There are two misconceptions about the economy I would like to dispel.
The first has to do with the government being constrained like a family by its budget and having to spend no more than it brings in.
The second has to do with government debt and how important it is to reduce it.
Both concepts reveal a complete ignorance of basic macroeconomics and make possible the abomination of “austerity” – a brutal and counterproductive economic policy.
Unlike microeconomics, which focuses on individual economic agents (individuals and businesses), macroeconomics deals with the economy as an aggregate. It requires a different way of thinking.
The key concept of macroeconomics is GDP (gross domestic product) which is a measure of the economic output of a country.
I am no fan of GDP as a measure of collective well-being and of the need for it to grow at all costs. I share the sentiments expressed by the then US-Presidential candidate Robert Kennedy during his speech at the University of Kansas on March 18, 1968.
Nevertheless, we need to understand GDP and its components in order to dispel the two misconceptions above.
The GDP can be expressed either in terms of expenditures or incomes.
The expenditure expression of GPD is the following
GDP = private consumption + gross business investment + government spending + (exports – imports)
or for short
GDP = C + I + G + (X – M)
We can also express GDP in terms of income. Here is a very stylized way of doing so.
GDP = wage for labor + interest for capital + rent for land + profits for entrepreneurship
Here is the key concept to understand. You as individual or any economic entity like a family or a business, have a luxury a nation as a whole does not have – the independence between income and expenditures. You can decide to spend less than you earn and save some of your income for the future. Or you might borrow and spend now beyond your current income.
The fact that GDP can be expressed either in terms of expenditures or in terms of incomes makes clear that, as soon as you expand your scope of analysis to the economy of an entire nation, there is no independence between income and expenditures – the total national income is equal to (is generated by) the total amount of expenditures in the economy! Every dollar of income in the economy comes from a dollar somebody else spent. From a macroeconomic standpoint, if you reduce expenditures (either because consumer spending is down, or business investments are down, or government spending is down or imports grow faster than exports) you will also reduce national income.
Hence, it becomes clear the role of government spending in counteracting the effects of an economic downturn. During an economic recession, consumers spend less and businesses invest less given the soft demand in the economy. The only way for the national income to remain at the same level is for the government to pick up the slack and increase its spending into the economy. To demand that a government balances its budget during an economic recession, while both consumers and business curtail their spending, or even worse to force it to reduce its debt like Greece, is to exacerbate the contraction of the economy and therefore to further reduce the national income.
During economic recessions governments are therefore likely to increase their indebtedness. The recession causes both a reduction in the tax receipts due to the slowdown in the personal and corporate income while at the same time government expenditures in terms of unemployment benefits and other programs to alleviate hunger and poverty go up. Raising taxes would exacerbate the problem, so it is typical, and in fact advisable, for a government to increase its borrowing during an economic recession to support the aggregate national income.
But isn’t government debt something bad and ideally something that need to be reduced and eventually eliminated?
The answer is no, if a government is monetarily sovereign. Let me explain.
A government that issues its debt in its own currency and has a central bank in a position to acquire its debt, will never be insolvent.
The central bank can buy government securities by simply expanding its balance sheet and there is no limit imposed on its size. The central bank actually creates the money it needs whenever it buys financial assets.
Debt doomsayers warn of skyrocketing interest rates on the national debt as it grows without realizing that the interest on the national debt is a policy lever that can be influenced by the Fed’s purchases.
Case in point, for a number of years starting during the Second World War, that Fed was tasked with engaging in open market operations (buying and selling government bonds) to keep the interest rates on government debt to 0.375%. The policy was abandoned in the early 50s to allow the Federal Reserve better flexibility in managing inflation. More recently, since 2008 the Federal Reserve has engaged in a massive purchasing spree of government debt with the goal of reducing long term interest rates showing one more time that the interest on the national debt is not controlled by free market forces but can be set as a policy variable by the Fed.
You might remember that a few years ago there was an ominous debt clock a block away from Time Square in NYC inexorably marching towards the level of $10,000,000,000,000. Debt doomsayers were warning about disastrous consequences and skyrocketing interest rates if that magic threshold was breached. Well since then the original debt watch ran out of digits and a new one was built a few blocks away, the national debt now stands at close to $19 trillion ($19,000,000,000,000) and interest rates are near their lowest level in recent history. Even the posturing of Republican US congressmen on the Debt Ceiling seems to have gone out of style.
Actually, the aggregate government debt expresses the desire of the private sector for savings. In other words, our national debt can be seen as our national savings. Let me explain.
We said before that GDP can be expressed as follows GDP = C + I + G + (X – M)
GDP is also equal to the national income and you can divide it into the portion of the income that is consumed, saved and taxed. So GDP = C + S + T
With grade school algebra you can rearrange the terms and get to this relationship which is called the sectoral balances equation.
(S – I) = (G – T) + (X-M)
Net saving at a national level (savings minus investments) is equal to net government spending (government spending minus taxes) plus net exports (exports minus imports). The nice thing about an accounting identity is that it has to be true and, unsurprisingly, the actual data confirms it.
There were only two periods in our recent economic history when the private sector had negative net savings and both times it ended badly – the first time was during the technology bubble of the late 90s and more recently during the buildup in the real estate bubble leading to the financial crisis of 2007-2008.
Most of the time the private sector is interested in accumulating net saving positions and that is primarily made possible by government net spending, in other words, by an increase in the national debt. It is also helpful to remember that the vast majority of the US national debt is held in the savings of other US individuals, businesses or other government entities.
The key insight regarding the relationship between national debt and private savings becomes crystal clear in the case of a closed economy, one without any trading with other nations (in other words with no imports and no exports).
In the case of a closed economy the sectoral balances equations becomes
Net private savings = net government spending
In other words the level of government debt expresses the desire of the private sector for net savings.
So it is time to toss the concept of government austerity in the dustbin of fallacious and barbaric ideas, to walk away from the preoccupation with the national debt and engage instead in a constructive discussion about the best way to utilize the power of government spending and its taxing power to address the collective challenges we face.
Marco came to the US as a Fulbright scholar in mathematics and economics at the University of California in Berkeley. After a stint in the financial industry, Marco worked as visual artist on a full-time basis for 5 years and obtained a MFA focusing on the intersection between public art and ecology. He later worked for 6 years managing investment equity portfolios primarily on behalf of large foundations and endowments. In April 2009 Marco left the finance industry and has since been instrumental in the formation and development of the Slow Money Northern California chapter. He is sharing his experience doing direct Slow Money investments with communities around the country to help them increase their capacity for local investing. Marco is currently developing Essential Knowledge for Transition – a curriculum for engaged citizens to understand the money and banking system, the economic system and the financial system and how we need to transform them.