What Happens When the Government Tightens its Belt? (Part II)

By Stephanie Kelton

In a recent post, I used a simple teeter-totter diagram to show how the government’s financial balance is related to the private sector’s financial balance in a closed economy. With only two sectors – government and non-government – I showed that a government deficit necessarily implies a surplus in the private sector.

As expected, this accounting truism ruffled the feathers of a flock of readers who have been programmed to launch into an anti-government tirade at the mere mention of the public sector and to regard the dangers of deficit spending as an unimpeachable fact. And while you’re certainly entitled to your own political views, you are not, as Senator Moynihan famously said, entitled to your own facts.

Other, less impenetrable minds, agreed that the private sector’s financial position must improve as the government’s deficit increases in a closed economy, but they argued that I had not demonstrated anything meaningful because I ignored the financial flows that occur in an open economy.

I still hope to convince both groups that they are acting against their own economic interests when they support policies to balance the budget or reduce the deficit, either by raising taxes or cutting government expenditures. So let’s continue the exercise and, as promised, extend the argument to the more realistic open-economy in which we actually live.

In an open economy, income flows into and out of the domestic economy as residents and foreigners buy goods and services (exports minus imports), make and receive payments such as interest and dividends (factor income) and make net transfer payments (such as foreign aid). Each country keeps track of these payments using a balance of payments (BOP) account, which summarizes the international monetary transactions that take place between the home country and the rest of the world. The BOP has two primary components – the current account and the capital account – and we can use either one to show whether, on balance, money is flowing into or out of a country.

When we incorporate these international flows, we transform the closed-economy accounting identity I used in my previous post:

[1] Domestic Private Surplus = Government Deficit

into the open-economy accounting identity shown below:

[2] Domestic Private   =  Government  +   Current Account
Surplus                      Deficit                  Balance

or, equivalently,

[3] Domestic Private =    Government   +  Capital Account
Surplus                       Surplus                Balance

When the current account balance is positive, it means that we in the private sector (households and domestic firms) are accumulating net financial claims on foreigners. When it is negative, they are accumulating net financial claims on us. Thus, a positive current account implies a negative capital account and vice versa.

To see this in the context of the teeter-totter model, let’s initially hold the public sector’s balance constant at zero (i.e. let’s assume the government is balancing its budget so that G = T). With the government budget in balance, Uncle Sam is a “weightless” entity on the teeter-totter, so that the private sector’s financial position will simply reflect the “weight” of the capital account. Suppose, first, that the current account is in surplus (i.e. the capital account shows an equivalent deficit):

The image above depicts the benefit (to the private sector) of a current account surplus (a.k.a a capital account deficit), and it is the outcome that many of you accused me of sidestepping in my previous post. Of course, the U.S. does not have a current account surplus, so let’s address that point before moving on. (And lest anyone begin to hyperventilate, I’ll also address the fact that G ≠ T). First, the current account.

Sticking with (G = T) for the moment, we can show how a current account deficit impacts the private sector’s financial position. As the capital account moves from deficit (diagram above) into surplus (diagram below), we see that the private sector’s financial position moves from surplus into deficit.

But does this all of this hold true in the real world, or is it some kind of economic chicanery? Let’s check the facts.

Equations [2] and [3] above are not based on economic theory. They are accounting identities that always “add up” in the real world. So let’s firm up the discussion about the implications of government “belt tightening” by running through some examples using the real world data found in the table below (Hat tip to Scott Fullwilir for sharing the file. All of the data comes from the National Income and Product Accounts (NIPA) and the Flow of Funds.)

[ Click here for Sectoral Balances Data (.xlsx format) ]

Let’s begin with the data from 1998 (Q3), when the public sector deficit was just 0.01% of GDP and the current account deficit was 2.56% of GDP. Plugging these numbers into equation [2] above, the identity tells us (and the data in the table confirm) that the private sector’s balance must have been:

[2] Domestic Private Sector’s Balance = 0.01% + (-2.56% )= -2.55%

Here, we can see that the private sector’s financial position was deteriorating because it was making large (net) payments to foreigners. Because this loss of financial resources was not offset by the public sector, the private sector’s financial position deteriorated.

