On financial balances

Some readers have expressed  bemusement at my claim in an earlier post that the only genuine deficit reduction policies are those which stimulate private sector investment and/or reduce their savings.I should expand.

Start from a trivial identity - that every pound someone borrows is a pound that someone else lends. This means that if one sector of the economy is a borrower, another must be a net lender - that is, its savings must exceed its investment.

My chart shows the net lending of the four sectors of the economy*. The most important point here is the negative correlation between public sector and companies' net lending. When companies were net borrowers in 1999-2001 the government ran a surplus, but corporate net lending in recent years has been associated with government borrowing.

But what's the direction of causality? Is government borrowing causing companies to be net lenders, or vice versa? In theory, government borrowing can depress firms' capital spending - and hence cause it to save more than it invests. But the mechanisms whereby it does so don't seem to operate now. For example:

- Financial crowding out. In this, government borrowing raises interest rates, which deters companies from investing. We know this hasn't happened, because index-linked gilt yields are now negative, and in fact were trending downwards ever since the early 00s when the government became a net borrower.

- Resource crowding out. It's possible that if the government is spending and borrowing heavily it is employing so many workers and materials that companies simply can't get the resouces they need to invest. It should be obvious that this isn't relevant today. And as there were four million unemployed even at the low point in 2005, I doubt it was relevant before the crisis.

- Ricardian equivalence. The idea here is that government borrowing means higher future taxes, and the private sector saves more in anticipation of that burden. This theory, though, runs into several problems, such as: why do people expect taxes to rise rather than public spending to fall? And why, before the crisis, did companies increase saving in anticipation of taxes rising for them, whilst households were saving less, presumably in anticipation of falling taxes?

Given these issues, I suspect the causality runs the other way. Before the crisis, foreigners were net savers, because they were building up FX reserves after the 1990s Asian currency crises, because oil exporters couldn't quickly reinvest oil revenues, and partly because of a lack of a welfare state in China. At the same time, a dearth of investment opportunities caused companies to save rather than invest. These savings caused interest rates to fall, helping to cause a housing boom and net borrowing by households. It also caused governments to borrow more, partly because tax revenues were weak, partly because low interest rates signaled that borrowing was cheap, and partly because  weak private capital spending led to the belief that a Keynesian stimulus was necessary.

Since the crisis, though, households have joined companies and foreigners in being net lenders as the housing bubble burst. With those three sectors all being lenders, the government must be a borrower. In more conventional terms, the reluctance of foreigners, households and companies to spend has created a weak economy and hence low tax revenues and the need for counter-cyclical spending.

Which brings me to where I started. The government's deficit can only fall if the other sectors reduce their net lending.

In normal times, fiscal austerity might achieve this by reducing interest rates and thus stimulating private investment. But with interest rates already below zero in real terms, these are not normal times. Osborne thought austerity "will have a positive impact through greater certainty and confidence about the future" - that higher confidence would stimulate private investment. But this hasn't happened so far.

So what policies might reduce private sector net lending? Policies such as the Funding for Lending Scheme, aimed at boosting borrowing, are intended to do so, as is QE. I suspect that the passage of time would also do so; an easing of the euro crisis and a need to replace worn-out capital will eventually boost investment.

But my point here isn't to advocate specific policies, but to merely describe the problem. The problem is that the government has less control over its finances than politicians pretend.

* Four quarter rolling totals. Don't read much into the fall in the corporate surplus recently - it's affected by the transfer of the Royal Mail pension fund.

Comments

[Nick]

I find myself writing this whenever you make this claim. You are either assuming that the real/natural interest rate should 'normally' be positive, or that the government HAS to defend a particular interest rate for savers.

Perhaps deferring consumption (making a claim on future resources) is expensive. Perhaps people are pessimistic about the future (for demographic, resource and tech stagnation reasons) and are willing to spend a lot of money in return for the right to consume in the future. If that is the case, then the government is giving a good deal to todays savers, and a bad deal to tomorrows workers.

The government isn't "forced" to borrow at any rate, negative or positive. It chooses to do so, in this case offering an above market rate of return. Rather than stimulating the economy, it could simply by subsidising rich savers.

