Now let us take a look some data from the US and Eurozone. h/t Scott Fullwiler and Financial Times for these images based on US Government and OECD data. Additional images for the Eurozone and Japan can be found in the Harrison article.
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| Fig.1 US Sectoral Financial Balances |
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| Fig. 2 Euro Sectoral Financial Balances |
See a pattern?
Private Financial Balance + Government Financial Balance + Capital Account Balance = 0
Private Financial Balance = -Government Financial Balance - Capital Account Balance
For those who are not familiar with these terms see here for definitions and examples. Current account is essentially the negative of the capital account. And negative government balance is the government deficit. So we have...
Private Financial Balance = Government Deficit + Current Account Balance
US sectoral balances for the last 60 years have been compiled into an excel spreadsheet by economist Stephanie Kelton, for easy reading. And here is the link to her original article for further reading. It should be clear that in all cases, whether a fiat system or not, when the government runs a budget surplus provided it is not offset by a current account surplus then the private sector is running a deficit, i.e: this is a subtraction to private sector net financial wealth. The inverse also holds true. If the private sector decides to net save (run a surplus), and if the current account is in deficit, then the government sector should run a budget deficit that balances the equation. If it embraces austerity instead, GDP falls, and thus private income falls as a consequence. The sectors will balance regardless, it is a matter of what level of GDP you want them to balance. This is the exact scenario we have been facing in the US and Euro zone since the beginning of the Great Recession.
Why does this hold?
For those who are economics inclined see the Scott Fullwiler article for an explanation. For the general reader I will explicitly spell out what Ed Harrison is stating in his article. I have been sending the source links to people for a year, what I found is many aren't aware that total financial balances always equal zero, even after reading those articles. So forgive the simple example illustrating just that, it maybe necessary for some. This is not an explanation, just an illustration..
Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note we are only dealing with financial assets balances here not real assets.
Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10
Transaction 2: Bob buys bread from Alice for $20.
Transaction 3: Jim buys plumbing service from Bob for $40
After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. In other words the balance for all three always sums to ZERO, after each transaction. Also note, for any single entity to run a surplus, the sum total of the rest must run a deficit of the same amount.
Alice Bal + Bob Bal + Jim Bal = 0
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| Table 1: Financial Balances |
Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups as Harrison was stating. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction, see above figures.
Government Financial Bal + Private Sector Financial Bal + Foreign Sector Financial Bal = 0
Private Financial Bal = -Government Financial Bal - Foreign Financial Bal
If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance.
Private Financial Bal = Govt Deficit + Current Account Bal[2]
What is a govt budget deficit?
To hammer the point home even more, let us take look at budget deficits. We obviously have a budget deficit when the federal government spends more than it taxes. So where does this extra deficit money go, does it disappear into thin air? If we assume the current account balance is 0 (exports=imports), then every single one of those government deficit dollars ends up in the private sector, whether it be an additional government workers salary, or the salary of a private employee hired to build railway infrastructure, or a corporate balance sheet from sale of computer equipment. In other words the deficit is income for the private sector. Thus, private sector net wealth as a whole increases by the exact same amount as the federal government deficit. The deficit is essentially creating new money for the private sector.
In the case of the USA, we do have a current account deficit so significant portion of the government deficit dollars, ends up overseas also. Does anyone think it is coincidence that the two countries (China & Japan) with which we have the largest current account deficits (mostly trade deficits) have the largest dollar holdings in the form of treasuries? Nevertheless it should be clear, a federal government deficit increases the net financial wealth of the private sector, provided it is not offset by a current account deficit.
On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your financial wealth by $100K? No of course not, it is an financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets change? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed.
What happens if the government runs a surplus. Obviously, it is literally taking more money out of the private sector than it puts back in - a subtraction to the net financial wealth of the private sector. If the budget surplus continues for an extended period, the private sector is literally being depleted. This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced the debt by 33%. Guess what followed, the Great Depression. Am I saying the the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing when the government budget is in surplus.
What are the constraints for deficit spending?
The only real constraint for deficit spending is the total output of the national economy. Spending beyond the economy's production capacity is what results in inflation. Our economy is well below capacity right now. The metaphorical factories are sitting idle. Which is why we have high unemployment. So right now large budget deficits are not a problem. As unemployment decreases, tax revenues increase, unemployment insurance payments decrease, and thus much of the deficit takes care of itself. Note MMT economists are just talking about this one type of inflation. Inflation may still happen due to other issues, such as supply constraints - for example oil supply disruptions or excessive commodity market speculation. Due to the fact the oil is a commodity, other prices may rise. But that type of inflation if it does happen, it would happen regardless of whether we have large deficits or not.
