Category Archives: The Federal Government Deficit

‘Monetization’ of Budget Deficits

Posted on August 25, 2009 by admin | 9 comments

It is commonly believed that government faces a budget constraint according to which its spending must be “financed” by taxes, borrowing (bond sales), or “money creation”. Since many modern economies actually prohibit direct “money creation” by the government’s treasury, it is supposed that the last option is possible only through complicity of the central bank—which could buy the government’s bonds, and hence finance deficit spending by “printing money”.

Actually, in a floating rate regime, the government that issues the currency spends by crediting bank accounts. Tax payments result in debits to bank accounts. Deficit spending by government takes the form of net credits to bank accounts. Operationally, the entities receiving net payments from government hold banking system liabilities while banks hold reserves in the form of central bank liabilities (we can ignore leakages from deposits—and reserves—into cash held by the non-bank public as a simple complication that changes nothing of substance). While many economists find the coordinating activities between the central bank and the treasury quite confusing. I want to leave those issues mostly to the side and simply proceed from the logical point that deficit spending by the treasury results in net credits to banking system reserves, and that these fiscal operations can be huge. (See Bell 2000, Bell and Wray 2003, and Wray 2003/4)

If these net credits lead to excess reserve positions, overnight interest rates will be bid down by banks offering the excess in the overnight interbank lending market. Unless the central bank is operating with a zero interest rate target, declining overnight rates trigger open market bond sales to drain excess reserves. Hence, on a day-to-day basis, the central bank intervenes to offset undesired impacts of fiscal policy on reserves when they cause the overnight rate to move away from target. The process operates in reverse if the treasury runs a surplus, which results in net debits of reserves from the banking system and puts upward pressure on overnight rates—relieved by open market purchases. If fiscal policy were biased to run deficits (or surpluses) on a sustained basis, the central bank would run out of bonds to sell (or would accumulate too many bonds, offset on its balance sheet by a treasury deposit exceeding operating limits). Hence, policy is coordinated between the central bank and the treasury to ensure that the treasury will begin to issue new securities as it runs deficits (or retire old issues in the case of a budget surplus). Again, these coordinating activities can be varied and complicated, but they are not important to our analysis here. When all is said and done, a budget deficit that creates excess reserves leads to bond sales by the central bank (open market) and the treasury (new issues) to drain all excess reserves; a budget surplus causes the reverse to take place when the banking system is short of reserves.

Bond sales (or purchases) by the treasury and central bank are, then, ultimately triggered by deviation of reserves from the position desired (or required) by the banking system, which causes the overnight rate to move away from target (if the target is above zero). Bond sales by either the central bank or the treasury are properly seen as part of monetary policy designed to allow the central bank to hit its target. This target is exogenously “administered” by the central bank. Obviously, the central bank sets its target as a result of its belief about the impact of this rate on a range of economic variables that are included in its policy objectives. In other words, setting of this rate “exogenously” does not imply that the central bank is oblivious to economic and political constraints it believes to reign (whether these constraints and relationships actually exist is a different matter).

In conclusion, the notion of a “government budget constraint” only applies ex post, as a statement of an identity that has no significance as an economic constraint. When all is said and done, it is certainly true that any increase of government spending will be matched by an increase of taxes, an increase of high powered money (reserves and cash), and/or an increase of sovereign debt held. But this does not mean that taxes or bonds actually “financed” the government spending. Government might well enact provisions that dictate relations between changes to spending and changes to taxes revenues (a balanced budget, for example); it might require that bonds are issued before deficit spending actually takes place; it might require that the treasury have “money in the bank” (deposits at the central bank) before it can cut a check; and so on. These provisions might constrain government’s ability to spend at the desired level. Belief that these provisions are “right” and “just” and even “necessary” can make them politically popular and difficult to overturn. However, economic analysis shows that they are self-imposed and are not economically necessary—although they may well be politically necessary. From the vantage point of economic analysis, government can spend by crediting accounts in private banks, creating banking system reserves. Any number of operating procedures can be adopted to allow this to occur even in a system in which responsibilities are sharply divided between a central bank and a treasury. For example, in the US, complex procedures have been adopted to ensure that treasury can spend by cutting checks; that treasury checks never “bounce”; that deficit spending by treasury leads to net credits to banking system reserves; and that excess reserves are drained through new issues by treasury and open market sales by the Fed. That this all operates exceedingly smoothly is evidenced by a relatively stable overnight interbank interest rate—even with rather wild fluctuations of the Treasury’s budget positions. If there were significant hitches in these operations, the fed funds rate would be unstable.

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Posted in L. Randall Wray, Monetary policy, Taxes, The Federal Government Deficit, The National Debt, Uncategorized

Tagged Fiscal Policy, Government's IOU, L. Randall Wray, Monetary policy, Taxes, The Federal Government Deficit, The National Debt

A Primer on Government Surpluses

Posted on August 15, 2009 by admin | 6 comments

By L. Randall Wray [via CFEPS]

What is a federal government surplus?

When the federal government’s revenue exceeds its spending over the course of a year, it is running a budget surplus and outstanding Treasury securities will be reduced by the same amount over the year. In 1999, the federal government’s surplus was $99 billion and it is projected to grow to $142 billion for fiscal year 2000. This means that US taxpayers will pay $142 billion more in taxes this year than the government spends. More concretely, taxpayers will write checks to the Internal Revenue Service in the amount of $1.914 trillion, while the US Treasury will write checks received by Americans in the amount of only $1.772 trillion—a difference of $142 billion. The only way that taxpayers can write checks to the IRS that exceed the amount of checks received from the Treasury is to surrender $142 billion of Treasury securities to the government. In other words, running a surplus necessarily means that the Treasury is reducing nominal wealth of the non-government sector. This is why federal budget surpluses reduce outstanding Treasury debt and non-government sector net nominal worth.

What is the long-term effect of running perpetual government surpluses?

On current projections, the federal government will run surpluses over this decade that will total more than $2.9 trillion, leading to an equivalent reduction of non-government sector net nominal wealth—of $2.9 trillion. This wipes out almost 80% all of the publicly-held US Treasury debt, including that now held by foreigners. No one can accurately predict how the economy will react to such an unprecedented reduction of its nominal wealth—especially when the most liquid assets will be removed from private portfolios. However, throughout our history, the US has experienced exactly six periods of substantial reduction of federal government debt, achieved through persistent budget surpluses, and each of those periods ended in one of our nation’s six depressions. Our last period of substantial surpluses occurred between 1920 and 1930, when Treasury debt was reduced by 36%; the Great Depression began in 1929. For a more recent example, Japan began to run government surpluses in 1987, which reduced non-governmental nominal wealth and generated a deep recession that has already lasted a decade. Note, however, that neither the US in the 1920s nor Japan in the late 1980s came close to draining $2.9 trillion worth of wealth from the economy, even after adjusting for higher prices today.

Doesn’t a budget surplus allow us to save for the future?

Those who believe that a surplus can be “saved” for the future, or “used” to finance tax cuts or spending increases simply do not understand the nature of a surplus. Does anyone really believe that we can “save for the future” by burning $3 trillion worth of private sector wealth? During any period, the government can always choose to spend more (or less), in which case the surplus over the period may be lower (or higher); similarly, it can increase (decrease) taxes and thereby may increase (decrease) the surplus. But, as Gertrude Stein said, “there is no there there”-a surplus exists only as a deduction from private sector income. The negative household saving that some commentators are finally noticing is merely the accountant’s flip-side to the budget surplus. A government surplus necessarily reduces private sector savings and cannot be “saved for the future”.

How do budget surpluses impact non-government sector financial balances?

There is another, less transparent, impact of government surpluses on the non-government sector. At the level of the economy as a whole, when one sector spends more than its income, another necessarily spends less for the simple reason that in the aggregate, total spending equals total income. Let us, then, disaggregate the economy into three sectors to determine the implications of government surpluses for the other sectors. First, we can consolidate all levels of government into a public (or, government) sector, and likewise consolidate households and firms into a domestic, non-government (or, private) sector. For completion, we must add a foreign (“rest-of-the-world”) sector. At the aggregate level, the spending of all three sectors combined must equal the income received by the three sectors. It is clear that if the public sector is spending less than its income—that is, it is running a surplus—this must imply that at least one other sector is spending more than its income (in other words, is running a deficit). Mathematically, the sum of the balances of the three sectors must equal zero. It is convenient for our purposes to write this as:

{Public Sector Surplus} + {Foreign Sector Surplus} = {Private Sector Deficit},

which merely moves the private sector balance to the right-hand-side and reverses the sign (in other words, writes the balance as a deficit rather than a surplus, since a negative surplus is the same thing as a deficit).

Because the US has been running a balance of payments deficit in recent years, this means that the foreign sector is in surplus (the rest-of-the-world receives more US dollars than it spends). A few years ago, our public sector ran a sufficiently large deficit to more than offset the foreign sector surplus, so that our domestic non-government sector was able to run surpluses. However, in the past two years, the US public sector’s balance has turned toward surplus. When combined with our balance of payments deficit (or foreign sector surplus), this means that the domestic private sector’s balance (that is, its savings) has turned sharply negative—toward large and growing deficits. The non-government sector deficit is now approximately equal to 5.5 percent of GDP—far and away the largest private sector deficit the US has seen in the post-war period.

Will the federal government really run surpluses for the next decade?

It is very difficult to take seriously any analyses that begin with the projection that our government will run surpluses for the next decade. Part of our skepticism comes from the inherent difficulty in making projections. More importantly, it is difficult to believe that our economy can continue to grow robustly as the government sucks disposable income and wealth from the private sector by running surpluses. When the economy slows, the surplus will eventually disappear—automatically—as unemployment compensation rises and tax revenue falls due to the slowdown. As the government spends more and taxes less, the surplus will vanish.

