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.