Wednesday, June 1, 2011

Private Saving Increases the Deficit

In a recent post, we derived the Financial Sector Balance equation by equating two equivalent expressions for GDP. The equation relates the financial balance among the domestic government, domestic private, and foreign sectors; and it is written simply as 
1) (S - I) + (T - G) = (X - M),
where the difference between private saving S and private investment I, is net private saving (S - I); the difference between government taxes T and government spending G, is net government spending (T - G); and the difference between exports X and imports M, is net exports (X - M).
In English, Equation 1) reads; net private saving plus net government spending is equal to net exports. This is an accounting identity that holds after the fact, ex post, regardless of the economic system or political ideology. The equation does not prove causality; it just balances the books as was verified in the earlier post.
Some economists rearrange Equation 1) to get 
2) I = S + (T - G) - (X - M), 
which in English reads; private investment or “national savings,” I is the sum of private saving and public saving minus net exports. It is used before the fact, ex ante, as a policy guide, and it advises reduced personal spending (net saving), budget surplus, and reduced exports. 
The idea is that savings enable investment just like it does for a household or business. When this austerity solution, which works for a household, is applied to the whole economy, we run into the Paradox of Thrift. When everyone avoids spending it drags down the whole economy.
Equation 2) is valid only for a fixed exchange rate and fixed money supply as with a gold standard. It is another example of irrelevant gold-standard thinking that gets things backwards. 
The concept of saving for a government that issues a sovereign, floating rate currency makes no sense. It serves no purpose for government to stockpile money that can be created at will. The money supply is neither constant nor knowable. It increases through deficit spending and bank loans and decreases through taxation and loan payoff as we discussed here.
Clearly, private net saving, in Equation 1), is closely connected to the government spending balance. When (S - I) is positive, the private sector is accumulating savings; when negative the sector is net borrowing - going more into debt. 
Continuing with Equation 1), we know that now and for years to come imports will be greater than exports so (X - M) will be negative. It follows that, if (S - I) is to be positive, which is generally good, (T - G) must be negative, which means deficit spending.
For example, if (X - M) = -2, and (S - I) = +2, then (drum roll, please) (T - G) = -4, it can be no other way.
Our government does a lot to promote saving as we have tax-advantaged saving programs including IRAs, 401-Ks, 403-Bs and others. The economy will try to accommodate private sector saving decisions by incurring budget deficits. Those deficits have to be large enough to include the foreign trade deficit. That is to say, private decisions to save and foreign trade deficits drive the government spending balance into deficit.
Efforts to reduce deficit spending will just make things worse unless the government promotes a big program to entice people to take on debt. Alas, we have already tried that; it resulted in the housing crisis.
The popular notion that budget deficits are bad and surpluses are good works for households; for the federal budget it is exactly wrong! 

Thanks to Duane for comments.

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