Should the US balance its budget?

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.

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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.

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Comments

  1. The problems of economies such as the US and Australia are much more deeply embedded than this MMT stuff allows. For one thing this is not a normal cyclical recession. Generally in MMT, as RA assumes here, the External Account is regarded as an infinite and free source of money. It isn’t.
    RA makes more concession to this fact more than other MMT theorists but the idea ‘Oh well! We’ll fix the external account when the economy is hunky-dory’ is a flawed notion. It assumes firstly that the rest of the world will continue to accept whatever amount of your currency you decide to print without either devaluing it or demanding a higher premium for holding it. Secondly it assumes that when the economy recovers the CAD will become a surplus. All the foreign debts incurred can then be easily paid off. Previous experience proves this is not the case. The CAD just gets worse.
    The problems with the fiscal deficits and current account in the UK are not the result of the austerity measures. They are the result of the loose fiscal and monetary policies, and in particular a total inattention to the problems of the external account, over decades past. This has resulted in a destruction of industry in favour of imports that has gone on so long that the problems cannot now be solved. Skills and capital have been lost. There is no easy answer.

    • Flawse — I won’t get into it for now, but my next post may answer some of your queries about the external account.

      For what it’s worth, I do not consider myself 100% in the MMT camp. I think it’s a very useful way to look at the world, but in my opinion, it’s silly to assume that any particular school of economic thought has ALL the answers.

  2. It is the politics of this situation that gives me the willies, not so much economics.

    I mean, for this to have a happy ending, we’re basically relying on US politicians to do the right thing and raise taxes, increase exports/decrease imports and confront the vested interests in defence and entitlement spending. So, their best hope is that politicians do the right thing, prefereably before the market forces the issue…? Lets give that 50/50.

    And as for the poor sods working at Walmart, etc, I’d say there is a 90% chance they’re going to get pwned, even more so.

    • You can’t raise taxes high enough to cover our massive deficits. One thing people always seem to forget is that the people that can afford to pay higher taxes are also the people that can afford to reduce their tax liabilities. If I own my own business I can easily give myself a pay cut and write off my expenses for business purposes. If you raise corporate taxes, that gets passed down to the consumer. Or perhaps the wealthy will simply choose to retire early or put their money towards investment and pay a 15% capital gains tax instead of a income tax that exceeds the current rate of 35%. Wealthy people have the canny ability to to use find all the tax loopholes because they can afford to pay the accountants, advisers and lawyers to help them utilize them. Lets also not forget that if you raise someones taxes they might save less or invest less. And “god” forbid they actually SPEND less. State revenues take a major hit when high taxes send taxpayers to other states with lesser tax burdens at the state level. That doesn’t bode well for States like California, Illinois, and New York.

      As for increasing exports and decreasing imports. How in the world do you encourage countries to import our goods without first reducing regulations and stopping the inflation of our currency? We import so much because Americans cannot afford to pay for goods that are expensive due to our high wages and regulations that increase costs to produce and manufacture and raise prices. That means nations can import less and we have to import more. Also if you decide to raise taxes how are you going to also create an incentive for nations to import more of our goods when business owners (who happen to be in the tax bracket you will have to tax) downsize or send more jobs oversees to cut costs.

      As for defense and entitlement spending, that is the bulk of the problems facing the United States. Welfare and warfare is what is bankrupting this country. The higher taxes and regulations are simply adding to the problem and putting the average American deeper in debt or less able to afford things.

  3. “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).”

    By this logic, the US was deleveraging between 1969 and 1996, according to the same graph. This was clearly not the case. You are confusing the “total net debt of the private sector” with the “total net debt of all private net debtors”. Even with no change in the current account, the government’s deficit can increase at the same time as an increase in the total net debt of all private net debtors, i.e. at the same time as the private sector is leveraging up. Conversely the government can run a surplus at the same time as the private sector is deleveraging.

    • Paul – I think there are a couple of issues here. Firstly, a positive balance means that the sector is a net acquirer of financial assets. They don’t necessarily have to be paying down debt and “deleveraging”.

      Secondly, the graph unfortunately lumps the household sector and the business sector together under “private sector.” The recent crisis was not driven by rising debt in the corporate sector (with the exception of banks), but by an unsustainable rise in household debt. And it is mainly the household sector that is deleveraging now, not the corporate sector (nonfinancial corporate leverage was fairly tame leading up to the crisis).

