Chart of the Day: Public deficits and private savings in the euro zone

In May I wrote a post asking "Why can’t people understand national accounting?" and I was heartened that the post seemed to get a lot of traction. Most people don’t get it. In fact, I didn’t get it until a few years ago.

I asked the question because in this post-crisis world, some people seem to act like cutting budget deficits has no effect on the private sector whatsoever. Or worse, they act like George Osborne does, thinking that confidence fairies will magically fly in to prop up the private sector when deficits get cut and all will be well. It doesn’t work that way at all. When the government’s balance changes, the balances for businesses and households change too. We need to know how changes in the government’s balance will affect the rest of the economy before we go off half-cocked and start talking about cutting deficits.

Here’s a chart that gets to what I am driving at. I got it from Warren Mosler who spied it on an Italian finance blog.

Here’s what I am seeing: when the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. So, to reduce the government deficit in any period, the private balance and the capital balance must increase by the exact same amount in that period.

What this means in effect is that when you say that you want to reduce government budget deficits, you are automatically saying you want to reduce non-government surpluses. Go ahead and just say it straight out:

The non-government surplus is too large, we need to reduce it now before it gets out of control.

If that’s not a statement you feel comfortable making, then you have to look at government deficits in a different way.

My view: Budget deficits are what results ex-post from an accounting identity between the sectoral balances and should not be a primary goal of public policy. What we want to do is target the cause of the deficits, insufficient demand which I believe is the result of the overhang of debt after a period of excess private sector credit growth. What you want to do is eliminate that debt overhang by reducing the debt or increasing private sector incomes to support the debt. That’s getting at root causes.

I know I’ve stripped this down at the risk of being simplistic but I don’t want to get into a discussion about how you increase private sector incomes or reduce private debt. I just want to put it out there that that’s what you want to do rather than just focusing on the government deficit. Focusing on the deficit is what Europe’s doing – and it doesn’t work.


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.