Today’s public finance numbers confirm what we all knew - that government borrowing is exploding. It’s quite possible that Darling’s forecasts made in November will be too optimistic. And ConservativeHome are talking about “bankrupt Britain.”
What’s not sufficiently appreciated, however, is that this is in large part just an inevitable effect of the credit crunch.
This follows from a basic national accounts identity - that across the whole economy, savings must equal investment.
Now, the credit crunch means that private sector savings are rising, relative to investment. This is not just because folk are paying down debt. It’s also because credit constraints mean that people who would like to borrow cannot do so.
If private sector savings rise relative to their investment - that is, they run a big financial surplus - someone else must run a deficit. There are only two candidates - foreigners or the government. But foreigners, especially those in Asia, are net savers.
As a matter of arithmetic, therefore, the government deficit must increase.
My chart shows this. It shows that for the last 20 years there’s been an inverse relationship between the government’s financial balance and the corporate sector’s. When companies save more than they invest, government runs a deficit. With companies now running the biggest surplus they ever have - partly because those who would like to borrow to invest cannot do so - it’s no surprise that the government is running a big deficit.
This has four implications:
1. Britain’s red ink is not just due to New Labour’s profligacy. The OECD expects government borrowing to rise in most developed economies (though granted, more in the UK and US than elsewhere). This is because the rise in the private sector’s financial balance is a worldwide fact, albeit more so in the UK and US than elsewhere.
2. It explains why gilt yields have stayed low. The same credit crunch that is, by simple arithmetic, responsible for government borrowing is also causing a “flight to quality” and low gilt yields.
3. Your view on how big government borrowing becomes should depend very much upon your view of the credit crunch. If you’re pessimistic about the latter, you should expect big borrowing.
4. It’s possible that the public finances might improve more than expected. If or when the credit crunch does end, companies might have a big backlog of unfilled capital expenditure plans. As these become realizable, the corporate surplus could swing into deficit, causing the public finances to improve quickly.
Seems unlikely? Maybe. But I remember being told both in 1989 and 2000 - when the government was in surplus - that we faced years of surplus. And I remember being told in the mid-90s that we faced years of deficits. It was all bull.
Experience, then, teaches me that long-term forecasts of the public finances aren’t worth a wet fart.
What’s not sufficiently appreciated, however, is that this is in large part just an inevitable effect of the credit crunch.
This follows from a basic national accounts identity - that across the whole economy, savings must equal investment.
Now, the credit crunch means that private sector savings are rising, relative to investment. This is not just because folk are paying down debt. It’s also because credit constraints mean that people who would like to borrow cannot do so.
If private sector savings rise relative to their investment - that is, they run a big financial surplus - someone else must run a deficit. There are only two candidates - foreigners or the government. But foreigners, especially those in Asia, are net savers.
As a matter of arithmetic, therefore, the government deficit must increase.
My chart shows this. It shows that for the last 20 years there’s been an inverse relationship between the government’s financial balance and the corporate sector’s. When companies save more than they invest, government runs a deficit. With companies now running the biggest surplus they ever have - partly because those who would like to borrow to invest cannot do so - it’s no surprise that the government is running a big deficit.
This has four implications:
1. Britain’s red ink is not just due to New Labour’s profligacy. The OECD expects government borrowing to rise in most developed economies (though granted, more in the UK and US than elsewhere). This is because the rise in the private sector’s financial balance is a worldwide fact, albeit more so in the UK and US than elsewhere.
2. It explains why gilt yields have stayed low. The same credit crunch that is, by simple arithmetic, responsible for government borrowing is also causing a “flight to quality” and low gilt yields.
3. Your view on how big government borrowing becomes should depend very much upon your view of the credit crunch. If you’re pessimistic about the latter, you should expect big borrowing.
4. It’s possible that the public finances might improve more than expected. If or when the credit crunch does end, companies might have a big backlog of unfilled capital expenditure plans. As these become realizable, the corporate surplus could swing into deficit, causing the public finances to improve quickly.
Seems unlikely? Maybe. But I remember being told both in 1989 and 2000 - when the government was in surplus - that we faced years of surplus. And I remember being told in the mid-90s that we faced years of deficits. It was all bull.