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Posted in L. Randall Wray, Taxes, The Federal Government Deficit, The National Debt, Uncategorized

Tagged L. Randall Wray, Taxes, The Federal Government Deficit, The National Debt

How to Implement True, Full Employment

Posted on August 12, 2009 by admin | 5 comments

By L. Randall Wray

We will briefly describe a program that would generate true, full employment, price stability, and currency stability. We will show that this program can be adopted in any nation that issues its own currency. Our presentation consists of three sections. First, we briefly examine a pilot program at the University of Missouri—Kansas City (UMKC). This provides the basis for the analysis in the second section of the functioning of a national monetary system. Finally, we show how this knowledge can be used to construct a public service program (PSE) that guarantees true, full employment with price and currency stability.

The Buckaroo Program

In the United States, there is a growing movement on college campuses to increase student involvement in their communities, particularly through what is known as “service-learning” in which students participate in community service activities organized by local community groups. It should become obvious that a modern monetary economy that adopts the full employment program described here will operate much like our community service hours program.

We have chosen to design our program as a “monetary” system, creating paper notes, “buckaroos” (after the UMKC mascot, a kangaroo), with the inscription “this note represents one hour of community service by a UMKC student”, and denominated as “one roo hour”. Each student is required to pay B25 to the UMKC “Treasury” each semester. Approved community service providers (state and local government offices, university offices, public school districts, and not-for-profit agencies) submit bids for student service hours to the Treasury, which “awards” special drawing rights (SDRs) to the providers so long as basic health, safety, and liability standards are met. The providers then draw on their SDRs as needed pay students B1 per hour worked. This is equivalent to “spending” by the UMKC treasury. Students then pay their taxes with buckaroos, retiring Treasury liabilities.

Several implications are immediately obvious. First, the UMKC treasury cannot collect any buckaroo taxes until it has spent some buckaroos. Second, the Treasury cannot collect more buckaroos in payment of taxes than it has previously spent. This means that the “best” the Treasury can hope for is a “balanced budget”. Actually, it is almost certain that the Treasury will run a deficit as some buckaroos are “lost in the wash” or hoarded for future years. While it is possible that the Treasury could run a surplus in future years, this would be limited by the quantity of previously hoarded buckaroos that could be used to pay taxes. Third, and most important, it should be obvious that the Treasury faces no “financial constraints” on its ability to spend buckaroos. Indeed, the quantity of buckaroos provided is “market demand determined”, by the students who desire to work to obtain buckaroos and by the providers who need student labor. Furthermore, it should be obvious that the Treasury’s spending doesn’t depend on its tax receipts. To drive the point home, we can assume that the Treasury always burns every buckaroo received in payment of taxes. In other words, the Treasury does not impose taxes in order to ensure that buckaroos flow into its coffers, but rather to ensure that student labor flows into community service. More generally, the Treasury’s budget balance or imbalance doesn’t provide any useful information to UMKC regarding the program’s success or failure. A Treasury deficit, surplus, or balance provides useless accounting data.

Note that each student has to obtain a sufficient number of buckaroos to meet her tax liability. Obviously, an individual might choose to earn, say, B35 in one semester, holding B10 as a hoard after paying the B25 tax for that semester. The hoards, of course, are by definition equal to the Treasury’s deficit. UMKC has decided to encourage “thrift” by selling interest-earning buckaroo “bonds”, purchased by students with excess buckaroo hoards. This is usually described as government “borrowing”, thought to be necessitated by government deficits. Note however, that the Treasury does not “need” to borrow its own buckaroos in order to deficit spend—no matter how high the deficit, the Treasury can always issue new buckaroos. Indeed, the Treasury can only “borrow” buckaroos that it has already spent, in fact, that it has “deficit spent”. Finally, note that the Treasury can pay any interest rate it wishes, because it does not “need” to “borrow” from students. For this reason, Treasury bonds should be seen as an “interest rate maintenance account” designed to keep the base rate at the Treasury’s target interest rate. Without such an account, the “natural base interest rate” is zero for buckaroo hoards created through deficit spending. Note that no matter how much the Treasury spends the base rate would never rise above zero unless the Treasury offers positive interest rates; in other words, Treasury deficits do not place any pressure on interest rates.

What determines the value of buckaroos? From the perspective of the student, the “cost” of a buckaroo is the hour of labor that must be provided; from the perspective of the community service provider, a buckaroo buys an hour of student labor. So, on average, the buckaroo is worth an hour of labor—more specifically, an hour of average student labor. Note that we can determine the value of the buckaroo without reference to the quantity of buckaroos issued by the Treasury. Whether the Treasury spends a hundred thousand buckaroos a year, or a million a year, the value is determined by what students must do to obtain them.

The Treasury’s deficit each semester is equal to the “extra” demand for buckaroos coming from students; indeed, it is the “extra” demand that determines the size of the Treasury’s deficit. We might call this “net saving” of buckaroos, and it is equal—by definition—to the Treasury’s deficit over the same period. What if the Treasury decided it did not want to run deficits, and so proposed to limit the total number of buckaroos spent in order to balance the budget? In this case, it is almost certain that some students would be unable to meet their tax liability. Unlucky, procrastinating students would find it impossible to find a community service job, thus would find themselves “unemployed” and would be forced to borrow, beg, or steal buckaroos to meet their tax liabilities. Of course, any objective analysis would find the source of the unemployment in the Treasury’s policy, and not in the characteristics of the unemployed. Unemployment at the aggregate level is caused by insufficient Treasury spending.

Some of thisanalysis applies directly to our economic system as it actually operates, while some of it would apply to the operation of our system if it were to adopt a full employment program. Let us examine the operation of a modern money system.

Modern Monetary Systems

In all modern economies, money is a creature of the State. The State defines money as that which it accepts at public pay offices (mainly, in payment of taxes). Taxes create a demand for money, and government spending provides the supply, just as our buckaroo tax creates a demand for buckaroos, while spending by the Treasury provides the supply. The government does not “need” the public’s money in order to spend; rather, the public needs the government’s money in order to pay taxes. This means that the government can buy whatever is for sale in terms of its money merely by providing it.

Because the public will normally wish to hold some extra money, the government will normally have to spend more than it taxes; in other words, the normal requirement is for a government deficit, just as the UMKC Treasury always runs a deficit. Government deficits do not require “borrowing” by the government (bond sales), rather, the government provides bonds to allow the public to hold interest-bearing alternatives to non-interest-bearing government money. Further, markets cannot dictate to government the interest rate it must pay on its debt, rather, the government determines the interest rate it will pay as an alternative to non-interest-earning government money. This stands conventional analysis on its head: fiscal policy is the primary determinant of the quantity of money issued, while monetary policy primarily has to do with maintaining positive interest rates through bond sales—at the interest rate the government chooses.

In summary, governments issue money to buy what they need; they tax to generate a demand for that money; and then they accept the same money in payment of the tax. If a deficit results, that just lets the population hoard some of the money. If the government wants to, it can let the population trade the money for interest earning bonds, but the government never needs to borrow its own money from the public.

This does not mean that the deficit cannot be too big, that is, inflationary; it can also be too small, that is deflationary. When the deficit is too small, unemployment results (just as it results at UMKC when the Treasury’s spending of buckaroos is too small). The fear, of course, is that government deficits might generate inflation before full employment can be reached. In the next section we describe a proposal that can achieve full employment while actually enhancing price stability.

Public Service Employment and Full Employment with Price and Currency Stability

Very generally, the idea behind our proposal is that the national government provides funding for a program that guarantees a job offer for anyone who is ready, willing and able to work. We call this the Public Service Employment program, or PSE. What is the PSE program? What do we want to get out of it?

1. It should offer a job to anyone who is ready, willing and able to work; regardless of race or gender, regardless of education, regardless of work experience; regardless of immigration status; regardless of the performance of the economy. Just listing those conditions makes it clear why private firms cannot possibly offer an infinitely elastic demand for labor. The government must play a role. At a minimum, the national government must provide the wages and benefits for the program, although this does not actually mean that PSE must be a government-run program.

2. We want PSE to hire off the bottom. It is an employment safety net. We do not want it to compete with the private sector or even with non-PSE employment in the public sector. It is not a program that operates by “priming the pump”, that is, by raising aggregate demand. Trying to get to full employment simply by priming the pump with military spending could generate inflation. That is because military Keynesianism hires off the top. But by definition, PSE hires off the bottom; it is a bufferstock policy—and like any bufferstock program, it must stabilize the price of the bufferstock—in this case, wages at the bottom.

3. We want full employment, but with loose labor markets. This is virtually guaranteed if PSE hires off the bottom. With PSE, labor markets are loose because there is always a pool of labor available to be hired out of PSE and into private firms. Right now, loose labor markets can only be maintained by keeping people out of work—the old reserve army of the unemployed approach.

4. We want the PSE compensation package to provide a decent standard of living even as it helps to maintain wage and price stability. We have suggested that the wage ought to be set at $6.25/hr in the USA to start. A package of benefits could include healthcare, childcare, sick leave, vacations, and contributions to Social Security so that years spent in PSE would count toward retirement.

5. We want PSE experience to prepare workers for post-PSE work—whether in the private sector or in government. Thus, PSE workers should learn useful work habits and skills. Training and retraining will be an important component of every PSE job.

6. Finally, we want PSE workers to do something useful. For the U.S.A. we have proposed that they focus on provision of public services, however, a developing nation may have much greater need for public infrastructure; for roads, public utilities, health services, education. PSE workers should do something useful, but they should not do things that are already being done, and especially should not compete with the private sector.

