Fiscal fallacies (2): accounting identities and the case for government loan-expenditures
Related to the fallacy of deficit spending are arguments around accounting identities and the ‘principle of sectoral balancing’.
The economics is extended from the government’s balance (its deficit or surplus), to the balances for all ‘sectors’, i.e. households, companies and the rest of the world. On this basis there are four balances, though they originate in the National Accounts where they are further subdivided (e.g. into private / public, financial / non-financial corporations).
In all cases each ‘sectoral balance’ corresponds to the difference between totals payments and total revenues; e.g. for households, the revenues include salaries, interest earnings from savings, payments include taxes and consumption expenditure. For the rest of the world, the balance corresponds basically to the difference between exports and imports, adjusted for other (net) flows such as on dividends and foreign direct investment.
The logic of the argument follows from accounting considerations that dictate the four balances must add to zero. This is simply illustrated; below I have used OBR figures and added the two private sector balances together. (Strictly, the figures are National Accounts estimates of net lending / borrowing as a share of GDP.)
Sectoral balances, % GDP
(Whether the identity is simple to understand is another matter, but taken as given for present purposes.)
So over the past five years, while the public deficit has narrowed (slowly), the private sector has moved from surplus into negative territory and the rest of the world surplus has risen (i.e. the UK current account deficit has increased).
According to the ‘accounting identity’ case for expansionary policy, government spending cuts are synonymous with deficit reduction. The logic then continues: if the government reduces its deficit then either the private sector deficits or rest of world surplus must increase to maintain the balance. Given the unprecedented scale of both household indebtedness and the current account deficit, either outcome is regarded as unsustainable.
So to prevent these unsustainable outcomes, the conclusion is that the government must not reduce its deficit.
The argument is a variant or extension of deficit spending arguments, and this approach was contested in the first of these two posts.
To me the argument seems an extension of the household sector budget fallacy, with the claim that one of any number of households spending less must mean others spending more. Even simplified in this way the balanced outcome doesn’t seem obviously to follow. Then in the macro case, how can accounting identities dictate changes to the behaviour of households corresponding to the behaviour of government?
Outcomes across the whole of the macroeconomy do not follow so directly.
As in the previous post, the problem is that the impact of any change in spending on aggregate income is ignored.
The whole purpose of increasing government spending is to increase incomes, and the logic of four balances is based on actions not affecting income (‘given income’ is the jargon).
In fact, it is the change in income that that ensures the identities are maintained. This was a key part of Keynes’s original justification for public spending. Under the rival ‘crowding out’ argument, public spending would draw on private saving, so that they were no longer available to private activity. Keynes saw from the macroeconomic perspective saving was the result of public or private investment. As he would later say,
“For the proposition that supply creates its own demand, I shall substitute the proposition that expenditure creates its own income” (Collected Writings, Volume XXIX,p. 81).
I am not sure how well the translation of this logic to the wider economy has been articulated. But plainly the starting point is very different when macroeconomic reactions on aggregate income are brought into play. The final sectoral positions do not follow from imposing a zero sum, but from understanding how the zero sum comes about through the changes to flows of incomes and expenditures for all sectors. In the case of Keynes’s policy, the object of the exercise (both monetary and fiscal) was to revive private investment expenditures. This would suggest in the short-term a widening of the private sector deficit, in opposition to the narrowing of the public sector one.
None of this is to oppose increased spending or deny the threats to the economy from the current account or household debt on the present trajectory. But the outcomes of spending or otherwise on the part of government cannot be so simply translated to the rest of the economy. It seems odd to want to argue the case for spending in such a complicated way, but I am troubled as well by the logic – though stand very ready to hear alternative explanations.