as profits. I’d rather surplus and profit were completely separated by definition so that surplus is understood to represent surplus value and profit relates to financial accounting. I know this isn’t a universally accepted definition but this distinction makes things much clearer. My definition of surplus would be production value in excess of essential consumption and replacement.

    What I’m leading up to is the assumption that all surplus is taken as profit (mentioned above). Private corporations give allocative control to beaurocratic leadership and executive pay is rising at a time when inflation adjusted median pay is falling. It’s quite likely that wages always included an element of surplus value, however it seems that an increasing proportion of surplus value is allocated to executives for no other reason than allocative control.

    The argument of pay for talent merely highlights the informational problems in recruitment (e.g. information asymmetry). This issue also highlights the importance of control over ownership which has wider implications relating not just to corporations but the financial sector and public ownership.

  5. “In reality, budget deficits create no such debt burden for societies whose governments are monopoly issuers of flexible exchange-rate fiat currencies”
    Question: Then why do we pay taxes at all? If budget deficits have no limits, then why collect taxes from its citizens? Lets just run the deficit to infinity and if that’s not possible for some reason, then that would mean federal deficit spending has limits.

  6. “But the debt that is problematic is private debt, not public debt”
    Question: If public debt is not problematic, then why doesn’t the Federal Reserve spend 40 billion a month paying off private debt instead of buying MBS’s? Or, what the heck, why doesn’t the Federal Reserve double down and keep spending the 40 billion a month they don’t have on MBS’s and spend another 40 billion a month they don’t have on paying off private debt, since private debt is problematic, lets eliminate it. What do you say to that?

  7. Hi Willie. Thanks for your comments.

    Question: Then why do we pay taxes at all? If budget deficits have no limits, then why collect taxes from its citizens? Lets just run the deficit to infinity and if that’s not possible for some reason, then that would mean federal deficit spending has limits.

    The role of taxation and constraints on fiscal policy are addressed in the previous post:

    Fiat Money and its Social Significance

    A more detailed answer can be found in the three Bill Mitchell posts linked to at the end of the present post.

    Regarding running deficits to infinity, nobody is suggesting that. The point is that the constraint is real resources, not financial; or expressed differently, the constraint is inflation, not solvency.

    since private debt is problematic, lets eliminate it. What do you say to that?

    The two options for addressing private debt are mentioned in the closing paragraph of the present post: orderly write down or deficit expenditure to underpin private saving and debt repayment. The latter is subject to a real constraint, both are subject to political constraints.

  8. So there is concern about inflation then? Of course real resources are finite. We have already spent 16 trillion over the years and we currenlty spend 140 billion a month in deficit spending and this seems to be not working. How much more do we need to spend to get the economy cranking then? And when we do say enough deficit spending is enough? How long does this go on? The last paragraph doesn’t explain why the Federal Reserve doesn’t just pay off the private sector debt.

  9. “To ensure the community accepts it, the government can impose a tax, payable only in the new fiat money. This ensures a demand for the currency” This statement makes no sense at all. There would still be demand for the fiat currency (dollar) if no taxes were imposed. If the Federal Reserve raised interest rates, stopped buying US treasuries, and halted printing altogether, the demand for the fiat currency (dollar) would rise. Imposing taxes on the fiat currency (dollar) has absolutely nothing to do with its demand. Why would you think otherwise?

  10. “Regarding running deficits to infinity, nobody is suggesting that. The point is that the constraint is real resources, not financial” I would also respectfully disagree with this statement. There is a financial constraint and you mentioned it. It is inflation.

  11. Of course real resources are finite.

    Agreed, but there is currently high unemployment and underemployment (available labor resources). These can be usefully employed. For example, it makes little sense to cut back public and social services in a recession / depression. In terms of real resources, these services are actually more “affordable” now than in a boom.

    The last paragraph doesn’t explain why the Federal Reserve doesn’t just pay off the private sector debt.

    True, which is why I mentioned political constraints in my initial response to you.

    For example, there may be a feeling that creditors should face the consequences of poor lending practices.

    In other words, the constraints are real or political (e.g. democratic).

    This statement makes no sense at all. There would still be demand for the fiat currency (dollar) if no taxes were imposed.

