I read an article in the Financial Times earlier this week (September 23, 2023) -…
Overnight a kind soul (thanks M) sent me the latest Goldman Sachs US Economist Analysis (Issue 10/27, July 9, 2010) written by their chief economist Jan Hatzius. Unfortunately it is a subscription-based document and so I cannot link to it. It presents a very interesting analysis of the current situation in the US economy, using the sectoral balances framework, which is often deployed in Modern Monetary Theory (MMT). While it relates to the US economy, the principles established apply to any sovereign nation (in the currency sense) and demonstrate that some of the top players in the financial markets have a good understanding of the essentials of MMT. But the bottom line of the paper is that the US is likely to have to endure on-going and massive employment gaps (below potential) for years because the US government is failing to exercise leadership. The paper recognises the need for an expansion of fiscal policy of at least 3 per cent of GDP but concludes that the ill-informed US public (about deficits) are allowing the deficit terrorists to bully the politicians into cutting the deficit. The costs of this folly will be enormous.
The GS briefing is entitled – Why Is the Economy So Weak? What Can Policy Do? and examines:
… two of the most basic questions about the economic outlook in the context of a “financial balances” framework. First, why have US growth and employment been so weak since 2007? And second, what can policymakers do about it?
They begin by emphasising the “unprecedented jobs shortfall”. So for those who consider that employment should not be a central concern of the policy debate or that Americans do not think employment is an issue at present at least the economists at GS would disagree.
By motivating their discussion with a very scary presentation on how far the US labour market is from its past performance levels in terms of employment growth, the GS economists are clearly indicating that they consider the lack of jobs to be a central policy issue.
They present this graph (reproduced from their paper) to show the jobs shortfall.
The graph shows:
… the extent to which the recent recession and its aftermath have diverged from postwar experience by plotting the level of nonfarm payroll employment against prior postwar cycles, starting from the peak of the business cycle (i.e. the start of the recession). Relative to the start of the recession, the level of employment payrolls is now about 8% lower than in the median cycle of the 1954-1982 period. Scaled to the current level of the labor force, this is a shortfall of roughly 10 million jobs.
So when you read about the historically high budget deficits (as if they matter per se. Not!) the magnitudes involved shouldn’t surprise you given how great the plunge in employment has been in the US in this recession.
As the GS paper says – there is an unprecedented jobs shortfall.
The latter takes taxpayers out of the picture and via the automatic stabilisers drives the deficit up. The real problem is the employment shortfall which is stark and reflects a monumental failure of policy.
They note that this has been an “unusually deep recession and an unusually weak recovery”, which have combined to create this unprecendented jobs gap. In saying this they reject the views of many mainstream economists who believed that there would be a V-shaped recovery even without government fiscal support. Implied, is a rejection of austerity approaches which are now gaining favour among policy makers across the world.
The GS paper says:
The sheer size of this gap suggests strongly that the cycle is fundamentally different from its postwar predecessors … at the most basic level, we view the distinguishing feature of the current cycle as a collective attempt by the different sectors of the economy-households, firms, governments, and the rest of the world-to reduce their debt loads by pushing spending below income. This does not mean that every sector is trying to run a surplus – as is well known, the US federal government is currently running a large deficit and planning to do so for many years. But it means that those sectors that are running deficits are moving less aggressively than those that are running surpluses. This implies a demand shortfall for the economy as a whole.
This is a very meaningful statement. It draws on the sectoral balances framework and interprets outcomes within that framework to the state of aggregate demand (spending) overall.
To refresh your memory (again, sorry! – skip through this if you know it by heart), the balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.
From the sources perspective we write:
GDP = C + I + G + (X – M)
which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).
From the uses perspective, 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 + (X – M)
So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.
(I – S) + (G – T) + (X – M) = 0
That is the three balances have to sum to zero. The sectoral balances derived are:
- The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
- The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
- The Current Account balance (X – M) – positive if in surplus, negative if in deficit.
These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.
This is also a basic rule derived from the national accounts and has to apply at all times.
The GS Paper says that:
Since the three sectors constitute a closed system, one sector’s borrowing must always be another sector’s lending. Hence, the three sectoral balances must sum
to zero …
private balance + public balance = CA balance.
So they are writing the identity as (S – I) + (T – G) = (X – M). It doesn’t matter how you express it as long as you know what a deficit or surplus balance means.
From my derivation, we can also simplify the balances by adding (I – S) + (X – M) to get the non-government sector balance. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances).
So when the government runs a surplus, the non-government sector has to be in deficit and vice-versa. There are distributional possibilities between the foreign and domestic components of the non-government sector but overall that sector’s outcome is the mirror image of the government balance.
To say that the government sector should be in surplus is to also aspire for the non-government sector to be in deficit. if the foreign sector is in deficit the national accounting relations mean that a government surplus will always be reflected in a private domestic deficit.
