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.

Is the US Living Beyond Its Means?

Today is Memorial Day and, for many, burgers are on the menu. As we celebrate our military heros, let us not forget about our jobless, who include many veterans among their ranks. 

While warming up the grill, I'll let others write for me. Prof. Bill Mitchell is an academic from Australia. Writing from the other side of the International Date Line, he is always, at least, a day ahead of us. Prof. Paul Krugman, a Princeton academic and columnist for the New York Times, gets us back on track regarding jobs.

Prof. Mitchell begins his blog, The US is living below its "means," with:

"The US press was awash with claims over the weekend that the US was “living beyond” its “means” and that “will not be viable for a whole lot longer”. One senior US central banker claimed that the way to resolve the sluggish growth was to increase interest rates to ensure people would save. Funny, the same person also wants fiscal policy to contract. Another fiscal contraction expansion zealot. Pity it only kills growth. Another commentator – chose, lazily – to be the mouthpiece for the conservative lobby and wrote a book review that focused on the scary and exploding public debt levels. Apparently, this public debt tells us that the US is living beyond its means. Well, when I look at the data I see around 16 per cent of available labour idle in the US and capacity utilisation rates that are still very low. That tells me that there is a lot of “means” available to be called into production to generate incomes and prosperity. A national government doesn’t really have any “means”. It needs to spend to get hold of the means (production resources). Given the idle labour and low capacity utilisation rates the government in the US is clearly not spending enough. The US is currently living well below its means. But the US government can always buy any “means” that are available for sale in US dollars and if there is insufficient demand for these resources emanating from the non-government sector then the US government can bring those idle “means” into productive use any time it chooses.

Spending equals income. Someone has to spend for incomes to exist. For incomes to grow there has to be growth in spending. There are three sources of spending growth in a macroeconomy – the external sector (if net exports are positive); the private domestic sector; and the government sector (if the budget is in deficit).

That is indisputable. Economic growth is defined in terms of production and production only occurs if there are goods and services being purchased. Firms do not produce to hold inventory. Firms may invest in response to their guesses about future sales. These guesses will be heavily influenced by current consumer actions.

So when you get commentators and high-level monetary officials arguing that growth comes from not spending you have to ask why anyone would listen to their views and why they are paid to express them. I don’t mind bloggers who do it for free saying what they like but when highly-paid and highly-visible express views that are not grounded in any economic theory that is comprehensible but nonetheless seek to influence the policy debate then I get angry."

He goes into more detail and "roasts" Gretchen Morgenson's article in the Sunday New York Times.


Prof. Krugman offers some remedies in today's column.

"The core of our economic problem is, instead, the debt — mainly mortgage debt — that households ran up during the bubble years of the last decade. Now that the bubble has burst, that debt is acting as a persistent drag on the economy, preventing any real recovery in employment. And once you realize that the overhang of private debt is the problem, you realize that there are a number of things that could be done about it.

For example, we could have W.P.A.-type programs putting the unemployed to work doing useful things like repairing roads — which would also, by raising incomes, make it easier for households to pay down debt. We could have a serious program of mortgage modification, reducing the debts of troubled homeowners. We could try to get inflation back up to the 4 percent rate that prevailed during Ronald Reagan’s second term, which would help to reduce the real burden of debt."

Happy Memorial Day!

Is Our National Debt a Burden to Our Grandchildren?

Today is October 25, 2011. Having learned more about the national debt, I didn't get this one right. So, I'll try again later. It's not as complicated as I made it.

Banks and Government Create Money

We use money every day without thinking about where in comes from, we’re concerned with what we can do with it. In a previous post we looked at some of the consequences of the passing of the gold standard. In preparation for upcoming discussions, we might take a closer look at the two sources of money.

Banks create money by lending to a borrower, who then deposits the money in The bank. (We can think of the whole banking sector as the bank.)The deposit is a liability for the bank and an asset for the borrower. The loan is a corresponding asset for the bank and a liability for the borrower. Both the bank and the borrower have equal assets and liabilities. As the borrower draws down the bank account, her asset decreases along with the bank’s liability. As the borrower pays off the loan, her liability decreases along with the bank’s asset. This all nets to zero in the banking system, because after the loan is paid off the money created is gone. However, if the loan was put to productive use, the borrower may have real assets and her wealth improved. 