To see how a bigger government deficit would have improved the private sector’s financial position, let’s look at the data from 1988 (Q1). As a percent of GDP, the current account balance was 2.59%, nearly the same as before, while the government’s deficit came in at a much higher 4.2% of GDP. We can use Equation [2] to see effect of the larger budget deficit:

[2] Domestic Private Sector’s Balance = 4.2% + (-2.59%) = 1.61%

In this period, the private sector ends up with a surplus because the government’s deficit was large enough to more than offset the negative effect of the current account deficit.

Again, this is simply a property of the sectoral balance sheet identities. Whenever the government’s deficit is too small to offset a deficit in the current account, the private sector will experience a net loss. The result my ruffle your feathers, but it is an unimpeachable fact.

So let’s go back to President Obama’s comment and the reason I wrote this blog in the first place. The President said:

“[S]mall businesses and families are tightening their belts. Their government should, too.”

Wrong! When we tighten our belts, it means that we are trying to build up our savings. We do this by spending less. But spending drives our economy. Sales create jobs. So unless Obama has a secret plan to reverse three decades of current account deficits, the Government needs to loosen its belt when we tighten ours. If it doesn’t, then millions of us will lose our shirts.

** An aside: I am aware that I have said nothing about the usefulness of the spending projects, the waste and inefficiency that exists with many government programs, cronyism, inequality, etc., etc. These are legitimate and important questions, but they are not the focus of this analysis. I wrote this series of blogs to try to get people to understand the interplay between the private, public and foreign sectors’ balance sheets. Criticizing me for not addressing a myriad of other issues is like reading Old Yeller and complaining, “What about the cat? You’ve completely ignored the genus Felis!”

30 Responses to What Happens When the Government Tightens its Belt? (Part II)

  1. When the current account balance is positive, it means that we in the private sector (households and domestic firms) are accumulating net financial claims on foreigners.”Does it make any difference if like in e.g. Norway they declared when extracting oil off shore became economic viable that this was the Norwegian peoples asset and the profits that would be belonged to the Norwegian people as a collective. They accumulate these proceeds in public sovereign wealth funds. In this case its not the private sector that primarily accumulate foreign surplus.An interesting comparison could be made with UK and Australia that also at the same time was in the position to extract oil. They choose different paths of privatization.

  2. Hahaha … I need to save this paragraph for future recycling:"As expected, this accounting truism ruffled the feathers of a flock of readers who have been programmed to launch into an anti-government tirade at the mere mention of the public sector and to regard the dangers of deficit spending as an unimpeachable fact. And while you’re certainly entitled to your own political views, you are not, as Senator Moynihan famously said, entitled to your own facts."Excellent posts. Thanks a lot!

  3. absolutely WONDERFUL post here Stephanie. Thank you so much!

  4. Thanks so much for your work and keeping up the good fight.These posts are great.

  5. Thank you, Stephanie. Your record of unimpeachable clarity is still unblemished. This is the clearest most understandable account of the open economy sectoral balance model I've seen yet. I hope people can wait till later to learn about the cat, and content themselves with thinking about Old Yeller.

  6. Your assumptions are based on free flows and ceteris parabus, and are therefore wrong, badly wrong. You completely ignore serious structural impediments imposed by government upon the otherwise "private" sector. They consist of increasingly stringent structural flaws embodied in education, regulations, taxes, political favoritism, etc. Government has changed the face of the private sector so drastically and so detrimentally over the past decades (increasing exponentially over the period from the 90's to now) that your balance model is flawed from the outset. The economy is more than equations, and money is more than just a psychological ploy to lead the sheeple around by their collective nose (ever heard of 'value'?). Good luck with all that.

