Currency Issuers and Users - Euro

Bishop John Shelby Spong is one of my favorite writers and progressive thinkers. Recently my friend Don called my attention to a recent weekly letter by the Bishop reporting on a trip to Europe with comments on its economy. Only recently would I have found the temerity to lecture the supreme lecturer. But, I did with the following comment on his website.

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Your interesting essay might have shed a different light on austerity in Europe had you appreciated the difference between a currency issuer like the US, UK, Sweden, and Hungary and a currency user, as are the states in the European Monetary Union.

After President Nixon took us off the gold standard in 1971, all major countries have had fiat currencies with floating exchange rates. In the early 1990s a growing community of heterodox economists centered at the University of Missouri Kansas City have been studying how a fiat monetary system functions. This community foresaw the trouble in the EMU as it was being constructed in the mid 90s, it foresaw the current global recession, it explains why the S&P downgrade of US debt was a non-event, and why the Fed's quantitative easing has been ineffective. The insights of this community provide some perspective on your observations in Europe.

The UK has imposed austerity on itself consistent with the neoliberal dogma dominating current global economic practice. And, it is suffering the inevitable consequences as you observed. A currency issuer unlike a household, business, or US state government has the policy latitude to deficit spend until the unemployed productive resources are fully employed. It can do this counter-cyclicly to normal business cycles to maintain a healthy economy. The UK is unnecessarily causing human suffering throughout the land.

Euro is not a sovereign currency

Members of the EMU do not have this policy latitude. As users of their currency, they are under a de facto gold standard where the euro takes the place of gold. To obtain euros they must either borrow them or be net exporters in trade with other euro nations. The members of the EMU have given up their monetary but not their political sovereignty. So, unlike states in the US, there is no avenue for a central government to share the prosperity of the whole for the common good.

Germany has reigned as the dominant mercantilist exporting to the other EMU nations, thereby enriching itself at the expense of the others. Now Germany is reluctant to take its boot off their necks and is imposing, along with the IMF, draconian austerity with the inescapable results - high unemployment especially among the youth, severe human hardship, falling GDP, and increasing deficits. The political unity once expected from the monetary alliance has not yet developed and might be threatened by increasing civil unrest.

The antidote to the depression is expansion of the monetary base to employ the unemployed. The European Central Bank, which issues the euro, could issue euros (the equivalent to mining gold) to relieve the crisis, if its charter permitted it. Such action would tend to be inflationary in regions of nearly full employment. Germany, having suffered the Weimar hyperinflation, will have nothing to do with the slightest hint of inflation.

So far, the ECB has kept the lid on debt defaults by purchasing member state bonds to keep interest rates from exploding disastrously as only a central bank can do. However, its charter and Angela Merkel are making sure that it can’t do more. The EMU states may muddle through after a long time, if civil unrest does not intervene Arab-spring style or worse.

You rightly observe that there is little difference in the plight of EMU states between those with conservative or liberal governments. Neither has much policy discretion, and like here in the US, the difference between conservative and liberal economics is the intensity of their devotion to austerian dogma. They are both basically and unfortunately neoliberal.

As one who has put religious myths in proper perspective, you might enjoy ongoing efforts to do the same with economic myths that are causing worldwide suffering and forestalling progressive objectives.

References:

http://neweconomicperspectives.org/2012/12/deprogramming-progressives-indoctrinated-into-supporting-austerity.html

http://macrobits.pinetreecapital.com/tag/euro/

http://www.nakedcapitalism.com/2010/08/guest-post-modern-monetary-theory-%E2%80%94-a-primer-on-the-operational-realities-of-the-monetary-system.html

http://www.modernmoneyandpublicpurpose.com/blog.html

http://www.alternet.org/story/155040/the_truth_revealed_about_debt_and_deficits?page=0%2C0

Representative Pearce is Confused

This post was printed as a letter-to-the-editor in the Albuquerque Journal North twice. First on Wednesday, Dec 26 with the title Pearce Wrong on "Printing Money" and again on Sunday, Dec 30 with the title Rep Pearce Gets Money Lesson. Either the Journal staff really liked it or, more likely, they were just confused. Thanks to the Journal for the exposure!

