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How To Reduce Government Budget Deficits

This is a wonkish post, but bear with me, because it’s important. Randall Wray’s last post sparked a thought regarding trade deficits and budget deficits which I wanted to run by you. Randy said:

We see from the chart that the "normal" situation in the US is a private sector surplus, and a (growing) current account deficit. These are offset by a government budget deficit. The exception was the Clinton years, when government ran a surplus and the private sector ran unprecedented deficits.

He was pointing to this chart from Scott Fullwiler:

sector financial balances thumb

Here’s where my thought process goes from that. The U.S. dollar is the world’s major reserve currency. Especially in the post-Bretton Woods world, this has meant capital account surpluses as foreigners accumulate U.S. dollar reserves. These capital account surpluses translate into current account deficits. So the "normal" situation, as Randy put it, absent a depreciating dollar, is a U.S. current account deficit.  Moreover, Randy writes that a private sector surplus is also normal. And I assume this is true absent some sort of malinvestment-induced capital spending or household dissaving spree. So, while Randy puts normal in quotation marks, I think there is something to this state of affairs being the baseline case for the U.S. sectoral financial balances.

This is where my prior statements on the Triffin Dilemma and the U.S. dollar’s reserve status comes to mind.

One big problem with the present set up is the Triffin Dilemma. The dollar’s role as a national currency with any domestic agenda of a balanced current account is fundamentally at odds with its role as the world’s reserve currency.  Especially post-Asian crisis, the desire by many was to accumulate US dollar reserves and that means running a capital account deficit/current account surplus with the US.

The current account imbalances become problematic during downturns and lead to protectionism, as I argued in my third post at Credit Writedowns

So, here’s my logic:

  • The dollar’s reserve currency status makes dollar accumulation by foreign central banks the default mode. This naturally leads to a capital account surplus and a current account or trade deficit for the U.S.
  • Meanwhile, absent serious incentives for private sector dissaving, the baseline sectoral balance for the non-government domestic sector, for households and businesses in the U.S., is surplus.
  • Whenever a major downturn hits, two things will happen. First, the current account deficits will become a lightening rod for protectionist sentiment. Second, the private sector will move to a net saving position inducing an increase in government deficits which will become a lightening rod for anti-deficit sentiment.

I use the term "major" downturn because my assumption is that a major downturn will induce large government deficits that will draw the attention of deficit hawks in a way that a smaller recession would not. And that means that there will invariably be a political effort to reduce that deficit irrespective of its root causes. See my post Does focusing on deficit reduction reduce deficits? for why I think this leads to a recessionary relapse. The long and short of that post is that, to the degree you want to reduce deficits, you need to either increase employment or reduce military and entitlement spending.

At the time, my conclusions were:

  1. Cyclical deficits are just that cyclical. Focusing on deficit reduction as a cause is likely to increase these cyclical deficits.
  2. Debt-to-GDP constraints are artificial and are implicit indications of fears of cronyism and government waste.
  3. Deficits matter only to the degree they steal real resources from productive use. This can be surmised from a rapidly rising debt-to-GDP ratio.

Right now, the Obama Administration is trying to have its cake and eat it too by avoiding too much austerity but talking a good game on budgetary restraint. For example, in the State of the Union Address, President Obama said he wants to freeze non-defense, discretionary spending as I predicted in my post on "Obama’s Economic Agenda for Re-election". However, the President has not taken on Social Security or Medicare to pre-empt deficit hawks as I had predicted, I suspect because the Democratic base is opposed to such a move.

But, if you look at my thinking on the sectoral financial balances, you can see you have a problem. The jobs are really not coming yet as this morning’s employment situation summary demonstrates. The private sector is back to its default savings. And the U.S. is still the world’s reserve currency. So the capital account surpluses continue. That necessarily means continued high government deficits – deficits that I think are politically unsustainable, meaning they will come under attack.

What are potential ways out of this?

  1. A reduction in the capital account surpluses. Obviously, a Chinese revaluation might help here because what would really end the capital account surpluses is a major devaluation in the dollar vis-a-vis its trading partners. Now, this is a de facto decrease in American per capita income but it will bring down capital account surpluses. Obviously, if central banks stopped accumulating dollars and switched to euros or yuan or yen, that would also help.
  2. A reduction in private sector surpluses. This could happen via the household or business sector. If we had a capital spending binge, then business savings would go down. If households starting seeing job growth and started to reduce savings levels due to the psychological effect’s from increased economic security, then this could reduce the private sector surplus. But given high household debt levels, this would be a bad thing.