      • “Firstly, a positive balance means that the sector is a net acquirer of financial assets. They don’t necessarily have to be paying down debt and “deleveraging”.”

        That’s right, but your article implies otherwise.

        “Secondly, the graph unfortunately lumps the household sector and the business sector together under “private sector.” The recent crisis was not driven by rising debt in the corporate sector, but by an unsustainable rise in household debt. And it is mainly the household sector that is deleveraging now, not the corporate sector (nonfinancial corporate leverage was fairly tame leading up to the crisis).”

        My point is that you have not demonstrated that a government deficit or surplus has any impact on private deleveraging. You have shown an accounting identity and then made a logical leap that “higher Private Sector Balance” is equivalent to “private sector deleveraging”.

        You state “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).”

        This is not “what we saw above”. The US budget can be returned to surplus without disrupting private deleveraging, and without affecting the current account or debasing the dollar, because private deleveraging can occur independently of changes in the government deficit. Private deleveraging consists primarily of private parties settling their debts with one another, or defaulting on their debts to one another, and has nothing to do with government.

        • “The US budget can be returned to surplus without disrupting private deleveraging, and without affecting the current account or debasing the dollar, because private deleveraging can occur independently of changes in the government deficit.”

          Paul – I understand your point that deleveraging can take place within the private sector without showing up in the data above, but what you say here does not make sense. If you are running a current account deficit and you return the budget into surplus, the private sector balance will be forced into deficit. This follows naturally from the accounting identity above.

          How can you be deleveraging when you are in aggregate spending more than your income?

          • “the private sector balance will be forced into deficit”

            Again, you are confusing two completely different things.

            The private sector balance is the change in the sum of all private sector balances, including debtors and creditors.

            Deleveraging is a reduction in the sum of all debtor balances.

            Obviously the sum of all debtor balances can reduce at the same time as the sum of all balances is increasing.

            For instance:

            Year 1:
            Government: -100
            John: -1000
            Bank: +1100

            Sum of private sector balances: +100
            Sum of private sector debtor balances: -1000

            Year 2:
            Government: +100
            John: -900
            Bank: 800

            Sum of private sector balances: -100
            Sum of private sector debtor balances: -900 (deleveraging from -1000)

          • Edit:

            Change: “Obviously the sum of all debtor balances can reduce at the same time as the sum of all balances is increasing.” to:

            “Obviously the sum of all debtor balances can reduce at the same time as the sum of all balances is decreasing (i.e. your ‘private deficit’ is increasing).”

          • Paul – You are right that theoretically speaking the household sector could be deleveraging even as the total private sector deficit is increasing. On this point, I should have been more precise.

            In reality though, this does not happen. Look again at the graph above. After every major recession (1990 for example), the private sector balance starts to rise. There has never been a major period of deleveraging that coincided with a net private sector deficit.

          • “Look again at the graph above. After every major recession (1990 for example), the private sector balance starts to rise. There has never been a major period of deleveraging that coincided with a net private sector deficit.”

            The graph above does not have a line for deleveraging. The line does not show the change in private sector debt owed by debtors.

            There was no deleveraging at the points where the green line is below zero. There was no deleveraging at all from the 1950s until 2008, for most of which time there was a government deficit.

          • Paul – You’re wrong. There was clearly household deleveraging after the 1990 recession, which you can see from Keen’s graph. Furthermore, I have never claimed that there is always deleveraging going on when the government runs a deficit. In any case, let’s agree to disagree. I have no interest in debating you further on every minor point in the post.

          • I concede that there was a brief and minor deleveraging in the early 90s according to Steve’s chart.

            It is unfortunate that you are cutting off debate without refuting or conceding on the other points made. It seems to me that the article has no basis – i.e. does not present a coherent argument for continued budget deficits. This is in line with many MMT-based articles floating around that use flawed language and logic to try to argue that governments can print and spend as much as they like without harm.

          • Paul – I am not cutting off debate and have never done so on this blog. Far from it – I have patiently responded to multiple comments of yours on this thread.

            I have already conceded that you have made a couple of good points, but you continue to misrepresent what I have written. When did I write that “governments can print and spend as much as they like without any harm.” for example??

            I don’t necessarily represent the MMT school, but if that’s what you think they are arguing, you clearly haven’t read any of the literature properly.

