If there is an external deficit of 2 per cent of GDP and the government balances its fiscal position then private capital formation
Answer: Will outstrip private domestic saving by a margin equal to 2 per cent of GDP.
The correct answer is Option (a) - "will outstrip private domestic saving by a margin equal to 2 per cent of GDP".
This is a question about the sectoral balances - the government fiscal balance, the external balance and the private domestic balance - that have to always add to zero because they are derived as an accounting identity from the national accounts. The balances reflect the underlying economic behaviour in each sector which is interdependent - given this is a macroeconomic system we are considering.
To refresh your memory the sectoral 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).
Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.
We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).
Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).
Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):
(2) GNP = C + I + G + (X - M) + FNI
To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:
(3) GNP - T = C + I + G + (X - M) + FNI - T
Now we can collect the terms by arranging them according to the three sectoral balances:
(4) (GNP - C - T) - I = (G - T) + (X - M + FNI)
The the terms in Expression (4) are relatively easy to understand now.
The term (GNP - C - T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.
The left-hand side of Equation (4), (GNP - C - T) - I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP - C - T).
In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.
The term (G - T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.
Finally, the other right-hand side term (X - M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.
In English we could say that:
The private financial balance equals the sum of the government financial balance plus the current account balance.
We can re-write Expression (6) in this way to get the sectoral balances equation:
(5) (S - I) = (G - T) + CAB
which is interpreted as meaning that government sector deficits (G - T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector.
Conversely, government surpluses (G - T < 0) and current account deficits (CAB < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.
Expression (5) can also be written as:
(6) [(S - I) - CAB] = (G - T)
where the term on the left-hand side [(S - I) - CAB] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.
This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).
The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)) plus net income transfers.
All these relationships (equations) hold as a matter of accounting and not matters of opinion.
In this case, private capital formation is investment (I) and private domestic saving is S.
The following table lets you see the evolution of the balances expressed in terms of percent of GDP. I have held the external deficit constant at 2 per cent of GDP across 6 periods, each demarcated by a different fiscal outcome.
| Sectoral Balance | Interpretation of Result | Period 1 | Period 2 | Period 3 | Period 4 | Period 5 | Period 6 |
| External Balance (X - M) | Deficit is negative | -2 | -2 | -2 | -2 | -2 | -2 |
| Fiscal Balance (G - T) | Deficit is positive | -1 | 0 | 1 | 2 | 3 | 4 |
| Private Domestic Balance (S - I) | Deficit is negative | -3 | -2 | -1 | 0 | 1 | 2 |
If we assume these Periods are average positions over the course of each business cycle (that is, Period 1 is a separate business cycle to Period 2 etc).
In Period 1, there is an external deficit (2 per cent of GDP), a fiscal surplus of 1 per cent of GDP and the private sector is in deficit (S < I) to the tune of 3 per cent of GDP.
In Period 2, as the government fiscal situation enters balance (presumably the government increased spending or cut taxes or the automatic stabilisers were working), the private domestic deficit narrows and now equals the external deficit. This is the case that the question is referring to.
So this is the situation described in the Question which means that the private sector is running an overall deficit - so incurring an "excess of spending over its income overall equal to 2 per cent of GDP".
This provides another important rule with the deficit terorists typically overlook - that if a nation records an average external deficit over the course of the business cycle (peak to peak) and you succeed in balancing the public fiscal balance then the private domestic sector will be in deficit equal to the external deficit. That means, the private sector is increasingly building debt to fund its "excess expenditure". That conclusion is inevitable when the government runs a fiscal balance of zero with an external deficit. It could never be a viable fiscal rule.
In Periods 3 and 4, the fiscal deficit rises from balance to 1 to 2 per cent of GDP and the private domestic balance moves towards surplus. At the end of Period 4, the private sector is spending as much as they earning.
Periods 5 and 6 show the benefits of fiscal deficits when there is an external deficit. The private sector now is able to generate surpluses overall (that is, save as a sector) as a result of the public deficit.
So what is the economics that underpin these different situations?
If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative - that is net drain of spending - dragging output down.
The external deficit also means that foreigners are increasing financial claims denominated in the local currency. Given that exports represent a real cost and imports a real benefit, the motivation for a nation running a net exports surplus (the exporting nation in this case) must be to accumulate financial claims (assets) denominated in the currency of the nation running the external deficit.
A fiscal surplus also means the government is spending less than it is "earning" and that puts a drag on aggregate demand and constrains the ability of the economy to grow.
In these circumstances, for income to be stable, the private domestic sector has to spend more than they earn.
You can see this by going back to the aggregate demand relations above. For those who like simple algebra we can manipulate the aggregate demand model to see this more clearly.
Y = GDP = C + I + G + (X - M)
which says that the total national income (Y or GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X - M).
So if the G is spending less than it is "earning" and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income.
Only when the government fiscal deficit supports aggregate demand at income levels which permit the private sector to save out of that income will the latter achieve its desired outcome. At this point, income and employment growth are maximised and private debt levels will be stable.
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