My analysis here says that the Clinton years’ achievement was due largely to a booming economy fuelled by a capital spending binge in the telecom sector and by business generally, mixed with an unsustainable decrease in household savings. Barring a repeat of this – something I would argue is a bad thing – the only way to get around the government deficit is to depreciate the dollar. Right now, getting back to full employment should be the first priority. That would go a long way to reducing the deficit. However, one must  accept that government deficits are inevitable with the world’s reserve currency; the private sector is net saving and the capital account is in surplus. Otherwise, you  really need a major devaluation, a reduction of reserve currency status or a private sector binge. I vote for a reduction of reserve currency status.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

11 Comments

  1. Scott Fullwiler says:

    totally agree, Ed. Nice post.

  2. Scott Fullwiler says:

    totally agree, Ed. Nice post.

  3. P_arnold says:

    And yet another path…

    A write-down of US dollar denominated private debt has the effect of decreasing the current account deficit and leave somewhat more intact the purchasing power of the USD for US citizens. And what’s more, in our world of bad wealth distribution in the US, it also has the added benefit and being an equalizer.

  4. P_arnold says:

    And yet another path…

    A write-down of US dollar denominated private debt has the effect of decreasing the current account deficit and leave somewhat more intact the purchasing power of the USD for US citizens. And what’s more, in our world of bad wealth distribution in the US, it also has the added benefit and being an equalizer.

  5. DavidLazarusUK says:

    My one concern is that governments will treat 10% unemployment as the new normal, and not attempt any serious job creation. Even 6% unemployment is too high.

  6. Anonymous says:

    My one concern is that governments will treat 10% unemployment as the new normal, and not attempt any serious job creation. Even 6% unemployment is too high.

  7. Neil Wilson says:

    %age unemployment shouldn’t even be discussed. The metric should be ‘nobody should be without incoming producing work for more than X months’.

    The economic system should then be designed to that parameter.

    %ages hide a dozen major cities worth of people in destitution and poverty.

    • DavidLazarusUK says:

      The US already has a unemployment system that does that. After 99 weeks they are abandoned. The unemployed have a purpose in that they keep wages down for business so it is one reason why “business friendly” politicians do so little about reducing unemployment.

  8. Neil Wilson says:

    %age unemployment shouldn’t even be discussed. The metric should be ‘nobody should be without incoming producing work for more than X months’.

    The economic system should then be designed to that parameter.

    %ages hide a dozen major cities worth of people in destitution and poverty.

    • Anonymous says:

      The US already has a unemployment system that does that. After 99 weeks they are abandoned. The unemployed have a purpose in that they keep wages down for business so it is one reason why “business friendly” politicians do so little about reducing unemployment.

  9. pdrub says:

    So, just because we don’t understand sectoral balances and think that govt deficits are a bad thing (and not simply a necessary offset of CAD and private sector’s surplus) we need to choose between the evils? Wouldn’t it be better to educate ouselves about our monetary system?

  10. pdrub says:

    So, just because we don’t understand sectoral balances and think that govt deficits are a bad thing (and not simply a necessary offset of CAD and private sector’s surplus) we need to choose between the evils? Wouldn’t it be better to educate ouselves about our monetary system?

  11. Susijumala says:

    Quote from the author, mr. Harrison:

    “Right now, getting back to full employment should be the first priority.”

    As much I have gotten new points of view reading articles from this portal this is something that is disturbing me and is very common. It’s like a parrot cry made by every single Western politician, too.

    I ask: is there any alternative? I think there is. We have automation, robots do most of our work and then the rest of it: human slave-labour in some Asian countries. We could share the workload a lot without having concerns of lowering our standards of living. Actually, most of human beings have seen standard of living decreasing as necessities; like shelter, food, water and energy do cost relatively more than before.

    How could we improve employment figures in our current world? Start manufacturing goods no one really needs? Hmm ok… How about start manufacturing goods someone needs, but because of the economical success it needs to be less-quality junk in order to be cheaper? It then ends up in trash vortecies into oceans and we have managed to waste our resources? That’s not working either. Well, we could invent new gadgets to help people in their everyday lives? True, but how can anyone expect someone inventioning anything while he has to worry 24/7 about his income? Albert Einstein once stated that science is marvellous and exciting, as long as you don’t have to make your living from it.