Experience, then, teaches me that long-term forecasts of the public finances aren’t worth a wet fart.
oh man, this confuses me. I'm not disputing your conclusion, but I'd like to understand how what you argue here differ from what Krugman calls: "one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship"?
(Krugman quote from here: http://krugman.blogs.nytimes.com/2009/01/27/a-dark-age-of-macroeconomics-wonkish/ )
Posted by: Luis Enrique | February 19, 2009 at 02:41 PM
Luis, it differs because Krugman's complaint basically boiled down to people using an accounting identity to claim that government can't boost GDP because anything the govt spends comes from somewhere. Krugman says yes it does come from somewhere, but that doesn't mean we can't make GDP bigger in the process.
Chris is saying that the total investment comes from somewhere, but nothing about how big it is. Notice he's got % of GDP on his graph.
In short, the De Long-Krugman/Fama blog war is about whether GDP can be increased by govt spending going up, Chris's point is about govt spending having to go up anyway.
Posted by: Andrew | February 19, 2009 at 04:20 PM
I wish Chris was right, but I think Luis is more accurate.
Let's take a simple example. ABC plc revises its estimates of future economic growth downward and thus decides to cut investment, keeping income and consumption fixed. It accumulates savings which it keeps in the bank. It is not incumbent on the government to borrow this money from the bank if it doesn't want to.
In exchange for the company's savings increasing, the bank's savings decrease (because it has accumulated a liability to the company).
[Incidentally: the bank should, in a functioning monetary market, reduce interest rates to encourage people to borrow their money (and consequently decrease private non-bank saving to offset the temporary increase caused by ABC). But the monetary market hasn't been functioning normally.]
So the increase in private saving (assuming the financial sector is included) is as much a consequence as a cause of government deficits. We can have a debate about the causality of this change and what decisions or behaviour led to it, but it doesn't arise spontaneously from the accounting relationship.
A separate phenomenon is the drop in national income which results from ABC's cut in investment (or equivalently, from the reduction in velocity of money). This in turn will reduce ABC's income and it may soon start drawing on some of those savings. But that isn't directly a factor in this argument.
Posted by: Leigh Caldwell | February 19, 2009 at 04:23 PM
@ Leigh - the drop in national income caused by ABC's cut in investment is central to the argument. This drop is what causes tax revenue to fall, which is the mechanism through which a higher private financial balance leads to a government deficit.
It's for this reason that I'm not making the error of mistaking an accounting identity for a behavioural relationship.
Posted by: chris dillow | February 19, 2009 at 06:15 PM
Chris has to be wrong. His comment about national accounts is only valid in a closed economy. In a global economy where savings can be placed anywhere there is no necessary correlation between savings and a national government deficit. A government can run as large a deficit as it wishes provided it can find someone to finance it.
Posted by: Ian Hislop | February 19, 2009 at 06:23 PM
I don't understand this idea of private public sector accounts being locked together to sum to a constant. Government debt has shot up in no small part because the Government has spent a lot on bail outs. They were not forced to do that by 'arithmetic', it was a political choice. If they had not done it, where would the arithmatic be then? Am I not getting something here?
Posted by: Keith | February 19, 2009 at 09:32 PM
I'm lost by this why if the private sector runs a surplus does the state have to run a deficit?
I don't see the relationship there is no have to about it.
Posted by: tbrrob | February 19, 2009 at 10:06 PM
Ian,
I think the open economy thing is not a problem - it could be that the counterparty of UK private sector surpluses is overseas deficits, but as Chris mentions, if anything the opposite is the case.
Chris, I didn't suppose you'd made that mistake, I just wanted to understand how not. I think I do now, but I still get in a muddle.
Looking at:
I(G)+I(P)=S(G)+S(P)
we have I(G) going up (govt stimulus spending) and S(G) going down (fiscal expansion) and I(P) going down (companies not investing), and S(P) up (private sector lending to govt) - that's a behavioural story that adds up. Whereas just saying I=SG+SP so if SP up, SG down, is the sort of error Krugman is getting at, I imagine.
