Sector Financial Balance: Is a Balanced Budget a Dream or Nightmare?

Recently while reading James Galbraith’s “The Predator State,” I came across a simple formula that exploded in my brain.  It is in his chapter entitled “The Impossible Dream of a Budget Balance” and goes like this.  For any country the public deficit (government spending minus taxes) plus the private deficit (net borrowing by households and companies) will equal the foreign trade balance (exports minus imports ).  This is an accounting balance having nothing to do with ideology or causality.  What it says to us laymen is that when we tinker with one part of the economy, we affect the whole.  Imagine a balloon that when squeezed in one place it pops out in another.

In the form of an equation it looks like this:

Current Account Balance = Public Deficit + Private Deficit 

Written in this manner a negative deficit is a surplus, which in the private sector means saving not borrowing.  The Current Account is closely approximated by exports minus imports, so a negative current account means more imports than exports.  The graphic below plots the terms of the equation as a percent of GDP from 1960 QI to 2010 QIII.  

Simply stated our equation means that when a dollar goes out of our country to pay for goods and services from another country, it must come from our domestic economy, which comprises the government sector and the private sector.  The countless transactions made by government, households and companies cause money to flow so as to satisfy our balance equation.  When a dollar goes out of one sector it goes into another.  The minutiae are tallied by the Bureau of Economic Analysis (BEA).

Prof. Scott Fullwiler discusses Sector Financial Balance more thoroughly and shows graphics similar to the one shown below, which is constructed from data available from the BEA.  The graphic illustrates that as the public deficit goes up the private deficit goes down (moves in the direction of more saving), and differences are represented by changes in the current account.  In a perfect world, the three terms would sum to zero at any point in time.

Chart: Sector Financial Balance as percent of GDP over the last 50 years

The roller-coaster lines in the chart have stories to tell.  In 1973 Saudi Arabia turned off the oil spigot creating our first oil crisis.  A recession followed as we see in the abrupt rise in public deficits and private saving (negative deficits).  This is the signature of recessions; private spending decreases abnormally, leading to unemployment. Then public deficits increase as tax revenues decrease and demands for government benefits increase.

Moving on we see the public surplus (negative deficit) in the late 1990’s, that was accompanied by a large private deficit.  Wealth moved from the private sector to the public sector and reduced the national debt.  More recently we see unprecedented public deficits and private saving as households and companies save to retire their immense debts.

The current account (blue line) also has a story.  The late 1970‘s marks the time when the current account went negative and for compelling reasons stayed there. Not only do we run large trade deficits with China and Japan, but there is another factor to consider. The US dollar serves as the international reserve currency.  So, to maintain liquidity in dollars worldwide, we must be willing to run consistent current account deficits.  If we consistently ran trade surpluses, dollars would flow out of foreign economies back to us, making needed dollars less available for international transactions.

For a country whose currency serves as the international reserve currency, Triffin's Dilemma points out that there are fundamental conflicts between short-term domestic and long-term international interests.

We are stuck, at least, for the near future with a big deficit on the left side of our equation.  Recently, the current account deficit is running at about $500 billion per year,  which will be balanced by deficits on the right side of the equation.  

For the moment, suppose we allow the Tea Party to balance the budget, which means zero public deficit.  Consequently, the accounting equation says that the trade deficit will be balanced by a private deficit.  But, that means net wealth loss in the private sector, as money moves into the other two sectors.  Now who do you suppose is going to carry the brunt of that wealth loss?  Based on the observation that our current economy does a good job of enriching the wealthy at the expense of the middle class, my guess is that wealth will be extracted from that middle class.

Now, suppose we defy the Tea Party and run a big public deficit and a private surplus, which is essentially the current situation.  The private sector is in saving mode while it struggles to pay off the huge housing debt.  As we are running an uncomfortably high public deficit, we might ask who is paying for what?  As taxes provide most of the income for the government, it is the wealthy, higher tax payers who will pay proportionally more interest on the rising debt.  Is it any wonder that they would want to shift the problem to the backs of the middle class by opposing increased taxes on the wealthy? 

In the near future, there is little that can be done about our public deficit, and immediate  attempts to reduce it will jeopardize the recovery by reducing private savings.  In the long term, options are limited.  We can increase exports to reduce the current deficit by finding new foreign markets for new products as President Obama has suggested.  Alternatively, we can further reduce the value of our currency to make our products more affordable in foreign markets.  That effectively gives us a pay cut, and foreign products become less affordable.  And, as suggested by Edward Harrison, we might give up responsibility for providing the international reserve currency.  Finally, as we have known since the 1970‘s, our dependency on oil adversely affects our security and has a huge effect on our trade balance.  Current oil imports add more than $350 billion per year to our Current Account deficit.

For many years, a balanced budget will be an impossible dream.  Let us be responsible and not turn it into a nightmare for the middle class by mindlessly slashing the public deficit.

Related Reading:

Government Deficits Translate into Surpluses for the Non-Government Sector

Do Deficits Matter? Foreign Lending to the Treasury

How the middle class became the underclass


Thanks to Duane Catlett for comments before posting.