In many nations, the pursuit of government surpluses squeezed the private domestic sector of liquidity. This proved to be an non-viable growth strategy because the private sector (which always faces a financing constraint) cannot run on-going deficits. Ultimately, the fiscal drag coming from the budget surpluses (structural or otherwise) forces the economy into recession (as private sector agents restructure their balance sheets by saving again).
At that point, the budget will typically move back in deficit via automatic stabilisers (if the external balance is is deficit).
Further, given the non-government sector will typically desire to net save overall in the currency of issue, a sovereign government has to run deficits more or less on a continuous basis. The size of those deficts will relate back to the pursuit of public purpose.
But you can see how an aggregate demand shortfall can occur. The government deficit has to be sufficient to support the desired non-goverment surplus.
Given that the sectoral balances are an accounting statement and they have to sum to zero at all times what sense is there to the statement that the government deficit might be insufficient to support the desired non-goverment surplus?
To answer this query we use the distinction between ex post (after the fact) outcomes and ex ante (desired or planned outcomes). This distinction is commonly used by economists.
As the GS paper notes the sectoral balances “must always hold ex post as a matter of accounting” but “need not hold ex ante”. So:
… it is quite possible for different sectors to pursue spending plans that are mutually inconsistent with one another, and such inconsistencies can keep aggregate demand away from the economy’s supply potential. In general, if all sectors taken together aim to run a financial deficit – i.e. want to spend more than their expected income and want to finance the difference by borrowing – the economy will tend to overheat. Conversely, if all sectors taken together aim to run a financial surplus – i.e. want to spend less than their expected income and use the difference to pay down debt – the economy will tend to operate below potential.
So our desires or plans motivate behaviour which then manifests as spending decisions and outcomes. Ultimately, once these decisions are implemented the sectoral balances accounting will generate the ex post zero sum of the balances. But this outcome doesn’t have to deliver desirable economic outcomes and some sectors may be unable to achieve their desired outcomes because of income adjustments in response to aggregate demand variations.
Thus, if there is a current account deficit, and both the government and private domestic sectors implement plans to generate surpluses there will be shortfall in aggregate demand which will generate cuts in output and income. These income shifts drive the budget towards or into deficit and stifle the private sector plans to save. So eventually the actual balances add to zero but neither the government or the domestic private sector will be achieving their plans.
That is the difference between the ex post and ex ante perspectives. The latter tells you about the behavioural motivations and direction of spending while the former tells you what happens after the income adjustments have taken place.
The following graph shows the ex post sectoral balances for the US and is reproduced from the GS Report (Exhibit 2). The chart carried the title “Private Sector Surplus Offsets Public Sector Deficit”:
The dramatic reversal in the private balance (into surplus) reflects the reaction to the private debt-binge in the period leading up to the crisis. During that period the mainstream economists were all applauding the “financialisation” of the economy and declared the business cycle was dead. Please see my blog – The Great Moderation myth – for an account of this failing.
But the collapse in aggregate demand which has generated the “unprecendented jobs shortfall” was brought about by the private desire to reduce their debt-exposed positions. The only way that can occur is for the sector is to shift back into surplus overall and start paying down the debt in net terms.
The GS paper says:
… the current configuration of the three balances. As of the first quarter of 20 I0, the private sector was running a 7% of GDP surplus, the public sector a 10% of GDP deficit, and the rest of the world a 3% of GDP surplus vis-a-vis the United States.
You can also see the Clinton surpluses were only made possible by the growth generated by the private sector going into significant deficit (which also pushed the current account further into deficit). The automatic stabilisers in the early Bush years wiped out those surpluses very quickly as the US economy went into recession.
The GS paper then considers the future. For simplicity, they “assume that the current account is fixed at a deficit of 3% of GDP”. They then invoke politicial (not financial) constraints on the size of the public deficit. They say:
we assume that the public is uncomfortable Congress believes that the public is uncomfortable – whenever the general government deficit is above 7% of GDP. While larger deficits are possible for short periods of time, Congress ultimately responds to them by cutting spending and/or raising taxes. The precise number is obviously arbitrary, but we do believe that there is a level of government deficits beyond which the political demands for retrenchment become difficult to resist.
So note they are not invoking a financial argument here. They realise that a sovereign government such as the US is never revenue constrained because it is the monopoly issuer of the currency.
These political constraints are reinforced daily by the relentless media attack on the deficits.
While the opinion polls suggest people don’t like deficits I think if there was a poll asking people to define a deficit correctly there would be an inverse result. Most people I talk to of lay status do not understand what a deficit is although they are not short of an opinion about them.
I see a major role for progressive leadership in this regard. The conservative think tanks are expert at scaring the britches of everyone knowing that the trouserless haven’t much idea of what they are scared of. The progressive side of the debate has fallen down badly in countering the mis-information both because it lacks financial support of the likes of Peter G. Peterson and because most progressives do not understand how the monetary system operates anyway.
But a political constraint is something that can be removed over time by appropriate education and activism. That is the challenge on our side of the debate. We are losing badly though.