These six features pretty well determine what a PSE program ought to look like. This still leaves a lot of issues to be examined. Who should administer the program? Who should do the hiring and supervision of workers? Who should decide exactly what workers will do? There are different models consistent with this general framework, and different nations might take different approaches. Elsewhere (Wray 1998, 1999) I have discussed the outlines of a program designed specifically for the USA. Very briefly, I suggest that given political realities in the USA, it is best to decentralize the program as much as possible. State and local governments, school districts, and non-profit organizations would be allowed to hire as many PSE workers as they could supervise. The federal government would provide the basic wage and benefit package, while the hiring agencies would provide supervision and capital required by workers (some federal subsidy of these expenses might be allowed). All created jobs would be expected to increase employability of the PSE workers (by providing training, experience, work records); PSE employers would compete for PSE workers, helping to achieve this goal. No PSE employer would be allowed to use PSE workers to substitute for existing employees (representatives of labor should sit on all administrative boards that make hiring decisions). Payments by the federal government would be made directly to PSE workers (using, for example, Social Security numbers) to reduce potential for fraud.

Note that some countries might choose a much higher level of centralization. In other words, program decentralization is dictated purely by pragmatic and political considerations. The only essential feature is that funding must come from the national government, that is, from the issuer of the currency.

Before concluding, let us quickly address some general questions. First, many people wonder about the cost—can we afford full employment? To answer this, we must distinguish between real costs and financial expenditures. Unemployment has a real cost—the output that is lost when some of the labor force is involuntarily unemployed, the burdens placed on workers who must produce output to be consumed by the unemployed, the suffering of the unemployed, and social ills generated by unemployment and poverty. From this perspective, providing jobs for the unemployed will reduce real costs and generate net real benefits for society. Indeed, it is best to argue that society cannot afford unemployment, rather than to suppose that it cannot afford employment!

On the other hand, most people are probably concerned with the financial cost of full employment, or, more specifically, with the impact on the government’s budget. How will the government pay for the program? It will write checks just as it does for any other program. (See Wray 1998.) This is why it is so important to understand how the modern money system works. Any nation that issues its own currency can financially afford to hire the unemployed. A deficit will result only if the population desires to save in the form of government-issued money. In other words, just as in UMKC’s buckaroo program, the size of the deficit will be “market demand” determined by the population’s desired net saving.

Economists usually fear that providing jobs to people who want to work will cause inflation. Thus, it is necessary to explain how our proposed program will actually contribute to wage stability, promoting price stability. The key is that our program is designed to operate like a “buffer stock” program, in which the buffer stock commodity is sold when there is upward pressure on its price, or bought when there are deflationary pressures. Our proposal is to use labor as the buffer stock commodity, and as is the case with any buffer stock commodity, the program will stabilize the commodity’s price. The government’s spending on the program is based on a “fixed price/floating quantity” model, hence, cannot contribute to inflation.

Note that the government’s spending on the full employment program will fluctuate countercyclically. When the private sector reduces spending, it lays-off workers who then flow into the bufferstock pool, working in the full employment program. This automatically increases total government spending, but not prices because the wage paid is fixed. As the quantity of workers hired at the fixed wage rises, this results in a budget deficit. On the other hand, when the private sector expands, it pulls workers out of the bufferstock pool, shrinking government spending and thus reducing deficits. This is a powerful automatic stabilizer that operates to ensure the government’s spending is at just the right level to maintain full employment without generating inflation.

REFERENCES

Wray, L. Randall. 1998. Understanding Modern Money: the key to full employment and price stability, Cheltenham: Edward Elgar.

—–. 1999. “Public Service Employment—Assured Jobs Program: further considerations“, Journal of Economic Issues, Vol. 33, no. 2, pp. 483-490.

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Posted in L. Randall Wray, Monetary policy, Policy and Reform, Taxes, The Federal Government Deficit, The National Debt, Uncategorized, Unemployment

Tagged Fiscal Policy, L. Randall Wray, Monetary policy, Policy and Reform, Taxes, The Federal Government Deficit, The National Debt, unemployment

Social Security: Truth or Useful Fictions?

Posted on August 11, 2009 by admin | 4 comments

By L. Randall Wray [via CFEPS]

I. SOCIAL SECURITY IS AN ASSURANCE , NOT A PENSION PLAN

Social Security is an intergenerational assurance plan. Working generations agree to take care of retirees, dependents, survivors, and persons with disabilities. Currently, spouses, children, or parents of eligible workers make up more than a quarter of beneficiaries on OASDI. A large proportion will always be people without “normal” work histories who could not have made sufficient contributions to entitle them to a decent pension. Still, as a society, we have decided they should receive benefits.

Further, the program is not means tested. One need only meet statutory requirements to receive benefits. Indeed, as the Bush Commission’s Report emphasizes, the Supreme Court has twice ruled Social Security does not make intergenerational promises to the dead, but, rather, only to their survivors. The Bush Commission sees that as a weakness; I see it as a strength.

II. TRUST FUNDS DO NOT INCREASE GOVERNMENT’S ABILITY TO MEET COMMITMENTS (Advance Funding is a Fiction)

The Greenspan Commission tried to change Social Security from paygo to advance funding in 1983. But that is impossible; it just demonstrated a misunderstanding of accounting. The existence of a Trust Fund does not in any way, shape, or form enhance government’s ability to meet Social Security commitments. This point is difficult to get across.

The Social Security Trust Fund is one of Uncle Sam’s cookie jars. He also has a defense cookie jar, a corporate welfare cookie jar, etc. (See Figure 1.) We count taxes as Uncle Sam’s income, and he can pretend he stuffs the various cookie jars with those tax receipts — the payroll tax goes into the Social Security cookie jar, and he pretends it pays for Social Security spending. Maybe he pretends capital gains taxes go into the corporate welfare cookie jar. And so on. That is all internal accounting.

Figure 1: Federal Government Internal Accounts

Say Uncle Sam spends more on corporate welfare than he pretends to have in that cookie jar. But he pretends the Social Security cookie jar is overflowing with tax receipts because he runs a huge surplus there. (See Figure 2.) So Uncle Sam writes some IOUs from the corporate welfare cookie jar to the Social Security cookie jar to remind himself. Over time, the Social Security cookie jar accumulates Trillions of dollars of IOUs from Uncle Sam’s other cookie jars.

Figure 2: Trust Fund

That is just the government owing itself, and has no effect on the external accounts. (See Figure 3.) The total spent on Social Security, corporate welfare, transportation and so on equals its total spending for the year. The total it collects from taxes, including payroll taxes, capital gains taxes, gas taxes, and so on, equals its total income for the year. If government spends more than its income, that is called deficit spending. If it spends less, it runs a budget surplus. The cookie jar IOUs cannot change that in any way.

Figure 3: Federal Government External Accounts

Note I’m not saying there is anything wrong with the Treasury Securities held by the Trust Fund-Social Security can count them as an asset. But they will not in any way change the external accounting in 2017 or 2027 or 2041 — when the government’s overall spending will be less than, equal to, or greater than its overall tax receipts. (See Figure 4.) When Social Security begins to run a deficit, the existence of the Trust Fund will not reduce the amount of Treasury Securities sold to the nongovernment sector.

Indeed, comparison of Figure 4a with 4b demonstrates that the external accounts are not changed by existence of a Trust Fund-the implications for the government are the same.

Figure 4a: Social Security Runs $10 Billion Deficit, With Rest of Federal Government Budget in Balance, WITH TRUST FUND

Figure 4b: Social Security Runs $10 Billion Deficit, With Rest of Federal Government Budget in Balance, WITHOUT TRUST FUND

III. TRUST FUNDS DO NOT PROVIDE POLITICAL PROTECTION (Proof: They Fuel Privatization Scams)

Many economists realize that from the perspective of Uncle Sam, the Trust Fund is just an internal accounting construction. But I’ve had top economic advisors of both Democrats and Unions tell me while that is true, the Trust Fund provides political protection. That is clearly false. It is only because Social Security runs surpluses accumulated in a Trust Fund that we have all these privatizat ion scams. Do you really believe Wall Street fund managers would have any interest in Social Security if it ran deficits?

IV. SOCIAL SECURITY CANNOT FACE A FINANCIAL CONSTRAINT (Except One Imposed By Congress)

Social Security is unusual because unlike most other government programs, we pretend a specific tax finances it. That makes it easy to mentally match payroll tax revenues and benefit payments, and to calculate whether the 75 year actuarial balance is positive or negative. No one knows or car es whether the defense program runs actuarial deficits — because we don’t pretend that a particular tax pays for defense. In reality, Social Security benefits are paid in exactly the same way that the government spends on anything else-by crediting somebody’s bank account. Social Security cannot be any more financially constrained than any other government program. Only Congress can establish a financial constraint.

V. SOCIAL SECURITY DOES NOT APPEAR TO FACE REAL CONSTRAINTS, (America Can Afford 7% of GDP for Social Security)

Today OASDI benefits equal 4.5% of GDP; that grows to 7% over the next 75 years. Does anyone doubt that we will be able to afford to devote 7% of our nation’s output to provide a social safety net for retirees, survivors, and disabled persons? That leaves 93% of GDP for everything else. We have easily achieved larger shifts of GDP in the past without lowering living standards of the working generations. I cannot imagine a future so horrible that we won’t be able support OASDI in real terms.