In spending, the government creates money by crediting bank accounts. The Fed marks up the balance of the Treasury’s account at the Fed. (It’s as if the Fed just picked money off the money tree.) The treasury then transfers those reserves to to the recipient’s bank, which then marks up the recipient’s account balance. The recipient has an additional asset with no corresponding liability in the banking system. This is the mechanism by which government spending adds wealth to the private sector.

The process is reversed upon taxation. The tax payer’s account at the bank is decreased and subsequently, the Treasury’s account at the Fed is decreased. Money is created by government spending and destroyed through taxation. If the tax payer paid in cash, it would go to the shredder. 

As explained in an earlier post, when the government spends more than it destroys by taxation, excess reserves build up in the banking system that must be drained by selling Treasury bonds. The government buys back Treasuries on the rare occasions that it runs a surplus. In this way, the government defends its target interest rate, which in turn influences the market for bank loans.

Related Reading:

Tom Hickey on MMT

Yes, Deficit Spending Adds to Private Sector Assets...

Sovereign Currency Rocks

What’s so special about a sovereign, floating rate currency? Until the mid 1990’s few bothered to appreciate its fundamental characteristics. The currency of a sovereign nation can have a profound and positive influence on the nation’s economy.

Our basis for understanding money and budgets is rooted in our knowledge of household, corporate, or state government budgeting as they use the currency of the land. We know that we must earn income or take out loans in order to spend. So it is thoroughly ingrained in our culture to think that federal spending and budgeting should be the same, but it is not. Such thinking is consistent with the time during which the value of the dollar was based on the fixed value of gold, and this thinking is reinforced by archaic rules that have not changed since we went off the monetary gold standard in 1971. One example is the debt limit, which is unnecessary for a sovereign, floating rate currency.

The federal government is the monopoly issuer of the currency, a fiat currency convertible not to gold but only to itself. Neither income in the form of taxes nor loans enable government spending. The government can and does create money out of thin air and spend without fiscal restraint, subject only to the capricious will of Congress.

Taxation, as explained in an earlier blog, is not necessary for the government to spend. It is a means of both reinforcing demand for the currency and avoiding inflation by reducing aggregate demand for private sector spending. It’s as simple as that even though it goes against most people’s thinking including that of most economists, pundits, and all of Congress.

Borrowing, also discussed in another blog, is the means by which the Fed controls the interest rate on interbank loans; and therefore, the rate for short-term treasuries. This is a choice that benefits the banks and bond holders. It would be possible to just pay interest on bank reserves, which has the advantage that reserves, unlike bonds, are not considered debt. The fact that the Fed sets the short-term bond rate explains why countries like ours, the United Kingdom, Australia, Canada, and Japan are not held hostage by the global bond market as are the countries in the European Monetary Union. For us, there is no risk of default on obligations denominated in our own currency absent political shenanigans.

In another previous blog, we tried to dispel the commonly held idea that deficits are bad and surpluses are good. While surpluses are desirable in household budgeting, history shows that national surpluses hinder household saving. Private saving is enabled by national budget deficits. It follows that metrics other than deficits should be used in managing the national budget.

Consider unemployment for a moment. If we monitor production capacity and utilization along with inflation, we might maintain higher employment rates. Currently, we plan on a consistent unemployment rate of 4% to 5% as a hedge against inflation. This is a terrible waste of productivity that holds back growth of our GDP. We might better look at the performance of the economy not an arbitrary budget deficit number. 

We might also look at taxes differently and argue, perhaps, that corporate taxes are not necessary except as an instrument of policy. Corporate sales are closely coupled to aggregate demand, which would be influenced by taxes on households. We can imagine flat rate income taxes, perhaps, in combination with consumption taxes. Taxes could be made much simpler when viewed in this different light.

It amazes me that conventional wisdom continually uses household budgeting as the model for national budgeting, and professional economists never mention the properties of a modern, sovereign currency. My conclusion is that pundits and politicians risk losing their credibility and livelihood if they stray from the wisdom of their communal brain. Perhaps Professor James Galbraith said it better almost a year ago.

Related Reading:

Limitations of The Government Budget Constraint:

Soft Currency Economics

Interest Rates and Fiscal Sustainability

Can Taxes and Bonds Finance Government Spending?

