Thursday, 21 May 2015

Economic Myths: The government needs to run a deficit to enable private saving.

Caveat: I whole heartedly agree with the basic tenant of Modern Monetary Theory i.e. that there is no real direct link between government spending, taxation, borrowing and debt repayments; in the very long run they sort of match up in accounting terms is all.

But then they go off on a complete tangent e.g. here:

It may not be apparent from perusing mainstream newspapers or watching the evening news, but the private sector’s capacity to save and pay off debt is inextricably linked to the government’s use of fiscal policy.

Attempts to slash budget deficits will actually work against private-sector efforts to get debt under control. By directly subtracting from demand, fiscal contraction will have a negative impact on output, employment, income and therefore private saving, frustrating private-sector attempts to pay off debt.

The following accounting identity shows an aggregate relationship that must hold by definition for a closed economy, such as the global economy as a whole:

(G – T) = (S – I)

In this identity, G is government expenditure, T is tax revenue, S is private saving and I is gross private investment.

Somehow or other, government deficits are spun as being a good thing as they enable private saving or enable the private sector to pay off debts.

This is all robbing Peter to pay Paul; if you allocate government debt back to the individual taxpayers who have to pay the interest and principal, it all cancels out. Admittedly, government debt is usually never paid off, it is just rolled forward indefinitely, that's the key to all this but a separate topic.

More importantly, if the government is running a balanced budget, then G-T = 0 and we are left with...

S-I = 0
Hence S=I
In other words, private (i.e. household) saving = Private (i.e. business) investment.

(The distinction between 'saving' and 'investment' should not be under-estimated, see my earlier post).

Overall, the optimum savings ratio for each individual and hence the population as a whole is zero but the overall optimum amount of business investment is positive.

So that means that S-I could be a negative number; if we want the equation to balance, then the government has to run a surplus i.e. G-T<0, i.e. T>G.

This strikes me as complete nonsense, ergo the original equation must also be nonsense; common sense tells us that lower taxation would, all things being equal, lead to more business investment (as long as it doesn't spill over into higher land prices - let's assume a sane tax system which taxes production less and land more).


Random said...

The government needs to run a deficit (unless you have very strong external sector, but external sectors balance to 0 worldwide allow NET private saving
"individual taxpayers who have to pay the interest and principal, it all cancels out. "
No they don't.
I would argue the causality is in the other direction - private savings and trade deficits lead to govt deficits. Hence Japan has large deficits.

Random said...

"common sense tells us that lower taxation would, all things being equal,"
Indeed. Tax cuts and/or spending increases do not necessarily increase the deficit.

Derek said...

Mark, my take on the (G-T)=(S-I) equation is that it involves only two sectors, so G is money that the gov gives the citizens, T is money that the gov takes from the citizens, S is money that citizens put into or take out of their piggy banks and I is money that the citizens give to the gov when they buy bonds or take from the gov when they cash bonds in. Looked at in this light the equation is perfectly sensible. But...

The equation is very simple because it doesn't really take account of investment between citizens and businesses. You would need to do more complex sectoral analysis involving banks and businesses to cover that. And that would give you a much more complex equation.

So it's nonsense because it's too simple. It does fully describe the behaviour of an economy with two people in it. But it doesn't fully describe the behaviour of a real economy.

Random said...

Actually the external sector (X -M) is included as well in open economy.

Derek said...

True, but the original article was talking about the global economy -- ie a closed one -- so we wouldn't have to worry about (X-M).

Mark Wadsworth said...

R, first two comments, nope.

If you are now saying that G>T for the economy to grow when the formula clearly implies the opposite, then the formula is clearly bollocks.

D, well yes, if that is how it is meant, then it is correct.

i.e. Net addition to private sector cash = govt cash spending minus govt cash taxation minus private cash spending on govt bonds.


That is not 'investing' in any way shape or form.

'Investing' is adding to the total stock of capital. So the govt builds roads, the private sector builds cars etc.

Derek said...

Agreed. That's the proper meaning of investment. Much more difficult to capture in an equation though. The thing is that equations have to be dimensionally correct. And physical capital comes in a bunch of different units (cows, cars, roads, etc.) making it difficult, but not impossible, to get the equations dimensionally consistent.

So the MMTers mostly stick to equations about money and debt where the units are relatively simple.

Random said...
Periods of private sector deficits are generally not sustainable as private households "have to live within their means." Only if there are strong external surpluses or a credit bubble does this happen. And LVTers want to end credit and especially land bubbles.
Mark, periods where Tax is greater than govt spending (i.e. surpluses) and where there is trade deficit result in unsustainable borrowing. You can see Keen/Minsky work on this.
On my second comment, interest payed to bondholders adds to private savings. Taxes don't pay for anything.

Random said...

Look, govt deficit spending works by crediting bank accounts. Taxes debit bank accounts. Deficits literally *causes* there to be savings there, whether in cash IOUs (QE) or bond IOUs.

Mark Wadsworth said...

R, LVTers would get rid of credit bubbles which would

a) boost exports/reduce imports (real life Georgist exercise in Denmark) and

b) keep house prices low boost real savings (observable fact)

… both of which are agreed to be Good Things.

Realistically, we know that in cash terms govt borrowing never gets repaid and that governments seldom run surpluses (whether you like it or not, and I don't). So there's no point arguing over that.

Last comment, yes, in a pure mechanical point of view that is quite correct, I'm not going to argue with statements that are self-referntial and inherently true.

Random said...

MW, I don't think we really disagree on anything. The fiscal statement "balance" should not be a goal. If good policy requires 10 percent surpluses or 20 percent deficits, that should be the policy. Everything should be defined in real resources not £.
Generally it is good policy to introduce contractionary fiscal policy when there is inflation and introduce expansionary policy when demand is lacking.
What pisses most MMTers off is the constant media BS about the UK government 'bankrupt', 'out of money', etc.
Deficits should meet private desires to net save or dissave, with auto stabilisers to nudge the balance in the correct direction working in real time.

Random said...
Here is a good article explaining the MMT view.

Mark Wadsworth said...

R, yes, I would agree with those statements. Clearly, the UK govt is neither bankrupt nor out of money. And every time somebody says "black hole" it annoys me no end... apart from the "Land monopoly black hole" of course.

Random said...

The conservative MMT approach is to cut taxes and implement JG, and freeze spending. And then continue to cut taxes until inflation becomes an issue, whereby you cut spending (or increase LVT in your case.) Once all taxes are abolished then we can start with CI or put in first £x not taxed on LVT.