  7. As a non-economist, this sentence confused me:"Thus, a positive current account implies a negative capital account and vice versa."After reading the link provided, I think the intended meaning would be conveyed better by:"Thus, a positive current account implies a negative (impact upon) the capital account, and vice versa."This is probably obvious to most people who read this blog, but it caused my only stumble in an otherwise spectacularly clear and accessible treatment of this very important topic, so…

  8. InvestorcsCan you read? I provided an air-tight description of the way private, public, and foreign sector balance sheets MUST move in relation to one another. This is not a ceteris paribus analysis. I provided 235 sets of data. The government may have been beating up the private sector the entire time, but the actual, real-world data fit the model in all 235 cases.Why don't you force yourself to look at the data. Maybe you're better with numbers than prose.

  9. Absolutely excellent presentation. If only I had Obama's email address — not that it would do much good, the man appears to be economically illiterate.

  10. And let me add to:http://neweconomicperspectives.blogspot.com/2011/06/what-happens-when-government-tightens.html?showComment=1307275757461#c8131083971360206624by saying that not one case in the data falsifies the sectoral balance model.Also, what does your reply have to do with the price of eggs. Why are you criticizing her for not talking about the cat? You say:"The economy is more than equations, and money is more than just a psychological ploy to lead the sheeple around by their collective nose (ever heard of 'value'?)."But where is this statement of yours contradicted in the post?

  11. "Your assumptions are based on free flows and ceteris parabus, and are therefore wrong, badly wrong. You completely ignore serious structural impediments imposed by government upon the otherwise "private" sector. "And then there are those individuals who are completely ineducable.

  12. As a quick initial comment, equation #3 in the post is incorrect. It should subtract the capital account, not add it.For instance, using the data set provided, for 2009 Q4: 7.5% = Domestic private surplus -10.34% = Govt surplus 2.84% = Capital Account.#3 above gives 7.5 = -(-10.34) + 2.84, which is incorrect. It should be 7.5 = -(-10.34) – 2.84.Equations 2 and 3 say that the current account equals the negative of the capital account, which I believe is the definition of the two concepts.

  13. The basic argument of these posts (government belt tightening is bad) is predicated on the assumption that a domestic private surplus (savings greater than investment) is good. For these posts to have any meaning, you need to show that economic growth is higher, unemployment is lower, or there is some other benefit when savings is greater than investment.I don’t have the time right now for a detailed comparison of the sectorial balances data set provided with GDP or unemployment figures. However, from a quick scan of the data I don’t see an obvious correlation between the domestic private surplus and economic health. Since I’m told the primary concern of MMT is with full employment, perhaps you can use the data to show that a domestic private surplus translates into lower unemployment.Without evidence showing that a domestic surplus (more savings than investment) provides a benefit to the economy these two posts appear to be a nice explanation of basic macro economic concepts with an assumption that government deficits and private surpluses are good. Now we need the evidence that the assumption is correct.

  14. Here, we can see that the private sector’s financial position was deteriorating because it was making large (net) payments to foreigners. Because this loss of financial resources was not offset by the public sector, the private sector’s financial position deteriorated.One could also say: Because this financial loss was not successfully avoided through active industrial policy (or, if you're a neoliberal: real wage depression) to keep the local economy competitive to the extent that the current account was in balance, the private sector's financial position deteriorated.To what extent do you believe that active management of the current account is a necessary or negligible part of good economic policy, or even possibly? And I ask this with respect to all kinds of open economies, say, US, Luxembourg, India and/or Vanuatu.Thanks, Oliver

  15. "Thomas W said… Without evidence showing that a domestic surplus (more savings than investment) provides a benefit to the economy these two posts appear to be a nice explanation of basic macro economic concepts with an assumption that government deficits and private surpluses are good. Now we need the evidence that the assumption is correct. "the alternative would be domestic deficit. Which means – increasing private indebtedness. This actually happened during Clinton years (years of surplus) – and we see the consequences now. Private indebtedness has clear limits – as private sector cannot net-create money to pay the debts back. Only the government can do that.

  16. Thomas W — way ahead of you. Spent yesterday afternoon working up a chart to assist with the point. Also discovered that Scott Fullwiler and Randy Wray made essentially the same point — emphasizing different data — in a piece they wrote for Levy. I'll cite and and write something up. Right now, we have a backlog of posts, so it might be Thur. before you see something. Hang tight!

