Deficit hysteria is alive and well in the United States as calls grow to slash spending and return the budget to a “sustainable” position.
Today I am going to ask what may seem like a very obvious question: should the US quickly balance its budget or even return it to surplus?
Of course it should, many would say. The US is living beyond its means and like a household that is spending more than it takes in, if they don’t tighten their belt soon, they are going to go broke.
Or so the argument goes. But is it really so simple?
Sectoral Balances 101
I have written before on this blog about the idea of sectoral balances (as has my fellow blogger Delusional Economics). As you may recall, this is a basic accounting identity which states that in any economy over a fixed period of time, the following must hold true:
Private Sector Balance + Government Sector Balance – Current Account Balance = 0
- The private sector balance is the excess of savings over expenditure for businesses and households.
- The government sector balance is government tax revenues less spending.
- And the current account balance is (in simplified terms) a country’s exports less its imports.
The chart below (thanks to Pragmatic Capitalism) show the evolution of these three balances over time for the United States. What you can see is that the green line plus the red line minus the blue line will always sum to zero.
What immediately stands out here is the massive increase in the private sector surplus (green line) since 2007. This represents the massive private sector deleveraging that has taken place since the crisis hit. Basically, the private sector has been cutting spending, raising their savings, and paying down debt (or defaulting on it). And as you can see, this deleveraging process has necessarily been offset by a huge increase in the government deficit (red line).
Now, if your eyes haven’t glazed over yet from all the maths, let’s address the big question.
What would happen if President Obama decided to immediately return the budget to surplus and start paying off the public debt? One or both of the following would automatically have to happen to compensate:
- A: The private sector balance returns to a deficit. In other words, businesses and households start leveraging up again and taking on more debt, possibly sowing the seeds for an even bigger private debt crisis down the road.
- B: The trade balance returns to a surplus. How would this happen? Most likely, a combination of a big depreciation in the US dollar and massive deflation and unemployment, which would reduce the relative cost of US goods in global markets.
Almost none of the politicians that you hear hyperventilating about the deficit every day are aware of this, which is why you constantly hear nonsensical statements to the effect that cutting government spending will restore confidence and boost the economy. The UK is currently finding out the hard way that life is not so simple.
The reality, as we saw above, is that returning the US budget to surplus now would either disrupt the necessary process of private deleveraging (which still has a long way to go) or it will result in a contraction of the trade deficit via higher unemployment and a “debasement” of the dollar. (or some combination of all these factors).
Now, what cannot be emphasized enough here is that this is not just a matter of opinion.
It is basic arithmetic that follows from the accounting identity of sectoral balances. If you insist we need a balanced budget right now, you have to explain why you think options A or B above are preferable to running budget deficits while the economy is getting back onto its feet.
In other words, there are no easy solutions.
Is Default Inevitable?
OK, some may say. The two scenarios above are unpleasant, but if we keep running huge government deficits, isn’t the US is going to end up defaulting on its debt, or hurtling towards hyperinflation?
A few quick points here are in order.
Firstly, as I have argued before on this blog, there is a big difference in the financial constraints faced by households and those faced by sovereign nations like the US .
Unlike Greece, which is constrained by its membership of the euro zone, The US is the monopoly issuer of its own currency. This means that it cannot default on US dollar denominated debt (if it did so, this would be purely a political decision, not a financial necessity).
Does this mean they can keep on “printing money” forever and running huge deficits without consequence? Not at all. When the economy has fully recovered, when capacity utilisation is much higher and when most or all of the unemployed have found jobs, continued government deficits could lead to high inflation and a falling currency.
Right now, with unemployment at around 9%, we are a very long way from that situation.
However, here is where I will make some concession to the fiscal austerity crowd. A large portion of the current deficit is simply caused by the collapse in tax revenues triggered by the recent crisis. That cyclical portion of the deficit is not a great concern since it will take care of itself as the economy recovers.
But soaring spending on entitlements (primarily health care) means that even when the economy has fully recovered, we could be left with fairly hefty deficits. (the US spends about 15% of its GDP on health care, around twice as much as most other developed nations)
There is absolutely nothing wrong with running large fiscal deficits when it is required (when the private sector desires to net save), but if there is no political will or flexibility to raise taxes or cut spending when the economy has returned to full capacity, we are going to run into problems.
Furthermore, regardless of the logic above, it is clear that with the rise of the Tea Party and austerian Republicans, there are increasing political constraints on deficit spending.
Regardless of which economic school you subscribe to, we should all be able to agree that it’s simply not politically sustainable for the US to run deficits of 10% of GDP for too much longer.
So what’s the solution in the longer term?
The answer can be found in the sectoral balances equation and chart above. But that will be the subject of my next post.
Note: Anybody interested in further reading on the sectoral balances approach (which is a key component of so-called Modern Monetary Theory), I would encourage to check out the posts on Pragmatic Capitalism, Billy Blog, or Warren Mosler‘s site.