This is the fourth in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.
“The family that pays together…”
During my college years, I used to look forward to seeing my hometown girlfriend when I came home at Christmastime. I’ll call her “Thelma” to protect her privacy in case she’s still trying to live down her association with me. One time when I was in her family’s kitchen, I noticed a posted sheet of paper that recorded all the borrowing and lending that had been going on among the children, probably related to Christmas shopping. So Thelma might have lent her brother Sam $5 when he was short of cash, and on other occasions Sam might have lent money to Dave, and later he might have lent money to Thelma, and so it went. After Christmas, I imagine they totaled up all the debits and credits to see where everybody stood. My contribution was to write at the bottom of the sheet, “The family that pays together stays together,” much to the parents’ delight.
Let’s suppose that when we balance it all out, Thrifty Thelma has lent $100 more than she borrowed, Sam has come out even, and Deadbeat Dave has borrowed $100 more than he lent. So the financial balances are:
Thelma +100, Sam 0, Dave -100
Every debt creates an asset for someone and a liability for someone else, so the balances have to add to zero.
Oh, I left something out. Thelma’s Chinese friend Meili had a yard sale, at which Thelma bought $140 worth of stuff. She was short of cash because of all the Christmas shopping, so she gave Meili an I.O.U. for the debt. That changed Thelma’s balance from +100 to -40. If we include Meili in the accounting, we now get:
Thelma -40, Sam 0, Dave -100, Meili 140
Notice that not only do the balances add to zero, but the sum of the balances inside the family (-140) must offset Meili’s external balance (140).
Debt can easily be moved around. Thelma could offset her $40 debt by lending $40 to Sam, which would give us:
Thelma 0, Sam -40, Dave -100, Meili 140
Taking it a step further, Sam could now assume the remaining family debt by lending $100 to Dave:
Thelma 0, Sam -140, Dave 0, Meili 140
Oh, Oh, “Uncle” Sam has wound up in debt to the Chinese! And Sam could even create surpluses for everyone except himself by borrowing from Thelma and Dave:
Thelma 100, Sam -340, Dave 100, Meili 140
You can probably see where I’m going.
Sectoral surpluses and deficits
Sectoral accounting in Modern Monetary Theory distinguishes three economic sectors: government, private domestic, and external (relating to foreign countries). Each sector can be in surplus or deficit, and the three financial balances have to add up to zero. For every surplus, there must be a deficit, and vice versa.
The government’s financial balance is given by T – G, where T is taxes net of transfer payments and G is government spending. The balance is a surplus when T > G and a deficit when T < G .
The private domestic financial balance is given by S – I, where S is saving and I is investment. If all saving is spent on investment, there is no financial surplus, just an addition to real assets like factories. If S > I, the surplus accumulates as financial assets. If S < I, the deficit results in some liquidation of financial assets. S – I is also called Net Acquisition of Financial Assets (NAFA). S – I was also discussed as a leakage from spending in the last post, when I was analyzing how much of the national income goes into spending.
The external financial balance is given by -CAB, where CAB is the Current Account Balance. I defined that earlier as the difference between money flowing into the country and money flowing out of the country, taking into account both trade and investment income. We are accustomed to looking at this from the U.S. point of view, where a positive value would indicate a surplus in our favor. Now we have to reverse the sign, because we want a positive value to indicate a surplus in favor of foreign countries. This is just what I did when I expressed Thelma’s debt to Meili as Meili’s surplus. For the United States, CAB is negative because of the trade deficit, so the external financial balance is positive, representing a surplus held by foreigners.
This surplus is different in one respect from Meili’s surplus. She held Thelma’s I.O.U. for goods Thelma hadn’t yet paid for. The Chinese hold a surplus in dollars for goods Americans have paid for. Those dollars are a financial asset for them, but a liability for us, because they are claims against our economy that we “owe” them. The dollar itself is a kind of I.O.U., and that makes the Chinese our creditors and Americans their debtors.
With the sector balances defined that way, the three balances must add to zero:
(T – G) + (S + I) + (-CAB) = 0
This formula follows logically from the formulas for GNP and GNI given in the last post, but I’ll spare you the proof.
Here are recent estimates derived from the National Income and Product Accounts tables published by the U.S. Bureau of Economic Analysis. (The numbers are published quarterly and revised frequently. They are annualized to estimate one year’s financial flows in billions of dollars.)
-1,022 + 609 + 413
The annual government deficit balances the private sector and foreign surpluses. The government takes on debt, while the private sector and foreign countries accumulate financial assets. Foreign investors now own about a third of the stock in U.S. companies, for example, and they got a nice financial windfall from the cut in corporate taxes.
Since the external sector has a surplus, the two internal balances must add up to a deficit just as large. And since both the external and private domestic sectors are in surplus, the government must have a deficit large enough to offset both of them.