I just find it all very confusing when I start thinking about mechanisms. For example, I'd have thought it would be possible for the private sector to hold investment I(P) constant and increase lending to the govt. Say S(P) goes up by 1 and S(G) down by 1, that means net invest can't change ... but why can't the govt have invested the money it just borrowed? I know the sort of error I'm making here, and could prob figure it out if I sat down with pen and paper, it's just easy to get confused, is all.
Posted by: Luis Enrique | February 19, 2009 at 11:34 PM
Ian,
I think the open economy thing is not a problem - it could be that the counterparty of UK private sector surpluses is overseas deficits, but as Chris mentions, if anything the opposite is the case.
Chris, I didn't suppose you'd made that mistake, I just wanted to understand how not. I think I do now, but I still get in a muddle.
Looking at:
I(G)+I(P)=S(G)+S(P)
we have I(G) going up (govt stimulus spending) and S(G) going down (fiscal expansion) and I(P) going down (companies not investing), and S(P) up (private sector lending to govt) - that's a behavioural story that adds up. Whereas just saying I=SG+SP so if SP up, SG down, is the sort of error Krugman is getting at, I imagine.
I just find it all very confusing when I start thinking about mechanisms. For example, I'd have thought it would be possible for the private sector to hold investment I(P) constant and increase lending to the govt. Say S(P) goes up by 1 and S(G) down by 1, that means net invest can't change ... but why can't the govt have invested the money it just borrowed? I know the sort of error I'm making here, and could prob figure it out if I sat down with pen and paper, it's just easy to get confused, is all.
Posted by: Luis Enrique | February 19, 2009 at 11:34 PM
Was that THE Ian Hislop?
Posted by: Andrew | February 19, 2009 at 11:47 PM
One of them
Posted by: Ian Hislop | February 20, 2009 at 10:42 AM
Surely, the fundamental national accounting identity is:
S+C+T = Y = C+I+G+X-M
where: S=Current saving; C=Consumption spending; T=Taxes paid on income, goods and services;
Y=GNP; C=Consumption spending; I=Business investment; G=Public spending on goods and services.
On rearranging in the fsmiliar way:
X-M = (S-I) + (T-G)
The counter-part of an improvement in a country's Current Balance of International Payments, it's necessary to increase the private sector surplus of Current saving over Business investment and/or increase the Public sector surplus of Tax revenues over Public spending on goods and services.
Btw for a particularly bleak assessment of where the global economy might be headed as the result of the credit crunch, try Martin Wolf in Wednesday's Financial Times (17 Feb), where he argues we could repeat the experience of Japan's economy in the 1990s after the breaking of its asset-price bubble in 1992:
http://www.ft.com/cms/s/0/ae540b20-fd5e-11dd-a103-000077b07658.html?nclick_check=1
Posted by: Bob B | February 20, 2009 at 11:29 AM
@ Luis - for the private sector to increase its savings for a given level of investment requires it to cut spending - say the wage-bill for companies. This leads to lower tax revenue and a government deficit. Of course, if the government invests the money it borrows, its deficit (I-S) rises further.
@ Ian - it is possible that a rise in private domestic saving causes a fall in foreigners' saving (that is, the UK's current account deficit) and hence no impact upon the government's balance. But given that imports fall only slightly as spending falls, this is only a small part of the story. Empirically, it's the government balance that bears most of the adjustment.
Posted by: chris dillow | February 20, 2009 at 01:35 PM
Ta. I thought that might be it, but got hung up on wondering whether it would be one for one (i.e. private sector lending to govt decreases tax revenues one for one) and whether it would need to be.
Posted by: Luis Enrique | February 20, 2009 at 03:32 PM
Typically, with large amounts of borrowing such as in a remortgage, they will carry out credit checks through the services of a credit reference agency. This is part of how they work out the potential risk to them of giving you the borrowing, and is fed into the deals that they offer you.
Posted by: Robert Prime | July 02, 2010 at 06:41 AM
Government debt has shot up in no small part because the Government has spent a lot on bail outs...great lens will credit this and save.
Posted by: scoremore | October 11, 2010 at 01:44 PM