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On the Journal's Nation page for December 22, Michael Coleman quotes Representative Pearce as saying "...we're just printing money because we can't even borrow it. Somebody needs to say this is ludicrous."

Confused

Representative Pearce's statement is shockingly ludicrous. Presumably, Pearce is referring to the Federal Reserve Bank buying US Treasury and mortgage backed securities. He and others, who refer to this action as printing money, apparently forget that the securities were purchased previously by drawing down bank reserves on the part of banks or their clients. When the Fed purchases these same securities, bank reserves are restored as the Fed takes possession of the securities. It is merely an asset swap. The net effect of the swap is that interest is paid to the Treasury instead of to the former holders of the securities in the private sector.

The second part of the quote, that we "print" this money "because we can't even borrow it" is equally ludicrous. Where does Pearce get the idea that we can't borrow money - that is, sell treasuries to the non-government sector? Even at historically low interest rates, Treasury securities are being purchased at every Treasury auction. In fact, such auctions never fail. In purchasing Treasury securities banks are just trading reserves, which earn little interest, for securities that earn more interest. It is just another asset swap.

Pearce's ludicrous statement implies that he thinks buying securities with "printed" money is equivalent to selling securities. Of course, the two operations are the opposite.  The first increases bank reserves; the other decreases reserves.

Representative Pearce's confusion is representative of the confusion of the nation's leaders. It leads to self contradictions and poor solutions to our economic problems.

Connecting Modern Economics with Progressive Politics

Connecting Modern Economics with Progressive Politics

As Los Alamos scientists and engineers working on nuclear weapons, our sole interest was accurately defining the problems and researching, developing, and implementing workable solutions.  Our jobs involved objective assessment of situations, separating the wheat from the chaff, and bringing people together with the right skills to fix problems.   Politics never entered the problem solving processes.

In retirement, several longtime Los Alamos colleagues and friends concerned over the political “wars” in Washington preventing us from addressing Climate Change began discussing how we might contribute to a solution to get our country moving in a positive direction.  We believed we had the right credentials and technical knowledge to address the issue and wanted to find some way to influence our elected officials.  Needless to say, we have not been successful!

Along this path, Dan started digging into economics to see if there was an economic component to the climate change issue that could make the argument for addressing carbon emissions more compelling to our Congressional decision makers.  In the process he found that economic issues were the most important consideration in almost every issue our country faces. 

Dan discovered a group of academics advocating an approach to Macroeconomics called Modern Money Theory (MMT) that is more an explanation of the way a sovereign’s fiat currency works , if unencumbered by needless restrictive legislation, than it is a theory.   

Needless imposed legislative constraints, like the “debt ceiling“ and the obsessive fear over an expanding “national debt,” are causing law makers to make unnecessary and destructive budget cuts that are killing jobs, hurting our economy, and preventing our government from investing in almost every phase of our national public service needs, including now urgent climate change issues.

Unfortunately, both Republicans and Democrats have fallen into the trap of believing economic myths driving our governments decision making in the wrong direction: “our federal government’s finances are no different than a household’s finances, it is going broke, it needs to increase tax revenue or borrow money from China to support our national debt, and it must make major cuts to our safety net programs to survive. “  

All of those often repeated statements are wrong, yet they are so firmly entrenched in our current culture that peoples’ eyes glaze over when they hear anything that conflicts with these myths.

Most people do not understand macroeconomics on any level, but conservatives purposely trumpet these myths to achieve their ideological small government, privatization agenda.  Claiming our government is running out of money is literally the only way to get citizen voters to accept cuts to our social safety net programs as necessary to prevent our country from going bankrupt.

