Why Can’t People Understand National Accounting?

What does all this mean then? Put simply, the financial sector balances framework means that when the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. So, to move any sector balance in an open economy, you need to move the other two balances exactly opposite in equivalent measure. To reduce the government deficit in any period, the private balance and the capital balance must increase by the exact same amount in that period.

Thinking about government deficits this way opens a whole new understanding of what cutting deficits means for the economy. What it should mean to you is that deficits are the effect and not the cause. Budget deficits are the result of the ex-post accounting identity between the sectoral balances and should not be a primary goal of public policy. Let me give you an example.

Why are deficits so high? What I have been saying is that private debt is the problem. Debt has been a substitute for income due to stagnant wages. Now that the credit bubble’s asset price inflation has turned to deflation, people, businesses and banks have found themselves saddled with debts that are not adequately underpinned by asset collateral. Businesses have done some serious heavy lifting here and debt in the corporate sector is not a problem. But households are still over-indebted. As long as household financial assets provide insufficient collateral for the debts that depend on them, the household sector will continue to maintain a reduced level of consumption and investment as a percentage of income to deal with that debt. Businesses see this and reduce their investment too. And we get stuck in a lower-investment, higher savings world that leads to deficits.

So, in that context, attempts at austerity make things considerably worse. If the government cuts back, the private debt overhang will still be there and the private sector will simply have less money to deal with it. The household sector will still attempt to keep its net saving, its surplus, high and so government cuts will be felt primarily in the form of reduced household consumption and increased private sector defaults. In the context of a still weak banking system, that could create the kind of downward spiral we witnessed during the Great Depression as banks failed. It creates the kind of paradox of thrift that makes deficit reduction harder which we are witnessing in the euro zone as many of us including James Montier predicted.

In my view, austerity is a failed paradigm. Clearly, government shouldn’t have wasteful programs to begin with. So there should be no need to cut them to cut a deficit. Moreover, the deficit is the result of an ex-post accounting identity between private savings, and capital account and government balances. It makes zero sense to target the effect (deficits) instead of the cause (excess credit growth and malinvestment). In plain English that means the policy prescriptions are the economic input and the deficit is the output. Focus on the policy and policy goals, not deficits.

The way I look at this crisis puts me into Ray Dalio’s camp. The right narrative for what has happened is that the depression has been the result of significant malinvestment that was built up during the so-called ‘Great Moderation’ as a result of loose monetary policy at the Fed and other central banks in a world awash in

via www.economonitor.com

Comments

[easy out source]

I'm happy to know that I'm reading your post. So great.

[Bookkeeping Service Caloundra]

This must be distinctly understood by people to know national accounting and awareness on how government sector runs. The government must have a proper attention for this fact. I absolutely agree that "Budget deficits are the result of the ex-post accounting identity between the sectoral balances and should not be a primary goal of public policy."