VI. PRIVATIZATION IS NOT NEEDED, NOR CAN IT HELP TO PROVIDE FOR FUTURE BENEFICIARIES (Any Future Problems Are Not Financial; Financial Fixes Cannot Help)

Future beneficiaries cannot eat stocks or bonds, and we can’t dig holes today to bury Winnebagos for future retirees. Whatever beneficiaries consume in 2050 will have to be produced for the most part in 2050. Financial Fixes cannot change that. Whether the stock market outperforms Treasury bonds is irrelevant. Whether future retirees have amassed $100,000 in personal accounts is irrelevant. All that matters is future productive capacity plus a method of distributing a portion of output to the elderly in 2050.

To accomplish that, all we have to do is credit the bank accounts of the elderly in 2050, and then let the market work its wonders. I am frankly shocked that the Cato Institute refuses to trust the market, backing what amounts to tax credits for playing in equity markets.

VII. PERSONAL ACCOUNTS ARE FINE, BUT ARE NOT RELEVANT TO DISCUSSION OF SOCIAL SECURITY (A Targeted $40 Billion Give-Away is Probably a Good Idea!)

I also find it ironic that the Bush Commission wants to increase government spending by $40 billion a year to give money away to encourage the poor to save. Hey, let’s give them $80 billion a year. I’d prefer that the poor spend it, but if they want to sock it away in personal accounts, that’s fine by me. But, please, let’s provide Big Brotherly advice that they keep it out of Telecom stocks. And leave Social Security out of it!

VIII. SOCIAL SECURITY IS, ALWAYS HAS BEEN, ALWAYS WILL BE, SUBJECT TO CONGRESSIONAL GOODWILL (Maintained At the Ballot Box)

Only Congress can decide who deserves support, and what level of support. Only Congress can decide how much of GDP ought to be devoted to support of the elderly. That’s Democracy and I’m willing to live with it. The Bush Commission says this generates insecurity, but I expect the elderly will continue to use the ballot box to hold the feet of Politicians to the fire of Social Security.

IX. HONESTY IS THE BEST POLICY (Convenient Fictions About Finances Cannot Help)

In spite of all the complex financial fictions, the truth is simple. In 2041, Social Security’s beneficiaries will have to rely on the working population, just as they do today. No financial scams can change that. Trust funds, actuarial balances, privatization, and relative rates of return don’t change it. There ain’t no crisis; there ain’t no urgency. We’ve got two generations to increase our capacity to produce.

X. TOWARD A PROGRESSIVE REFORM (Stop Taxing Work!)

In 1960 it might have made some kind of twisted logic to levy a tax on payrolls and to pretend this paid for Social Security benefits. There were few benefits to be paid, but lots of payrolls to tax, so the tax rate was low. Today, and increasingly in the future, there are more benefits to pay relative to taxable payrolls. In just a few years, only 1/3 of National Income will be subject to the payroll tax- hence ever-higher payroll tax rates will be required to maintain the delusion.

Let’s stop pretending. Payroll taxes simply discourage work-which is as perverse as policy can get. We need people to work to provide all the goods and services the elderly need. Abolish the payroll tax, abolish the Trust Fund, abolish actuarial gaps, and let’s recognize that Social Security is an intergenerational assurance program.

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Posted in L. Randall Wray, Policy and Reform, Social Security, Taxes, The Federal Government Deficit, The National Debt, Uncategorized

Tagged L. Randall Wray, Policy and Reform, Social Security, Taxes, The Federal Government Deficit, The National Debt

Teaching the Fallacy of Composition: The Federal Budget Deficit

Posted on August 10, 2009 by admin | 32 comments

by L. Randall Wray (via CFEPS)

SUMMARY: One of the most important concepts to be taught in economics is the notion of the fallacy of composition: what might be true for individuals is probably not true for society as a whole. The most common example is the paradox of thrift: while an individual can save more by reducing spending (on consumption), society can save more only by spending more (for example, on investment). Another useful and very topical example involves the federal government’s budget deficit. Politicians and the media often argue that the government must balance its books, just like a household. If a household were to continually spend more than its income, it would eventually face insolvency; it is thus claimed that government is in a similar situation. However, careful examination of macroeconomic relations will show that this analogy is incorrect, and that it would lead to improper budgetary policy. This example can drive home the fallacy of composition.

One of the most important concepts we teach in economics, and most importantly in macroeconomics, is the notion of the fallacy of composition.

Students and others who haven’t been exposed to macroeconomics naturally extrapolate from their own individual situation to society and the economy as a whole.

This often leads to the problem of the fallacy of composition. Of course, that isn’t just restricted to economics. While a few people could exit the doors of a crowded movie theatre, all of us could not.

The macroeconomics example of the fallacy of composition most often used is the paradox of thrift. Any individual can increase her saving by reducing her spending—on consumption goods. So long as her decision does not affect her income—and there is no reason to assume that it would—she ends up with less consumption and more saving.

The example I always use involves Mary who usually eats a hamburger at Macdonald’s every day. She decides to forego one hamburger per week, to accumulate savings. Of course, so long as she sticks to her plan, she will add to her savings (and financial wealth) every week.

The question is this: what if everyone did the same thing as Mary—would the reduction of the consumption of hamburgers raise aggregate (national) saving (and financial wealth)?

The answer is that it will not. Why not? Because Macdonald’s will not sell as many hamburgers, it will begin to lay-off workers and reduce its orders for bread, meat, catsup, pickles, and so on.

All those workers who lose their jobs will have lower incomes, and will have to reduce their own saving. You can use the notion of the multiplier to show that this process comes to a stop when the lower saving by all those who lost their jobs equals the higher saving of all those who cut their hamburger consumption. At the aggregate level, there is no accumulation of savings (financial wealth).

Of course that is a simple and even silly example. But the underlying explanation is that when we look at the individual’s increase of saving, we can safely ignore any macro effects because they are so small that they have only an infinitely small impact on the economy as a whole.

But if everyone tries to increase saving, we cannot ignore the effects of lower spending on the economy as a whole. That is the point that has to be driven home.

We can then again return to the notion of the multiplier, and show that the way to increase aggregate saving is by increasing spending, specifically, nonconsumption spending—spending on investment, spending by government, or spending by foreigners on our exports.

I don’t want to go into that particular example any further. Another example that is less frequently used concerns unemployment.

The view shared by most of my undergraduate students is that unemployment is caused by laziness or lack of training. The argument they often use is that “I can get a job, therefore all the unemployed could get jobs if only they tried harder, or got better education and training”.

The way I go about demonstrating that fallacy is a dogs and bones example. Say we have 10 dogs and we bury 9 bones in the backyard. We send the dogs out to find bones. At least one dog will come back without a bone.

We decide that the problem is lack of training. We put that dog through rigorous training in the latest bone finding techniques. We bury 9 bones and send the 10 dogs out again. The trained dog ends up with a bone, but some other dog comes back without a bone (empty-mouthed, so to speak).

The problem, of course, is that there are not enough bones and jobs to go around. It is certainly true that a well-trained and highly motivated jobseeker can usually find a job. But that is no evidence that aggregate unemployment is caused by laziness or lack of training.

We could also go into the common belief that minimum wages cause unemployment. It is at least partly true that for an individual firm, higher wages reduce the number of workers hired. But we cannot extrapolate that to the economy as a whole. Higher wages mean higher income and thus higher consumption spending, which induces firms to employ more labor. So the truth is that economic theory does not tell us that raising minimum wages will lead to more unemployment, indeed, theory tells us it can go the other way—raising the minimum wage could increase employment.

Again, the reason we can reach the wrong conclusion in all of these cases when we aggregate up from the micro level to the macro is because we ignore the impacts that behavior of individuals or firms has on other individuals or firms. That can be OK for the case of the individual firm or household, but is almost certainly incorrect for firms and households taken as a whole.

Let me move on to a more important fallacy of composition. We hear politicians and the media arguing that the current federal budget deficit is unsustainable. I have heard numerous politicians refer to their own household situation: if my household continually spent more than its income year after year, it would go bankrupt. Hence, the federal government is on a path to insolvency, and by implication, the budget deficit is bankrupting the nation.

That is another type of fallacy of composition. It ignores the impact that the budget deficit has on other sectors of the economy. Let me go through this in some detail, as it is more complicated than the other examples.

We can divide the economy into 3 sectors. Let’s keep this as simple as possible: there is a private sector that includes both households and firms. There is a government sector that includes both the federal government as well as all levels of state and local governments. And there is a foreign sector that includes imports and exports; (in the simplest model, we can summarize that as net exports—the difference between imports and exports—although to be entirely accurate, we use the current account balance as the measure of the impact of the foreign sector on the balance of income and spending).

At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income).

Historically the US private sector spends less than its income—that is it runs a surplus. Another way of saying that is that the private sector saves. In the past, on average the private sector spent about 97 cents for every dollar of income.

Historically, the US on average ran a balanced current account—our imports were just about equal to our exports. (As discussed below, that has changed in recent years, so that today the US runs a huge current account deficit.)

Now, if the foreign sector is balanced and the private sector runs a surplus, this means by identity that the government sector runs a deficit. And, in fact, historically the government sector taken as a whole averaged a deficit: it spent about $1.03 for every dollar of national income.

Note that that budget deficit exactly offsets the private sector’s surplus—which was about 3 cents of every dollar of income. In fact, if we have a balanced foreign sector, there is no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Sure, one individual can spend less than her income, but another would have to spend more than his income.

While it is commonly believed that continual budget deficits will bankrupt the nation, in reality, those budget deficits are the only way that our private sector can save and accumulate net financial wealth.

Budget deficits represent private sector savings. Or another way of putting it: every time the government runs a deficit and issues a bond, adding to the financial wealth of the private sector. (Technically, the sum of the private sector surpluses equal the sum of the government sector deficits, which equals the outstanding government debt—so long as the foreign sector is balanced.)

