Wednesday 21st November 2018

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Government Debt Is Not Like Household Debt

By Marshall Auerback

Politicians and the media argue that the current US Federal budget deficit is unsustainable. Politicians personalize this — 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.

This is a fallacy. It ignores the full impact of budget deficits. We can divide the economy into three sectors. The private sector that includes both households and businesses. The government sector: Federal, State and local. And the foreign sector that includes imports and exports. We use the current account balance (trade surplus or deficit) as the measure of the impact of the foreign sector on the balance of income and spending.

Government Debt Is Not Like Household Debt

At the aggregate level, the spending of all three sectors combined must equal the income received by the three sectors combined. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector may run a deficit, so long as another runs a surplus.

Historically, the US private sector runs a surplus. Historically, the US ran a balanced current account — our imports were just about equal to our exports. That has changed in recent years, and the US today runs a huge current account deficit.

Now, if the foreign sector is balanced and the private sector runs a surplus, this means that the government sector runs a deficit. And, in fact, the US government sector taken as a whole has averaged a deficit, spending about $1.03 for every dollar of national income.

Note that that budget deficit exactly offsets the private sector’s surplus — which was about three 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.

While it is commonly believed that continual budget deficits will bankrupt countries, they are in fact the only way the private sector can save and accumulate net wealth. If households save by spending less than they are earning, and businesses save by reinvesting less than their retained earnings, both incomes and total economic activity will tend to contract until saving is reduced or until depreciation leaves businesses and households inclined to invest once again in durable assets.

Common sense suggests that when personal incomes fall while personal debt is high, debt defaults and insolvencies will follow–unless creditors are willing to generously renegotiate. This situation invites what economist Irving Fisher called the cumulative debt – deflation spiral. So unless some other sector is willing to reduce its net saving (as with the foreign sector recently, via a reduction in the US current account deficit, as US imports have fallen faster than US exports) or increase its deficit spending (as with government sector of late) the mere attempt by the domestic private sector to save from income, given the existing private debt, can prove very disruptive.

Would that our politicians recognized this. Instead, we have the spectacle of governments across the world engaged in significant fiscal retrenchment at a time when the private sector is demonstrating a strong predisposition to save. This is understandable, given high unemployment, low-capacity utilization ratios and relatively sluggish aggregate demand.

Who, then, can fill that gap? If it doesn’t come from exports (and it’s impossible for all countries to run trade surpluses), it can come only from governments. A lack of jobs is the result of a lack of spending. Governments have the capacity to provide that extra aggregate demand and could do so easily by directly creating the necessary work.

Government Debt Is Not Like Household Debt

The question is whether the US government can run deficits forever. The answer is: that depends. Too much government spending in times of full employment (approximately 4% to 6% unemployment) would clearly be inflationary, as it would represent the government competing with the private sector for scarce resources. Full employment is when government spending should be cut.

The truth is that governments can run deficits considerably longer than private households or businesses, both of which are users of currency, not issuers. Going back to 1776, the US Federal budget has been in continuous deficit except for seven short periods. The first six of those were followed by depressions, such as the Great Depression, which followed a 1930 surplus. The one exception was the Clinton surplus, which was followed only by a recession.

Why has this happened? 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.

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 macroeconomic relations between the private sector, the government sector and the foreign sector.

The US government’s situation is in no 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. This is not “Keynesianism”; it’s Accounting 101.

Marshall Auerback is Director of and Corporate Spokesperson for Pinetree Capital Ltd, a Toronto-headquartered diversified investment, financial advisory and merchant banking firm focused on investing in early stage micro and small-cap resource companies.

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