Be careful what you wish for, Mr. Cameron

Be careful what you wish for, Mr. Cameron

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My colleague John Aziz observes:

And yet every government deficit is by definition also a private surplus.

He is, of course, referring to my favourite equation, the sectoral balance equation, which shows the accounting relationship between the private, public and external sectors. It is usually written like this:

(S – I) = (G – T) + (X – M)

where (S – I) is the private sector’s saving over and above the amount required for private sector investment, (G – T) is the government deficit, and (X – M) is the trade balance.  In a closed economy, (X – M) = 0, and so it is correct to say – as John does – that the private sector’s surplus is equal to the public sector’s deficit.

But as Hilary points out in the comments, the UK is not a closed economy:

UK budget deficit = UK private surplus? No. Has to be adjusted for balance of payments current account. We do not live in a one-nation economy. The counterpart to a UK budget deficit may be held entirely by foreigners.

Indeed it may. The counterpart to the UK budget deficit could be an equivalent trade deficit. When G – T = X – M, then S – I is zero. As Hilary says, the budget deficit is effectively funded by foreign capital inflows. In practice it is not as simple as that: some of the foreign capital actually goes into private sector investment, while some domestic saving is actually held as government safe assets. But the aggregate effect is that the counterpart to the government deficit is held by foreigners.

So is this true of the UK? According to the OBR’s Economic and Fiscal Outlook for December 2014, the government deficit is only slightly larger than the trade deficit:

Main article image

The domestic private sector’s net saving (“lending”) is currently only around 0.5% of GDP and is made up entirely of the retained earnings of corporations. Households, it seems, aren’t net saving at all now, though four years ago they were. The fall in the government deficit since 2010 it is an almost exact mirror image of the fall in household net saving. Similarly, the rising trade deficit is the mirror image of falling corporate saving since 2012. Surplus, what surplus?

Since 2010, household and corporate saving has fallen so much that the counterpart to the government’s deficit is now almost entirely held by foreigners. What would happen if those foreigners suddenly decided to pull their funds? It’s not at all clear why they would choose to do so, but it is this fear that drives the current obsession with deficit reduction. If only we could eliminate the deficit – and ideally the legacy stock of debt as well – we would eliminate the (remote) possibility that foreigners might refuse to fund us. The deficit obsession and the immigration obsession both stem from the same source. We distrust foreigners and fear strangers: we do not want them in our country and we do not want to be beholden to them. Close the borders, pay off foreign debts, force banks to lend only to the British, dig for victory…..anyone would think we were preparing for war.

But what happens to these sectoral balances if the government eliminates its deficit, as all the main political parties have proposed? 

In the absence of government deficit spending, a trade deficit drains the domestic private sector. If (X-M) is negative and (G-T) is zero, then (S-I) must also be negative. The amount by which I exceeds S is the deficit of the domestic private sector. It is the capital that domestic households and corporations must import from abroad to meet investment needs.

So if UK politicians succeed in their ambition to eliminate the government deficit, then unless they also eliminate the trade deficit, the UK’s private sector will necessarily have to take on more debt. Indeed if the government achieves a budget surplus while still running a trade deficit, as the OBR projects, then the UK’s private sector will be drained by both the external sector and the government. Yet the UK’s main political parties regard eliminating the deficit as a vote-winner. Perhaps turkeys do vote for Christmas.

How likely is it that the trade deficit would be eliminated in parallel with the government deficit? The OBR is not optimistic: the chart above shows the trade deficit gradually falling, but it is still projected to be 2% of GDP in 2020. This is because the prospects for increasing UK exports are far from bright. The EU is the UK’s largest trading partner, comprising 50% of exports and rather more of imports: the depression in much of the EU makes it unlikely that the UK’s trade deficit with the EU will reduce any time soon. Nor is increasing exports to other parts of the world a straightforward alternative: global growth is slowing and many emerging market countries are experiencing difficulties due to falling commodity prices.

Realistically, the only way in which the UK can make a serious dent in its trade deficit is by sharply cutting imports. As we have seen in the Eurozone, fiscal consolidation does cause imports to fall, especially if it is accompanied by recession. This is because eliminating a fiscal deficit involves extracting money from the private sector. This applies regardless of the manner of the consolidation – tax rises or spending cuts. The saving of the private sector is the residual income left after consumption and taxes:

S = Y – C - T

Raising taxes increases T, obviously: cutting government spending reduces Y, at least in the short run*. So either the private sector must cut saving, or it must cut consumption. If it chooses to cut consumption, imports are likely to reduce. So eliminating the fiscal deficit may also shrink the trade deficit.

But the OBR’s chart suggests that imports would not fall enough to eliminate the trade deficit, let alone generate the trade surplus that would be required to offset the government surplus projected for 2019-20. Yet corporations and households have already pared saving to the bone. If the fiscal deficit is to fall further, therefore, they must take on debt.

Ideally, it would be corporations taking on debt – borrowing to invest for the future. But the OBR forecasts that corporations will remain net savers for several years to come. That leaves households. And the OBR’s forecast for them is shocking. Here is the OBR’s projected increase in household debt/income:

Main article image

The Conservatives’ planned fiscal consolidation would drive household debt/income up to higher than it was immediately before the 2007-8 financial crisis. By 2020, it would be over 180%, mainly due to rising house prices. And this would be unequally distributed over the population. The old would remain asset-rich and largely debt-free: the burden of the increased debt would fall predominantly on the young, many of whom would face even higher debt/income ratios. This cannot possibly be sustainable.

I said recently that there wouldn’t be another financial crisis until we had entirely forgotten about the last one. But it seems that politicians have already forgotten about it. The 2008 crisis was not caused by foreigners refusing to fund government deficits. It was caused by foreigners refusing to fund excessive private sector debt – debt that politicians now wish to increase in order to “fix the public finances”.

Mr. Cameron should be careful what he wishes for. As should Mr. Miliband, and Mr. Clegg. By eliminating the mythical risk of capital flight from a public sector deficit, they may unleash the real horror of private sector debt deflation.

Related reading:

The Chancellor's incredible spending cuts

The economics of Ed

Smaller state does not equal smaller deficit - Alex Little

Public borrowing bad, household borrowing good? - Alex Little

Image from Getty Images via The Telegraph.


* That lower G means lower Y, at least in the short run, is clear from the expenditure version of the national accounting equation:

Y = I + C + G + (X – M)

It is possible that Y could increase in the medium term if I were to rise due to lower G reducing crowding-out. However, the OBR observes that the severe cuts to unprotected departments, and particularly to local authority budgets, envisaged by the Conservatives would have a “direct impact on GDP”. In English, that means the Conservatives’ plans are likely to cause another recession.


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