Who should carry the debt burden?
Reducing the government’s debt burden requires either reducing the external trade imbalance or reducing the private sector’s surplus.
The United States would like to be more competitive in world markets, but there are several strong reasons why we aren’t:
- As a country with a relatively high median income, we can afford to buy a lot from other countries.
- The dollar is a strong currency on world markets. Other countries are willing to hold dollars and financial assets denominated in dollars, especially bonds issued by the U.S. Treasury.
- Countries with low wages are able to produce more cheaply many products formerly made in America.
- Some countries engage in unfair trading practices, although that is beyond the scope of the authors’ analysis.
Most of these will be very hard to change, even if we can agree they should be changed. Given that the external sector is in deficit from our point of view, and so has a surplus from the foreign perspective, which of our internal sectors should balance it with a deficit?
The text argues against allowing the private domestic sector to be in deficit:
We know that the private sector cannot sustain deficits permanently. This is because the flows of spending which deliver deficits have to be funded…. Private deficits ultimately manifest in an increasing stock of debt being held on the private sector’s balance sheet.
This process of debt accumulation is limited because at some point the susceptibility of the balance sheet to cyclical movements (for example, rising unemployment) increases and the risk of default rises….
In the long-term, the only sustainable position is for the private sector to be in surplus. An economy can absorb deviations around that position but only for short periods.
That leaves the government as the sector to take on deficits and debt accumulation. Unlike the private sector, government can sustain deficits because it has the power to create money when it spends beyond its tax revenue. I’ll describe the monetary operations by which it does that in the next post. Like Sam in my family example, government assumes the burden of debt so that the other sectors can maintain and grow their financial assets.
Under these conditions, regularly balanced budgets are hard to imagine. Not only would they reduce GNP, national income, consumption and saving, as discussed earlier; but they would force the private sector to incur annual deficits about as large as our trade imbalance, constantly shrinking our financial assets.
American society has done a useful—and maybe at least temporarily unavoidable—thing by piling its debts onto the entity most able to sustain them. That has enabled private wealth to keep flowing—to the rich anyway—even as our manufacturing declined and our global competitive position worsened. That’s one way to keep an economy growing, albeit at a sluggish rate with little gain for most workers.
Sectoral accounting reveals just how much creditors and debtors are mutually interdependent. If debtors want to spend more than their current income, they need creditors. If creditors want to acquire financial assets, they need debtors to accept the corresponding liabilities. In foreign relations, the U.S. is the debtor and our trading partners are, on average, the creditors. In domestic sector relations, the public sector is the debtor and the private sector is the creditor.
If we are to blame one side or the other, which side should it be? If debt is the fault of the deadbeat debtor, then we should be beating up on the United States for being a debtor nation, instead of attacking our trading partners for selling us more than we sell them. If debt is the fault of the predatory lender, then we should be angry at the private sector for accumulating assets, not at the public sector for accepting the liabilities. Who is doing whom a favor here?
Government is not some kind of alien invader or colonial power that preys on the “free market.” By giving in to the demands of assertive constituencies, government runs up the debts that become financial assets for someone in the private sphere. These include demands for high transfer payments from the elderly and the poor, demands for low taxes from corporations and the wealthy, and demands for the world’s highest military spending from the military industrial complex.
Too much of a good thing?
I think the text makes a pretty strong case that public debt is more sustainable than private debt, and that public deficits can stimulate the private sector. The authors would actually like to see more such stimulus, through government spending aimed at putting more people to work.
But this analysis also got me thinking about something the text does not discuss. If public deficits are not as bad as we’ve been led to believe, is it also possible that private surpluses are not as good as we’ve been led to believe? The private sector is better off running surpluses than deficits, yes, but is there any limit to how big the surpluses should be, especially when the financial assets are going primarily to make the rich richer?
I’m not worried about the government running out of money, because technically a government that controls its own currency never has to. I am more worried that a large pile of surplus capital not invested in productive assets supports a booming, high-flying financial sector that engages in too much speculation. In a worst-case scenario, business investment is flat, and the economy is growing only because of government’s deficit spending. Income, consumption and saving are rising, but the growing gap between S and I indicates a growth of surplus capital. Capital always seeks a good return, and if businesses aren’t investing enough to provide it, capitalists are tempted to resort to financial speculation. Financial firms can raise money selling “junk bonds” promising high interest rates, then use the money to buy up existing companies not to expand them, but to loot them of their assets or flip them for a quick profit. Banks can make risky mortgage loans to unqualified buyers, but then package them and pass them off as AAA-safe investments. Speculation can take many forms. But when it becomes rampant and people lose confidence in the value of financial assets, bubbles burst and financial crises occur.
We know what a financial crisis looks like because we have recently lived through one. Have the underlying dynamics of our economy changed very much since then?