I read an article in the Financial Times earlier this week (September 23, 2023) -…
Even the most simple understandings are lost in the public debate about budget deficits and public debt. The Flat Earth Theorists who whip up deficit hysteria each day like to stun people with large numbers. They produce debt clocks that relentlessly tick over and try to get us to believe that impending doom is upon us. But if we just take a deep breath and think the situation through we would see that the ticking debt clock is really just a measure of the portion of non-government wealth embodied in public debt. We would then learn that budget deficits are just the mirror image of non-government savings. Saving is usually considered to be something we should aim for. Increased wealth is also something we usually aspire to. So the increasing deficits and increased debt outstanding is, in fact, beneficial to the private sector (overall). Once we understand that then the deficit hysteria becomes transparently ideological. These characters just hate government and want to get their greedy hands on more of the real pie.
I thought this article – The national debt is money the government owes us – which appeared in the UK Guardian (June 17, 2010) was interesting. If more people understood the argument that the journalist (Paul Segal) is making then the Flat Earth Theorists would starve for oxygen.
Politicians on the right love to scare us. George Osborne, in his Mansion House speech cited “fears” over government solvency and sovereign debt crises. David Cameron has declared the fiscal deficit a “threat” to “our whole way of life,” and “a clear and present danger to the British economy”. This is nonsense. The threat we face is ideologically driven cuts that risk causing a double-dip recession.
The fiscal deficit seems scary because it is debt. Cameron argues that within five years the national debt will rise to “some £22,000 for every man, woman and child in the country”. This may be true, but what he doesn’t tell us is that it is money the government owes to us – not money that we owe to anyone else. That’s right: 80% of our government debt is owed to the British people. What is called “national debt” is our own savings, looked at from the other side of the balance sheet.
People get very confused about the concept of national saving. They assume that saving is spending less than you earn and then apply that to budget surpluses and conclude that the surpluses add to national saving. But this view is erroneous. A sovereign government does not save. What sense does it make to say that the government is saving in the currency that it issues? Households save to increase their capacity to spend in the future. How can this apply to the issuer of the currency who can spend at any time it chooses?
As a matter of national accounting, a government budget deficit adds net financial assets (adding to non government savings) available to the private sector and a budget surplus has the opposite effect. The last point requires further explanation as it is crucial to understanding the basis of modern money macroeconomics.
While typically obfuscated in standard textbook treatments, at the heart of national income accounting is an identity – the government deficit (surplus) equals the non-government surplus (deficit). The only entity that can provide the non-government sector with net financial assets (net savings denominated in the currency of issue) and thereby simultaneously accommodate any net desire to save (financial assets) and thus eliminate unemployment is the currency monopolist – the government.
It does this by net spending – that is, running deficits. Additionally, and contrary to mainstream rhetoric, yet ironically, necessarily consistent with national income accounting, the systematic pursuit of government budget surpluses is dollar-for-dollar manifested as declines in non-government savings.
A simple example helps reinforce these points. Suppose the economy is populated by two people, one being government and the other deemed to be the private (non-government) sector. We abstract from the distinction between the external and private domestic sectors here – which mostly only involved distributional considerations anyway.
If the government runs a balanced budget (spends 100 dollars and taxes 100 dollars) then private accumulation of fiat currency (savings) is zero in that period and the private budget is also balanced.
Say the government spends 120 and taxes remain at 100, then private saving is 20 dollars which can accumulate as financial assets. In the first instance, they would be sitting as a 20 dollar bank deposit have been created by the government to cover its additional expenses. The government deficit of 20 is exactly the private savings of 20.
If the government continued in this vein, accumulated private savings would equal the cumulative budget deficits. The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not have to do this to finance its deficit. If the savers transfer their deposits into bonds their overall saving is not altered and it has no implications for the government’s capacity to spend. It has the advantage for savers that they now also enjoy an income flow from their saving.
However, should government decide to run a surplus (say spend 80 and tax 100) then the private sector would owe the government a net tax payment of 20 dollars and would need to sell something back to the government to get the needed funds. The result is the government generally buys back some bonds it had previously sold. The net funding needs of the non-government sector automatically elicit this correct response from government via interest rate signals. Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus.
So it is clear that the government surplus has two negative effects for the private sector: (a) the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and (b) private disposable income also falls in line with the net taxation impost.
Some may retort that government bond purchases provide the private wealth-holder with cash. That is true but the liquidation of wealth is driven by the shortage of cash in the private sector arising from tax demands exceeding income. The cash from the bond sales pays the Government’s net tax bill. The result is exactly the same when expanding this example by allowing for private income generation and a banking sector.
From the example above, and further recognising that currency plus reserves (the monetary base) plus outstanding government securities constitutes net financial assets of the non-government sector, the fact that the non-government sector is dependent on the government to provide funds for both its desired net savings and payment of taxes to the government becomes a matter of accounting.
This understanding reinforces why the pursuit of government budget surpluses will be contractionary. Pursuing budget surpluses is necessarily equivalent to the pursuit of non-government sector deficits. They are two sides of the same coin.
The decreasing levels of net savings financing the government surplus increasingly leverage the private sector and the deteriorating debt to income ratios will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.