Many thanks to Duane for improvements to this blog.

Refocus on Unemployment and Shared Risk

Everybody in Washington, DC is focussed on the wrong problem. And, I mean everyone from the President, to Congressional Democrats and Republicans alike, to the news media, to jabberwocky pundits. Did I leave out anyone? Oh yes, the President’s Deficit Reduction Commission. It’s as if they were all plugged into the same lame brain. 

Apparently, there was never any doubt that the deficit must be reduced soon. Well, deficits have been an obsession since Nixon got crossways with Congress in 1974, which was only about three years after he took us off the gold standard.

Also, the notion of shared sacrifice has dominated all discussion as some badge of seriousness. No one is considered serious unless they give up argument and accept both the deficit reduction and shared sacrifice mandates.

Meanwhile their common brain is telling these people to be very fearful of what isn’t actually happening. The deficit is causing inflation; it’s not happening nor is it about to happen. It is causing interest rates to rise; it’s not only not happening, it can’t happen. It is causing dollar depreciation; it’s not happening.

We should be concerned about what is happening. Unemployment is still too high and is recovering too slowly. The financial, educational, and sociological consequences will be with us for a generation or more. There is a way out; it was demonstrated 76 years ago with the advent of the WPA (Works Progress Administration). It was a government “jobs” program that touched nearly every town in America. We are still benefitting from the infrastructure built under that project even though that infrastructure is deteriorating.

We should also rethink the shared sacrifice mandate. We have learned that shared sacrifice means cutting benefits for Social Security, Medicare, and Medicaid. Shared sacrifice translates to sacrifice by the elderly, disabled, and sick. Good grief, what kind of a people are we?

Let’s look instead at shared risk. None of us knew as we started out in life how things would turn out for us. Those who fared well can help out those for whom wealth or health did not turn out so well. Shared risk translates to maintaining social safety nets for the disadvantaged by those who have fared well.

Social Security and Medicare are insurance (shared risk) programs not annuities. If one doesn’t need the benefits they go to those who do. Funding for Social Security is a little soft, but can be fixed by raising the upper limit on pay roll taxes. Medicare, an efficient program, suffers not from its own defects but those of the larger health care system. We need to solve the larger problems not cut benefits. 

Let’s overcome the deficit hysteria and the false rhetoric of shared sacrifice and turn to what is really important, unemployment and shared risk. 

Related Reading

Getting America Back to Work...

Don’t Count on Job Growth....

Boehner’s Views on Economy Contradicted...

Financial Sector Balance II

In a previous blog I plucked an equation out of James Galbraith’s “The Predator State” and tried to put it to the test graphically. One of my friends, whose initials are Duane, objected to having the equation in terms of deficits so that a negative deficit was a surplus. Another friend was unconvinced. Apparently my first attempt was a pedagogical flop.

This is a very important top topic even if it is basically bookkeeping. Economists call it macroeconomics. We are concerned with the three sectors; foreign, which is just exports and imports; private, which comprises all domestic households and businesses; and public, which comprises federal, state, and local governments. All the people are in the private sector. This is where business and governments find their labor. Ultimately, households end up with all income, and households contribute the bulk of GDP.

Figure 1. Sectors that contribute to GDP

What follows is a simple derivation of the sector balance equation. GDP is a measure of the market value of all goods and services in the country in a year and can be expressed in, at least, two ways. First we look at it in terms of sources of money in the domestic economy, which we express as follows: 

(1)    GDP = C + I + G + (X - M),

where C is the sales side of household consumption, I is business investment, G is federal government spending. (X - M) represents the net value of exports. 

Alternatively, we can look at uses of income, which gives us

(2)   GDP = C + S + T,

where C is spending side of household consumption, S is total household saving, and T is federal taxes.

Equating (1) and (2) and canceling the C’s we have 

 (3)    S + T  = I + G + (X - M).

After rearranging terms, we have our sector balance equation

(4)     (S - I) + (T - G) = (X - M).   Each term is positive in surplus and negative in deficit.

(S - I) in surplus indicates net saving in the private sector, and net borrowing in deficit. (T - G) indicates public surplus when positive and deficit when spending exceeds taxes. (X - M) is net exports and is in deficit when imports exceed exports.