[Will Davies]

I'm-not-an-economist-but...

Doesn't your hypothesis overlook the post-Keynesian argument, that money is created initially by banks, not by deposits, and there is therefore no requirement for lending to be correlated to savings? No doubt I'm missing something here.

[paulc]

"Doesn't your hypothesis overlook the post-Keynesian argument, that money is created initially by banks, not by deposits, and there is therefore no requirement for lending to be correlated to savings?" Will Davies

Doesn't alter the fact that the only takers for loans are the Gov'. The private sector is being frugal.

[Doc at the Radar Station]

Excellent post. If the government takes on the policy choice of reducing their deficit, then the private sector would have to "dis-save" in order for the sector balance to be maintained. For households, that would usually mean losing your job and being forced to spend your savings. Not a desirable outcome.

[Nathan Tankus]

@ Will Davies: you're missing the fact that net borrowing and net lending are terms used in flow of funds methodology that aren't supposed to imply causality. what this post is talking about is this: deficits=surpluses. for the government to have a smaller deficit some other sector must have a bigger deficit and/or a smaller surplus. this has nothing to do with the causality between lending and saving.

[Shinsei1967]

You use this argument to demonstrate that Osborne's "austerity" is self-defeating.

But isn't an opposite government economic policy, ie borrowing more, also self-defeating as it would just cause the household, corporate & foreign sector to save more (it's all just an accounting identity that must sum to zero).

[Neil Wilson]

"The government isn't "forced" to borrow at any rate, negative or positive."

The government doesn't have to borrow. The government never needs to borrow. It owns the central bank. It is irrational to borrow from a third party when you own a bank.

So it can't be borrowing. It's saving. Saving that without a countercyclical response would be the seeds of its own destruction.

What has to happen when people start saving is somebody else has to do the spending. And that is what government is doing - spending.

The causality is from spending to saving. The government is accommodating the net-saving desires of the non-government sectors - in order to prevent a cataclysmic depression

[Andy Cooke]

Sorry if I'm being obtuse, but isn't this logic predicated on a single economy, with no external flows?

If the domestic private sectors are net lenders, then either the domestic government sector must be a net borrower, or overseas entities (either domestic or government) must be net borrowers.

So if the Government had balanced their books, then the lending would be to overseas entities (would that then make our trade balance better?)

[paulc]

"So if the Government had balanced their books, then the lending would be to overseas entities (would that then make our trade balance better?)" Andy Cooke.

Just as logical to say that households would have to go much deeper into debt [become large net borrowers] since balancing the budget would by necessity mean draconian cuts to this and that public service forcing distress borrowing by those without sufficient savings. This could also lead to lower labour costs [real wages]via a reserve army of newly unemployed which in turn might lead to a better trade balance as our cost base goes down. Not sure what state we'd be in by the time that happens. My guess is we'd have to adopt Irish or Latvian tendencies toward emigration of our young in order to manage the induced hardship...but where would they go to?!

[chris]

@Shinsei1967 - the key thing is the level of economic activity at which savings=investment.
Under current conditions (NOT all circumstances), fiscal austerity will depress activity, whereas if the private sector starts borrowing again (say because "confidence" improves) activity will rise; government borrowing would fall because the higher GDP would raise tax revenues.
@ Andy - I'm not ignoring foreigners at all; they are one of the four sectors.
Yes, governments could have run a tighter fiscal policy, which would have reduced foreigners' net lending to us. But this would have happened because tighter fiscal policy would have depressed domestic demand, thus reducing imports and the UK's current account deficit.
@ Neil - yes, governments can borrow from the BoE. But why do they need to do so at all? It's because other sectors are net lenders, which (via the weaker activity and lower tax revenues resulting from such high savings) forces the government into deficit.

[Andy Cooke]

Paulc,

I was thinking more of the time during the boom when the Government continued running a deficit. Had they balanced the books then, it wouldn't have caused huge hardship, surely?

Chris,
Sorry about skipping over that - I meant that the "obvious" (ie, the thing that sprung to mind, regardless of whether or not it was correct) implication was that the line regarding "foreign" investment/borrowing would be the balancing remainder. That is, if domestic private sector and public sector debt was increasing, then (as every pound borrowed is a pound lent), the foreign sector had to be the source of the funds.

