|Figure 1. Three sectors comprise global economic activity as seen from the US.|
Friday, March 30, 2012
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.
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.
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.