Our challenge is to find better ways to communicate to all citizens, public policy makers, and advocates of progressive policies the message of how money and our banking system really work and the key role the federal government plays in sustaining full employment for all those wanting work.

 

Arguments for saving Social Security, Medicare, and Medicaid from destruction and making the necessary investments to improve our “public common good” would be enormously strengthened by an understanding and integration of MMT principles into our discussion of all the critical issues of our time.

My hope is that others will join us in this quest!

Fiscal Cliff is Great Drama and Bad Economics

We recall the “Fiscal Cliff,” or more appropriately the “Austerity Bomb,” is a sequel to the summertime drama created around the “Debt Ceiling.” All this drama is founded on irrational fear of federal deficits and the resulting increase in national debt. The Austerity Bomb is draconian by design and portends both tax increases and reduced government spending to an extent agreed by almost all to throw the country into another recession. 

Bad economics; bad result.

The fear stirred up by the “Deficit Hawks” is that interest rates on the national debt will increase dramatically because of national insolvency produced inevitably by a large deficit. Meanwhile the “Deficit Doves” tell us that we will have to reduce the deficit in the future, but now is too soon. And, the wise “Deficit Owls” know that there is no solvency risk for a country with its own sovereign fiat money and that deficits, the debt and their ratios to GDP will decrease when the nation gets back to full employment, which federal deficits can hasten.

At the moment, it doesn’t matter who is right. The drama is set up to play out as the script has been written in recent months. President Obama campaigned hard for reelection insisting that taxes on the rich must be increased while those on the middle class remain untouched. His reelection now demands that he follow through on the tax hike or face ridicule for not being tough enough.

On the other side, all elected Republicans depended on campaign funds contingent on their pledge to Grover Norquist never to support tax increases.

For the President to get the tax hikes he needs in some "Grand Bargain," Republicans must renege on their pledge. They will only do that if there is a prize greater than assured campaign funding. Such a prize would be the ultimate Republican goal of getting rid of the great Democrat legacies of Social Security, Medicare, and Medicaid or, at least, cut a lot of webbing from these safety nets, which they demean as “entitlements.”

Will the President get his tax hike? Will the Republicans weaken our safety nets? Will the Austerity Bomb detonate ruining the economy? Will Republicans realize that that the Norquist pledge is not in the best interests of the nation? Whatever happens, the drama will be intense and the outcome detrimental to the economy. Any outcome is programmed to produce too much austerity too soon.

The owls know that increased deficits are symptoms of the disease of unemployment and that increased government spending and/or tax relief will enable private consumption and job growth. That approach is foreclosed by the neoliberal economic prescription that dominates the world today. That is, to resort to medieval bleeding rather than nourishment.

Professor Bill Mitchell comments on austerity in the UK:

"By failing to acknowledge that when non-government sector spending is insufficient to drive economic growth at levels sufficient to reduce unemployment there is a need for increased discretionary government net spending to support growth, the British government not only is creating an increasing economic malaise but failing to achieve its own (mindless) targets – a reduction in the deficit and outstanding public debt. The lesson is that fiscal austerity is self-defeating on all counts – the things that matter (the real economy including unemployment) and the things that don’t matter (financial ratios)."

At risk is the prosperity of the middle and lower income classes, as has been the case for at least three decades. The same people denied a reasonable share of the prosperity that increased over these years will suffer the reduced benefits in the offing because of deficit and debt hysteria. Had their incomes increased in proportion to the increased wealth acquired by the upper classes, the base for payroll taxes would have increased and the safety-net funding would have been much better. We might call that the double whammy of neoliberal economics.

So we see the fiscal-cliff threat for what it is; high political drama to convince the masses to accept political decisions detrimental to their own best interests. Our problem going forward is not that our deficits will be too large but that they will be too small.


Related Reading
Even a deal on the budget is bad for the American economy
Franc Thoughts on Bond Vigilantes

Austerity is no answer!