Of course, the opposite would also be true. Assume we have a balanced foreign sector and that the government runs a surplus—meaning its tax revenues are greater than government spending. By identity this means the private sector is spending more than its income, in other words, it is deficit spending. The deficit spending means it is going into debt, and at the aggregate level it is reducing its net financial wealth.

At the same time, the government budget surplus means the government is reducing its debt. Effectively what happens is that the private sector returns government bonds to the government for retirement—the reduction of private sector wealth equals the government reduction of debt.

Now let us return to the Clinton years when the federal government was running the biggest budget surpluses the government has ever run. Everyone thought this was great because it meant that the government’s outstanding debt was being reduced. Clinton even went on TV and predicted that the budget surpluses would last for at least 15 years and that every dollar of government debt would be retired.

Everyone celebrated this accomplishment, and claimed the budget surplus was great for the economy.

In the middle of 2000, I wrote a contrary opinion (“Implications of a budget surplus at mid-year 2000, CFEPS Policy Note 2000/1). I made several arguments. First, I pointed out that the budget surplus meant by identity that the private sector was running a deficit. Households and firms were going ever farther into debt, and they were losing their net wealth of government bonds.

Second, I argued that this would eventually cause a recession because the private sector would become too indebted and thus would cut back spending. In fact, the economy went into recession within half a year.

Third, I argued that the budget surpluses would not last 15 years, as Clinton claimed. Indeed, I expected they would not last more than a couple of years. In fact, the budget turned around to large and growing deficits almost immediately as soon as the economy went into recession.

And of course we still have large budget deficits. No one talks any more about achieving budget surpluses this decade; almost everyone agrees that we will not see budget surpluses again in our lifetimes—if ever.

The question is whether the US government can run deficits forever. The answer is emphatically “yes”, and that it had better do so. If you look back to 1776, the federal budget has run a continuous deficit except for 7 short periods. The first 6 of those were followed by depressions—the last time was in 1929 which was followed by the Great Depression. The one exception was the Clinton budget surplus, which was followed (so far) only by a recession.

Why is that? By identity, budget surpluses suck income and wealth out of the private sector. This causes private spending to fall, leading to downsizing and unemployment. The only way around that is to run a trade or current account surplus.

The problem is that it is hard to see how the US can do that—in fact, our current account deficit is now rising toward 7% of GDP. All things equal, that means our budget deficit has to be even larger to allow our private sector to save. Given our current account balance, the budget deficit would have to reach 9% of GDP to allow our private sector to have a surplus of 2% of GDP.

I don’t want to give the impression that government deficits are always good, or that the bigger the deficit, the better. The point I am making is that we have to recognize the macro relations among the sectors.

If we say that a government deficit is burdening our future children with debt, we are ignoring the fact that this is offset by their saving and accumulation of financial wealth in the form of government debt. It is hard to see why households would be better off if they did not have that wealth.

If we say that the government can run budget surpluses for 15 years, what we are ignoring is that this means the private sector will have to run deficits for 15 years—going into debt that totals trillions of dollars in order to allow the government to retire its debt. Again it is hard to see why households would be better off if they owed more debt, just so that the government would owe them less.

There are other differences between the federal government and an individual household. The government is the issuer of our currency, while households are users of the currency. That makes a big difference, and one explored in many other CFEPS publications. However, the purpose of this particular note is to explain why we cannot aggregate up from the individual household situation to the economy as a whole. The US government’s situation is not in any way similar to that of a household because its deficit spending is exactly offset by private sector surpluses; its debt creates equivalent net financial wealth for the private sector.

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Posted in L. Randall Wray, Taxes, The Federal Government Deficit, Uncategorized

Tagged Fiscal Policy, L. Randall Wray, Taxes, The Federal Government Deficit

Leakages and Potential Growth

Posted on August 6, 2009 by admin | 1 comment

By L. Randall Wray

In his book, Leakages, Treval Powers makes the outrageous claim that without leakages, the US economy could grow at a sustained rate of 13% annually. According to his calculations (based on empirical evidence), normal leakages of 7.4% reduce the rate of growth to 5.6%, leaving the economy operating at only 92.6% of its capacity. Periodic restrictive policy by the Federal Reserve adds another layer of leakages, which can reduce growth to zero, causing the economy to operate at only 87% of potential.

Ironically, the Fed imposes tight policy because it wrongly believes that inflationary pressures result from excessive demand, even though the economy chronically operates well below capacity. Indeed, Powers argues that the greater the leakages, the higher the price level, hence, when the Fed tightens it actually puts upward pressure on prices. In his view, the economy has not been supply constrained, at least in the postwar era, so there has been no reason to fight inflation by constraining demand.

All of this goes against the conventional wisdom. Powers might be dismissed as a crank, as someone who simply does not understand economics. While I do find most of his analysis of monetary policy somewhat confusing, I agree with the general conclusions. What I will do in this note is to concur on two main points:

1. the US economy suffers from chronic inadequate demand, and has rarely been subject to any significant supply constraints—whether of productive capacity or of labor;

2. and leakages have been the cause of the demand constraints

Thus, I also agree with the policy conclusions of Powers: Fed policy can be seen as a string of mistakes guided by a fundamentally flawed view that causes the Fed to tighten policy exactly when it should be loosened. Inflation in the US does not result from excessive aggregate demand and, indeed, our worst bouts with inflation have come during periods of above-normal slack.

However, I do not believe that Fed policy normally has a huge impact on the economy, and for that we should be eternally grateful given how misguided it has been. This is the major disagreement I would have with Powers and other critics of the Fed. I could go even further and argue that we really do not know whether restrictive policy by the Fed actually reduces aggregate demand—and whether lower interest rates stimulate demand—but that would take us too far afield.

Fiscal policy is the primary way in which government impacts the economy, and, unfortunately, it has become increasingly misguided in ways that many do not understand—especially during the Bush dynasty era in which populists, leftists, and the Democratic party have wrongly advocated a return to what they call fiscal responsibility. Thus, rather than focusing on monetary policy failings as the cause of demand slack, I highlight the role played by fiscal policy.

Let me begin with my argument that the US economy, as well as the economies of all the other major nations, have suffered from demand constrained growth. Figure 1 compares the per capita inflation-adjusted GDP growth of the major developed nations—indexed to 100 in 1970. Note the relatively rapid growth of Japan.

Per capita (inflation adjusted) GDP growth can be attributed by identity to growth of the employment rate (workers divided by population) plus growth of productivity per worker. Figure 2 shows employment rate growth by nation. Note that only the US and Canada had much growth of the employment rate. The long term trend in these two countries is rising as more women come into the labor force. There are also obvious cyclical trends—especially in Canada—when employment rates can actually fall off due to unemployment. Employment rates actually fell in France on a long-term trend, while they were more or less stable in the other nations.

I attribute the low growth of employment rates to slow growth of aggregate demand; that is, if aggregate demand does not grow at a clip sufficiently above productivity growth, then employment rate growth must (identically) suffer. Indeed, growth in Japan and Europe has not been high enough to increase employment rates—so they have come up with all these schemes to increase vacations, lower retirement ages, and share work (France’s experiment with mandated work week reductions is the most glaring example).

Figure 3 shows productivity growth. Recall that the sum of growth of the employment rate plus growth of productivity equals total per capita GDP growth. Japan, Italy and France had the best productivity growth—these are all nations that had no employment growth. Note that the US is at the bottom here. In the US our employment rate grows fairly strongly (for a number of reasons: population growth, immigration, and women entering the labor force) but given low growth of GDP, our productivity suffers. Figure 4 shows that our growth is just about evenly divided between employment growth and productivity growth.

These two figures shed light on a three-decades long controversy over productivity growth in the US. All during the 1970s and 1980s there was this hysteria about low productivity growth that was supposed to be the cause of low GDP growth. This is a supply side argument and led to all the policy measures, like tax cuts for the rich and other schemes to raise saving, to try to stimulate productivity through induced investment. In fact, the low productivity falls out of an identity; if the US grows at only 3% and if our employment rate grows at 2% it is mathematically impossible for productivity to grow at anything other than 1%.

Figure 5 shows a hypothetical trade-off for the US, Europe and Japan. In other words, for the US to have productivity growth as high as that of Japan or Europe—or as high as we had during the so-called new economy boom under Clinton–we must grow above 4 or 5% per year. This is something we rarely achieve for very long—for reasons I’ll get to in a second. During the Clinton boom there was all this nonsense about information technology that had suddenly made it possible to grow at such rates precisely because productivity was supposed to be able to grow fast. In reality, the fast growth of the Clinton years could have been achieved at any time, if only demand had been that robust.

That brings me to my second main point—the leakages that constrain demand, resulting in chronic underperformance. We can think of the economy as being composed of 3 sectors: a domestic private sector, a government sector, and a foreign sector. If one of these spends more than its income, at least one of the others must spend less than its income because for the economy as a whole, total spending must equal total receipts or income. So while there is no reason why any one sector has to run a balanced budget, the system as a whole must. In practice, the private sector traditionally runs a surplus—spending less than its income. This is how it accumulates net financial wealth. For the US this has averaged about 2-3% of GDP, but it does vary considerably over the cycle. That is a leakage that must be matched by an injection.

Before Reagan we essentially had a balanced foreign sector—we ran trade surpluses or deficits, but they were small. After Reagan, we ran growing trade deficits, so that today they run about 5% of GDP. That is another leakage.