            I very clearly say above that continued budget deficits could cause high inflation when unemployment falls.

            So who is using flawed language and logic here?

          • Sorry RA, I didn’t mean you were cutting off debate in the sense of disallowing further debate. You indicated you didn’t want to debate every minor point, and I took that to mean you weren’t going to comment further.

            My main point is that the sectoral balance argument is highly misleading. It defines “private sector balance” to mean “total of all private debtor and creditor balances”. It defines “private sector surplus” to mean a situation where this total adds to a credit balance. It then takes as axiomatic that a private sector surplus must be good, which most people would agree with – after all, it sounds good, does it not?. From this it draws the conclusion that government deficits are good, because they increase the private sector surplus.

            However, what most people think of when they think of a private sector surplus is not a total credit balance in the private sector taken as a whole. They think of growing real wealth – a surplus of goods, services and capital. This is a totally different thing. It is also the important thing – what matters is what happens to quality of life, which depends on availability of food, shelter, services and productive capacity, not on the availability of dollars.

            And deleveraging does not refer to an increase in the private sector surplus as defined by the sectoral balances approach. As I have pointed out, deleveraging occurs when the total of all debtor balances shrinks, not the total of all debtor and creditor balances added together (i.e. netted off against one another).

            The two things are fundamentally different.

          • Paul – No worries. You’re right that the definition of the “private sector balance” in the sectoral balances approach is a bit confusing. A rise in the overall private sector balance does not tell you what is going on with the distribution of the balances within that category. So whether such a rise is good or bad, depends. I agree with that. I also take your point on the definition of deleveraging.

            But if you look at the chart above, it’s very clear that the total “private sector balance” always rises after a recession, as it has in a very big way in the past couple of years. Putting aside your points about the nuances, the accounting identity says that if the private sector in aggregate desires to save and you have a current account deficit, then this necessarily means the government must run a deficit.

            Are you objecting to this simple conclusion? This was really my main point. In any case, you’ve given me an incentive to do a bit more reading on this stuff…

          • These are not nuances – quite the opposite.

            “if the private sector in aggregate desires to save and you have a current account deficit, then this necessarily means the government must run a deficit.”

            Absolutely not, if to save means to accumulate real assets. The private sector can create new assets – e.g. capital goods, houses etc. without a government deficit.

            If by “to save” you mean accumulate financial assets, then still absolutely not. Values of firms, reflected in share prices, can of course be improved without a government deficit.

            If by “to save” you mean accumulate financial claims on others, then yes the statement holds, but this definition is hardly a useful one. After all, by this definition the sum total of all governments and private parties in the world can never save, as all financial claims on others will net to zero if all added up together.

            The definitional differences above are not nuances. They are fundamental differences.

            Even if we look solely at financial claims on others, it is the behaviour of individual actors that matters, not the aggregate. If there is a “desire to save” this will be reflected mainly by net debtors working for net creditors in order to pay down debt. There are lots of net debtors but only a few net creditors, so the vast majority may desire to save at the same time as there is a decrease in the aggregate of all debtor and creditor balances.

            As for the “private sector balance” always rising after a recession, you need to be careful about causality. Usually the government applies stimulus to get out of recession, which of course would increase the government deficit and increase the so-called “private sector balance”.

          • Paul – Of course by savings we are not talking about real assets; we are talking about financial assets. Capital goods and houses are not savings according to any usual definition of the word. It doesn’t make sense to count share holdings either. They are not savings until you sell them for cash. Maybe that is where we differ.

            And yes, of course the total of all financial claims in the world should sum to zero, just like all current account balances in the world have to sum to zero.

            This is the whole point. If the private sector wants to save in aggregate (accummulating financial assets) then somebody (either the gov or the foreign sector) must have a corresponding liability. Similarly, all three sectors cannot run a surplus at the same time. That’s all. Very simple.

          • What is important economically to a society is accumulation of real assets – goods, capital equipment, real estate, productive companies, etc. A lot of Australia’s wealth is in superannuation, which in many cases comprises of equity in companies. Do you agree that an increase in the amount of all of these things is not the same thing as your “private sector surplus” as defined?

        • Paul – Yes I agree with that but you are making an entirely different argument here. Your issue is not so much with my post but with the whole basis of the national accounts and even the way that GDP is measured.

          Sure, there are many things that the national accounts don’t include. Are they directly correlated with happiness? Do they account for things like environmental degredation? No.