The Peter G Peterson Foundation, in a futile attempt to reduce federal deficits, is investing in a big program to promote austerity, which demands reduced federal government spending. Unfortunately, the program has a high probability of being implemented, because many pundits, politicians, and a few economists seem to like the idea.

Austerity deprives the private sector of dollars, which reduces household demand for products, which, in turn, reduces the incentive of private industry to invest. This fatal attraction to austerity during recovery from a depression has afflicted the euro zone and the misdirected economies of Britain, Australia, and Japan. We don’t have to repeat those mistakes, and we must not.

The allure of austerity comes from the old, gold-standard view of money. In this old view, before government can spend, it must first acquire money from the private sector through taxation or borrowing.

From this gold-standard regime came the present-day myths, "Government must balance its budget just like a household," “national debt is a burden on our grandchildren,” and “international bond markets will not want to buy our debt.”

The new way money operates in our economy began when we went off the gold standard, which was finalized with the demise of the Bretton Woods Agreement in 1973. The modern US dollar is fiat money with a floating, foreign exchange rate. As a consequence the real value of the dollar depends not on the arbitrary value of a metal dug out of the ground but on our nation's productive output. That is something that can neither be taken from us nor given to us. It depends on our own hard work and stewardship of our economy. 

Dig money from the ground? Better to use the effort to build a school or bridge.

The modern dollar changes everything. A sovereign country that issues its own fiat money with a floating exchange has no economic reason to tax or borrow from the private sector to acquire money. Instead, government creates the dollars necessary to purchase goods and services from the private sector. These purchases put dollars into the private sector by the amount of government spending minus tax revenue. Yes, deficit spending increases the financial assets of the private sector exactly to the dollar of the deficit. This, of course, raises the question of why we tax at all.

Taxation creates demand for money issued by the government, takes dollars out of the private sector to avoid inflation, and provides a means of wealth redistribution from the rich to the poor.

In what is called borrowing, government sells Treasury bonds to provide a means for risk-free preservation of private financial assets and a way for the government to balance reserves in the banking system. Banks gladly use their reserves to buy bonds, which provide greater interest. The process is just like a household taking money from a checking account to buy a Certificate of Deposit.

Our US economy, measured by gross domestic product (GDP), depends on the sum of household consumption, business investment, government spending, and net exports. As we are a net importer, net exports is a negative number. So, consumption and investment must usually carry the load, but each depends on household willingness to go buy things. Business will not invest more in the means of production unless there is consumer demand for things, and households will not buy things unless they have money to spend.

Contrary to common assertions, in the absence of household willingness to buy things, no amount of lower taxes or reduced regulations will induce business to invest. Household demand drives GDP.

In an economic downturn, such as we have experienced since 2008, when consumers are cautious about spending and business investment is waiting for customers to return, fiat money provides a solution.

The federal government can deficit spend to maintain GDP and increase employment by investing in the future. Such investment might include infrastructure (transportation, utilities, and education), new means of energy production, and scientific research and development. The government can never spend too much money as long as there are unemployed people and equipment that can be put into  production.

Those who promote austerity assert that federal deficits will increase interest rates and burden our grandchildren with increased national debt. They are wrong.

Interest rates are set, not by the “market,” but by the central bank in any sovereign country with floating-rate, fiat money. Our grandchildren will inherit both the interest-bearing bonds that constitute the so-called "national debt," and the means of production embedded in a modern infrastructure. 

Austerity reduces GDP, increases unemployment benefit costs, and increases the deficit by reducing employment of our productive resources. We should not keep any resources on the sidelines; we need to keep them all working and producing.

Related Reading:
Pete Peterson Has Won
Lerner on “The Burden of the National Debt”
Unemployment is a misallocation of resources

Our Grandparents Knew Better

We see the results: high unemployment, the collapse of the middle class, more children in poverty, outrageous wealth inequities, declining opportunities for both jobs and education. We are experiencing the result of four decades of conservative, neoliberal domination of our economic agenda that has been advanced by both political parties. After simmering for years, the breakout came when Reagan declared, "Government is not the solution; government is the problem." He was wrong - dead wrong.