Finally, our government sector taken as a whole almost always runs a budget deficit. This has reached to around 5% under Reagan and both Bushes. That is the injection that offsets the private and foreign sector leakages. With a traditional private sector surplus of 3% and a more or less balanced trade account, the “normal” budget deficit needed to be about 3% during the early Reagan years. In robust expansions, before the Clinton years, the domestic private sector occasionally ran small and short lived deficits—an injection that allowed a trade deficit to open up, and reduced the government budget deficit. See Figure 6.

Until the Clinton expansion, the private deficits never exceeded about 1% of GDP and never lasted more than 18 months. However, since 1996 the private sector has been in deficit every year, and that deficit climbed to more than 6% of GDP at the peak of the boom. This actually drove the budget into surplus of about 2.5% of GDP. With the trade deficit at about 4% of GDP, the private sector deficit was the sum of those—almost 6.5%. While everyone thought the Clinton budget surplus was a great achievement, they never realized that by identity it meant that the private sector had to spend more than its income, so that rather than accumulating financial wealth it was running up debt.

Let me link this back to the leakages discussed by Powers. The trade deficit represents a leakage of demand from the US economy to foreign production. There is nothing necessarily bad about this, so long as we have another source of demand for US output, such as a federal budget that is biased to run an equal and offsetting deficit. Private sector net saving (that is, running a surplus) is also a leakage. As discussed above, that was typically 2-3% in the past. If we add in the trade deficit that we have today (5% of GDP), that gives us a total “normal” leakage out of aggregate demand of 7 or 8%–about equal to the estimates of Powers.

This leakage has to be made up by an injection from the third sector, the government. The only way to sustain a leakage of 7-8% is for the overall government to run a deficit of that size. Since state and local governments have to balance their budgets, and on average actually run surpluses, it is up to the federal government to run deficits. The federal budget deficit is largely non-discretionary over a business cycle, and at least over the shorter run we can take the trade balance as also outside the scope of policy.

The driving force of the cycle, then, is the private sector leakages. When the private sector has a strong desire to save, it tries to reduce its spending below its income. Domestic firms cut production, and imports might fall too. The economy cycles downward into a recession as demand falls and unemployment rises. Tax revenues fall and some kinds of social spending (such as unemployment compensation) rise. The budget deficit increases more-or-less automatically. That is where we are today, with Bush budget deficits rising to 5% of GDP and, soon, beyond. They will probably need to reach 8% before we get a sustained recovery.

In sum, we experienced something highly unusual during the Clinton expansion because the private sector was willing to spend far more than its income; the normal private sector leakages turned into very large injections. The economy grew quickly and tax revenues literally exploded. State governments and the federal government experienced record surpluses. These surpluses represented a leakage that brought the expansion to a relatively sudden halt. What we have now is a federal budget that is biased to run surpluses except when growth is very far below potential. This means is that the “normal” private sector balance now must be a large deficit in order for the economy to grow robustly.

Rather than the government sector being a source of injections that allow the leakages that represent private sector savings, we now have the private sector dissaving in order to allow the foreign and government sector leakages. This sets up a highly unstable situation because private debt ratios rise quickly and a greater percentage of income goes to service those debts. While I said at the beginning that Fed policy normally doesn’t matter much, in a highly indebted economy, rising interest rates can increase debt problems very quickly—setting off bankruptcies that can snowball into a 1930s-style debt deflation. A far more sensible policy would be to reverse course and lower interest rates, then keep them low.

At the same time, the federal government should take advantage of slack demand and abundant labor by increasing its spending on domestic programs. Robust economic growth fueled by federal deficits is the best way to reduce over-indebtedness. It is hard to say what to do (if anything) about euphoric stock or real estate markets that could be stoked by renewed growth. But the Fed’s sledgehammer approach of jacking up interest rates does not work. We will probably need selective credit controls to constrain financial speculation, if such is desired.

In conclusion, I agree with Powers that growth in the postwar period has mostly been demand constrained, due to leakages. If demand were to grow at 7% or even 10% on a sustained basis, I see no reason to believe that supply could not keep pace. This is all the more true in today’s global economy with massive quantities of underutilized resources all over the world, and with the rest of the world desires to accumulate dollar-denominated financial assets. This requires that they sell output to the US—which is just the counterpart to our trade deficit leakage. In real terms, a trade deficit means we can enjoy higher living standards without placing pressure on our own nation’s productive capacity. While it is hard to project maximum sustainable growth rates, there can be little doubt that our economy chronically operates far below feasible rates. The best policy would be to push up demand, allow growth rates to rise, and try to test those frontiers.

Reference:

Treval C. Powers, Leakage: The bleeding of the American economy, Benchmark Publications, Inc, New Canaan, Connecticut, 1996.

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Posted in L. Randall Wray, The Federal Government Deficit, Uncategorized, Unemployment

Tagged Fiscal Policy, Government's IOU, L. Randall Wray, The Federal Government Deficit, unemployment

Social Security: Another Case of Innocent Fraud?

Posted on August 5, 2009 by admin | 1 comment

By Warren Mosler* and Mathew Forstater**

In his recent book, The Economics of Innocent Fraud, John Kenneth Galbraith surveys a number of false beliefs that are being perpetuated among the American people about how our society operates: innocent (and sometimes not-so-innocent) frauds. There is perhaps no greater fraud being committed presently—and none in which the stakes are so high—as the fraud being perpetrated regarding government insolvency and Social Security. President Bush uses the word “bankruptcy” continuously. And the opposition agrees there is a solvency issue, questioning only what to do about it.

Fortunately, there is a powerful voice on our side that takes exception to the notion of government insolvency, and that is none other than the Chairman of the Federal Reserve. The following is from a transcript of a recent interview with Fed Chairman Alan Greenspan:

RYAN… do you believe that personal retirement accounts can help us achieve solvency for the system and make those future retiree benefits more secure?

GREENSPAN: Well, I wouldn’t say that the pay-as-you-go benefits are insecure, in the sense that there’s nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase. (emphasis added)

For a long time we have been saying there is no solvency issue (see C-FEPS Policy Note 99/02 and the other papers cited in the bibliography at the end of this report). Now with the support of the Fed Chairman, maybe we can gain some traction.

Let us briefly review, operationally, government spending and taxing. When government spends it credits member bank accounts. For example, imagine you turn on your computer, log in to your bank account, and see a balance of $1,000 while waiting for your $1,000 Social Security payment to hit. Suddenly the $1,000 changes to $2,000. What did the government do to make that payment? It did not hammer a gold coin into a wire connected to your account. It did not somehow take someone’s taxes and give them to you. All it did was change a number on a computer screen. This process is operationally independent of, and not operationally constrained by, tax collections or borrowing.

That is what Chairman Greenspan was telling us: constraints on government payment can only be self-imposed.

And what happens when government taxes? If your computer showed a $2,000 balance, and you sent a check for $1,000 to the government for your tax payment, your balance would soon change to $1,000. That is all—the government changed your number downward. It did not “get” anything from you. Nothing jumped out of the government computer into a box to be spent later. Yes, they “account” for it by putting information in an account they may call a “trust fund,” but this is “accounting”—after the fact record-keeping—and has no operational impact on government’s ability to later credit any account (i.e., spend!).

Ever wonder what happens if you pay your taxes in actual cash? The government shreds it. What if you lend to the government via buying its bonds with actual cash? Yes, the government shreds the cash. Obviously, the government doesn’t actually need your “funds” per se for further operational purpose.

Put another way, Congress ALWAYS can decide to make Social Security payments, previous taxing or spending not withstanding, and, operationally, the Fed can ALWAYS process whatever payments Congress makes. This process is not revenue constrained. Operationally, collecting taxes or borrowing has no operational connection to spending. Solvency is not an issue. Involuntary government bankruptcy has no application whatsoever! Yet “everyone” agrees—in all innocence—that there is a solvency problem, and that it is just a matter of when. Everyone, that is, except us and Chairman Greenspan, and hopefully now you, the reader, as well!

So if solvency is a non-issue, what are the issues? Inflation, for one. Perhaps future spending will drive up future prices. Fine! How much? What are the projections? No one has even attempted this exercise. Well, it is about time they did, so decisions can be made on the relevant facts.

The other issue is how much GDP we want seniors to consume. If we want them to consume more, we can award them larger checks, and vice versa. And we can do this in any year. Yes, it is that simple. It is purely a political question and not one of “finance.”

If we do want seniors to participate in the future profitability of corporate America, one option (currently not on the table) is to simply index their future Social Security checks to the stock market or any other indicator we select—such as worker productivity or inflation, whatever that might mean.

Remember, the government imposes a 30% corporate income tax, which is at least as good as owning 30% of all the equity, and has at least that same present value. If the government wants to take a larger or smaller bite from corporate profits, all it has to do is alter that tax—it has the direct pipe. After all, equity is nothing more than a share of corporate profits. Indexation would give the same results as private accounts, without all the transactional expense and disruption.

Now on to the alleged “deficit issue” of the private accounts plan. The answer first—it’s a non-issue. Note that the obligation to pay Social Security benefits is functionally very much the same as having a government bond outstanding—it is a government promise to make future payments. So when the plan is enacted the reduction of future government payments is substantially “offset” by future government payments via the new bonds issued. And the funds to buy those new bonds come (indirectly) from the reductions in the Social Security tax payments—to the penny. The process is circular. Think of it this way. You get a $100 reduction of your Social Security tax payment. You buy $100 of equities. The person who sold the equities to you has your $100 and buys the new government bonds. The government has new bonds outstanding to him or her, but reduced Social Security obligations to you with a present value of about $100. Bottom line: not much has changed. One person has used his or her $100 Social Security tax savings to buy equities and has given up about $100 worth of future Social Security benefits (some might argue how much more or less than $100 is given up, but the point remains). The other person sold the equity and used that $100 to buy the new government bonds. Again, very little has changed at the macro level. Close analysis of the “pieces” reveals this program is nothing but a “wheel spin.”

