The Continual Failure to Understand the Balance Sheet Recession

Ezra Klein and Bill McBride are excited that the government is reducing spending in the next years because he says it’s “real progress on the debt”.  He says:

“Let’s do some quick math. Start the clock — and the deficit projections — on Jan. 1, 2011. Congress cut expected spending by $585 billion during the 2011 appropriations process. It cut another $860 billion as part of the resolution to the 2011 debt-ceiling standoff. And it added another $1 trillion in spending cuts as part of the sequester. Then it raised $600 billion in taxes in the fiscal cliff deal.

Together, that’s slightly more than $3 trillion in deficit reduction. After accounting for reduced interest payments — as there’s now less debt to pay interest on — it’s more like $3.6 trillion. That’s real money!

In fact, that’s about enough to stabilize the nation’s debt-to-GDP ratio over the next decade. If over the next few years, say, there’s another $800 billion in deficit reduction — imagine a new deal that cuts $400 billion from Medicare and other mandatory spending while raising $400 billion in taxes — then the country is put on a declining debt path.”

 Of course, he’s not alone.  This has been a perpetual concern by policymakers and pundits for years running.  And it’s completely wrong.  The saddest part is that this isn’t terribly hard to understand.  The balance sheet recession is a rather simple concept.  We know from Wynne Godley’s sectoral balances that the sum of the private (private), foreign (x-m) and government (t-g) sectors must add up to zero.  In wonk talk, that’s:

(S-I) + (T-G) + (M-X) = 0

If we get a bit more granular we can really break this down to understand how the economy grows.  Monetary Realists like to use this breakdown:

S = I + (G – T) + (X – M)

Which rearranges to:

S = I + (S – I)

This takes the private sector component and breaks it down to shows a clear distinction between households and businesses by showing a focus on private investment.  In other words, the (S-I) piece grows primarily through two pieces – household consumption AND private investment.  But what happened in the last recession?  Private investment and domestic consumption fell in unprecedented ways.  And while both are crawling back we’re still digging out of a deep hole.  So that left two sectors to bring us out of the hole.  The foreign sector in the USA is a current account deficit so it’s a drag  on growth.  That leaves the government sector to drive spending.

The most interesting part about this entire recession is that we’re seeing two real-time experiments play out.  In Europe, where the problems were largely the same, many of the economies are in depression because the government sector pulled back spending at a time when the foreign and private sectors couldn’t sustain growth.  So you ended up with depressionary economic environments in many countries.  But in the USA you’ve seen continued (meager) growth.  Why?  Because the government continued to run a large budget deficit.  This isn’t to imply that deficits are always good and that government spending can’t ever go wrong, but this environment was literally “different this time”.

But still, we hear endlessly about how this deficit has been bad.  We hear about how the debt in the USA, a nation that can’t “run out of money” is somehow going to drive us to bankruptcy.  It’s all wrong.  Yet we still read about the same myths on a daily basis.  It would be funny if it wasn’t so sad.

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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