Our grandparents understood what we have forgotten. They understood the role of government in the economy. And, they understood that the economy is not all about money; it is about productive capacity. They understood that government spending puts financial assets into the private sector. So, government can spend in a manner that is counter-cyclical to the business cycle to maintain a healthy economy.

In recent decades we have become burdened not with unsustainable public debt but with the myth that government finances are the same as those of the household. Where once we could afford, as a nation, anything we could actually do (moonshot); now we can afford very little, because we don't have enough money, which is asinine. We think that we can only do what we already know how to do (drill, baby drill). Then we must relax environmental standards and financial regulations to make our efforts more profitable. We fear opening new horizons, because we can't afford them.

We have been duped! Our elder statesmen tell us we are burdening our grandchildren with debt, and that increasing deficits are caused by too much government spending. The truth is different. Government spending enriches our grandchildren and deficits are caused by too little production. Thus, we have been frightened into accepting economic conditions contrary to our own best interests, but quite acceptable to the elite 1%.

The scales will be tilted toward the elite 1% until we citizens of a great nation realize the following simple truths that our great productive capacity affords us.

    •    We can assure a decent standard of living for our elderly.
    •    We can provide health care for all our citizens so that no family need become impoverished by adverse health issues.
    •    We can educate our youth to provide a highly capable workforce in support of an entrepreneurial society.
    •    We can assure opportunities and prosperity for all industrious citizens.
    •    We can regulate our financial institutions so that they can not "stack the deck" against their own customers.

In short, we can do anything we put our minds to once we again accept the idea that we are a "can-do" society. We have lapsed into a "can't-do" society, because we have been duped by false economic myths perpetrated by a wrongheaded, neoliberal economic ideology. 

Related Reading
New Sense - Common Sense

The Deficit is Uncontrollable!

There is a very important macroeconomic accounting relationship that is so simple it boggles the mind. Yet many economists disregard it or think people are too simpleminded to understand it. With understanding we all might become better informed than most pundits and politicians.

The accounting relationship merely states that if any country has a foreign trade deficit, which means that it imports more than it exports, that country consequently will have a matching deficit in its domestic economy. This happens because imports cause money to flow from domestic bank accounts into foreign bank accounts.

Accounting matters.

Someone might reasonably ask, “So what?” The answer lies in realizing that the domestic economy comprises a public sector and a private sector. So, if a foreign trade deficit exists, one or both of the domestic sectors will incur a deficit. We discus below that the public deficit depends in large part on how much the private sector decides to save and import. The deficit can not be determined beforehand.  Accountants can always figure out what happened but not what will happen, because government has no control over private decisions.

When a sector is in deficit, that sector incurs increasing debt. But, there is a significant difference between the debt incurred within the private sector and and that in the public sector (federal government).  Increased debt in the private sector means increased bank loans. Deficits in the public sector contribute to the so called “national debt,” which results in more treasury holdings, which are risk-free savings instruments, in the private sector. 

In the late 1990’s, our government ran surpluses that most people thought was a good outcome. They didn’t realize that, if the public sector ran a surplus, the private sector would consequently have to run a deficit. In fact, there began a decade-long period of increasing private debt due to increasing foreign trade deficits and inadequate public deficits.

Of course, as it turned out, the mounting private debt exacerbated by unscrupulous financial practices all came to an abrupt halt at the start of our current economic crisis. Since early 2008, the private sector has been saving and, therefore, has been in surplus like never before. Consequently, the public sector is forced to incur the debt necessary to match the foreign trade deficit as well as the extraordinary private saving. Private decisions to save and to import can affect the deficit more than public policy. Those private decisions, like buying foreign cars or saving more of discretionary income, which are beyond government control in a free society, make the federal deficit impossible to control.  