Conversely, if the public and private sectors were themselves both in surplus (ie paying down debt), then the debt they must be paying down would be (net) the foreign sector debt they had borrowed.

That seemed to be about the limits of the axiomatic argument; beyond that we've got arguments over the motivations and abilities of the various sectors to control their balances. If domestic demand had been decreased as per your statement, would it therefore have promptly led to an expansion in Government borrowing at a 1:1 equivalence to what unfolded anyway, or simply a slower growing economy but one where net debt had not grown as quickly? Because if it's the latter, then it's due to a political decision rather than an inexorable arithmetic conclusion.

[Luis Enrique]

"the post-Keynesian argument, that money is created initially by banks, not by deposits, and there is therefore no requirement for lending to be correlated to savings?"

I think there's a famous quote saying something like "this is both true and original - the parts that are true are not original and the parts that are original are not true."

I still haven't located anything in this supposed "post-Keynesian" theory that differs from the standard account of private money creation, except perhaps the (in most contexts) unimportant detail that banks don't need deposits before they can lend, they can lend first and finance later. In any case, bank balance sheets still have to balance, so if you're just thinking about banks then there's your correlation between saving and lending (once you've netted out interbank activity)

[paulc156]

@Andy Cooke. Had they 'balanced the books' in the period 2002-2007 period the effects on the economy would not have been so severe.
That they chose to spend above their revenue stream is a wider argument about the need then for capital spending [schools hospitals etc] which [if the case for such spending is accepted] might have implied increases in taxes to fund such spending, rather than borrowing via gilts.

In fact Chris Dillow does explain that those earlier deficits were in fact a response to the dearth of corporate investment even in the face of rising profits, so once again forcing the governments hand to a large extent. See here:
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2011/01/labour-the-deficit.html

One could thus deduce that both the borrowing in the first decade of the millenium and the borrowing now being conducted by the state is merely a reaction to the capitalists going on an investment strike. Reinforcing the notion that our capitalist system does not require anything like full employment to remain profitable.
Tricky one huh?

[Andy Cooke]

paulc156,
Chris's article linked there is using the same argument that he is developing in detail here, with the same questions to be raised.

The argument over the need, or choice for capital spending is orthogonal to the argument presented that it is an axiomatic corollary that the Government deficit is simply the balancing portion of the equation at the top of the thread. To state that they should have done so is to accept that they may not have done so.

[paulc156]

@Andy Cooke. In some cases it can be shown that deficit spending is 'optional' in the sense it was always possible to have had a recession instead of trying demand management. That could be argued of the period during the 70's, but the point here is that during the 21stC we have
a different problem. Lack of investment is itself giving rise to deficits. This is borne out by looking at interest rates which despite increased government borrowing have remained stubbornly low. We have had a national and global savings glut. There has been precious little crowding out of the private sector and the same sector has been somewhat reliant on governments to maintain demand so protecting their headline profits.
As said before, IF the government had decided earlier on to run a balanced budget [pre-2008] it would have done so with quite high underemployment even before the crash as a backdrop and would have expected either recession or very little growth in response.

Folks [private households] already running up debts would have run them up faster as the state reduced demand and ultimately our trade balance would have improved to the extent that ever larger levels of underemployment [forcing down wages and so increasing the rate of profit] would ensue.
The extent that 'running a deficit' is not an 'axiomatic corollary' of an investment strike is only true to the extent that labour can be impoverished quickly enough to benefit our trade balance before great hardship and anarchy take hold. [eg; Greece, Italy and Spain etc].

[Nick]

"So it can't be borrowing. It's saving. Saving that without a countercyclical response would be the seeds of its own destruction.

What has to happen when people start saving is somebody else has to do the spending. And that is what government is doing - spending.

The causality is from spending to saving. The government is accommodating the net-saving desires of the non-government sectors - in order to prevent a cataclysmic depression"

Why is that? The government could instead accommodate people's desire for saving (excess demand for money) by increasing the money supply. No need for actual government spending, just send more money to people, randomly if necessary, evenly if possible. That has the advantage of not building up excessive debt that could lower growth expectations in the future.

