Noah Smith asks: Do government deficits equal private surpluses? The answer is rather simple, but often misconstrued by people. Here’s the basic gist of it.
When the government runs a deficit (spends more than it taxes) they sell a T-bond to Peter who supplies his bank deposits to the government and the government then spends those bank deposits into Paul’s account. The deposits get redistributed and the T-bond is a new financial asset for the non-government sector. That T-bond is technically a liability of the US Treasury so the US Treasury’s new liability is the owner’s asset (the Treasury has a new liability and Paul owns the T-bond which is an asset). Said differently, the government’s deficit results in surplus for the non-government (some of this surplus could be held by the foreign sector or even the Fed so we really shouldn’t say “government deficits equal private surpluses” or the accounting nerds will have our necks!). This is a net financial asset (NFA) because there is no private sector corresponding liability.¹
Of course, we should note that the income to service government debts and the instruments that make government debt sustainable come from the private sector so, in a sense, the private sector is liable for public debt. And in the aggregate public debt is an asset with a corresponding liability so at the aggregate level government assets have corresponding liabilities.
That’s all pretty obvious. What’s more confusing is the way some people use all of this to describe how the monetary system works. For instance, the sectoral balances equation can be broken down from the GDP equation where:
GDP = C + I + G + (X – M)
Where C = consumption, I = investment, G = government spending, X = exports & M = imports
Or stated differently;
GDP = C + S + T
Where C = consumption, S = saving, T = taxes
From there we can conclude:
C + S + T = GDP = C+ I + G + (X – M)
If rearranged we can see that these sectors must net to zero:
(I – S) + (G – T) + (X – M) = 0
Where (I – S) = private sector balance, (G – T) = public sector balance & (X – M) = foreign sector balance.
Take that a step further:
(S – I) = (G – T) + (X – M)
Close the foreign sector out and you get:
In other words, the private sector’s balance is equal to the public sector’s balance. But this view is saving NET OF INVESTMENT. If you view the world through this lens then the private sector can’t NET save without government spending and NFA issuance. But is it best to net out investment when trying to understand how the monetary system works? After all, the private sector is built largely on the back of private investment. Using (S-I) to describe private saving is not only misleading in my opinion, but a lot less interesting than some people might have you believe. A really simple example might help clarify this point.
Let’s say you borrow $100 to build your dream home and the homebuilder banks at your bank. The bank ends up with a $100 asset and a $100 liability (the loan and the deposit – loans create deposits). The homebuilder will end up with $100 in retained earnings and you will end up with $100 in debt. If you net out the investment (you made $100 in residential real estate investment) then the private sector has no change in financial assets and you might presume the private sector is no better off than it was before. Remember, your $100 investment resulted in $100 in saving for the homebuilder. But are we actually no better off than we were before? Of course not. You have your dream house, the corporation has $100 in profit and the bank will presumably make a profit on its loan. We are all actually better off! In a credit based monetary system this process can go on in perpetuity, but the problem is that a capitalist economy will tend to veer towards disequilibrium. So we don’t just build 1 house. We build 1 million houses and then prices get euphoric and then lenders make more loans than present incomes can pay off those loans and you get something like 2008. You don’t need government in all of this, but it sure can help if used properly.
For instance, the government can step in like it did in 2008 and provide net financial assets to help improve balance sheets, but that’s not really the point here. The point is that (S-I) tells us a very incomplete story about the private sector so focusing too much on it misses the point. Netting out investment is essentially netting out the most important piece of the entire economy. After all, it is investment that makes all of the wonderful things in this world that help us live a better standard of living (in a pure financial sense). Alternatively, there are cases where government spending caused private sector savings to become less valuable in nominal and real terms. Many hyperinflations involve situations where the economy suffers a high inflation and government policies exacerbate the inflation. In these cases the government spending and deficit would add net financial assets to the private sector, but would exacerbate the core of the problem (because that money printing didn’t result in corresponding net investment). So it’s important not to assume that government deficits are some sort of panacea. They can be the cause of real declines in private sector living standards so we have to be mindful of the specific environments in which a government is able to run a deficit without causing harm to private sector savings. Since it is difficult to quantify how and when a government deficit will harm private sector savings I want to focus on the primary way that the private sector saves – this is primarily against itself in the form of investment spending.
If you wanted to more accurately portray how the private sector saves you might take a step backwards and say:
(S – I) = (G – T) + (X – M)
S = I + (G – T) + (X – M)
Which rearranges to:
S = I + (S – I)
Why do we do this? Well, private investment is the backbone of private sector equity. As we showed above, private investment can add to private sector saving. When we built our house we were not wealthier in financial asset terms because our assets netted. But when you consider the investment spending produced a real asset then we are better off. In the case of reality, the net worth in US households of roughly $70 trillion is largely built on the back of private investment. If you just took (S-I) = (G-T) you might presume that we are all just sitting around sucking our thumbs waiting for the government to spend money and issue bonds so we can live our lives. But that doesn’t accurately reflect reality. Net out investment and you’ve missed the most important piece of the economic puzzle. It’s better to start to understand the monetary system by focusing on private investment and thinking of government as an important facilitating piece. Get that backwards and you’ll build a world view that gets the relationship precisely backwards by assuming that the monetary system starts with the government or, worse, you’ll misunderstand the important relationship between investment and the real goods and services we produce.
Of course, this is a financial asset view of the world. At the aggregate level all financial assets net to zero and so stripping out sectors leaves us with a fallacy of composition. So, anything saved in financial terms was dissaved by some other sector. Balance sheets balance. And all the various sectors are claims by other sectors. For instance, the corporate sector issues assets, but the household sector owns the corporate sector so its liabilities and assets necessarily offset. Same thing is true for the government which is essentially owned by the domestic residents of any particular economy. So, what’s important for the purpose of understanding “net” financial assets is not just the balance of finance assets, but the balance of financial assets relative to non-financial assets. Non-financial assets, after all, are the only true measure of “net” assets since they have no corresponding liability in the aggregate economy.
In sum, a lot of this discussion is contingent on specific details and the specific intra-sector relationships and how they produce net assets for the economy. That requires a discussion about each specific economy and its various balance sheet relationships. Therefore, we should be careful making generalizations based on accounting identities.
NB – It’s worth noting that some economists (such as MMT advocates) distort this concept to try to show that government deficits are not only good but necessary. They generally construct a two sector model to try to argue that the private sector cannot “net save” without government deficits. This is massively misleading. The private sector net saves within the private sector against other sectors. A government deficit might be good at times, but there is no law of accounting that deems deficits necessary or automatically beneficial in the way MMT sometimes presents them.
1 – It’s easier to understand this topic if you use an example where the government spends deposits when it runs a deficit. So, in this scenario the govt would create deposits via its Central Bank rather than creating bonds. These deposits would be liabilities of the Central Bank and assets for the recipient of government spending. These are “net financial assets” for the private sector, but it would be illogical to think that printing these new deposits necessarily creates “net wealth” or is necessarily good. Creating new financial assets isn’t necessarily good or bad (this is as true for the creation of private sector financial assets as it is for public sector financial assets). It depends on how those financial assets are used. And while government spending SOMETIMES has a positive net present value the fact that they are “net private financial assets” should not be confused to mean that they ALWAYS have a positive net present value.
Read more on this topic:
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.