Once we understand the accounting relationships it is easy to reject the argument that budget surpluses represents “public saving”, which can be used to fund future public expenditure. Public surpluses do not create a cache of money that can be spent later. National governments spend by crediting a reserve account in the banking system. The credits do not “come from anywhere”, as, for example, gold coins would have had to come from somewhere. It is accounted for but that is a different issue. Likewise, payments to government reduce reserve balances. Those payments do not “go anywhere” but are merely accounted for.
There is an elaborate institutional structure in place to obsfucate the true nature of these transactions. But in an accounting sense, when there is a budget surplus, then base money and/or private wealth is destroyed. The opposite is the case for budget deficits.
Given that most of us do not knowingly buy government debt, how do our savings end up as the fiscal deficit? We put our savings in banks and pensions funds. But they are just intermediaries: they invest our savings by buying bonds and other securities that pay interest. Some of these bonds will be from private sector companies that want to borrow for investment. But when private companies do not want to invest as much as we, the people, want to save in a given year, then the only alternative is to invest the money in government bonds, ie public debt. The fiscal deficit is just the lending that we make to the government. The fiscal deficit is so high because we are demanding more bonds – that is, we want to save more – than the private sector is willing to invest.
Incidentally, this is not Keynesianism: it’s just accounting, familiar to any macroeconomist.
So after a promising start, Segal gets things a little backwards here.
First, the relationship between the government and non-government balances is just a matter of accounting. But the accounting is just a measure of the underlying behaviour of the various economic sectors.
Further, there multi-directional causality operating between the two sectors. Decisions taken in one sector can generate outcomes in the other sector, and vice versa. So it is not as simple as saying the government supplies debt up to the gap between what the private sector wants to save above the same sector’s willingness to invest.
In an accounting sense, that would be true for a closed economy. The sectoral balances are much simpler in that case.
So total expenditure would be:
GDP = C + I + G
which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), and total government spending (G).
National income (GDP) can be used for:
GDP = C + S + T
which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.
Equating these two perspectives we get:
C + S + T = GDP = C + I + G
So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts:
(I – S) + (G – T) = 0
That is, the two balances have to sum to zero.
(G – T) = (S – I)
The sectoral balances in this case are:
- The Budget Deficit (G – T) – positive if in deficit, negative if in surplus.
- The private domestic balance (S – I) – positive if in surplus, negative if in deficit.
It is clear that for any income (GDP) level, the deficit has to be equal to the excess of saving over investment in the private sector.
The current institutional arrangements imposed on governments by the dominant neo-liberal ideology adopts the so-called government budget constraint (GBC) as the model for handling deficits. The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:
which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
However, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.
So in terms of Modern Monetary Theory, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.
The money base changes every time the government spends because bank reserves rise. But the dominant paradigm argues that this will be inflationary and thus demands that institutional arrangements be set in place so that the governments match the deficits $-for-$ with bond sales. They even go so far in some countries as forcing the government to issue the debt first and then spend out of the account the debt sales accumulate.
All of this is a total smokescreen. But the point is that the change in high powered money (H) will be zero and the change in Bonds (B) will equal (G-T) in any period.
So that is Segal’s contention.
Of-course it leaves out the fact that there is an external sector. In that case the following sectoral balance identity applies:
So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.
(G – T) = (S – I) – (X – M)
where X is total exports and M is total imports and (X – M) is net exports. Please read my blog – Saturday Quiz – June 19, 2010 – answers and discussion – for more discussion on this derivation.
The point is that the deficit now reflects the excess saving of the private domestic sector less net exports. The latter injects aggregate demand into the economy (if positive) while the former (S – I) drains aggregate demand.
If a nation is running an external surplus, then some of its “saving” will be going abroad.
The other point to note relates to causality. The budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved.
Budget Balance = Revenue – Spending = (Tax Revenue + Other Revenue) + (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the budget balance are the so-called automatic stabilisers.
In other words, without any discretionary policy changes, the budget balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the budget balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the budget balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.
Decisions by the non-government sector to increase its saving will reduce aggregate demand and the multiplier effects will reduce GDP. If nothing else happens to offset that development, then the automatic stabilisers will increase the budget deficit (or reduce the budget surplus).
So in that sense, the causality runs from the non-government sector to the government sector.
However, the government may decide to expand its discretionary spending and/or cut taxes. This will add to aggregate demand and increase GDP. The deficit will increase by some amount less than the discretionary policy expansion because the automatic stabilisers will offset that increase to some extent. But the non-government sector will also enjoy the increased income and this allows them to increase total saving.
So the causality in this situation runs from the government sector to the non-government sector (and feeds back again as the automatic stabilisers go to work).
In general, if the private sector desires to increase its saving, the role of the government is to match that to ensure that the income adjustment will not occur – with the concomitant employment losses etc. In that sense, fiscal policy has to be reacting to private spending and saving decisions (once a private-public mix is politically determined).