    I think we’ve got to face it: there isn’t enough rational work for human labour because of the automation and population increasement. Therefore this system based back to years and even centuries when everyone needed to farm the lands and worked in mills and factories is over. If there were new inventions making our lives easier shouldn’t it be seen on our work-time?

    • DavidLazarusUK says:

      A simple solution is greater provision of services. These use considerably less resources to provide the same employment. Hair dressers and plumbers being good examples. Government provided services like teaching, police and judicial services also are effective but these are being cut in many countries.

      • Susijumala says:

        And what good comes if we get bloated service sector? I’ll stick on your examples, but I like to draw mr. Enrico Fermi, a famous scientist, in this picture. While he was gathering up staff for the Manhattan Project he had formed one question of many others: “How many piano tuners live in Chigaco?” Of course, mr. Fermi’s idea was not to get exact answer, but to see how people can estimate the numbers. It didn’t matter if the applicant answered 400 or 700, but if he answered ‘a dozen’ or 10 000 there was something wrong in his conclusions.

        Now, how many hairdressers we need more? At the time of austerities it is more common that people seek their hair cut e.g. by relatives for free. If I did your laundry for a fee and you did mine for the same fee there is only one institution that benefits from this: government via taxation. Plumbers are slightly different. They usually do installing, maintenancing and if latter fails: repairing. But having rational work of installing new pipes we need construct e.g. an apartment someone willing to move in. That’s where less pretty pictures of Spain comes in. Vacant houses, whole streets and even blocks totally deserted. Maintenance is something we really should do. Letting our infrastructure to go rotten we need to rebuild it, although rebuilding would be shown more delightul in GDP-measuring. But… at the times of austerity measures public maintenance suffers heavily. I fear that within a couple of years a bridge collapses or a passenger train derails because lack of maintenance. In private companies I can give you example how neglecting maintenance does cost: Deepwater Horizon. I say that if BP had hired a 5-men-group to do maintenance on the rig by e.g. switching dead batteries from alarm systems it would have be a lot of cheaper for the company. Even if BP would have hired these guys for life. But it never happened.

        So yes, we need services. But we are concentrating on wrong services. We try to invent services no one really needs to make profit and meanwhile neglecting the services we really need, but because they do not yield instant cash they’re forgotten.

        • DavidLazarusUK says:

          I am not proposing that we create millions of service jobs. Though if you accept that there will be a peak resource problem then you cannot build an economy based on manufacture. Manufacture will be there but as a foundation. Even China realise that. That is why they have had an export ban on their rare earth minerals. Government service jobs are the ones that create a foundation for businesses to operate within, create skilled trained employees and maintain the roads that allow businesses to operate most effectively. Infrastructure maintenance is also excellent.

          Using the hairdresser analogy, as you say in austerity people will get their haircut for free or let it grow and cut it less frequently. There is a limit to the numbers that can be employed in that way, based on hair growth. The same applies to plumbing, there is a limit to the numbers of people that can realistically be employed in such a way. The same would apply to lawyers, though would the world be better with another 30 million lawyers suing all and sundry to earn an income? No.

          You mentioned Spain’s construction boom. Yes they have millions of empty homes as does the US. One solution is to demolish them to boost property values, but that is very wasteful if you remember the coming resource problems. Better to finish them and use them.

          Yes manufacturing is the best option, because it allows the nation to reduce its balance of trade through import substitution, and creates well paid jobs.

          The problem is that unless the UK and the US has fundamental tax reform I can easily see another crisis. Why? Because much business is now done for tax efficiency, That means that if possible companies and individuals will adjust their incomes to minimise their overall tax. One consequence is that a lot of effort is pushed into turning profits into capital gains and reducing tax takes considerably. Business owners have the greatest flexibility to do this. The average employee has no prospect for the huge savings that means the entire tax burden is slowly being dumped on the workers and not the elites. A great recipe for revolution.

          If income, capital gains and business taxes were all the same then the fiddling would not be so great. Also eliminate the perks of offshoring profits, make such earnings subject to a tax audit, that will mean that profits will not be hidden offshore. If a company decides to relocate to a tax haven, treat it like a tax dodger and bans its employees from ever returning to the US. Tell some execs wife that she cannot go to Neiman Marcus or the Opera in New York, ever again, that there children cannot see their friends there, their chances of even buying a wing at Yale to get university admission are pointless, that they will all have to apply for foreign citizenship, and the perks of being in a tax haven are minimal. Even ban its products from being sold in the US. It would create business opportunities galore. It will never happen because the rich will have to pay more tax, and that is something that to paraphrase Leona Helmsley that only the little people do.

