Saturday, September 17, 2011

Why the Federal government should never run a budget surplus?

In an earlier post I covered why the US Federal government should never run a budget surplus, unless there is an offsetting trade surplus. And given that the US runs a large trade deficit,  a budget surplus would indeed be harmful. Let me address this topic again in the simplest possible terms. For more details and policy proposals and spending constraints see the original post.

The thing to remember throughout is that a sovereign currency issuer like the US, doesn't face a solvency constraint, i.e: we are not going to run out of dollars.  The constraint for government spending is not solvency but inflation.  This is covered more in the earlier post.

Why not a budget surplus?

If I give you $20, and you give me $15, you are now financially wealthier by $5, everyone can agree on that.  It doesn't matter whether a real good/service was bought/sold or not, as far as financial assets (such as cash, deposits etc:) are concerned, the outcome is the same, you are financially wealthier by $5.  If that one transaction is all that you engage in for a given year, you can think of the $15 as your spending for the year, while the $20 is your gross income. Your income less spending is $5.  Obviously, your financial position is better off (by $5) at the end of the year. The same also holds true at the macro level, let us take a look at government budget deficits/surpluses to demonstrate this.

We obviously have a budget deficit when the federal government spends more than it taxes. Let us say taxes are $2 Trillion, while government spending is $3.5T, then the government deficit is $1.5T. So where does this extra $1.5T go, does it disappear into thin air as some believe?  For simplicity, if we assume for now, the foreign trade balance is 0  (exports equals imports), then every single one of those government deficit dollars ends up in the domestic private sector. In other words the government budget deficit, to the penny, can be thought of as net income for the domestic private sector as a whole.

The deficit spending may be income for an additional federal govt. employee. It may be an additional firefighter or teacher's salary, via a transfer to a state government.  It may be income for a private construction worker hired to repair the nation's ailing bridges. It may be retained earnings for a business which provides services to the government.  It may be dividends to the investors of that business. It maybe in the form of a tax cut for lower income folks. Or it maybe even wasted on bank bailouts.[1] 

Given that inflow is larger than outflow by $1.5T, domestic private sector net financial wealth (financial assets minus debts) as a whole rises by $1.5T.[2]  This is not rocket science, it is no different than if I give you $20, and you give me $15, you are now financially wealthier by $5. Similarly, when the government spends $1.5 trillion on top of what it takes out in taxes, domestic private sector net financial wealth (as a whole) rises by $1.5T.  Where else can the money ago? To the residents of planet Vulcan? Any spending within the private sector just transfers financial wealth within the sector.  If you buy a $500 Dell computer, you are financially poorer by $500, while Dell, its employees, investors, suppliers etc: are financially richer by $500.  Total private sector net financial wealth has not changed. It just moved within the private sector.

Guess what happens when the government runs a budget surplus.  Let us say taxes are $3 Trillion, while government spending is $2.5T, then the budget surplus is $500 Billion. In our example this would be like if I give you $20, and you give me $25, you are now financially poorer by $5.  The government is literally taking more out of the domestic sector than it is putting back in.  A $500B subtraction to private sector net financial wealth (as a whole). 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 government 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 government debt by 33%.  Guess what followed, the Great Depression. Am I saying that the budget surplus was the cause of the depression?  No, but it certainly doesn't help, as the private sector would be net borrowing (in deficit) if it is to keep up the same level of spending, when the government budget is in surplus.  Actually, it is far more likely that the causation is reverse, a private debt binge is reflected in the government budget as a surplus.[3] The point is that sectors always balance. If the private sector does decide to reduce its debt fueled spending (which is bound to happen eventually), then GDP falls, given that GDP is total spending. As a consequence total income falls due to the fact the someone's spending is someone else's income. And now we have a recession.

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 net financial  wealth by $100K? No of course not, it is a financial asset swap.  If you move your money from a checking account to a bank CD does your total financial assets fall?  Buying a treasury is just like buying a CD, it is in you asset column.  Your net financial wealth hasn't changed, only the composition of your asset portfolio has changed.