The fiscal deficit adds to the stock of government debt owed to us, and it is true that we do not want that debt to grow as a proportion of GDP forever. But relative to GDP, the stock of national debt in the UK remains below that of the US, France and Germany. And when the economy starts to recover, the deficit will decline in any case, as investment and tax receipts rise. Household saving will also decline with time from its current high rate: saving rose because we became so indebted during the boom years, running down our savings and buying goods on credit. Having built up so much debt we now want to pay some of it off. But once we have paid off enough of that debt, our saving rate can decline and private spending pick up, further helping reduce the deficit.
This is not the statement a person who really grasped the situation would make. The public debt to GDP levels in France and Germany have no relevance to those in the US and the UK. The monetary systems are different and the capacity of the respective governments to service the debt is fundamentally different.
Further, it makes no sense to even focus on the public debt to GDP ratio. What exactly does it tell us? Answer: Not much. It is the history of the public deficits scaled by the size of the economy. That is all it signals. The more complete understanding comes from analysing what was going on in the real economy to generate those deficits over time.
Were they the manifestation of a government intent on expanding its share in total production and squeezing private spending out as a political strategy?
Were they a sign that private spending was weak and the automatic stabilisers were operating to provide some support for aggregate demand?
Were they are sign of added discretionary fiscal support to failing private demand?
What was happening to employment growth and unemployment?
These are the questions that need to be focused on.
Paul Krugman’s story in the UK Guardian last Friday (June 18, 2010) – The price of economic posturing – captures this point well, although I doubt that Krugman would support my logic to its conclusion if pushed.
German hawk: “We must cut deficits immediately, because we have to deal with the fiscal burden of an ageing population.”
Ugly American: “But that doesn’t make sense. Even if you manage to save 80 billion euros – which you won’t, because the budget cuts will hurt your economy and reduce revenues – the interest payments on that much debt would be less than a tenth of a per cent of your GDP. So the austerity you’re pursuing will threaten economic recovery while doing next to nothing to improve your long-run budget position.”
German hawk: “I won’t try to argue the arithmetic. You have to take into account the market reaction.”
Ugly American: “But how do you know how the market will react? And anyway, why should the market be moved by policies that have almost no impact on the long-run fiscal position?”
German hawk: “You just don’t understand our situation.”
Segal’s other points about how growth is the way forward rather than austerity are well-taken. They are so obvious that you cannot understand why the general populace would tolerate politicians who want to cut government support for their economies at a time when they most need it.
Segal also argued that the austerity programs will drive down aggregate demand and as a consequence “companies … [will] … go bankrupt and workers … [will] … get fired”. He said:
With unemployment already at 8% and GDP well below capacity, this would spell double-dip recession. Ironically, this would lower tax receipts and could make the deficit even worse.
And then the calls for austerity will be even greater. The problem is that these programs are relying if anything on an increase in external competitiveness by internal deflation. It is a grinding way to get any relief and the damage done in the meantime will be very significant and span generations. It is a mindless way of managing the economy.
Segal then tried to make sense of the motivation:
This reveals the underlying reason why politicians on the right really want to reduce the deficit: expenditure cuts today imply tax cuts and smaller government in the long run. And once we see that the fiscal deficit is our saving with the government, it becomes obvious that Cameron and Osborne’s claim that the deficit has us “living beyond our means” is nonsense. Any politician who cares more about public services than tax cuts should be relaxed about a few years of fiscal deficits.
Exactly. The unemployed are not “living beyond their means”. No economy (whichever one you want to choose) is living beyond its means – how could they be when there is such a large output gap present across the world. That output gap manifests as unused machines, idle labour and a huge capacity to increase real output.
The austerity programs will worsen that situation not improve it.
Seabrook said that:
The coming cuts aren’t just austerity measures. They are the Tories’ way of proclaiming the ultimate victory for the free market
when … [David Cameron] … said the effects of his policies would be felt for decades to come, he meant something more than a mere diminution of the structural deficit. He admitted as much – it is a question of seeing what competences can be removed from government and outsourced to private interests.
So the austerity drive is really about reducing the size of government and restoring the “primacy of the market” as the neo-liberals see it.
Today’s detestation of “big government” stems from this same source, and the affection of Cameron and his colleagues for the “big society” is a euphemism for the reduction of public funds in assisting the poor: rolling back the state, leaving the market to distribute its rewards in accordance with the natural order of things … the market mechanism is as flawless a creation as the earth, and should remain untouched by the hand of meddlers, whose only effect is to upset its power to enrich us all … Once more, the state shrinkers, the advocates of vanishing government, the cutters of red tape and regulation, the liberators of a humanity constricted by statist straitjackets, believe they have a mandate for freedom. But it is freedom under the law of an imagined jungle; by a savage irony, at a time when the smoke from the stumps of felled trees in the real jungle darken the horizon of a used-up future.
That seems to be a suitably depressing note to finish on.
The point is that whatever the mainstream economists say the policy agendas they advocate cannot be justified in terms of the financial issues they hide behind – crowding out, inflation, sovereign insolvency etc.
Once you understand the way the monetary system operates their agendas become transparently ideological and intent on redistributing real output to the rich and way from the poor.
They might be clothed in the sophistry of the market and supported by mathematical models but when you distil the arguments down to their essentials you realise they just represent a crude and unsophisticated grab for wealth.