  12. Susijumala says:

    Quote from the author, mr. Harrison:

    “Right now, getting back to full employment should be the first priority.”

    As much I have gotten new points of view reading articles from this portal this is something that is disturbing me and is very common. It’s like a parrot cry made by every single Western politician, too.

    I ask: is there any alternative? I think there is. We have automation, robots do most of our work and then the rest of it: human slave-labour in some Asian countries. We could share the workload a lot without having concerns of lowering our standards of living. Actually, most of human beings have seen standard of living decreasing as necessities; like shelter, food, water and energy do cost relatively more than before.

    How could we improve employment figures in our current world? Start manufacturing goods no one really needs? Hmm ok… How about start manufacturing goods someone needs, but because of the economical success it needs to be less-quality junk in order to be cheaper? It then ends up in trash vortecies into oceans and we have managed to waste our resources? That’s not working either. Well, we could invent new gadgets to help people in their everyday lives? True, but how can anyone expect someone inventioning anything while he has to worry 24/7 about his income? Albert Einstein once stated that science is marvellous and exciting, as long as you don’t have to make your living from it.

    I think we’ve got to face it: there isn’t enough rational work for human labour because of the automation and population increasement. Therefore this system based back to years and even centuries when everyone needed to farm the lands and worked in mills and factories is over. If there were new inventions making our lives easier shouldn’t it be seen on our work-time?

    • Anonymous says:

      A simple solution is greater provision of services. These use considerably less resources to provide the same employment. Hair dressers and plumbers being good examples. Government provided services like teaching, police and judicial services also are effective but these are being cut in many countries.

      • Susijumala says:

        And what good comes if we get bloated service sector? I’ll stick on your examples, but I like to draw mr. Enrico Fermi, a famous scientist, in this picture. While he was gathering up staff for the Manhattan Project he had formed one question of many others: “How many piano tuners live in Chigaco?” Of course, mr. Fermi’s idea was not to get exact answer, but to see how people can estimate the numbers. It didn’t matter if the applicant answered 400 or 700, but if he answered ‘a dozen’ or 10 000 there was something wrong in his conclusions.

        Now, how many hairdressers we need more? At the time of austerities it is more common that people seek their hair cut e.g. by relatives for free. If I did your laundry for a fee and you did mine for the same fee there is only one institution that benefits from this: government via taxation. Plumbers are slightly different. They usually do installing, maintenancing and if latter fails: repairing. But having rational work of installing new pipes we need construct e.g. an apartment someone willing to move in. That’s where less pretty pictures of Spain comes in. Vacant houses, whole streets and even blocks totally deserted. Maintenance is something we really should do. Letting our infrastructure to go rotten we need to rebuild it, although rebuilding would be shown more delightul in GDP-measuring. But… at the times of austerity measures public maintenance suffers heavily. I fear that within a couple of years a bridge collapses or a passenger train derails because lack of maintenance. In private companies I can give you example how neglecting maintenance does cost: Deepwater Horizon. I say that if BP had hired a 5-men-group to do maintenance on the rig by e.g. switching dead batteries from alarm systems it would have be a lot of cheaper for the company. Even if BP would have hired these guys for life. But it never happened.

        So yes, we need services. But we are concentrating on wrong services. We try to invent services no one really needs to make profit and meanwhile neglecting the services we really need, but because they do not yield instant cash they’re forgotten.

        • Anonymous says:

          I am not proposing that we create millions of service jobs. Though if you accept that there will be a peak resource problem then you cannot build an economy based on manufacture. Manufacture will be there but as a foundation. Even China realise that. That is why they have had an export ban on their rare earth minerals. Government service jobs are the ones that create a foundation for businesses to operate within, create skilled trained employees and maintain the roads that allow businesses to operate most effectively. Infrastructure maintenance is also excellent.

          Using the hairdresser analogy, as you say in austerity people will get their haircut for free or let it grow and cut it less frequently. There is a limit to the numbers that can be employed in that way, based on hair growth. The same applies to plumbing, there is a limit to the numbers of people that can realistically be employed in such a way. The same would apply to lawyers, though would the world be better with another 30 million lawyers suing all and sundry to earn an income? No.

