Sunday, May 25, 2014

Where's our economic recovery coming from?

We have previously discussed how the private sector's surplus/deficit (i.e. what most of us think of as "the economy") MUST EQUAL net government deficits/surplus (spending less taxes) + net foreign trade (exports minus imports). This is a simple double-entry accounting truism -- all transactions with money must balance out.

Understanding this simple ECON 101 principle is critical to understanding the essential role of Government money in the economy. 
Net Domestic Financial Savings = Net Government Spending + Net Foreign Trade (economists use the terms Current Account and Capital Account for the Foreign Trade component)
From this formula, it should be quite obvious that if we change financial assets in one sector, it has to affect at least one of the others

  • Example 1: if exports fall by $1 billion, that means there is $1 billion less in the Private Sector, unless that difference is made up by an increase in Private Sector debt or Government deficits.
  • Example 2: if imports exceed exports ($ flow out of the domestic economy) and the Government runs a surplus (removes more $ from the economy via taxation than it adds via spending), then the Private Sector must significantly increase debt levels in order to run a sufficient deficit to overcome these monetary drains. (This is exactly what occurred during the Clinton years as shown in the chart below).
  • Example 3: if the Private Sector lowers debt and increases savings (i.e. has a surplus), and if imports exceed exports (i.e. net $ flow out as goods flow in), then by definition, the Government MUST be running a deficit equal to the net import outflows + Private Sector savings.
For a net importing nation, in order for the Private Sector to have a surplus,
the Government must run deficits.
Example 3 above happens to reflect the recent US economy after the Great Financial Crisis (GFC). We can rearrange our accounting equation to solve for the Government Sector as follows:
Government Deficits = Domestic Savings minus (Exports less Imports)
Like it or not (and we really should like it), Government money is a partner in the economy. We generally want the Private Sector to be in surplus. Note that you can't have ALL countries net exporting - there has to be a 50-50 split, so for all the nations that net import, deficit spending is NORMAL, and trade partners also support it by holding currency reserves and bonds of the nations they seek to export goods to.

Government deficits ALWAYS rise and fall in response to what is going on in the economy. Recessions cause a drop in tax receipts and increase in government spending on unemployment and welfare. Naturally, this results in a rise in deficits which help push the Private Sector into surplus. Such counter-cyclical balance to the economy is GOOD

A Fiscal Trap Occurs When Fiscal Policy Aims to 
Balance the Budget—And Private-sector Financial 
Fragility Can Worsen the Problem
Unfortunately, politics and misguided economic thinking (such as debt & deficit hysteria) cause many to see the rising deficits as bad and thus seek to reign in government spending and raise taxes. Of course this just leads back to Private Sector hardship which lowers tax receipts and increases government spending again - a "fiscal trap".

This way of thinking cuts off one leg from our three-legged stool: we rely only on increased private debt or increased exports to get out of trouble, cutting our most powerful ally, the nation's monetary system, out of the game. 

So now that we have established the importance of the sector balance equation, how do we apply this logic to the current economic malaise in the US economy? If we look at our sectors, we can see the following:
  1. We are a net importer, so $ are flowing out of our economy in exchange for goods from abroad. We are starting our equation negative.
  2. Private sector debt levels are still very high and there's still evidence of strong savings desires and de-leveraging (Private Sector reducing debt). We are unlikely to see the Private Sector significantly spending above its income for a while.
So where else can our economic recovery come from? Here are our choices, and it should be quite obvious that Government money can play a key role:
  1. Export more to increase domestic income. As stated above, the US is unlikely to become a net exporter in the near term due to our Reserve Currency status and mutual trade interests.
  2. Private sector borrows more. Again, with record debt levels and falling real wages, there is little room for productive credit expansion (of course the financial industry will always try for more Ponzi credit until defaults rise and it all collapses again, but I'll save that for another day).
  3. Lower taxes to increase spendable incomes. The payroll tax holiday was exactly the right kind of fiscal response needed, but it ended too quickly (see the fiscal cliff comments above). Tax cuts for businesses or capital gains will have little effect since there is no increase in demand.
  4. Write off/down debt to increase spendable income. In addition to reducing the tax burden, reducing debt burdens will free up income which increases demand for goods & services. We could use more debts write-downs than bank bailouts.
  5. Increase government spending. We seem to have no trouble doing this during wartime (WWII deficit spending is arguably what ended the Great Depression), but refuse to take the same approach to help our citizens during times of peace. We can certainly debate what are the most beneficial uses of Government money, but a functioning government & legal system, education, national defense, world-class infrastructure, sustainable low cost energy, care for the elderly, a social safety net and affordable medical care, and full employment should all be high on most lists.
  6. Reduce Private Sector savings. The current tax structures provide strong incentives to save, funneling trillions into real estate, mutual funds, 401k/IRA/529 plans, and bonds. These savngs are dollars that are NOT being spent on goods and services, and is a big reason for the size of our national deficits. Remember, the so-called national "debt" is exactly the non-government sector financial savings. Without tax reform and re-regulation of the financial industry, it is unlikely we will see much change here. 

In summary, with the Private Sector still seeking to increase savings and reduce debt, and net imports from the Foreign Sector, our solution lies in fiscal policy - reduce taxes and increase Government spending. 

A strong economy and real prosperity for our children is not just feasible - it is the fiscally responsible thing to do!