Suppose that the government announced it intended to cut its deficit from 4 per cent of GDP to 2 per cent in the coming year and during that year net exports were projected to move from a deficit of 1 per cent of GDP to a surplus of 1 per cent of GDP. If the private domestic sector engaged in debt reduction which resulted in it spending less than it earned to the measure of 5 per cent of GDP, then the fiscal austerity plans will undermine growth even if the net export surplus was realised.
Answer: True
The answer is True.
This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.
From an accounting sense, if the external sector goes into surplus (positive net exports) there is scope for the government balance to move into surplus without compromising growth as long as the external position (injection of spending) more than offsets any actual private domestic sector net saving.
In that sense, the strategy requires net exports adding more to aggregate demand than is destroyed by the government via its fiscal austerity. But it also implicitly assumes the private domestic sector will not undermine the strategy via increased saving overall.
Skip the next section explaining the balances if you are familiar with the derivation. 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:
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.
A simplification is to add (I - S) + (X - M) and call it the non-government sector. 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).
This is also a basic rule derived from the national accounts and has to apply at all times.
If the nation is running an external surplus it means that the contribution to aggregate demand from the external sector is positive - that is net spending injection - providing a boost to domestic production and income generation.
The extent to which this allows the government to reduce its deficit (by the same amount as the run a surplus equal to the external balance and not endanger growth depends on the private domestic sector's spending decisions (overall). If the private domestic sector runs a deficit, then the EU/IMF/ECB strategy will work under the assumed conditions - inasmuch as the goal is to reduce the fiscal deficit without compromising growth.
But this strategy would be unsustainable as it would require the private domestic sector overall to continually increase its indebtedness.
The following graph captures what might happen if the private domestic sector (households and firms) seeks to increase its overall saving at the same time the net exports are rising and the government deficit is falling.
In Period 1, there is an external deficit of 1 per cent of GDP and a fiscal deficit of 4 per cent of GDP which generates income sufficient to allow the private domestic sector to save 3 per cent of GDP.
The Government plans to cut its deficit to 2 per cent of GDP by cutting spending. To achieve that at the same time that net exports is rising to 1 per cent of GDP then the government would be implicitly assuming that the private domestic sector would not change its saving behaviour overall.
However, what happens if the private sector, fearing the contractionary forces coming from the announced cuts in public spending and not really being in a position to assess what might happen to net exports over the coming period, decides to increase its saving. In other words, they plan to increase net saving to 5 per cent of GDP - the situation captured under the Private Plan option.
In this case, if the private sector actually succeeded in reducing its spending and increasing its saving balance to 5 per cent of GDP, the income shifts would ensure the government could not realise its planned deficit reduction.
The public and private plans are clearly not compatible and the resolution of their competing objectives would be achieved by income shifts.
In other words, as the private sector and the public sector reduced their spending in pursuit of their plans, income would contract even though net exports were rising.
The situation is that unless private sector behaviour remains constant the government cannot rely on an increase in net exports to provide the space for them to cut their own net spending.
So in general, with the government contracting the only way the private domestic sector could successfully increase its net saving is if the injection from the external sector offset the drain from the domestic sector (public and private). Otherwise, income will decline and both the government and private domestic sector will find it difficult to reduce their net spending positions.
Take a balanced fiscal position, then income will decline unless the private domestic sector's saving overall is just equal to the external surplus. If the private domestic sector tried to push its position further into surplus then the following story might unfold.
Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.
The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract - output, employment and income all fall.
The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.
The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.
So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.
The decline in income then stifles firms' investment plans - they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus
With the economy in decline, tax revenue falls and welfare payments rise which push the public fiscal balance towards and eventually into deficit via the automatic stabilisers.
If the private sector persists in trying to increase its saving ratio then the contracting income will clearly push the fiscal balance into deficit.
So the external position has to be sufficiently strong enough to offset the domestic drains on expenditure. For Greece at present that is clearly not the case and demonstrates why the EU/ECB/IMF strategy is failing.
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