Never has so much been said by so many about a non-issue. It is a clear case of “innocent fraud.” And what has been left out? Back to Chairman Greenspan’s interview—what are we doing about increasing future output? Certainly nothing in the proposed private account plan. So if we are going to take real action, that is the area of attack. Make sure we do what we can to make the real investments necessary for tomorrow’s needs, and the first place to start for very long term real gains is education. Our kids will need the smarts when the time comes to deal with the problems at hand.

Bibliography

Galbraith, John Kenneth, 2004, The Economics of Innocent Fraud: Truth for Our Time, Boston: Houghton Mifflin.

Wray, L. Randall, 1999, “Subway Tokens and Social Security,” C-FEPS Policy Note 99/02, Kansas City, MO: Center for Full Employment and Price Stability, January, (http://www.cfeps.org/pubs/pn/pn9902.html).

Wray, L. Randall, 2000, “Social Security: Long-Term Financing and Reform,” C-FEPS Working Paper No. 11, Kansas City, MO: Center for Full Employment and Price Stability, August, (http://www.cfeps.org/pubs/wp/wp11.html).

Wray, L. Randall and Stephanie Bell, 2000, “Financial Aspects of the Social Security ‘Problem’,” C-FEPS Working Paper No. 5, Kansas City, MO: Center for Full Employment and Price Stability, January, (http://www.cfeps.org/pubs/wp/wp5.html).

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[*] Associate Fellow, Cambridge University Centre for Economic and Public Policy;
Distinguished Research Associate, Center for Full Employment and Price Stability

[**] Associate Professor and Director, Center for Full Employment and Price Stability, University of Missouri-Kansas City

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Posted in Social Security, The Federal Government Deficit, The National Debt, Uncategorized

Tagged Social Security, The Federal Government Deficit, The National Debt

Subway Tokens and Social Security

Posted on August 5, 2009 by admin | 4 comments

By L. Randall Wray

There is a wide-spread belief that Social Security surpluses must be “saved” for future retirees. Most believe that this can be done by accumulating a Trust Fund and ensuring that the Treasury does not “spend” the surplus. The “saviors” of Social Security thus insist that the rest of the government’s budget must remain balanced, for otherwise the Treasury would be forced to “dip into” Social Security reserves.

Can a Trust Fund help to provide for future retirees? Suppose the New York Transit Authority (NYTA) decided to offer subway tokens as part of the retirement package provided to employees—say, 50 free tokens a month after retirement. Should the city therefore attempt to run an annual “surplus” of tokens (collecting more tokens per month than it pays out) today in order to accumulate a trust fund of tokens to be provided to tomorrow’s NYTA retirees? Of course not. When tokens are needed to pay future retirees, the City will simply issue more tokens at that time. Not only is accumulation of a hoard of tokens by the City unnecessary, it will not in any way ease the burden of providing subway rides for future retirees. Whether or not the City can meet its obligation to future retirees will depend on the ability of the transit system to carry the paying customers plus NYTA retirees.

Note, also, that the NYTA does not currently attempt to run a “balanced budget”, and, indeed, consistently runs a subway token deficit. That is, it consistently pays-out more tokens than it receives, as riders hoard tokens or lose them. Attempting to run a surplus of subway tokens would eventually result in a shortage of tokens, with customers unable to obtain them. A properly-run transit system would always run a deficit—issuing more tokens than it receives.

Accumulation of a Social Security Trust Fund is neither necessary nor useful. Just as a subway token surplus cannot help to provide subway rides for future retirees, neither can the Social Security Trust Fund help provide for babyboomer retirees. Whether the future burden of retirees will be excessive or not will depend on our society’s ability to produce real goods and services (including subway rides) at the time that they will be needed. Nor does it make any sense for our government to run a budget surplus—which simply reduces disposable income of the private sector. Just as a NYTA token surplus would generate lines of token-less people wanting rides, a federal budget surplus will generate jobless people desiring the necessities of life (including subway rides).

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Posted in L. Randall Wray, Policy and Reform, Social Security, The Federal Government Deficit, The National Debt, Uncategorized

Tagged L. Randall Wray, Policy and Reform, Social Security, The Federal Government Deficit, The National Debt

Financial Engineers and The Brave New World

Posted on August 4, 2009 by admin | Comments Off

And some people say that no one saw this crisis coming. Bright people almost 10 years ago foresaw and understood the risks and consequences of private sector indebtedness and its relation to government surpluses.

by Warren Mosler and Eileen Debold

Just as the Corps of Engineers sustains the army’s fighting ability, our financial engineers have been sustaining the US post-Cold War economic expansion. Financial engineering has effectively supported an expansion that could have long ago succumbed to the ‘financial gravity’ economists call ‘fiscal drag.’ For even with lower US tax rates, the surge in economic growth has generated federal tax revenues in excess of federal spending. This has led to both record high budget surpluses and the record low consumer savings that is, for all practical purposes, the other side of the same coin. As the accounting identity states, a government surplus is necessarily equal to the non-government deficit. The domestic consumer is the largest component of ‘non-government’ trailed by domestic corporations, and non- resident (foreign) corporations, governments, and individuals.

It is our financial engineers who have empowered American consumers with innovative forms of credit, enabling them to sustain spending far in excess of income even as their net nominal wealth (savings) declines. Financial engineering has also empowered private-sector firms to increase their debt as they finance the increased investment and production. And, with technology increasing productivity as unemployment has fallen, prices have remained acceptably stable.

Financial engineering begins deep inside the major commercial and investment banks with ‘credit scoring.’ This is typically a sophisticated analytical process whereby a loan application is thoroughly analyzed and assigned a number representing its credit quality. The process has a high degree of precision, as evidenced by low delinquencies and defaults even as credit has expanded at a torrid pace. Asset securitization, the realm of another highly specialized corps of financial engineers, then allows non-traditional investors to be part of the demand for this lending-based product. Loans are pooled together, with the resulting cash flows sliced and diced to meet the specific needs of a multitude of different investors. Additionally, the financial engineers structure securities with a careful eye to the credit criteria of the major credit rating services most investors have come to rely on. The resulting structures range from lower yielding unleveraged AAA rated senior securities to high yielding, high risk, ‘leveraged leverage’ mezzanine securities of pools of mezzanine securities.

Private sector debt growth can only exceed income growth for a limited time, even if the debt growth is also driving asset prices higher. At some point the supply of credit wanes. But not for lack of available funds (since loans create deposits), but when even our elite cadre of financial engineers exhaust the supply of creditworthy borrowers who are willing to spend. When that happens asset prices go sideways, consumer spending and retail sales soften, jobless claims trend higher, leading indicators turn south, and car sales and housing slump. There is a scramble to sell assets and not spend income in a futile attempt to replace the nominal wealth being drained by the surplus. Consequently, as unemployment bottoms and begins to increase, personal and corporate income decelerate, and government revenues soon fall short of expenditures as the economy slips into recession. The financial engineers then shift their focus to the repackaging of defaulted receivables.

Both Presidential candidates have voiced their support for maintaining the surplus to pay down the debt, overlooking the iron link between declining savings and budget surpluses. For as long as the government continues to tax more than it spends, nominal $US savings (the combined holdings of residents and non-residents) will be drained, keeping us dependent on financial engineering to sustain spending and growth in the global economy.

Mr. Mosler is the chairman of A.V.M. L.P. and director of economic analysis, III Advisors Ltd. Ms. Debold is vice president, Global Risk Management Services, The Bank of New York.

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Another interesting piece, an interview of Professor L. Randall Wray, almost 9 years old saw the current crisis coming.

Q:Based on the current economic scenario, and taking into account the recent interest rates increases, how probable is the hypothesis of a “soft-landing” for the American economy?

LRW: It is highly improbable that an economic slowdown could stop at a “soft-landing”, given economic conditions that exist today. The U.S. expansion of the past half dozen years has been driven to an unprecedented extent by private sector borrowing. Indeed, the private sector has been spending more than its income in recent years, with its deficit reaching 5.5% of GDP in 1999. In order for the economy to continue to grow, this gap between income and spending must continue to grow. My colleague at the Jerome Levy Economics Institute, Wynne Godley, has projected that the private sector’s deficit would have to climb to well over 8% of GDP by 2005 in order to keep economic growth just above 2.5%. Even that is below the current rate of growth (about 4%). A smaller private sector deficit would mean even lower growth. There are two problems with this scenario. First, our private sector has never run deficits in the past as large as those experienced in this current expansion. In the past, private sector deficits reached a maximum of about 1% of GDP and then quickly reversed toward surplus as households and firms cut back spending to bring it below income. Not only are current deficits already five times higher than anything achieved in the past, they have already lasted two or three times longer than any previous deficits. Even more importantly, the private sector has had to borrow in order to finance its deficit spending, which increases its indebtedness. Private sector debt is already at a record level relative to disposable income. As interest rates rise, this increases what are known as debt service burdens—the percent of disposable income that must go to pay interest (and to repay principal) on debt. In combination with an economic slowdown, which reduces the growth of disposable income, many firms and households will find it impossible to meet their payment commitments. Defaults and bankruptcies are already on the rise, and things will only get worse. Thus, I believe there is a real danger that an economic slowdown could degenerate into a deep recession—or even worse.

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Wray also saw it coming (see here), as he put it:

How would Minsky explain the processes that brought us to this point, and what would he think about the prospects for continued Goldilocks growth?