Despite conventional wisdom solvency is not a constraint. Our government is the sovereign issuer of our own flexible exchange rate currency. How can an entity with its own currency ever fail to make a payment in that currency, other than through self-imposed limitations? If you had your own currency that you could issue at will, and your currency is accepted everywhere in exchange for goods and services, will you ever fail to make a payment in the currency. Would you ever need to issue debt, what does debt issuance even mean in this case? But yet that is the dominant conversation these days. Solvency considerations and government debt issuance are gold standard relics. This might seem shocking for those not familiar with MMT, I will address this in a future post. While everyone is aware that we have a fiat system, national economic policy is crafted as though we are still in a gold standard system.
State and local governments, and even European governments (such as Greece, Ireland and even Germany) do indeed have a solvency constraint, as they do not have sovereign control of their currency. On the other hand, governments like Japan, USA, Canada, Australia are true fiat systems, and they do not have a solvency constraint. Japan as of now has a debt level at 200% of GDP and yet their 10yr government bonds are going for just 1.3%. Mainstream economists have been predicting the demise of Japan for the last 20 years, due to high debt levels, high inflation, and high government bond rates, none of which has come to pass. That is because they still base their views on an archaic system. Are MMT economists saying these governments will never default? No, they are saying there will be never a reason for them to default. Lawmakers may still have a collective lobotomy and choose to do so. Japan may choose to default next week, but there is not a single economic reason for them to do that. The US may choose to default if the Republicans don't raise the debt ceiling, but these are self-imposed constraints. It would be about as brilliant as taking a gun and shooting yourself in the leg one day, randomly.
Conclusions
The sectoral financial balances always equal zero, regardless of whether we are in a fiat system or not. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth.
So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should accommodate that and run a larger budget deficit. This will naturally happen due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity while the private sector wishes to save will not end well. Two sectors cannot save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance. So given that now there is less spending overall (in economics saving is defined as not spending) a further worsening of the recession occurs. If you are familiar with the concept that all spending (GDP) in a country, is all income made in that country, why this happens should be clear. Thus, as spending drops private sector income also drops. Ironically, austerity actually makes the government deficit worse, as government revenues drop due to loss of private income. This is exactly what is going on in many European countries that have chosen austerity. See Ireland, Estonia, Greece. Take a look at Ireland's austerity program begun in 2008, and see how devastating it has been. The GDP finally stopped dropping (for now), but since the article was written unemployment increased another 1% to 14.2%.
The main advantage a true fiat system like ours has over Ireland, is that we have no solvency constraints in running a budget deficit, so austerity makes no sense at all. The only real constraint in deficit spending is inflation. But, our economy is well below capacity, the metaphorical factories are sitting idle, so any additional money injected into the economy is highly unlikely to cause inflation. As unemployment falls, tax revenues rise and unemployment insurance falls, much of the deficit takes care of itself. Approximately 30% of the current deficit is due to the recession alone.
Just any deficit spending probably may not be optimal. If the target is the financial sector(bailouts)it is relatively useless. Even a conventional pump-priming stimulus, (while it does improve things) is unlikely to be that very efficient. MMT economists would say, the best way to reduce the long-term deficit is not worry about the deficit right now, but aim government resources at targeting unemployment directly. The best month the private sector had this year was 200,000 jobs/month. Seems significant, but that is not going to cut it. If we add 200K jobs/month it will take us 11 years to get to 4.5% employment according to this study. If 300K jobs/month then 5 years, if 500K jobs/month then only 2.5 years. Private business are running record profits, but yet they are not hiring, as their hiring decisions are based on consumer demand, which is still very weak, and leaning towards a double dip The government should fill in the employment gap directly, (not through indirect stimulus), if we want a quick recovery. We have a lot of idle construction, why not put that to good use (at least temporarily) repairing the nation's crumbling infrastructure. From 1933-37 this approach was highly successful, when a population adjusted figure of 750,000 jobs/month was the norm, GDP growth averaged 10%/yr and unemployment fell from 23% to 10%. That is, until FDR decided to massively cut the deficit in 1937. Does it is seem that any politician actually learned from this experience? Yeah a government role in job creation conflicts with the ideology of some, but should we run our economy based on unverified ideologies or reality?
Notes:
1. MMT or Modern Monetary Theory is an explanation (not just a theory) of how a modern fiat/credit monetary system really works. And that is what we have in the US and most other major economies except for those European countries under the euro regime.
2. We could have additionally split the private sector into two, whatever is suitable for analyzing financial flow. This maybe even more relevant. In my view, what is really the aim of economic policy but to increase the net financial wealth of the household sector. What is important to know is that the sectoral financial flows always balance, regardless of how many sectors we choose to use. For the household sector to be in surplus the sum of the rest must be in deficit by the same amount. Govt Fin Bal + Household Sector Fin Bal + Business Sector Fin Bal + Foreign Sector Fin Bal = 0