Boehner Not Looking Out for Our Grandchildren

John Boehner, Majority Leader in the US House of Representatives and his sidekicks are not looking out for our grandchildren.

Boehner says the “country is broke,” and a sidekick speaks of bankruptcy.  They are wrong.  The debt scare is the same old, oddly effective tactic of inducing fear.  No country that controls its currency can go broke or bankrupt.  Public debts are private assets.  If those assets get too large, the country can experience inflation.  And, we are no where near inflation trouble now.  At least it isn’t showing up in the Core Consumer Price Index shown below.

Percent change in CPI quarterly

Boehner says current deficits will “shackle our children and grandchildren,”  but he doesn’t say how.  They don’t have to pay off the debt any more than we do.  They will have to pay the interest, which in an expanding and more productive economy they will be able to afford.

Boehner and his cronies want to revoke “entitlements,”  Social Security and Medicare.  Social Security was reviewed in 1983 under Reagan.  The Greenspan Commission knew all about the baby boom generation and “fixed” Social Security at that time.  There is no immediate Social Security problem.

Also, Medicare is not a problem.  The root problem is rising health costs in the whole Health-Profit system.  We pay twice as much of our GDP for health care as any other modern nation.  For that we get poorer medical outcomes and cover fewer people.  If we could raise the level of our Health Care to that of the rest of the modern world, we could save $1 trillion per year.  Therein lies much of our future deficit problem.

Modern-day conservatives are looking more and more like the mean landlord in a bad melodrama.  They are trying to remove the social safety nets that should exist in a prosperous, modern economy.  The conservatives’ view of the future doesn’t look good for our grandchildren.

The real threats to our nation’s future lie not in entitlements as the Republicans claim, but in, at least, four Republican sacred elephants that will really “shackle” our grandchildren: 

1. The Military-Industrial complex that would keep us in perpetual war.  The consequences of war are loss of blood and treasure.  The former counts thousands dead and 10’s of thousands wounded, the later amounts into trillions of dollars.  These numbers dwarf our foreign aid.  Why don’t we extend a helping hand instead of pointing a loaded gun?
2. The Health-Profit complex that puts profit ahead of care. The profit motive is inconsistent with care, which is evident when health insurance companies deny care on technicalities.  Other modern countries have controlled costs through single-payer or non-profit operations.  Another possibility is utility-like regulation.  Once again: This is a $1 trillion per year problem.
3. The Financial-Predator complex that continuously moves wealth to the rich at the expense of the average worker by privatizing profits and socializing losses.  Big business has successfully worked through Congress so that now 10% of the most wealthy families garner 50% (2007) of the nation’s income, which is up from 33% in the 1970’s.  Meanwhile the other 90% have seen very little income growth.  
4. The Fossil-Fuel complex that stands in the way of any forward-looking energy policy.  Coal and oil companies have funded enough anti-science to relegate carbon emission measures to an afterthought, while at the same time thwarting large-scale development of alternative energy.

Related Reading:

The Right Kind of Spending Can Fuel Real Growth

Striking it Richer: The Evolution of Top Incomes in the United States

It's the Unemployment: Now is Not the Time To Tackle Deficit

The following letter written with the help of my friends Duane and Don appeared in the Albuquerque Journal this morning.

"Contrary to all the deficit hype, federal deficit austerity will not restore prosperity in the wake of our recession.  Unnecessary attention to the deficit has overshadowed the real problem, unemployment.

Instead of deep federal budget cutting, we must focus on getting people back to work even if it means more government spending.  Deficits will decrease as employment is restored.

Product demand is what keeps companies in business and employment high.  Demand has several well known components.  Specifically, total demand is the sum of household spending, government purchases, private investment, and net exports.  When demand is in balance with production, the economy is healthy, there is full employment, and everyone is happy.

In the current recession, demand destruction started when huge private investment firms on Wall Street went belly up.  Indeed, the entire banking system would have collapsed without massive infusion of federal funds.  People and companies found themselves in debt, so household spending and private investment plummeted.

As demand fell companies laid off workers, which reduced the household component of demand further.  As the bad news spread, more companies followed suit.  As the unemployment increased, household demand continued to decrease and the recession deepened.  Without a dramatic increase in exports, the only recourse to reverse the vicious downward cycle is for the government to increase spending to prop up employment.  

There are those who believe that a recession is necessary to reallocate resources more productively.  That is, let the free market take its course.  To them, an observation attributed to John K. Galbraith applies, 

They are often applauded for the old-fashioned soundness of their views and their courage in committing other people to hardship. 

For every $100 billion cut from the federal budget a million jobs are lost.  These are not just federal employees; they include private sector crafts and professionals across the country.  This reduces total demand further and reinforces the vicious demand cycle.  

Politicians, who want to decrease the deficit now, should hold that thought until nearly full employment is restored.  Policies that increase the deficit in good times and decrease it in bad times are just plain wrong."  