US Sectoral Financial Balances

So far we addressed a hypothetical situation where the foreign trade balance is zero. In the case of the USA, we do have a trade deficit (imports > exports), hence in reality a significant portion of dollars ends up overseas also.  Does anyone think it is coincidence that the two countries  (China & Japan) with which we have the largest trade deficits also have the largest dollar holdings in the form of treasuriesIn the the real world, the federal government deficit increases the net financial wealth of the domestic private sector, provided it is not offset by a trade deficit.  In our original example where the trade balance is zero the domestic private sector balance equals the government deficit as we would expect.

Domestic Private Sector Balance = Government Deficit + Current Account Balance

For those who are not familiar with the term Current Account, it is mostly the foreign trade balance (exports - imports). It also consists of net factor income. For more details on terms see here. The domestic private sector consists of households, firms and financial firms and its balance is the addition/subtraction to net financial wealth of the private sector in a given period. If the private sector is net borrowing (in deficit), then its balance will be negative; if it is net saving (in surplus), then its balance will be positive.

Economist Scott Fullwiler has compiled actual financial balances of each sector from US national accounts. See figure below. See here for actual examples from US national accounts- see footnotes 1, 3 and 5 in that post for source data.  Notice the formula always holds true.  Notice how during the late 90s as the government runs a budget surplus and the current account is in deficit (negative), the private sector balance (as a whole) is in deficit for the first time.  The same happens during much of the 2000s as the government budget deficit was not large enough to offset the large current account deficit.[3] A private sector deficit is a subtraction to private sector net financial wealth.

Fig 1: US Sectoral Financial Balances (from Scott Fullwiler)
Note: the red line in the chart is shown as positive since the label is Govt. deficit (i.e: negative Govt. balance)

Why does this hold?

For an explanation see economist Stephanie Kelton's article here and here. For an advanced version see this article by economist Scott Fullwiler.  For the general reader, I will use a simple example to illustrate this. 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 the keyword NET, Jim may have $2000 of financial assets, and debt of $1500, in which case his net financial wealth is still $500.  Also note the keyword FINANCIAL we are only referring to financial assets (such as cash, deposits, stocks etc:). Real assets (such as houses, cars etc:) are not included in the calculation.  They engage in 3 transactions during a period of time...

Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10. The sum of the balances is ZERO. This is just a fancy way of saying if Alice gives Jim $10, then Alice doesn't have $10 anymore. Alice's net financial wealth falls by $10, while Jim's rises by $10. The total net financial wealth of the system ($1500) hasn't changed as we would expect, given that sum of the balances is zero. $10 of financial wealth transferred from Alice to Jim.
Transaction 2: Bob buys  bread from Alice for $20.  Bob, now is down $20 (his balance is in deficit), while Alice's balance which was in in deficit of $10 after transaction 1, is up $20, so now she has a surplus of $10.  Jim's balance remains at a surplus of $10. Once again the sum of the balances of all three is ZERO, not exactly rocket science here.
Transaction 3: Jim buys plumbing service from Bob for $40. Yup still ZERO.

Fig 2: Financial Balances

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.  For any single entity to run a surplus, the sum total of the rest in the system must run a deficit of the same amount. In other words the balances always sum to ZERO, after each transaction, and you can see that in the 'total' column for each row.  The total financial net wealth never changes, it still remains $1500.  Ever wonder why we have double-entry accounting?  For every credit, there must be an equal debit somewhere else, for balances to sum to zero. Anyway in our example...

Alice Bal + Bob Bal + Jim Bal = 0

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.  The government sector, the private sector and the foreign sector.  This still holds, and real world data confirms the prediction.

Government Bal + Private Sector Bal + Foreign Sector Bal = 0

Private Sector Bal = -Government Bal - Foreign Sector 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. And obviously negative government balance is the same as the government deficit.