[paulc156]

People are saving/reducing borrowing because they are either unable to service debts [households] or unable to find worthwhile investments [companies].

Increasing the money supply to the effect that it works simply redistributes wealth from creditors to debtors.Zero sum.

While 'helicopter money creation' might allow greater borrowing or less saving by households why would worthwhile investments suddenly appear because prices are rising [the object of increased money supply]. Bearing in mind [for the UK economy] we already had a 25% reduction in our exchange rate early on in the crisis without any concomitant increase in our trade balance.
In other words we could just become more uncompetitive.

[Blissex]

Two technical points which are very important:

«Start from a trivial identity - that every pound someone borrows is a pound that someone else lends.»

That's both necessarily true and substantively false, because it is an identity only by definition, that is ex-post, and it is made into an ex-post truism simply by adjusting the definitions and the numbers until they match.

In a substantive sense it is entirely false, as money is endogenous in most modern economies, and therefore it has the same nature as goals or air miles, purely a unit of account.

Unless there is the trick here is to give for granted that «someone else lends» refers to the special power of banks of lending money while also keeping it, which is contrary to the common understanding of "lending" which is a transfer, not a copy.

«post-Keynesian argument, that money is created initially by banks, not by deposits, and there is therefore no requirement for lending to be correlated to savings?»

That is not at all post-Keynesian, as a central argument of Keynes' "General Theory" is that investment decisions and savings decisions operate in totally different markets and do not necessarily equalize, and indeed usually are different.

This obvious point led him to conclude that the interest rate is not at all the price of money that equalizes investments and savings, because they don't, it is instead the cost of being liquid, or conversely the price for being illiquid, one of the many exceptionally interesting insights of his work that has been lost in many deliberate betrayals.

[Blissex]

And a couple of non-technical points:

«why would worthwhile investments suddenly appear because prices are rising [the object of increased money supply].»

The object of an enormously increased money supply is and to keep interest rates low and to drive up or reduce the fall of asset prices, and the effect on other prices is just spillover.

What the government wants is for house prices to stay as high as possible, or at least to decline as slowly as possible, because most UK banks are insolvent, and would become even more glaringly insolvent if house prices went down, driving an even bigger hole in the vast amount of mortgages they hold.
Higher interest rates would also make the burden of interest on UK debt unberable, and while the government has a mountain of such debt, most of it is still long term at fixed interest rates; what really worries the government is the truly apocaliptic mountain of private debt, especially finance sector debt, which is usually very short term and where higher interest rates would be devastating.

Also, keeping up asset prices is politically essential, as high house prices are the single most important electoral factor especially in the South East and London, where the Coalition has most voters, and where the Tories face a big UKIP threat. If house prices returned to their sustainable value of less than 1/3 of their current value in London and less than 1/2 in the South East, the UKIP would take a large number of Tory seats.

Therefore the current Coalition policy is to bolster as much as possible the mostly insolvent City, and the mostly unsustainable South East and London house prices, at the expense of ferocious cuts to welfare and after tax wages which mostly affect areas in Scotland, the North and other fringe areas, as those will vote Labour regardless, and there is no UKIP threat there.

The goal of the Coalition is to choose the Ireland model of guaranteeing all credits by large investors at the expense of the living standards of ordinary people, and to additionally protect the living standards of London and South East landlords by depressing living standard even more than otherwise would be case outside that area.

[Andrew]

Good points everyone (I like Blissex's in particular).

I do find this analysis rather simplistic; pushing around trivial accounting identities in order to recommend the government "stepping in" to up GDP and reduce deficits.

Upping GDP by policy is incredibly easy and could be done instantly. Upping *sustainable* GDP is next to impossible and some childish accounting identities won't indicate how to do it.

Why is the private sector on an "investment strike"? It frightens me that this is treated as a root cause to be addressed by policy, rather than a symptom to be examined.

Was it on investment strike when "investing" in the housing/finance boom? Since this was in fact a major cause of the most recent crash, why should we think that broad macro stimulation now is a good idea? So we can juice up GDP for 5 years in a new damaging boom?

