Suppose a 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 private domestic sector deleveraging 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 more than offsets any actual private domestic sector net saving.
In that sense, the government strategy in the question 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.
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 (CAB). 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.
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 and not endanger growth depends on the private domestic sector's spending decisions (overall). If the private domestic sector runs a deficit, then the 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 Table 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.
| Sectoral Balance | Interpretation of Result | Period 1 | Government Plan Succeeds | Private Plan Succeeds |
| External Balance (X - M) | Deficit is negative | -1 | +1 | +1 |
| Fiscal Balance (G - T) | Deficit is positive | +4 | +2 | +4 |
| Private Domestic Balance (S - I) | Deficit is negative | +3 | +3 | +5 |
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.
This is specified as the situation in column 2 'Government Plan'.
But, what happens if the private domestic 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 overall. In other words, they plan to increase net saving to 5 per cent of GDP - the situation captured under the 'Private Plan Succeeds' option.
In this case, if the private domestic sector actually succeeded in reducing its spending and increasing its saving balance overall to 5 per cent of GDP, the income shifts would ensure the government could not realise its planned deficit reduction - the loss of overall spending would generate falling output and employment and falling tax revenue and rising welfare spending by government.
The public and private plans are clearly not compatible and the resolution of their competing objectives would be achieved by national income shifts in response to spending 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 offsett 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 position into deficit.
So the external position has to be sufficiently strong enough to offset the domestic drains on expenditure.
The following blog posts may be of further interest to you:
That is enough for today!
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