Why run a deficit?

Unless you’ve been living under a rock (or living on a planet that makes sense), you will have no doubt heard repeated rhetoric over the last few years from politicians of all shades, stating that “tough decisions” must be taken to close the deficit and balance the budget.

Without prior knowledge, all these claims make sense, but all these claims do is propagate myths built on the misunderstanding that the government finances are comparable to a household, politically constraining the government’s ability to support the private sector’s ability to net save, and in turn subduing the consumer demand required to keep the economy growing.

In my previous post I covered national accounting and the zero-sum relationship between the government, private and foreign sectors. As stated there, an attempt by one or two sector to spend less than its income (i.e. save) is balanced by the remaining sector(s) spending more than it income, resulting in a deficit. On average, the private sector is a net saver, and its desire to save can be met either by a government deficit, a trade surplus, or a combination of the two. A strong trade surplus provides an alternative source of earnings for the private sector (as well as more taxes for the government) which can be saved, reducing the need for a government deficit. An example of a country like this is Germany, which has a history of running a trade surplus that helps sustain its budget surplus.

In countries with a trade deficit (typically developed countries where it is generally cheaper to import goods from abroad due to lower manufacturing costs), the ‘burden’ falls on the government to provide a source of earnings to support saving (the alternative is an increase in private debt, which increases the susceptibility of the economy to shocks), and run a deficit. A simplified illustration of the flow of money between the government and non-government sectors is shown below (note that there are other sources of income  other than taxation, but this is the primary one).

national accounts arrangement

Government spending provides a safe financial asset for the non-government sector to use as payment for goods, services, debt and taxes, as well as an asset to hold as a form of savings. The national debt simply represents the cumulative sum of all government deficits, and the sum of all financial assets (denominated in £s) held by the non-government sector. Deficit spending increases the supply of these assets in aggregate, increasing the amount that can be held for the purpose of saving. During downturns, deficit spending (this typically occurs in the form of welfare payments, which increase as more people become unemployed during a downturn) helps reverse the fall in aggregate demand by meeting the non-government sector’s desire to save, without lowering its level of spending.

So deficits, not so scary right?

I will (probably) touch on why the government can sustain its deficits, and why the size of the deficit on its own is irrelevant to the health of the economy in the next post.

National accounting: easy as pie

This is the first of at least three posts in relation to deficits and public debt. I hope by the end of this you should have enough knowledge to understand why things haven’t returned to normal since 2008. This post covers national accounts, which underpins most of what I will mention.

At the simplest level, the economy is compromised of 3 sections, namely the government sector, the non-government (private) sector, comprised of households, business firms and banks and the foreign sector (the sum of which equal to imports – exports).

Following the rules of double-book accounting (i.e. if I pay you, my balance  goes down by the amount I pay, and yours goes up by the same amount, so in the end between the two of us there is no net change in the amount of money) these sectors must (no ifs, no buts!) add up to zero. In essence, a deficit (the amount of spending that exceeds income) in one or two of the sectors must be balanced by a surplus (unspent income) in the remaining sector(s), this applies at all times.

Our current government has decided to aim for a surplus by 2020, a noble aim if you don’t understand national accounting. Unfortunately, we are currently running a trade deficit, as such, the foreign sector is running a surplus! This means we are spending more on goods abroad than we make from selling our goods abroad. Therefore for the government to derive its surplus, the private sector as a whole must run a deficit to fund the foreign sector’s and government’s surplus, so the accounts will add up to zero.

As the government’s deficit falls, the private sector’s deficit will rise, and our ability to spend less than we earn is compromised, making deleveraging (paying off our debt) increasingly difficult and, could be a driving factor in why household debt has risen so rapidly since 2010 as consumers resort to debt to make ends meet.

So next time you hear someone on TV or radio insisting on balanced budgets, what they are really doing is promoting unsustainable economic growth based on private debt, a tale that only ends in tears.

Note. There are times where running a surplus is appropriate, something I might touch on later. For a more mathematical explanation (simple algebra) of national accounting, click here.