Because the deficit is uncontrollable, it is bad policy to attempt to control it by reducing public spending, which only serves to increase unemployment that, in turn, leads to higher public deficits. We need something like a speedometer on a car that allows us to monitor the performance of the economy. Unemployment and productive capacity work together as such a speedometer, because unemployment and productive capacity are basic to both inflation and GDP growth. 

As a matter of policy, we should try to control what we know how to control instead of something that is inherently uncontrollable. The need to balance the federal budget is a myth promoted by those, who benefit from private sector debt. We need less not more private debt to benefit the whole economy.

When government spends responsibly by investing in job creation programs like infrastructure modernization, public education, and science and technology research, it can reduce unemployment and grow GDP while at the same time improving the public good. The deficit will then take care of itself by reducing its size relative to GDP. 




Thanks to Duane for help on this post.

Bill Clinton is still bragging about his surpluses!

Because presidential elections turn on the economic condition of the country, we might expect candidates to know something about the subject of economics. Apparently, neither they nor their advisors know very much.

As lovable Bill brags about running government surpluses, we might ask a couple of obvious questions. 

Why should the government run a profit?  And, from whom does that profit come?  That profit comes from household money. It doesn't make sense for the government to compete with private industry for profits, does it?

It makes more sense, particularly during recessions, for the government to run deficits, which put financial assets into households. That helps maintain household spending, which is the main driver of our economy.

Bill Clinton should stop bragging about his surpluses, they did more harm than good. Unfortunately, Obama and Romney both fail to see the inevitability and virtue of deficits.

Unemployment is a misallocation of resources

Unemployment is wasted production, and it mounts into the trillions of dollars. Our economy is about production not money. The US government can afford to buy anything for sale in US dollars, because it is the source of US dollars. That is to say, it can buy anything that the country can produce. 

If private industry can’t or won’t use our nation’s full productive capacity, it costs nothing for the government to make use of those resources, especially the unemployed to produce goods and services of value to the nation. Utilization of unemployed resources pays for itself.

Back in 1933, three years before I was born, Mariner Eccles, a successful capitalist of that time, had the vision that we lack today. It was the vision that led the country out of the Great Depression despite the cries of the ultra-conservatives, who counseled austerity. Here is a quote from his testimony before the US Senate in 1933.

“Before effective action can be taken to stop the devastating effects of the depression, it must be recognised that the breakdown of our present economic system is due to the failure of our political and financial leadership to intelligently deal with the money problem. In the real world there is no cause nor reason for the unemployment with its resultant destitution and suffering of fully one-third of our entire population. We have all and more of the material wealth which we had at the peak of our prosperity in the year 1929. Our people need and want everything which our abundant facilities and resources are able to provide for them. The problem of production has been solved, and we need no further capital accumulation for the present, which could only be utilised in further increasing our productive facilities or extending further foreign credits. We have a complete economic plant able to supply a superabundance of not only all the necessities of our people, but the comforts and luxuries as well. Our problem, then, becomes one purely of distribution. This can only be brought about by providing purchasing power sufficiently adequate to enable the people to obtain the consumption goods which we, as a nation, are able to produce. The economic system can serve no other purpose and expect to survive.”

(emphasis added)

Present-day politicians seem to have lost faith in our country. The deficit hawks are either idiots or liars. We have put the unemployed to work before, incurred large deficits and debt, and we prospered. Those who say it is not possible now have lost faith in our country’s ability to innovate and produce.

From Krugman, we have the following graphic revealing that at a time when the government should have been hiring, it was increasing unemployment by laying off government workers. My take is that Obama was too compliant in the face of the Tea Party, which knows nothing of economics but a lot about emotional manipulation of the uneducated, which is politics.

The blip at 16 months in the Obama curve is census hiring. Government hiring includes federal, state, and local. While the Obama administration tried to support state and local government, he was effectively outsmarted by the Tea Party.

This is not to give Obama a pass on this horrendous result. It was he, who appointed a Deficit Reduction Commission co-chaired by two notorious deficit hawks. Ultimately, the Commission failed to produce a report. However, some people often refer to the Commission Report, which is merely the opinion of the co-chairs, Simpson and Bowles. 

