What is the deficit?

In my previous post on government spending (How are we going to pay for it?), I wrote that unless people choose to save it, then extra government spending all comes back as extra tax. If this were true, then what does not come back, the deficit, must be equal to private sector savings? We can test this by plotting data available in the Quarterly National Accounts provided by the ONS.

By plotting the public sector surplus/deficit (black) and the private sector surplus/deficit (grey) on the same graph (top plot below – the World’s most important chart) we should see that they are mirror images of one another. Roughly they are!

When there is a recession as in 1990-1992 and 2007-2008, GDP and tax revenues fall so if government spending remains the same, the deficit increases which appears as a larger private sector surplus. The government cannot force a cut in the deficit by reducing their spending, because there is no guarantee that the private sector will not choose to do the same. If the private sector reacts by saving more, then the deficit will continue to rise. This is one reason why austerity can be counter-productive.

If we add public deficit and private surplus together there is a difference which turns out to be exactly equal to another column in the national accounts called overseas transfers (middle plot). If we add in overseas payments we get exactly zero (bottom plot). So the data proves that the

deficit = private sector savings + overseas transfers.

Overseas payments should balance over the longer term due to fluctuations in the exchange rate bringing us back to deficit = savings. However, for the UK balance of trade is mostly negative – we import more than we export. The fact that the pound does not fall to cancel this imbalance tells us that overseas investors are happy to hold pounds, and at least for the moment, retain confidence in the UK economy.

Looked at in one way these sectoral balances are a simple accounting identity but it makes an important point about the way that money flows. When money is spent, it is does not disappear it ends up somewhere else, ready to be spent again. A government deficit means the money has flowed to the private sector and has not yet returned. If we want to reduce the deficit you need people (and business) to spend rather than save. A solution is to offer people security about their future, encourage them to take risks, start businesses, etc. and to close other leaks in the government spend and tax circuit.

Comments

  1. Sean Danaher -

    I suspect you are not a fan of “Expansionary Fiscal Contraction” and “austerity” which seems to be core to the present governments economic policy?

    What has been interesting since Brexit that many people feel optimistic about the future and have not only been spending but borrowing. I believe this optimism to be misplaced. Whereas consumer spending and borrowing has largely kept the economy in decent shape; Industry/business has singularly failed to invest sitting on large amounts of cash. Indeed this has been the case since the 2008 banking crisis.

    You say “If we want to reduce the deficit you need people (and business) to spend rather than save. A solution is to offer people security about their future, encourage then to take risks, start businesses, etc. and to close other leaks in the government spend and tax circuit”.

    Very true, but sadly the future looks very uncertain. Whereas the open and upfront negotiating position of the EU is helpful, the secretive (one might almost naive, incompetent and shambolic) handling by the UK Government has been very unhelpful for business. At least the phoney war will be over as of this opportunistic GE on the 8th June.

    1. Charles Adams -

      The initial reaction to increased uncertainty is to stock up just in case, only when the storm hits do we start to batten down the hatches. The economy is like a oil tanker and we should always keep an eye on the longer term trends. I am not going to make any predictions because I do not know what the government is going to do. But one thing is sure, if the government follows an austerity path that transfers the debt onto the private sector who have to pay a much higher ‘rent’ (by which I mean interest), and rent extraction is not a good way to improve productivity and hence prosperity over the longer term.

  2. Ben -

    How does the creation/annihilation of money, either by the government or by private banks, effect these balances?

    1. Charles Adams -

      Banks create money by spending except that we call it a loan. The loanee is in debt. Government creates money by spending which we could call a loan. The government is in debt. In both cases someones account is credited and money is created. This money creation demands that something happens in the real economy. Something happening eventually pays off the loan.

      The distinction between private and public debt is supposed to be that in the private sector, individuals are responsible for paying off their loans whereas in the public sector we are collectively responsible. However, too big to fail undermines this distinction and it turns out that we are collective responsible for the loans of the private sector too! The lender of last resort is all of us!

      In the banking circuit, money is annihilated by loan repayments. In the government circuit, money is annihilated via tax. The sectorial balance tells us how much of the money is sloshing from one circuit to the other, and hence who is carrying the debt.

      You could look at this way. A growing economy requires a growing amount of money which means that someone has to take on debt. Macroeconomic policy is partly about how much of that debt should fall on one sector or another. The case for public debt is that governments can borrow much more cheaply than individuals and that way more gets done. Still governments have to spend carefully to maintain stability and confidence, i.e., the value of the pound. The same applies to banks – if they create money too fast we end up with a credit bubble followed by a debt overhang as in 2007-08.

  3. Peter May -

    To me the major leak in the government tax and spend circuit are tax havens where money may never come back. So by, say, shopping in places that are prominent users – Boots springs to mind – could we not be said to be actively making the state poorer?
    If that is the case then the government, in allowing such havens to be used by British business, would seem to be actively promoting its own impoverishment.

    1. Vicky (Windsorlass) -

      I was wondering the same, Peter.
      Charles, to me the biggest question in your graphic is the overseas leakage and what appears to be an exponential change in that element. Does it include Peters tax haven flows? Does it also reflect increased inward investment (or rather the asset grab by non uk investors)?
      What else might be in there? And how do you see that trend continuing? Would there not come a point where having hollowed out the UK at base to such an extent, that either govt or private (uk based) spending would have to step in if the economy is to function at all?
      I have a feeling that this overseas element is the most worrying factor, but not enough economic knowledge to know exactly why.

      1. Charles Adams -

        Both the private sector and overseas components may give rise to leaks where no tax is being paid. Closing leaks which give only some parts of society a tax advantage should be a priority for all governments and we should be looking for evidence on whether they are making progress on this.

        The overseas deficit is mostly about us buying more stuff from abroad than we export and yes this kind of imbalance cannot go on forever. Eventually, it will correct via a fall in the value of the pound.

        Overall, I am less worried about the overseas deficit than trying to put our own house in order which in practice is all we can do. If we take care of domestic policy then the overseas deficit will take care of itself.

  4. Spudt Astic -

    When the global financial crisis hit the UK, government spending increased by about twice the drop off in receipts. In nominal terms. You can tweak for inflation but you still find that spending increased by more than the reduction in income.
    And the follow-on period from 2010-2015 saw the highest real aggregate government spend per head of any Parliament in UK history ( Professors Palan & Murphy have produced graphs to show this ). So why anyone would regard that as a period of austerity is a mystery to me.
    It should be regarded as a period where spending was badly allocated.

    1. Peter May -

      Spending primarily to ‘protect’ the City! Which means they’re ok and the rest of us must pay…

    2. Charles Adams -

      I would agree that the spending was badly allocated.

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