First, I think he would argue that consumers became ready, willing, and able to borrow, probably to a relative degree not seen since the 1920s. Credit cards became much more available; lenders expanded credit to sub-prime borrowers; bad publicity about redlining provided the stick, and the Community Reinvestment Act provided the carrot to expand the supply of loans to lower income homeowners; deregulation of financial institutions enhanced competition. All of these things made it easier for consumers to borrow. Consumers were also more willing to borrow. As Minsky used to say, as memories of the Great Depression fade, people become more willing to commit future income flows to debt service. The last general debt deflation is beyond the experience of almost the whole population. Even the last recession was almost half a generation ago. And it isn’t hard to convince oneself that since we’ve really only had one recession in nearly a generation, downside risks are small. Add on top of that the stock market’s irrational exuberance and the wealth effect, and you can pretty easily explain consumer willingness to borrow.

I would add one more point, which is that until very recently, most Americans had not regained their real 1973 incomes. Even over the course of the Clinton expansion, real wage growth has been very low. Americans are not used to living through a quarter of a century without rising living standards. Of course, the first reaction was to increase the number of earners per family—but even that has allowed only a small increase of real income. Thus, I think it isn’t surprising that consumers ran out and borrowed as soon as they became reasonably confident that the expansion would last.

The result has been consistently high growth of consumer credit…The expansion might not stall out in the coming months, but continued expansion in the face of a trade deficit and budget surplus requires that the private sector’s deficit and thus debt load continue to rise without limit…What would Minsky recommend? So long as private sector spending continues at a robust pace, he would probably recommend that we do nothing today about the budget surplus. He would oppose any policies that would tie the hands of fiscal policy to maintenance of a surplus. Rather, he would push toward recognition that tax cuts and spending increases will be needed as soon as private sector spending falters. That means it is time to begin discussion of the types of tax cuts and spending programs that will be rushed through as the recession begins. For the longer run, he would recommend relaxation of the fiscal stance so that surpluses would be achieved only at high growth rates (in excess of the full employment rate of economic growth). For the shorter run, he would oppose monetary tightening, which would increase debt service ratios and push financial structures into speculative or Ponzi positions. He would support policies aimed at reducing “irrational exuberance” of financial markets; most importantly, increased margin requirements on stock markets would be far more effective and narrowly targeted than are general interest rate hikes that have been the sole instrument of Fed policy to this point. Most importantly, Minsky would try to shift the focus of policy formation away from the belief that monetary policy, alone, can be used to “fine-tune” the economy, and from the belief that fiscal policy should be geared toward running perpetual surpluses—in Minsky’s view, this would be high risk strategy without strong theoretical foundations.

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Tagged Credit crunch, Financial crisis, Fiscal Policy, The Federal Government Deficit, The National Debt

Another Take on the Financial Balances

Posted on July 24, 2009 by admin | 5 comments

By Eric Tymoigne

First, regarding the identity itself, for a domestic economy we have, in terms of economic flows:

GFB + PDFB + RWFB ≡ 0

With PDFB the private domestic financial balance, RWFB the financial balance of the Rest of the World, and GFB the government financial balance. This identity holds all the time, in any domestic economy (in a world economy RWFB disappears). For economic analysis, it is insightful to arrange this identity differently in function of the type of monetary regime.
In a country that is monetarily sovereign the federal government has full financial flexibility. By monetary sovereignty, one means that there is a stable and operative federal/national government that is the monopoly supplier of the currency used as ultimate means of payment in the domestic economy, and that the domestic currency is not tied to any asset (like gold) or foreign currency. Other posts have already explained the implications of this in terms of federal government finance (taxes and T-bonds do not act as financing sources for federal government spending, the federal government always spends by creating monetary instruments first, etc.) and banking (bank advances create deposits, credit supply is endogenous and is created ex-nihilo (i.e. banks do not need depositors to be able to provide an advance of funds to deficit spending units), higher reserve ratios do not constrain directly the money supply process in a multiplicative way, etc.). All this also has implications in terms of accounting and in terms of modeling.

First, in terms of accounting identity, in a monetarily sovereign country, the government financial balance (GFB), through the federal government financial balance, is the ultimate means to accommodate the changes in holdings of the domestic currency by other sectors (private domestic sector and the Rest of the World). This means that, for a monetarily sovereign country, the most insightful way to arrange the national accounting identity is:

-GFB ≡ PDFB + RWFB

-GFB ≡ NGFB

Where NGFB is the non-government financial balance (the sum of the financial balance of the private domestic sector and the Rest of the World). This way of arranging the identity shows well that the government sector (through its federal branch) is the ultimate provider/holder of domestic currency: government fiscal deficit (surplus) is always equal to non-government financial surplus (deficit). The graph below shows the identity for the US.

Fiscal balances for the United State (billions of dollars)

Source: BEA (Table 5.1).
Note: Statistical discrepancy was distributed evenly among the three sectors (Private Domestic, Rest of the World, and Government).

Any net injection of dollars (i.e. financial deficit) by any sector must be accumulated somewhere else (i.e. financial surplus). As the monopoly supplier of ultimate domestic means of payment, usually the US government sector is the net injector of dollars, while the private domestic sector and the Rest of the World usually accumulate the dollars injected. For a while, like from 1997 to 2007 in the US, the private domestic sector and the Rest of the World may transfer the domestic currency among each other while the government runs a surplus; however, this cannot last because ultimately one of them (private sector or Rest of the World) will run out of domestic currency and/or will have to become highly indebted in domestic currency leading ultimately to a Ponzi process that collapses. Only the federal government has a perfect creditworthiness and can always meet its financial obligations denominated in the domestic currency (that is why US Treasury bonds are not rated, default rate is zero).

In addition, one may note that the Rest of the World and the private sector cannot accumulate any domestic currency unless the government sector injects them in sufficient quantity in the first place. Stated alternatively, the Rest of the World (e.g., the Chinese) does not help to finance the deficit of the federal government (US federal government). On the contrary, the federal government deficit allows the Rest of the World to accumulate dollars. This pressure to generate a deficit is all the more strong on the dollar that it is the reserve currency of the world, so there is a net demand for the dollar from the Rest of the World.

This also works the other way around, i.e. if the Rest of the World disaccumulates the domestic currency the government must be the ultimate acquirer of this domestic currency and so must run a surplus if the private domestic sector does not accumulate it in a large enough quantity.
Once it acquires the domestic currency, the government may destroy them (federal government has huge shredders or they are deleted from the computer memory), or store them into a safe/computer for later use (especially true for state and local governments). Destruction of bank notes occurs usually because they are in bad shape. Hundreds of millions of dollars worth of bank notes are destroyed every month at the Fed banks in the US; then they are used as compost (during my last tour of the San Francisco Fed last March, I was told that about $56 million worth of bank notes are destroyed every day at the SF Fed, and then are spread on the fields of California). If you go visit a fed bank this will be the main attraction.

Besides the poor condition of some bank notes, the destruction of dollars by the federal government may also occur for other reason, e.g., because there is a lack of storage capacity (safe is too small, computer memory is too small). One central point is that the dollars that are accumulated by the federal government do not increase its financing capacity because the federal government created those dollars in the first place. It chooses not to destroy them all because it takes time and it is costly to destroy and to make monetary instruments, and because it has the storage capacity.

For the moment, we stayed at the level of the identity, which basically tracks where the domestic currency comes from and where it goes. Every dollar comes from somewhere and must go somewhere. There is no dollar floating around that is not held by a sector. No desire/behavioral equation were included in the analysis above. However, even that basic identity provides us a powerful insight. Indeed, it shows us that it is impossible for all sectors to be in surplus; at least one of them must deficit spend and usually it is the government sector because of its monetary sovereignty. The reverse is also true, i.e. not all sectors can be in deficit at the same time; at least one of them must be in surplus (usually the private domestic sector). As Randy noted in a previous post, this is probably not understood well; even the Wall Street Journal did not make the connection in early the 2000s between the federal government surplus and the households’ negative saving. It is often assumed that if they wish, all sectors could be in surplus; one just needs to work hard enough at it (note that this is one of the promises that is always made during presidential campaigns: “we should save more, reduce our trade deficit and reach a fiscal surplus”). Economic reality does not work that way.

In terms of the model (where one includes desires and so behavioral aspects as well as an explanation of the adjustment mechanisms to those desires in relation to the state of the economy), for the analysis of a monetarily sovereign country, I would rather put the desired financial balance of the Rest of the World with the desired private domestic financial balance and call the sum the desired financial balance of the non-government sector (NGFBd). The model does not deal with stocks at all and their relation to flows (IS-LM did try but failed to do it correctly; read Hicks’s own account in his JPKE article “IS-LM: An explanation”); however, the financial-balance model is a good place to start in Econ 101. If students can understand the model, the identity and how they relate to each other, it would be a HUGE step forward in terms of removing this counterproductive phobia of government fiscal deficits (then one would have to learn about government finance and the monetary creation process, which, like many other things, are all taught backward in textbooks).

If the Rest of the World has too many dollars relative to its taste it and cannot bring them back into the domestic economy, by buying enough goods and services or financial assets from the private domestic and government sectors, the currency depreciates and/or long-term interest rate falls. This boosts exports and reduces imports. This may also promote investment and consumption if the state of expectations is stable.

If the non-government sector desires to save more, then, unless the government sector increases its spending propensity or reduces tax rates, the economy will enter a slump; possibly a debt-deflation process if debt levels are far too high. All this was done nicely in previous posts.
Before, during, and after the adjustment processes (variation of flows, levels and prices) the identity holds and the actual financial balance always sum to zero. The sum of GFBd and NFGBd will be different from zero except when the adjustment is completed, i.e. when actual and desired balances are equal (“at equilibrium” if you want to call it that way, even though markets may not be cleared).