Martin Wolf, in today’s Financial Times, uses modern monetary theory (!), also known as the fiscal balances approach, to explain why calls for fiscal belt tightening are premature.
Let’s provide a little background, courtesy Rob Parenteau of the Levy Institute:
…if we divide the economy into three sectors – the domestic private (households and firms), government, and foreign sectors, the following identity must hold true:
Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0
Note that it is impossible for all three sectors to net save – that is, to run a financial surplus – at the same time. All three sectors could run a financial balance, but they cannot all accomplish a financial surplus and accumulate financial assets at the same time – some sector has to be issuing liabilities [borrowing].
Since foreigners earn a surplus by selling more exports to their trading partners than they buy in imports, the last term can be replaced by the inverse of the trade or current account balance. This reveals the cunning core of the Asian neo-mercantilist strategy. If a current account surplus can be sustained, then both the private sector and the government can maintain a financial surplus as well. Domestic debt burdens, be they public or private, need not build up over time on household, business, or government balance sheets.
Domestic Private Sector Financial Balance + Fiscal Balance – Current Account Balance = 0
Again, keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong.
Yves here. Many readers reject the message here instinctively. You cannot have the private sector save in aggregate AND have government run a surplus UNLESS you run a trade surplus. And the problem we have is:
1. The private sector in pretty much every advanced economy is deleveraging, as in saving. Most people, yours truly included, think that’s a good idea.
2. If those economies want to run government surpluses too, then they need to run pretty big trade surpluses
3. It is impossible for all countries to run trade surpluses at the same time.
4. Moreover, some countries that have been running large trade surpluses for quite a while (in particular China and Germany) are not willing to change course, at least not in the near future.
5. So if all these new hairshirt-wearers want to shirk public and private debt at the same time, some countries will need to run correspondingly large trade deficits (which also means they will experience rising private or public sector debt levels). There appears to be a dearth of candidates for this role.
Wolf ‘s article today reads as if he is speaking more to fellow economists, particularly those in policy circles, than his typical, more layperson friendly, offering. Be sure to look at his charts at the end.
From the Financial Times:
Let us look at where we now are, courtesy of the financial balance approach of the late Wynne Godley…. In 2010, according to the International Monetary Fund’s latest forecasts, the private sectors of every large high-income country will run a huge excess of income over spending (see chart). This is forecast at 7.8 per cent of gross domestic product for these countries as a group, at 12.6 per cent for Japan, at 9.7 per cent for the UK, at 7.7 per cent for the US and at 6.8 per cent for the eurozone.
What we are seeing, in short, is an epidemic of private sector frugality – just as many economic doctors recommended. Yet such thrift entails either current account surpluses or fiscal deficits. Of these countries, only Germany and Japan have current account surpluses. The rest are capital importers. These countries will duly run fiscal deficits that are bigger than their private surpluses. We have, as the hysterics note, a tide of fiscal red ink.
Which came first – private retrenchment or fiscal deficits? The answer is: the former. In the case of the US, the huge shift in the private balance between the fourth quarter of 2007 and the second quarter of 2009, from a deficit of 2.2 per cent of GDP to a surplus of 6.6 per cent, coincided with the financial crisis (see chart). The fact that aggregate demand and long-term interest rates tumbled at the same time shows that the collapse in private spending “crowded in” the fiscal deficits. Wild private behaviour drove the wild public behaviour.
In his recent FT column, Jeffrey Sachs of Columbia University argued that fiscal stimulus was unnecessary: monetary policy would have been enough. I disagree. Despite the most aggressive monetary policy ever, private sectors moved into huge surpluses. Monetary policy was “pushing on a string”. The fiscal offsets – overwhelmingly due to built-in fiscal stabilisers, not the discretionary stimulus – helped sustain demand in the crisis. But they were insufficient, even with monetary support, to prevent deep recessions. The argument that stimulus was unnecessary is hard to accept. It is easier to believe it was too small, albeit also ill-targeted.
So how quickly should deficits be eliminated? We must recognise the danger here: cutting public spending will not automatically raise private spending. The attempted reduction in the structural deficit might lead, instead, to a rise in cyclical fiscal deficits, which would be running to stand still, or to a reduction in the private surpluses only because income fell even faster than spending. Either outcome would be grim. Yet neither can be ruled out.
As long as output remains depressed, the fiscal support is most unlikely to be inflationary. Nor will it crowd out the private sector: it is more likely to crowd it in. The big question, then, is whether deficits can be financed. My answer is: yes. Remember that so long as the private sector runs financial surpluses it must buy claims on the public sector, unless the developed world as a whole is about to move into huge external surpluses.
True, the private sector can pick and choose among governments. But it is unlikely to abandon the US, at least. It has shown no sign of doing so, so far (see chart). The problem for peripheral Europeans is that they have little chance of an early return to growth. Markets do not trust in the political sustainability of hair-shirt economics. It is not so much fiscal deficits as an inability to grow out of them that is worrying.
The best policy is to put together measures that sustain strong growth in demand in the short run, while constraining the huge deficits in the long run. This is walking and chewing gum at the same time. Why should that be so hard?
Yet it would now be particularly damaging for fiscal austerity to overcome the European economy and so force beggar-my-neighbour outcomes on the hapless US. As Fred Bergsten of the Peterson Institute for International Economics in Washington noted in the FT last week, such policies could be very dangerous. Thus, far from being stabilising, premature fiscal retrenchment threatens destabilisation of the world economy. In this case, a decision to turn the eurozone into a huge Germany would – and should – be seen as an act of mercantilist warfare upon the US. How long would the latter put up with the hypocrisy of surplus countries that blame borrowers for the deficits their own surpluses make inevitable? Not much longer, would be my guess, at least now that the US government has become the world’s borrower of last resort.
Yes, I understand that huge fiscal deficits make people nervous. I understand, too, the desire to make solvency credible. But following fiscal rules blindly, while ignoring what is going on in the private sector or in external balances, is a recipe for disappointment and political conflict. Fiscal stabilisation that supports growth is welcome. Premature fiscal stabilisation that undermines it is yet another folly.