Anyway, putting the two assumptions together (3 per cent external deficit and 7 per cent budget deficit), the GS paper concludes that:
These assumptions imply that the private sector cannot aim to run a financial surplus of more than 4% of GDP without sapping aggregate demand. This is a serious problem because our analysis a few weeks ago concluded that the private sector may target a financial surplus of significantly more than 4% of GDP for the next few years in order to reduce its debt burden at an acceptable pace.
The GS paper predicts that the private surplus will have to be around 7 per cent of GDP for several years, that is, “large surpluses are likely to be necessary in order to bring the private debt/GDP ratio back to historically more normal levels.”
You can then do the sums. If the private sector continues to push towards this overall desired surplus and the political situation forces the US government to contract their fiscal position, then on an ex ante basis there will be a shortfall of spending and income by at least 3 per cent. The GS paper concludes that:
This demand shortfall saps production, and consequently the income from production. As a result, private sector income is lower than expected, which pushes the private sector balance below 7% of GDP (i.e. to a “looser” position than desired by the private sector) unless there is a further downward adjustment in private sector spending. Moreover, lower private sector income implies lower tax revenues, which has a similar impact on the government balance and could trigger further austerity moves by Congress. Ultimately, this adverse feedback loop doesn’t end until someone accepts a smaller surplus or a larger deficit.
In other words, the political constraint that the US government has accepted after all the goading of the deficit terrorists not only damages the private sector (leaving it more indebted than it desires to be) but also creates bad deficits and an even larger jobs shortfall.
An education campaign is required by governments around the world to elucidate their constituencies about the damage that the terrorists are causing.
The other point is that the deficit rises anyway – and you have only dread to show for it.
The GS paper then asks “What can policymakers do?” They conclude that:
In the context of the financial balances framework, the most straightforward response is to boost aggregate demand by targeting a government deficit of at least 10% of GDP – indeed, a bigger target would be better because a period of sharply above – trend growth would be highly desirable to fill in the economy’s large output gap.
For aggregate output to be sold, total spending must equal the total income generated in production (whether actual income generated in production is fully spent or not in each period).
Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal.
As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment.
MMT then concludes that mass unemployment occurs when net government spending is too low.
To recap: The purpose of State Money is to facilitate the movement of real goods and services from the non-government (largely private) sector to the government (public) domain.
Government achieves this transfer by first levying a tax, which creates a notional demand for its currency of issue.
To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed.
The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.
This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets).
It is also clear that if the Government doesn’t spend enough to cover taxes and the non-government sector’s desire to save the manifestation of this deficiency will be unemployment.
Keynesians have used the term demand-deficient unemployment. In MMT, the basis of this deficiency is at all times inadequate net government spending, given the private spending (saving) decisions in force at any particular time.
Shift in private spending certainly lead to job losses but the persistent of these job losses is all down to inadequate net government spending.
Thus, 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).
If 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.
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).
Please read my blog – Deficits are our saving – for more discussion on this point.
The GS paper argues that:
The main objection to such a policy is that higher public deficits raise the risks of a public debt crisis of confidence. Our own view is that these risks have been exaggerated, at least in the case of the United States. Public debt and especially public debt service are still at moderate levels, and the bond market is showing few signs of discomfort with the US fiscal outlook. Moreover, as a practical matter it is in any case difficult to avoid large deficits as long as the private sector is retrenching and the current account is in deficit. As already noted, this saps revenue growth. So it is better to accept the need for these deficits on an ex ante basis since, to a large extent, they will happen ex post anyway.
In other words, there is no solvency risk. There will be budget deficits anyway. And it is better to fill the spending gap and generate employment growth.
The conservatives and the deficit terrorists simply fail to comprehend the points being made here. They think that the government can reduce debt by running surpluses at the same time the private sector is reducing debt by running surpluses in an environment where the external balance is in deficit. Those desired aims are impossible to achieve.
If the respective sectors try to enforce these aims, the income adjustments will be severely negative and the ex post outcomes will negate the intended outcomes.
Why the US government is not running coast-to-coast advertisements about this is beyond me.
The GS paper says that the current situation is that policy that “may be sensible economically but unrealistic politically” is being hindered. They conclude that:
The upshot of our discussion: given the forces of retrenchment and balance sheet repair, the risks to the growth of aggregate demand-as well as risk-free interest rates—over the medium term are tilted to the downside. Policymakers can provide some relief, but realistically will find it hard to neutralize the headwinds altogether. Thus, the risks to growth over the medium term are clearly tilted to the downside.
So we have a situation where the US is likely to have to endure on-going and massive employment gaps (below potential) for years because the US government is failing to exercise leadership.
It is clear that there is an urgent need for an expansion of fiscal policy of at least 3 per cent of GDP. But given the appalling state of politics in the US that is unlikely to happen.
So the US public is going to suffer for their ignorance at the hands of those who will continue making money and accumulating wealth but who are most vocal in the call for fiscal austerity.
In some future time, we will be invaded by another planet and they will conclude we were a really stupid race of people.
That is enough for today!