          You mentioned Spain’s construction boom. Yes they have millions of empty homes as does the US. One solution is to demolish them to boost property values, but that is very wasteful if you remember the coming resource problems. Better to finish them and use them.

          Yes manufacturing is the best option, because it allows the nation to reduce its balance of trade through import substitution, and creates well paid jobs.

          The problem is that unless the UK and the US has fundamental tax reform I can easily see another crisis. Why? Because much business is now done for tax efficiency, That means that if possible companies and individuals will adjust their incomes to minimise their overall tax. One consequence is that a lot of effort is pushed into turning profits into capital gains and reducing tax takes considerably. Business owners have the greatest flexibility to do this. The average employee has no prospect for the huge savings that means the entire tax burden is slowly being dumped on the workers and not the elites. A great recipe for revolution.

          If income, capital gains and business taxes were all the same then the fiddling would not be so great. Also eliminate the perks of offshoring profits, make such earnings subject to a tax audit, that will mean that profits will not be hidden offshore. If a company decides to relocate to a tax haven, treat it like a tax dodger and bans its employees from ever returning to the US. Tell some execs wife that she cannot go to Neiman Marcus or the Opera in New York, ever again, that there children cannot see their friends there, their chances of even buying a wing at Yale to get university admission are pointless, that they will all have to apply for foreign citizenship, and the perks of being in a tax haven are minimal. Even ban its products from being sold in the US. It would create business opportunities galore. It will never happen because the rich will have to pay more tax, and that is something that to paraphrase Leona Helmsley that only the little people do.

  13. selise says:

    “However, one must accept that government deficits are inevitable with the world’s reserve currency; the private sector is net saving and the capital account is in surplus. Otherwise, you really need a major devaluation, a reduction of reserve currency status or a private sector binge. I vote for a reduction of reserve currency status.”

    completely agree until the last sentence. why is usa fed gov deficit spending worse than losing reserve status? maybe it’s just my ignorance of the subject, but i need answers to some questions before accepting/understanding that the policy of “reduction of reserve currency status” is the way to go. here are a few:

    1. what is the magnitude of the decrease in standard of living your proposal will induce?
    2. what segment of the population will be most affected? how will the damage be apportioned?
    3. what can the usa do to reduce the reserve currency status and how could a controlled transition be managed?
    4. how will loss of reserve currency status affect our ability to address our real long term problems (for example environmental destruction, especially climate change).
    5. if the foreign sector still desires to accumulate financial assets (denominated in a reserve currency other than the dollar) where will the deficit spending (to balance the global demand loss) come from if not the usa current account deficit? on a global basis, it seems to me the issue is the desire to net save — not specifically to net save in dollar denominated financial assets.

    thanks to anyone who can provide some education for me on the above questions.

    finally, just because something is “politically unsustainable” today doesn’t mean it can’t become politicly feasible in the future.. it’s not like a law of physics or something. an active, engaged and informed citizenry might help facilitate that change — especially if we can be shown the expected impacts of the policy options.

  14. selise says:

    “However, one must accept that government deficits are inevitable with the world’s reserve currency; the private sector is net saving and the capital account is in surplus. Otherwise, you really need a major devaluation, a reduction of reserve currency status or a private sector binge. I vote for a reduction of reserve currency status.”

    completely agree until the last sentence. why is usa fed gov deficit spending worse than losing reserve status? maybe it’s just my ignorance of the subject, but i need answers to some questions before accepting/understanding that the policy of “reduction of reserve currency status” is the way to go. here are a few:

    1. what is the magnitude of the decrease in standard of living your proposal will induce?
    2. what segment of the population will be most affected? how will the damage be apportioned?
    3. what can the usa do to reduce the reserve currency status and how could a controlled transition be managed?
    4. how will loss of reserve currency status affect our ability to address our real long term problems (for example environmental destruction, especially climate change).
    5. if the foreign sector still desires to accumulate financial assets (denominated in a reserve currency other than the dollar) where will the deficit spending (to balance the global demand loss) come from if not the usa current account deficit? on a global basis, it seems to me the issue is the desire to net save — not specifically to net save in dollar denominated financial assets.

    thanks to anyone who can provide some education for me on the above questions.

    finally, just because something is “politically unsustainable” today doesn’t mean it can’t become politicly feasible in the future.. it’s not like a law of physics or something. an active, engaged and informed citizenry might help facilitate that change — especially if we can be shown the expected impacts of the policy options.