Private Sector Bal = Government Deficit + Current Account Bal

Update: The main difference is that Alice, Jim and Bob cannot create new dollars when they spend.  The US government as the sovereign issuer of the dollar, creates new dollars when it deficit spends. It can run perpetual deficits, and it has in the past.  In the entire history of the US there has only been 5 periods, where we had 5+ continuous years of government budget surpluses.  From 1946 to 1981 when we reduced the debt/GDP from 121% to 32%, guess how many surplus years we had?  Just 5 surplus (barely) years in total. As you can see in Fig 1, the red line rarely crosses into positive territory.  Solvency is not a constraint for currency issuers, inflation is the only constraint.

Conclusions

The sum of sectoral financial balances always equal ZERO. 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. A surplus of one sector must result in a deficit for another.

So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should be accommodating and run an appropriate budget deficit. Some of this will happen naturally due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance).  Any attempts at fiscal austerity (trying to balance the budget) while the private sector wishes to save will not end well.  Two sectors cannot net save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance.

If both sectors attempt to net save, that is if the government doesn't pick up the slack for loss of private sector spending, there is obviously now less spending overall in the economy (saving is defined as not spending in economics).  Less spending means GDP falls, and as a consequence income falls and the recession worsens. And of course now the sectors balance at a lower GDP level. Since income falls, taxes fall and ironically the government deficit actually gets worse, when the budget cuts are attempted.  This is what we are seeing with Ireland and Greece.

The sectoral financial balances model is not rocket science, it is not any more complicated then if I give you $20, then I don't have $20, you have it.  What applies for individuals also applies to sectors also. But yet this still has not made much inroads into mainstream economics, although that is slowly changing now. The experiences of countries like Ireland and Greece shows the prescription of mainstream economics, government fiscal austerity, is downright disastrous.  Just in Q2 2011 Greece's GDP was falling at an annualized rate of 7.0%.  The last chart  shows that the government budget cuts starting in 2010 have been the biggest drag on GDP.  But yet the calls for budget cuts continue in the Eurozone officialdom.  Unless this course is reversed this is unlikely to end well.

Not a single person running our government seems to understand this basic fact as well.  The airwaves are saturated with talk about balancing the government budget, when it is not even close to being an issue.  It is not even necessary to run a budget surplus to reduce our debt to GDP ratioThe real issue is excessive private debt. When was the last time we heard about that from the congressional talking heads.  We hear talk about balancing the budget from even the most liberal faction of Congress (although to be fair, at least they are talking about balancing down the road not in the middle of the recession).[4].  Running an economy based on faith based beliefs, rather than facts is bound to be disastrous. 

Updated 9/21/2011: Reorganized things a bit
Updated 3/20/2012: Moved some notes up to the article
Update 4/9/2012: Fixed broken links,fixed some errors

Notes

1. Not all government deficit spending is created equally. Some are more efficient than others. A bank bailout is one of the most inefficient way of spending government resources.
2. Note the key word financial we are only talking about financial assets (such as cash, checking deposits, stocks etc:) in the above examples. Real assets (such as houses, cars etc:) are not included. Financial transactions are a ZERO sum game from a global perspective for users of a currency,  that is what we are trying to show here.
3. Or the causation maybe that the private sector gets itself into debt, the sectors balance and the government budget is in surplus, that is more likely. Either way the sectors always balance. The private sector could have chosen to reduce its debt fueled spending, and if another sector doesn't pick up the slack, then GDP falls and the sectors balance at a lower level of GDP, but that is not what happened (except for the 2000 recession).  This is what is happening now, the private sector is trying to pare it is debt burden. While the government did pick up some slack, it was only enough for a small growth in GDP.  Which, by the way is fading as the government cuts its budget. 
4. Update 9/19: 30% of the deficit is due to the recession alone, given that there is  less tax revenue and more social safety net spending.  The best way to cut the deficit ($4T in 10 yrs) is to do nothing at all with the deficit, get to full employment as fast as possible.  But if you must cut it now, best to do it it in a way that impacts the least amount of spending.  For example, richer people save rather than spend much  of their income, so raising their taxes is less likely to impact GDP that much.

3 comments:

Jovan said...

