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
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.