Sunday, July 8, 2012

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.