I don't get it. If government deficits results in equal increase in private sector wealth, why not run huge deficits for astronomical wealth creation? Where is the money coming from to finance the deficit? Government must borrow it. In that case it came from the private sector. There is no net gain in wealth to the private sector then when government spend the money it got from the private sector to begin with. $1.5T that the private sector lent to the government came back so no net gain there. If on the other hand the Fed printed money to cover the deficit that same money must be repaid via taxes which again represents no net gain to the private sector. In fact there is a reduction in wealth because of added cost of financing the debt. Additionally there seem to be a confusion between wealth and money. Increase in money quantity is not synonymous with increase in wealth otherwise Zimbabwe would be the wealthiest nation on earth.

J Ondish said...

Inflation reply: I am actually replying to your post: "No, the dollar did NOT really lose 95% of its value since 1913" since you disabled comments for some reason which i am hoping is not because you want to avoid a dissenting opinion. I think that your spot on, on pretty much every single thing, EXCEPT, like other commenters stated why does it take 2 earners in a household to support a family and in many cases barely. You say it is not inflation but the capture of the wealth by the top 1%. Well lets take it a step further. Every so often, something is invented that literally changes the world we live in. Those people sold their idea, and others bought it. Both parties benefitted and there was no force required in the transaction.

Inventions like Facebook are good examples of this. Rightfully so, Zuckerberg deserves to be in the 1%. Then, there are individuals that rape the wealth of a nation in order to get into the top 1%. How they do it is through inflation like other commenters suggest. If money is brought into circulation through the federal reserve issuing money to banks who are fractional reserve lending and creating money from nothing, than wouldn't it make sense that over time those financial institutions would begin to consume the vast majority of the labor (wealth) of a nation? How else could they possibly amass trillions in assets? As of 2015-09-30, bank of Americas assets stand at 2.153 trillion dollars. Whilst their liabilities are 1.897 trillion leaving a small equity of 255 billion dollars. These institutions are growing exponentially for several reasons. They inject artificial liquidity into the market which among other things, creates artificial borrowers. These artificial borrowers then go and buy homes and increase the demand for them. As such the price of homes rise. A higher demand creates higher prices. Higher prices makes it harder to purchase a home out right, resulting in more people having to apply for loans in order to buy homes. More people having to apply for loans to buy homes consumes the profit of their labor and transfers it to the financial institution in the form of amortized interest in exchange for nothing. Peoples labor is literally being traded for the banks money. The banks money is was created for nothing. That means that the people are trading their labor for, NOTHING.

The banks did not do anything to obtain this money they are lending from the Federal Reserve and if inflation was taken away by the removal of the Federal Reserve and a gold standard, none of this would be possible. Fractional reserve lending might still exist but the only assets the banks would be able to lend would be their own or that of their depositors, not newly printed money that devalues whatever savings people have. Take it a step further and remove the FDIC insurance and banks would fail regularly, especially in the beginning. However, people would eventually wise up like many of the people that survived the great depression and instead of even bothering with banks, they personally stored their wealth in assets or in cash, in the case of my grandmother in law, hidden in her non-functional dish washer.

J Ondish said...

Banks are a cancer to society, and inflation is their tool to extract your wealth from you, without your consent or in many cases knowledge. After a few bank failures people would begin to realize, "hey, I can look at the assets liabilities and equity of a bank whenever i want and i can determine how much they have lent out", and at that time, if they saw something like the books of Bank of American, Chase, PNC etc. they would not deposit with them. This would end the boom and the bust cycle and only permit sustainable growth. It would severely slow down the derivatives market (rightfully so) and transfer the wealth back from underserving 1% that contribute nothing to society back to the middle and lower class.

Despite the fact that Milton Friedman was a proponent of Central Banking, he did say that without inflation there would be increased unemployment for a time but eventually the market would correct itself and it would be the end of the boom and bust cycle and only sustainable growth would follow. I find it hard to believe that Milton Friedman did not see Central banking as a problem, but who knows he could have been paid off, OR he just didn’t have enough information at the time to grasp how damaging central banking is.