Where Obama has acceded somewhat slowly to the demands for austerity, we can expect Romney to go full speed ahead, because Paul Ryan will be whispering shouting in his ear. 

It is frustrating to see our leaders cower before the future instead of striding boldly towards a well-educated, highly productive nation.

Related Reading

Testimony of Marriner Eccles to the Committee on the Investigation of Economic Problems in 1933

Mariner Eccles Full Testimony, Feb. 13 - 28, 1933

The Most Important Macroeconomic Relationship

In 1999, the late Wynn Godley (1926-2010) predicted the great financial crisis. His insight into the economy was through the lens of the three-sector financial flow accounting discussed in the last blog. 

We can state the relationship in words as

Public Net Income + Private Net Savings + Net Foreign Imports = 0.

Godley noticed that with a perennially positive import balance and the then current government surpluses, which politicians and pundits applauded, the private sector savings would have to be negative. That is, the private sector was borrowing to finance imports and the public surpluses. Only a few economists noticed this conundrum, and Godley, a proponent of the Financial Sector Balance (FSB) accounting relationship, was among the first. 

At the Bureau of Economic Analysis (BEA) our nation’s bookkeepers compile piles and piles of data in their National Income and Production Account (NIPA) Tables. From these tables we can find the data series that illustrate the FSB relationship including what Godley saw and foretold. An FSB history is shown in Figure 1, where there are several characteristics to note. 

Figure 1. Financial sector balance flows add to zero at each point in time in accordance with the three- sector relationship.

• When private saving increases (blue line) public deficit increases (red line). 
• The oil crises that caused high oil prices in the 1970s resulted in a recession characterized by unusually high private saving and increased public deficits. Such is the signature of recessions.
• During the 1980s, the Reagan tax cuts in 1981 increased public deficits contrary to “supply side theory.” In any event, the recession of 1982, possibly triggered by tight money policies, dominated the economy. The stock market crash in 1987 was laid at the feet of high deficits though high imports contributed to the deficit.
• H W Bush promised in 1988 to hold the line on taxes, just read his lips. But, deficit hysteria put pressure on him to do something. In 1990, he reached a compromise that resulted in some tax increase. Then the recession of 1992 took over, private savings and deficits increased in unison and Bush lost reelection.
• During the Clinton years, 1992-2000, a combination of tax increases and spending restraint produced both a public surplus and competition between Democrats and Republicans to take credit for what was interpreted to be a successful budget outcome.

We want to focus on what Godley noticed. As the public deficit was declining and becoming a surplus private saving was diminishing and becoming borrowing instead. Clearly, obsession with the deficit distracted our leaders from what was going on in the private sector.

It might have been worse but for the Bush tax cuts that allowed the deficit to increase again and gave the private sector some relief. But, it was too late. The housing crisis of 2007 took over the whole show. In a resounding example of Keynes’ “Paradox of Thrift” the private sector stopped spending, unemployment increased, automatic stabilizers (food stamps, unemployment insurance) kicked in and the deficit exploded.

Figure 1 gives us flows into and out of the sectors not the stock of debt or saving. It would be appropriate to ask how high did the private debt go and how does it compare to the public debt that everyone seems to be worried about? 

To answer those questions, we call upon Prof. Steve Keen of the University of Western Sydney, Australia, where he is noted for his mathematical modeling of financial instabilities. Figure 2 is taken from Keen’s presentation at the Berlin 2012 INET (Institute for New Economic Thinking) Conference.

Private debt, which is a burden, far exceeds public debt, which is a private asset.

Once again the data are clear. Concentration on public deficits and public debt distracted us from noticing the accumulation and huge build up of private debt. After the Great Depression in the 1930s, regulations were put in place to prevent financial instabilities. But, over the last four decades, Presidents, both Republican and Democrat, have presided over deregulation of the financial markets with the results we experience today. And, still we hear cries for more deregulation, and another Democrat President seems ready to oblige.