Figure 2 shows a chart of the terms in equation (4) using data from the Bureau of Economic Analysis. For this chart, I was able to find more appropriate data series than in the earlier post. Clearly, the data validate equation (4) quantitatively.

Figure 2. Sector data from BEA as per cent of GDP from 1960 QI to 2010 QIV

Perhaps the most striking feature of the chart is the consistency with which public deficit (T - G) is reflected in private saving (S - I). It is good for some saving to occur. We like to have a prospering and growing economy with increasing wealth. But, when facing hard times, we run into the Paradox of Thrift. If one household saves it is good for that household, but when every household saves the economy suffers. As households reduce consumption, firms lay off workers, tax revenues fall while unemployment insurance rises leading to increased deficits. We see these effects in the 1973 and 1979 oil crises and the subsequent recessions. And, we see it big time currently.

There is another interesting period in the late 90’s where the foreign deficit (X - M) is growing rapidly and is demanding a deficit on the domestic side of equation (4). Uncharacteristically, during this period the public sector is in surplus and the private sector takes on the role of running a deficit by continued borrowing. 

In the run-up to the election in 2000, there was some argument about what to do with the surplus. Al Gore wanted to put it in a “lock box.” G W Bush bided his time and reduced taxes in 2001 and 2003 in addition to introducing Medicare drug benefits and launching a war. That got rid of the surplus but, perhaps, produced insufficient deficit to overcome the mounting borrowing in the private sector. Overweighted with debt, the private sector collapsed into the Great Recession. Then private saving zoomed to unprecedented levels as did public deficits.

With persistent trade deficits, the public sector, the private sector or both will be in deficit. In the period around 2006, both sectors shared the load. When the private sector is in deficit, wealth is flowing out to the other sectors. Likewise, when the public sector is in deficit, it is feeding the other two.

It is important to realize that sector balance observations do not prove causation, but they are valuable in understanding where money flows under various circumstances. 

Understanding the nature of the sector flows, it is hard to understand why anyone would want to balance the public budget or especially, run it into surplus. Assets would move from the private sector tending to make people poorer.

Related Reading

Saturday Quiz - May 7 Q1

Sector Financial Balances Model...

The CBO’s long-term outlook

Taxes are Necessary but Buy Nothing

It’s counter-intuitive, but it’s correct. Tax receipts buy nothing. We all think we know all about budgets. And, if we have run a household, a company, or a state government, we would probably be correct as those are users of currency. The federal government is the issuer of currency; the same rules do not apply. Indeed, they are for the most part the opposite, which is characteristic of a floating exchange rate currency. 

In a previous post, Gold is Gone, we pointed out that our fiat currency is created by federal government spending to buy goods and services from the private sector. Some of the dollars spent are retrieved by taxation. If, as usual, spending is in excess of taxes, the difference remains in the private sector as savings.

Logically, spending must occur before taxation or there would be no funds to tax. Unlike the family which is fiscally constrained by available resources, federal spending is fiscally unconstrained. It does not need to have income or loans to spend and can spend without limit - not that it should. 

A family must have resources like wages, savings, or loans to provide money to spend. The national government creates whatever it needs. It cannot run out of dollars, “go broke,” or face insolvency. This is much different than countries like Greece and Ireland, which are users of the Euro. Similar to our states, all countries that use the Euro are fiscally constrained. Unfortunately, we are still unnecessarily burdened in our thinking by constraints left over from the gold-standard years when our currency was also constrained.

It would be fair to ask, if taxes are not income for government, why does it tax? There are two reasons.

First, taxation makes our currency legitimate, because it creates a need for people to acquire dollars. We could imagine different locations around the country having their own currency to encourage local commerce. In fact, that is done. Those currencies could be unconvertible fiat currencies or convertible to coal or seashells. But, we “are one nation, indivisible with liberty and justice for all.” As soon as the government uses its coercive power to levy taxes that must be paid in its dollars, the local currencies become fiscally constrained and convertible to dollars. Dollars win.

Second, taxation serves to restrain aggregate demand in the private sector. As the government spends to buy the goods and services it needs, the private sector acquires assets and purchasing power. If the total demand of the private sector and the public sector exceeds the nation’s capacity to produce goods and services, inflation or currency devaluation will follow. Taxation prevents inflation.