    Enforceable taxation is a sufficient — not necessary — condition. The argument is discussed further, for example, here:

    Value of the Currency
    Resistance to the Chartalist View of State Money
    Crank at the Financial Times

    Scholarly references can be found in the linked posts.

    The argument has a long history in economic thought, going back at least to Adam Smith:

    More on Cranks at the Financial Times

    There is a financial constraint and you mentioned it. It is inflation.

    Inflation is not a financial constraint. The argument is that the issuer of a sovereign floating-rate currency is not revenue constrained, and so need only be guided by the consequences (impacts) of the deficit spending, along the lines of Lerner’s functional finance:

    Functional finance

  12. “Inflation is not a financial constraint” I respectfully disagree with this statement because at some point in time if the money printing continues and we don’t have production behind the new money, prices will rise. It will in fact take more and more dollars to buy said good until eventually the consumer is priced out. This rings especially true today because wages are not keeping up with price increases. If and only if wages were keeping up with price increases (inflation) would there be no financial constraints. So, as long as wages are not keeping up with price increases, there are financial constraints to money printing.

  13. I would also like to state that if prices were to decline and we go into a period of deflation, this would stimulate growth at this particular point in time. Consumers, especially the poor and lower middle class are getting squeezed to death by rising prices; this is reducing demand. It’s my belief that we need lower prices to increase demand at this juncture in time. This would require raising interest rates to reduce liquidity and increase the strength of the dollar. This would help those less fortunate and help the ageing population that is living on a fixed income. We have already thrown money at this problem and is not working, it is time to turn conventional thinking on its head.

  14. Net exports + budget deficit = private saving.
    Fine, but most of the time if not always, budget deficits result from growing taxes and even faster growing gvt spending, never (except maybe Reagan) from spending cuts and deeper tax cuts!
    In other words, politicians believe they are smarter than the private sector in spending and/or (occasionally) investing.

    At the beginning of this article, it is said “In reality, budget deficits create no such debt burden for societies whose governments are monopoly issuers of flexible exchange-rate fiat currencies”.
    A government who would directly finance its deficit by printing money would debase its currency and unless the said country would be an extremely efficient exporter, the deteriorating net export component of the equation would eat up the private saving. (the japanese current experiment will be interesting in this respect).
    I personally doubt that a country might spend countlessly because it can print its own money. If it were so easy, our dear politicians would have already used this recipe.

  15. Question: the video recently posted, comparing Keynes and Greenspan, shows both low household debt and a gov’t surplus during the “golden age of capitalism.”

    was there a great deal of private firm/investor debt or NX to make up the difference? Or were other factors involved?

    Also, does this account for money creation? Which I think, money currently enters the economy in the form of either gov’t payments exceeding taxation (deficit) or private banks making loans? Is this mechanism separate from the one detailed above, which you said was based on the creation of demand, which would drive up wages?

    Forgive me if these questions are basic or confused; i’ve only recently begun trying to study economics seriously

  16. doug: Consulting the video (around 1:58), it’s actually showing the government in deficit most the time. The exception is in the ‘great moderation’ period during (some of) the Clinton and early Bush II years. External trade in the ‘golden age’ period (see around 1:51) was pretty much balanced, more often than not slightly in surplus (typically on the order of 1% of GDP or less). Along with the government deficits, this left room for a domestic private sector surplus and created less need for private debt creation.

    If money is defined as currency + deposits, as it often is, then yes, private bank lending (by creating deposits) creates money, as does government spending in excess of taxes. A difference, though, is that government net spending creates not only money in this sense but net financial assets. Another difference is that government net spending adds additional demand without involving additional private debt creation.

  17. One issue I have with this post is that it seems to assume that net exports are fixed, e.g. “For trade deficit countries such as the US… it is impossible for the private sector to net save unless the government runs a budget deficit.” While that statement is true, I think a more appropriate phrasing would be, “It is impossible to reduce the current account deficit (which is roughly the trade deficit) without the government reducing the budget deficit and/or the private sector increasing its net savings rate”. If the net saving of the combination of the government and the private sector increases, other currencies will strengthen relative to the dollar thus reducing the trade deficit.

    Also, as has been alluded to in other comments, the whole “having debt denominated in domestic currency is no problem” thing only goes so far. You can’t wish the public debt problem away; there ain’t no such thing as a free lunch.

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