Posted: February 16, 2005

Macroeconomic illiteracy rules!

The headline in the Sydney Morning Herald report Greenspan feels heat on deficits and savings by Craig Torres and Alison Fitzgerald, published February 16, 2005 once again proves that the rudiments of macroeconomics are poorly understood by the financial reporters. The report says that "The US Federal Reserve chairman Alan Greenspan faces questions from Congress this week on the record budget and trade deficits and social security. Chances are there will be less talk about the common issue behind each of those problems: the need to boost US savings."

Now the thrust of the questioning will be on how the US Government should be aiming to "to reduce the federal deficit, the biggest drain on total domestic savings." Excuse me! Yes, you read it right. The budget deficit is alleged to be the biggest drain on total domestic savings. I guess you don't have to understand macroeconomics and the basic accounting that underlines the national accounts to be a financial reporter. It would be better though that they did because then we would not see so much disinformation pushed into the public domain.

The report argues that at the same time as the US Treasury is increasing the budget deficit, "the Fed's recession-fighting low-interest-rate policies helped drive down household savings in 2004 to the lowest level since the Great Depression, analysts say." Which analysts? First, the low interest rate policies are independent of the so-called 'record' deficits, so we should at least be clear on what we are implicating in the falling household savings.

Second, and more importantly, a federal budget deficit provides the net financial assets to underpin private sector savings. Budget surpluses drain private savings. Exactly the opposite to what is being conceived here. A simple example helps reinforce these points (taken from a paper I wrote with Warren Mosler - download Here). Suppose the economy is populated by two people, one being government and the other deemed to be the private sector. If the government spends 100 dollars and taxes 100 dollars (balanced budget) then private accumulation of fiat currency (savings) is zero in that period and the private budget is balanced. Say the government spends 120 and taxes remain at 100, then private saving is 20 dollars which can accumulate as financial assets (in this case, 20 dollar notes although to encourage saving the government may decide to issue an interest-bearing bond). The government deficit of 20 is exactly the private savings of 20. Now if government continued in this vein, accumulated private savings would equal the cumulative budget deficits. However, should government decide to run a surplus (say spend 80 and tax 100) then the private sector would owe the government a net tax payment of 20 dollars. The government may agree to buy back some bonds it had previously sold. Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus. The government surplus has two negative effects for the private sector: (a) the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and (b) private disposable income also falls in line with the net taxation impost. Some may retort that government bond purchases provide the private wealth-holder with cash. That is true but the liquidation of wealth is driven by the shortage of cash in the private sector arising from tax demands exceeding income. The cash from the bond sales pays the Government's net tax bill. The result is exactly the same when expanding this example by allowing for private income generation and a banking sector.

The US economy needs larger deficits to sustain growth and to underpin the private credit structure such that households can in aggregate save. When the federal government runs a surplus, the only way the economy can grow is if the private sector becomes increasingly indebted. The authors quote a 'senior' financial economist from a large investment bank in New York: "Greenspan is trying to walk a tightrope ... He doesn't want to declare that consumption needs to slow down, because that puts the economy at risk ... [at the same time] ... the low savings rate may be the most critical variable that needs to be corrected." Exactly correct. But the solution is to use the budget deficit to maintain aggregate spending as households render their balance sheets more robust (increase savings and reduce consumption) and inject the necessary net financial assets into the economy to underpin this financial consolidation. If households attempt to increase their saving in an environment accompanied by fiscal drag (budget surpluses) then a nose-dive in output and high unemployment will soon follow.

Meanwhile, Bloomberg reports that Japan has gone back into recession because consumer spending has declined and net exports have stalled. GDP has now declined for three consecutive quarters. The report said that "Higher taxes and falling wages may further damp consumer spending" and extraordinarily, the Finance Minister Sadakazu Tanigaki is quoted as saying that "the contraction won't change plans for spending cuts and tax increases to curb the world's largest public debt." Spare the thought. The only thing that has kept the Japanese economy from collapsing completely has been the willingness of the Government to run large deficits. Not large enough though. It is beyond belief that they would anticipate a neo-liberal budget contraction.

Blog entry posted by bill