If private households and firms decide to lift their saving ratio the national government has to increase its net spending (deficit) to fill the spending gap or else economic activity will slow down.
Answer: False
The answer is False.
Please refer to the conceptual explanations in Question 1.
To help us answer the specific question posed, we can identify three states all involving public and external deficits:
When the private domestic sector (that is, households and firms) decide to lift their overall saving ratio, we normally think of this in terms of households reducing consumption spending or firms reducing investment.
The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.
The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.
Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms layoff workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.
At that point, the economy is heading for a recession. Interestingly, the attempts by households overall to increase their saving ratio may be thwarted because income losses cause loss of saving in aggregate - the is the Paradox of Thrift. While one household can easily increase its saving ratio through discipline, if all households try to do that then they will fail. This is an important statement about why macroeconomics is a separate field of study.
Typically, the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur - in the form of an expanding public deficit or an offsetting increase in net exports.
The budget position of the government would be heading towards, into or into a larger deficit depending on the starting position as a result of the automatic stabilisers anyway.
If there are not other changes in the economy, the answer would be true. However, there is also an external sector. It is possible that at the same time that the households are reducing their consumption as an attempt to lift the saving ratio, net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).
So it is possible that the public budget balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.
The important point is that the three sectors add to demand in their own ways. Total GDP and employment are dependent on aggregate demand. Variations in aggregate demand thus cause variations in output (GDP), incomes and employment. But a variation in spending in one sector can be made up via offsetting changes in the other sectors.
The following blogs may be of further interest to you:
Question 5 - Premium question
In Year 1, the economy plunges into recession with nominal GDP growth falling to minus -1 per cent. The inflation rate is subdued at 2 per cent per annum. The outstanding public debt is equal to the value of the nominal GDP and the nominal interest rate is equal to 2 per cent (and this is the rate the government pays on all outstanding debt). The government's budget balance net of interest payments goes into deficit equivalent to 1 per cent of GDP and the debt ratio rises by 4 per cent. In Year 2, the government stimulates the economy and pushes the primary budget deficit out to 4 per cent of GDP in recognition of the severity of the recession. In doing so it stimulates aggregate demand and the economy records a 4 per cent nominal GDP growth rate. The central bank holds the nominal interest rate constant but inflation falls to 1 per cent given the slack nature of the economy the previous year. Under these circumstances, the public debt ratio falls even though the budget deficit has risen because of the real growth in the economy.
The answer is False.
This question requires you to understand the key parameters and relationships that determine the dynamics of the public debt ratio. An understanding of these relationships allows you to debunk statements that are made by those who think fiscal austerity will allow a government to reduce its public debt ratio.
While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.
The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.
Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.
Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.
It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.
Mainstream economics starts with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be "financed" in two ways: (a) by borrowing from the public; and/or (b) by "printing money".
Neither characterisation is remotely representative of what happens in the real world in terms of the operations that define transactions between the government and non-government sector.
Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
However, the mainstream framework for analysing these so-called "financing" choices is called the government budget constraint (GBC). 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 MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.
But for the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
Further, in mainstream economics, money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money.
This is called debt monetisation and you can find out why this is typically not a viable option for a central bank by reading the Deficits 101 suite - Deficit spending 101 - Part 1 - Deficit spending 101 - Part 2 - Deficit spending 101 - Part 3.
The mainstream view claims that if governments increase the money growth rate (they erroneously call this "printing money") the extra spending will cause accelerating inflation because there will be "too much money chasing too few goods"! Of-course, we know that proposition to be generally preposterous because economies that are constrained by deficient demand (defined as demand below the full employment level) respond to nominal demand increases by expanding real output rather than prices. There is an extensive literature pointing to this result.
So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases.
But not to be daunted by the "facts", the mainstream claim that because inflation is inevitable if "printing money" occurs, it is unwise to use this option to "finance" net public spending.
Hence they say as a better (but still poor) solution, governments should use debt issuance to "finance" their deficits. Thy also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be "paid back".
Neither proposition bears scrutiny - you can read these blogs - Will we really pay higher taxes? and Will we really pay higher interest rates? - for further discussion on these points.
The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to "prove" that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt.
A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the real GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
The real interest rate is the difference between the nominal interest rate and the inflation rate. Real GDP is the nominal GDP deflated by the inflation rate. So the real GDP growth rate is equal to the Nominal GDP growth minus the inflation rate.
This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.
MMT does not tell us that a currency-issuing government running a deficit can never reduce the debt ratio. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time.
Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.
But if growth is not sufficient then the public debt ratio can rise.
Here is why that is the case.
While a growing economy can absorb more debt and keep the debt ratio constant or falling an increasing real interest rate also means that interest payments on the outstanding stock of debt rise.
From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r - g.
The following Table simulates the two years in question. To make matters simple, assume a public debt ratio at the start of the Year 1 of 100 per cent (so B/Y(-1) = 1) which is equivalent to the statement that "outstanding public debt is equal to the value of the nominal GDP".
In Year 1, the nominal interest rate is 2 per cent and the inflation rate is 2 per cent then the current real interest rate (r) is 0 per cent.
If the nominal GDP grows at -1 per cent and there is an inflation rate of 2 per cent then real GDP is growing (g) at minus 3 per cent.
Under these conditions, the primary budget surplus would have to be equal to 3 per cent of GDP to stabilise the debt ratio (check it for yourself).
In Year 1, the primary budget deficit is actually 1 per cent of GDP so we know by computation that the public debt ratio rises by 4 per cent.
The calculation (using the formula in the Table) is:
Change in B/Y = (0 - (-3))*1 + 1 = 4 per cent.
The situation gets more complex in Year 2 because the inflation rate falls to 1 per cent while the central bank holds the nominal interest rate constant at 2 per cent. So the real interest rate rises to 1 per cent.
The data in Year 2 is given in the last column in the Table below. Note the public debt ratio at the beginning of the period has risen to 1.04 because of the rise from last year.
You are told that the budget deficit rises to 4 per cent of GDP and nominal GDP growth shoots up to 4 per cent which means real GDP growth (given the inflation rate) is equal to 3 per cent.
The corresponding calculation for the change in the public debt ratio is:
Change in B/Y = (1 - 3)*1.04 + 5 = 1.9 per cent.
That is, the public debt ratio rises but at a slower rate than in the last year. The real growth in the economy has been beneficial and if maintained would start to eat into the primary budget balance (via the rising tax revenues that would occur).
In a few years, the growth would not only reduce the primary budget deficit but the public debt ratio would start to decline as well.
So when the budget deficit is a large percentage of GDP then it might take some years to start reducing the public debt ratio as GDP growth ensures.
The best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn't have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves.
The discussion also demonstrates why a falling inflation rate makes it harder for the government to reduce the public debt ratio - which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.