          But this in itself doesn’t invalidate the sectoral balances approach. Of course it’s crude analysis, but this is economics. It’s more of an art than a science.

          • http://www.mises.org

            Keynes was an artist, Mises was a scientist at least in regards to economics.

            I don’t pretend to know a great deal about economics but I can assure you that the Austrian theory of the business cycle makes logical and empirical sense.

          • My issue is with your post.

            The same issue does exist with GDP calculation etc.

            That doesn’t make your post any more valuable.

            I agree that the economics of today is closer to art than science. My impression of macrobusiness is that it is trying to peel away the layers of pseudo-science and obfuscation to get to some truth. This article merely perpetuates some of the pseudo-science.

  4. Great post RA. This is why macrobusiness is such a valuable voice. Most newspaper opinion pieces would have an idealogue speaking with absolute certainty on this.

    I’m probably wading in a bit over my head here so please bear with me. I’ve read Steve Keen for a while now and he frequently uses total debt as a proportion of GDP in nominal terms(see link, second chart ), where as you seemed to have used the % increase/decrease per year.

    http://macrobusiness.com.au/2011/02/the-us-governments-debt-spiral/

    My question (to everyone) is , do you think the actual nominal levels of debt make a difference?

    Also, how do theories of endogenous money creation factor in to this analysis of the US, where money is primarily created through bank credit? If you buy in to this theory for a second, to get hyperinflation you’d need rapidly escalating lending levels as a result of low interest rates AND massive increases in investment confidence. Does that maybe explain Japan’s lack of inflation regardless of huge government deficits and central bank money creation?

    • alex78

      Keen’s charts show actual private sector debt (including debts to private parties).

      Rotten Apple’s charts show the change in debt of the private sector in total.

      They are completely different things.

      e.g. if I owe the bank $1000, and the bank owes you $1000, Rotten Apple’s chart will not register this, as the total private sector net debt is zero. However Steve’s chart would register $1000 of private sector debt (the money that I owe the bank).

      Steve’s charts are much more relevant and illustrative of the leveraging and deleveraging process.

  5. alex78 – Correct me if I am misunderstanding you, but the two graphs are showing something different. The one above shows the private sector’s sectoral balance as a % of GDP. In other words the difference between private sector income and spending. If this is negative, then the private sector is either taking on more debt, or it is selling down its net financial assets. In any case, this is one is showing a flow, not a stock.

    Keen’s chart, on the other hand, is showing the stock of total nominal debt. If households continue to delever and the green line above stays solidly in surplus, you would expect the nominal level of household debt shown in Keen’s chart to gradually come down over time.

    This is a necessary process (yes I do think that nominal levels of debt matter).

    • “If this is negative, then the private sector is either taking on more debt, or it is selling down its net financial assets.”

      Be careful here. If this is negative, the private sector is not necessarily taking on more debt, in the way that people usually refer to private sector debt. If you define “private sector taking on more debt” as “an increase in the total net debt of all private parties added up together” then you are correct. However this is not the sense in which people normally refer to private sector debt. What they normally mean is more akin to the “total debt owed by all private net debtors”. i.e. They are not referring to a simple sum of all balances, they are referring to a sum of the balances of debtors only. You need to be very careful as a responsible blogger to distinguish between the two things, because it is far too easy to confuse them due to the limitations of natural language.

        • Yes I know. That is not what is usually meant by the total debt in the private sector.

          You are adding all debtors and creditors together.

          What is usually meant is the total of the debtors only.

    • That’s right RA, apologies for not being clearer. I was trying to reconcile the two and the key words, as you say, are stock and flow.

      • alex78,

        This does not resolve your question. RA’s graph is a flow, yes (change in sum of all private sector debtor and creditor balances).

        And Keen’s debt to GDP chart does refer to a stock, but it’s a stock of a different thing – the sum of all debtor balances. Keen also charts flows, which will also not match RA’s because they are flows of the change in total debt – i.e. total of debtor balances, not netted off against creditor balances.

  6. RA,

    fyi,

    The sectoral balances approach is the baby of the late Wynne Godley who used to work at the British Treasury and was the head of the Cambridge Economic Policy Group, UK in the 60s-80s and then at Levy Institute/Cambridge in 90s/00s.

    He described himself as an “Unrepentant Keynesian”, so sectoral balances belongs to Keynesian Economics!