Perhaps there is a "dearth of investment opportunities" because we have been pissing our resources up against the wall and in the wrong direction for decades? Why would the government stepping in to prevent a recession be a good thing, on a long term view, in those circumstances?

[Andrew]

In general muddy thinking again about causation. Let me help.

One side of an identity CANNOT cause the other in a chain-of-events, natural law sense of the word. The other side of the identity is merely a rewording of the first side, true by definition.

So it is just meaningless to wonder whether a public sector deficit is causing the private sector surplus or vice versa. It is a silly as wondering if the 4 caused the 2+2.

What you CAN ponder is whether any particular public policy or private sector state of affairs caused any shift in the balance between sectors in that identity. The policy has to be more specific than "government borrowing" - you have to consider under what circumstances it took place and for what purpose.

[Andrew]

- "Financial crowding out" you say. How about financial crowding in?

In the housing boom the government used taxation from the malinvestment flows and additional borrowing to fund spending on workforce, investments and benefits.

This increased national incomes, making the private sector debt boom, and government balance sheet, look more sustainable than they were.

This in turn stimulated further private sector credit expansion and malinvestment in the boom.

A government may not crowd out a sector, but cause or perpetuate a boom in it, by making demand appear higher that it would otherwise be. If you have a predictable state buyer, you are also going to have private sector front runners and eventual public participation.

The narrow blinkers of sectoral balance sheet thinking in fact allows a massive credit expansion boom whilst leaving the public/private balance little changed, whatever it was!

Then when it all ends in tears economists pore over whether the state was a net lender or borrower, and whether it should now "step in"!

[Andrew]

Per Blissex, there are very good reasons to think the government stepping in to fill this private sector demand deficit will actually lead to impaired long term wealth.

Basically, in desperately keeping private sector home borrowers and bank balance sheets above water they have created a zombie economy where labour and capital is tied up in non-productive and damaging pursuits and burdened by debt service loads that would become crushing the minute financial repression ends.

If they allowed these entities to liquidate, there would be a devastating crash, but quite possibly a subsequent reallocation of resources towards something of more lasting value. But would a democracy ever volunteer for this path?

The issue is the best long term GDP path, not next quarter's print.

[Nick]

Paulc156: I sort of agree and sort of disagree.

When you say:

"Increasing the money supply to the effect that it works simply redistributes wealth from creditors to debtors.Zero sum."

I agree on one level, it is zero sum, but that you have it backwards. Right now, the government is supporting creditors at the expense of debtors by not allowing interest rates to fall to their natural (negative rate) by selling loads of debt that creditors are gleefully buying up.

If the Government stopped doing that and printed money instead, creditors would certainly be less well off than they are right now, and debtors better off. But the other advantage is that at least the interest rate wouldn't be distorted any longer and it would be easier to see exactly how keen people are to save rather than spend, and it would reveal which private sector capital projects are worth investing in. It would allow credit and debt markets to clear, which would benefit everyone.

In fact, allowing that to happen might lead to a rise in real interest rates once people discover what is worth lending to, and then we will back on a path to growth.

The point is the tendency of households, companies to save MUST be relative to the interest rate they can get. If you lower the interest rate enough, they will start spending at some point.

Oh and I wouldn't look to foreign exchange values as a sign of the money supply. Its too noisy with extra variables (not least the various policies of other countries). Just worry about NGDP which is what matters for output anyway.

[Luis Enrique]

I'm confused by many of the above comments.

profits=revenues-costs is an identity, yet we may still discuss the prospects for increasing profits by either increasing revenues or reducing costs. My point is that accounting identities can be useful when thinking about causality.

I also don't see the importance of endogenous money arguments. We know the quantity of money is endogenous, at least in the short-run, when the CB targets an interest rate. What does this have to do with the argument that if the government wants to reduce its deficit, companies will probably have to reduce their net lending?

Finally, the OP isn't saying the government ought to try and stimulate the economy, it's pointing out some realities IF the government wishes to reduce its deficit.

[Andrew]

Luis - it's a bit of a semantic nit-pick, so I would just ignore my point about causation.

Its just that strictly speaking one side of an identity can't cause another. Both sides may however change *together* due to outside causes.

But in general conversational use, I know what Chris means.