  17. Thomas W –Good catch! I don't know how the little dash got there. Pragmatic Capitalism picked it up as soon as it was posted, and it appears correctly on their site. http://pragcap.com/what-happens-when-the-government-tightens-its-belt-part-2 In any event, I am removing the (-) that appears before the Government Surplus in Equation [3]. As you rightly show, the government surplus will be a negative number when the government runs a deficit, so you will get: 7.5% private surplus = -10.34 government surplus + 2.84 Capital Account so all is well.

  18. Thomas W wrote "The basic argument of these posts (government belt tightening is bad) is predicated on the assumption that a domestic private surplus (savings greater than investment) is good. For these posts to have any meaning, you need to show that economic growth is higher, unemployment is lower, or there is some other benefit when savings is greater than investment."The basic idea is that government has no control of private saving desire but can respond to it. If government offsets demand leakage to saving, then the contraction that would take place otherwise need not occur.If S>I then C is unequal to I so not all goods available for sale are bought, resulting in unplanned inventory, which is the signal business uses to reduce production, which results in rising unemployment. If G makes up the difference, then output remains consistent with the objective of full employment.The objection is that this will be inflationary. The MMT response is that as long as government limits its net injection to offsetting demand leakage, inflation will not occur.

  19. Tom Hickey wrote: "If S>I then C is unequal to I so not all goods available for sale are bought, resulting in unplanned inventory, …"I don't understand. I is investment, C is consumption. I don't see what inventory has to do with it, and I'm unaware of any economic theory that investment must equal consumption.If I understand the concepts correctly, from a non-MMT standpoint: (S-I) equals (G-T) + (current account balance)(S-I) is private money not spent on consumption and not invested. This must equal net money spend on imports (current account balance) plus money spent funding the government deficit (G-T).Thus, (S-I) is private savings which cannot be used for investment because it must be used elsewhere (imports, deficit). In asking if a larger (S-I) is a good thing, the question seems to be whether (S-I) is larger because S increased (more savings, possibly good) or because I decreased (less investment, which doesn't seem good).However, the real question is still whether empirical data shows that a larger (S-I) corresponds with a healthier economy.

  20. New Economic Perspectives writes: In any event, I am removing the (-) that appears before the Government Surplus in Equation [3]. As you rightly show, the government surplus will be a negative number when the government runs a deficit, so you will get: 7.5% private surplus = -10.34 government surplus + 2.84 Capital Account so all is well.This is still incorrect: 7.5 = -10.34 + 2.84is not true. You either need to use "Domestic Private Deficit" on the left side or express the equation as in my comment — keep the minus sign and subtract the capital account balance.Either way, equations 2 and 3 say the same thing, just looking at opposite perspectives.

  21. Thomas,No. This is a sectoral balance sheet identity, so "one man's surplus is the other man's deficitt", so to speak. The sign on the left is, of necessity, different from the sign on the right.

  22. I'm new to this, but it looks to me like you are leaving out something important.These are flows right, so I>S implies a drain on some store of wealth (private assets?) and S>I implies an inflow to the store. Likewise of G and T for the equivalent government store.So what happens at the "bottom" of these stores. I can see a few options:1: The low one borrows from the other, don't we then need to account for interest payments? if that goes on indefinitely the interest payments will grow to dominate all other terms.2: The amount of money in play can be increased, most directly through printing, but that effectively changes the units, if you double the number of dollars in the world then they will half in value.What am I missing here?