Neither taxes nor borrowing, as shown previously, are needed for government spending, which is completely different from households. With that knowledge, we can start thinking of metrics less arbitrary than deficit and debt to evaluate the health of our economy. Unemployment and productivity would be much better metrics. In the face of high unemployment and excess production capacity, deficits are actually not all that important.

Related Reading

The S&P Downgrade: Much Ado about Nothing...

Taxpayers do not fund anything

Soft Currency Economics

Borrowing Does Not Fund the Deficit

There is a persistent misperception that the US must borrow to fund its deficit. In a previous post, Gold is Gone, we pointed out that economic rules have changed since we went off the gold standard in 1971. 

The US now has a sovereign, floating exchange rate, fiat currency that is actually created out of thin air by government spending to acquire goods and services from the private sector (firms and households). Taxation takes money from the private sector and destroys it. If taxation does not equal what was spent, we buy or sell bonds according to whether we are in surplus or deficit, respectively. Accordingly, that leaves the private sector with less or more wealth in savings. This might leave the impression that taxes and borrowing enable spending. Let’s look more closely.

Government spending is accomplished by depositing money in a recipients bank account. This deposit causes an increase in the bank’s reserve requirement.

Every bank has a reserve account at the Fed, which requires them to keep some fraction of their deposits in these accounts.  For big banks this minimum is 10%. Also, the banks must keep enough in their reserve accounts to clear the checks presented for payment on any day. Banks earn only about 0.25% interest on these accounts; before 2008 it was zip.

As a instrument of policy, the Fed tries to control demand for loans in the private sector by controlling the overnight Fed funds interest rate. This is the rate at which banks can borrow money to cover loans made at profitable rates.

Because they make little profit on excess reserves, banks try to keep them at the required minimum. A day's activity at any one bank can leave it with an excess or a shortage. Overnight the banks have a scramble to acquire needed reserves or dump excesses, which they do by loaning funds to one another in the money market.  

If the government is running a deficit, there will usually be excess reserves in the system, because deficit spending puts assets into the private sector. There is no way that the banking system can, by itself, get rid of excess reserves, so the forces of supply and demand will drive the interest rate on reserves to the minimum rate. To keep the overnight rate up, the Fed drains excess reserves by selling bonds at somewhere near its target rate. Buyers will be eager to buy bonds having yields better than the minimum rates, so bond sales never fail.

We do not borrow to fund the deficit; we sell bonds to maintain the Fed funds rate. That is a big difference between our floating rate currency and that of fixed rate currencies like those of Greece and Ireland. Such countries are vulnerable to default on their securities and face high interest rates in the global market. We are not vulnerable to default, because we can always meet commitments made in our currency.  That is, unless we do something politically stupid like not raising the debt ceiling, an archaic rule left over from the gold-standard days.

The above is for normal times. Currently, banks are reluctant to lend and the private sector would rather save than borrow. Consequently, the Fed funds rate sits at the minimum. The Fed can’t control something that isn’t happening.

Related Reading:

The S&P Downgrade

Saturday Quiz Answers & Discussion Q4

A Modest Proposal for Ending Debt Limit Gridlock

Ryancare

It's time to be really frightened.  At last, we see the true stripes of the modern Republican Party. After, giving tax breaks to the rich, busting the unions, and giving tax advantages to big business; they will attack the deficit by reducing benefits for the elderly, the sick, and the poor.  Privatizing Social Security and vouchering Medicare will be good for Wall Street and the insurance companies but not for the would-be beneficiaries.  

Rep Paul Ryan states that his "Plan for Prosperity" will pay off the debt.  That may sound good to some, but we know that it doesn't stand up to simple accounting. As long as the we run a foreign trade deficit, dollars will be going out of the country.  Those dollars will come from either the government sector or the private sector.  If the government does not run a deficit those dollars shipped abroad will come from the private sector. That is, wealth will be drained from the private sector excluding, of course, Wall Street and the insurance industry.  Is that what we mean by "prosperity?"

The Ryan budget is both inhumane and stupid.  It further enriches the rich at the expense of the disenfranchised and doesn't pass the simple test of basic accounting.

Related Reading:

Sector Financial Balance