It wasn’t the public sector that got into debt trouble and couldn't pay its bills, it was the private sector. So, we might conclude; it’s the private sector debt, stupid!!

Related Reading

Derivation of the most important macroeconomic equation

The Sector Financial Balances Model of Aggregate Demand—Revised

Why MMT is Like an Autostereogram

Deficit! It's Not a Choice.

It's all in the accounting. Paul Ryan, US House of Representatives Budget Committee, Chair, can't just decide to cut the deficit. There is more going on than he seems to understand. However, that didn't keep him from being honored last year by the deficit hawks at the Peterson Institute which gave him a "Fi$cy Award" for his fiscal responsibility. Apparently his budget for this year, which passed the house yesterday, is an attempt for a repeat award, although he still hasn't made clear where he would make his draconian cuts. But, he damn well intends to cut the deficit. We will show he can't do that.

All we need to do is look at the way dollars flow from one economic sector to another. Let's start with the domestic and foreign sectors. When we import from another country we give that country dollars. That is, dollars are debited in US accounts and credited to foreign accounts. Debits decrease account balances and credits increase them. Accounting dictates that the sum of debits, which are minuses, and credits, which are pluses, must add up to zero.

We could write a simple equation like this for any period of time, say a quarter or a year.

Domestic Balance + Foreign Balance = 0

When we net import, the Foreign balance is positive and the Domestic balance is negative by the same amount. If we net export the reverse is true. As a matter of fact, the US has been net a importer for many years and will remain so for many more.

It is informative to decompose the Domestic sector into a Public (Government) sector and the domestic Private sector, which includes households and businesses, as shown in the Figure 1. 

Figure 1. Three sectors comprise global economic activity as seen from the US.

It might not be obvious at first blush, but the Public sector has no people. It is just buildings, books, laws and, let us not forget, a Constitution. The Public sector hires people (janitors, justices, soldiers, and President) from the household sector to acquire goods and services. In so doing dollars flow from the Public sector to the Private sector and, possibly, to the foreign sector.

Also, for completeness we mention, firms hire people from the household sector. But, these interactions do not cause dollars to flow between the colored sectors. It follows upon a bit of reflection, that all income flows to households (in wages, dividends, and interest), and households pay for everything. Household consumption compensates firms for all costs of production from taxes, to wages, to raw materials and, of course, profit.

All economic activity takes place within these sectors, which form a closed system, at least until we engage in interplanetary commerce. All intersector economic activity causes dollars to move between sectors, and at the end of the day, the sum all debits and credits will  be zero.

Now, we can expand the Financial Sector Balance (FSB) equation to

Public Balance + Private Balance + Foreign Balance = 0

Figure 2. defines the terms in the FSB equation.

Figure 2

In this equation, the Public Balance is taxes net of public (government) spending, deficits are minuses, surpluses positive. Private Balance deserves quite a bit of attention, which we will reserve for another day. Today, we will note that the Private sector will net save or borrow. If it saves, the wealth of the sector will increase. Net borrowing will increase net private indebtedness, which in our analysis would be net deficit. So, with a positive foreign balance, at least one of the Public and Private sectors must be in deficit.

As a matter of history, the Private sector started a borrowing (deficit) binge in the late ‘90s. Remember the fabulous Clinton-Gingrich surplus? The binge continued until the crash in 2008 at which time the private sector began a saving binge that continues today. With the Foreign and Private balances in surplus the public balance must be in deficit. 

Our FSB equation is an accounting relationship not a law of physics. It doesn't predict what will happen, it just reports what happened. Whether or not the public balance is in deficit or surplus depends on more than government decisions. It depends, also, on people's decisions in the aggregate to import, like shop at Walmart or buy foreign cars, or to save in hard times more than they would in good times.

Because of these private-sector decisions the deficit is not a choice; it is a result. Paul Ryan simply doesn't know what he is doing.

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