  23. Tolomea – the government "store of wealth" (financial wealth in its own currency) is effectively infinite, as you recognize when you mention printing. #2 is wrong, because doubling the number of dollars is highly ambiguous. The only way that there would be a mere "unit change" is if all assets and debts were doubled too. As if everybody started counting their wealth and liabilities in half-dollars. Why bother?Money is credit/debt, and most of the dollars running around were created from private debt, are bank liabilities. The net "number of dollars" is the national debt, which in modern capitalistic economies is much smaller than the "number of dollars" / money supply / national + private dollar debt. All the recent deficit spending has barely kept up with ongoing debt-deflation. Doubling the national debt would be a lot better than what we are doing. It would mean a great deal of government spending that could do a great deal of good, get the unemployed back to work, help debtors pay their debts and stabilize the financial system. The USA has skimped on an enormous amount of government spending since the late 60s and has a zillion obvious uses for the money. Might be inflationary, especially if one tried to do it all at once (for no reason) but would be nowhere near doubling the "number of dollars" or halving the value of the dollar.

  24. Thomas WI doubt that data will support a correlation of healthy economy with higher private sector surplus. But building on what Tom Hickey has said, the beginning of period balance sheet is relevant to the private sector in a way that it isn't for the govt sector. Healthy private sector balance sheets cushion fluctuations in economic conditions, and promote spending and investment. In other words, the stance taken in flow terms is affected by stock considerations for the private sector, but not for the govt. Isn't this rationale compelling for you?

  25. Thomas W, sorry to have apparently confused you. I've attempted to lay out this point about demand leakage due to saving more clearly in a separate post. http://mikenormaneconomics.blogspot.com/2011/06/mmt-and-sectoral-balances-its-demand.html

  26. @Anders: I'm afraid your explanation doesn't make sense. You seem to be saying a private sector surplus won't correlate with a healthy economy, but it's needed anyway.@Tom Hickey: I'm afraid your longer explanation doesn't really help, you seem to assume I'll know what "demand leakage" is, which I don't (and a quick web search brings up lots of water supply links). Though thank you for the link to Hyman Minsky's paper, I've wanted to read some of Mr. Minsky's work but don't really have the time for a full book.I'll watch the MMT primer and see what it says. I'd still like some data showing that any given method has some connection to reality (as should be expected from a discussion which started with physics concepts, in physics theory doesn't matter if it doesn't match observation). Too many people have had to live in poverty because of some economic or social theory which worked better on paper than reality.

  27. Thomas WThe theoretical basis is quite simple:1. Strong balance sheets provide security and a cushion for when economic conditions fluctuate2. For a monetarily sovereign govt, there is no such thing as a 'strong' or 'weak' balance sheet, so no need to run a surplus to build a strong balance sheet – so it's the private sector balance sheets one should worry about3. You need to allow private surpluses to happen, in order to build strong private balance sheetsWhich of these three don't you agree with?The empirical basis will be less clear, but this is to be expected in macroeconomics, as an open economy is such a complex system that any fact pattern can submit to multiple explanations. The contrast with physics is inevitable: you can't do controlled experiments in an economy. That said, MMT associates govt surpluses with a rising private sector indebtedness. Every period of govt surplus since the early 1800s in the US has been followed by recession. I would think that the greater the level of private sector indebtedness (eg Japan 1992, US 2007), the deeper and more prolonged the subsequent recession.

  28. Thomas W said…"The basic argument of these posts (government belt tightening is bad) is predicated on the assumption that a domestic private surplus (savings greater than investment) is good. For these posts to have any meaning, you need to show … there is some … benefit when savings is greater than investment."I agree with the above poster and just wanted to add that for most people (including myself) it is not self evident that a private surplus (S > I) is a good thing, or a bad thing for that matter. For us laymen it would be quite useful if the implications, both short and/or long term, of a private surplus(S > I) & deficit(S < I) could be explained in more detail.I ask this because my father, who is a financial planner, had the opposite reaction believing that a private deficit(S < I) would be a good thing. How can I convince him or at least explain your MMT position that the opposite is true?

  29. Anders:You mention a recession after every period that the US government ran a surplus. I also find recessions after the government runs a deficit. I find recessions ending with both surpluses and deficits. The same is the case with the Domestic Private Savings (S-I) number that MMT treats as important — I can find recessions that began while (S-I) is positive or recessions that began while (S-I) was negative.I'd still like to see the data (note I haven't read Scott Fullwiler's latest post, will try to do so Sunday).

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