Gold is Gone

We old timers had our economic education when currency had value, because it was backed by gold.  We were happy to know that every dollar we possessed represented a little bit of gold at Fort Knox.  Nixon took us off the gold standard in the early 70's, because our foreign creditors, who helped finance the Viet Nam War, wanted to be paid in gold.  That was decimating our supply.


Now the rules have changed, our dollar bills have no intrinsic value.  Rather, we have "fiat" money instead of "commodity" money.  Fiat money has value only because the government says it is legal tender and requires that we pay taxes with it.  It is counterintuitive, but once we get our heads around it, we have a better understanding than most Congressmen and any newscaster.


Even someone with no tax liability has to use the fiat money, because others need it to pay taxes.  Taxation creates demand for fiat money.


Government creates money by spending it into the private sector to buy goods and services to provision itself for tasks laid upon it by the Constitution and the US Congress.  Government retrieves the spent money by taxation and balances a shortfall by the sale of bonds.  A balanced budget would not require the bond sales.  A budget surplus would, through taxes, withdraw money from the private sector.  Money retrieved by taxation is effectively destroyed.  Let’s follow simply what happens.


When the government spends its annual $3.5 trillion budget, it injects the money into the economy.  When Bill takes out a loan from the bank or uses his credit card, money is created and injected into the economy.  But, as Bill pays off the loan the money is removed from the economy, so there is no net creation of money.  If Bill loans money to Joe, and Joe pays it back with interest, Bill is richer, but it has involved no creation or destruction of money.  It's just a private transaction.  The net money in the economy is the difference between money spent into existence by the Government and that extracted by taxes.


If the Government runs a deficit, the difference between the $3.5 trillion spent and that retrieved by taxes remains in the private sector as savings in the form of Treasury securities.  If Government were to take back in taxes the whole $3.5 trillion that it had spent, there would be nothing left for us to save that year.  So, as the Government runs a deficit the economy is able to grow.  By consistently running a deficit the Government accumulates debt, which is now wealth in the private sector.  A debt in the public sector is an asset in the private sector.  To reduce the debt, Government takes wealth out of the private sector.


There is no need for us to pay off the debt.  But, we have to maintain our ability to pay the interest on that debt if only as a measure to keep it from growing faster than GDP.


Loans and private business transactions move money around the economy.  We all work, innovate, and scheme to get more of it, but there is no net input of money without Government spending.


This is not a liberal scheme for irresponsible spending.  It's just the way things work.  Too much deficit leads to inflation; too little stunts economic growth and may lead to deflation.  Of the two, should one occur, inflation is easier to cure.


We should also note that too much private surplus is a bad sign.  In fact, the signature of a recession is high private saving as people avoid spending and high public deficit as tax revenues decrease.  Currently the public deficit and private surplus are both running at historic highs of about 10% of GDP.


Our national debt represents the cumulative savings of many in the world including you and me.  We might be proud that so many seek the safety of our currency, and that it functions as the world’s primary reserve currency even though there are some drawbacks.


Related reading:

In Defense of Deficits  

Money: What It Is and How It Works  

Virtue in Regulations

Last Sunday, Feb 12, 2011 I published the following letter to the editor in the Albuquerque Journal.


"Governor Martinez and US Representative Pearce favor reducing environmental regulations as part of a pro-business posture.


It makes sense to reduce unemployment to recover from the recession.  It makes no sense to reduce regulations to reduce unemployment.


Environmental regulations help us preserve the the quality of air and water that are essential to life.  We need environmental regulations to sustain our quality of life, which is as important as wealth.


Regulations have another virtue; they promote competition.  Regulations require businesses to compete by finding ways to meet requirements at lowest cost to the customer.  So, they stimulate innovation and, perhaps, new companies that leave behind old companies that can’t measure up.  Ultimately, we improve our environment and industry at the same time.


A good example is found in the US car industry that used its political power to fight against mileage standards for years rather than compete.  Meanwhile, foreign companies invented ways to improve mileage under the threat of increasing mileage regulations.  This put them in position to meet regulations and profit from increased gasoline prices.


Reducing regulations makes life easier for existing companies and jeopardizes our life-sustaining resources.  It is inconsistent, if not disingenuous, for those who champion the advantages of a competitive, free-market economy to circumvent it by reducing competition."

How I Got Here

Apparently there is a liberal gene.  It took me along time to find mine, but I'm sure I have it.  For all my working years I was a passive Republican, financially conservative, socially unconscious, and politically inert.  I did my job and expected politicians and public servants to do theirs.

After retirement some 17 years ago as a physicist/engineer, I began to think about other things and found to my surprise that I must have a liberal gene.  Now, I'm still fiscally conservative, socially liberal, and a flaming liberal politically.  I have compassion for my conservative friends as they were not blessed with this gene.

Occasionally, I write a letter to the editor of the Albuquerque Journal, but newspapers are a dying breed, so here I am blogging against all my previous expectations.  Open to new experiences, I'm trying to go modern despite my 74 years.