Sunday, February 27, 2011

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:
How the middle class became the underclass

Thanks to Duane Catlett for comments before posting.

No comments:

Post a Comment