Sunday, May 22, 2011

National income accounting and the federal deficit

Earlier this month, Dean Baker gave a good summary of the concept of national income accounting in Has Anyone at the Washington Post Heard of National Income Accounting? CEPR 05/01/2011:

One of the identities in national income accounting is that the trade surplus (actually current account surplus, but these can terms can be used pretty much interchangeably for the United States) is equal to the net national savings. Net national savings in turn is equal to the government budget surplus (public savings) and the excess of private savings over private investment (private savings).

As a conscious policy under the Clinton administration (pushed by his second Treasury secretary, Robert Rubin) the United States begin to push for a high dollar. It used its control of the IMF in dealing with the East Asian financial crisis and subsequent crises in the developing world to put muscle behind the high dollar policy.

The high dollar in turn led to a large trade deficit. If the dollar is over-valued by 25 percent it has roughly the same impact as imposing a 25 percent tariff on all U.S. exports and giving a 25 percent subsidy to all imports. In other words, we expect a high dollar to be associated with a large trade deficit. This is exactly what happened in the late 90s, the high dollar sent the trade deficit soaring to record levels.

Using national income accounting, if the United States has a trade deficit of 4.0 percent GDP (roughly the 2000 level), then it must have negative national savings equal to 4.0 percent of GDP. There is no way around this, it has to be true. [my emphasis]

No doubt this is a bit on the wonky side. But it's something that should be a prominent part of any public debate over the federal deficit.

But what he describes in those paragraphs isn't really controversial. It's accounting. Jamie Galbraith does rely heavily on this accounting reality in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too (2008). Galbraith adds a couple of other steps in framing the federal deficit. One is that the US dollar is the world's reserve currency in a world with floating exchange rates. As long as those conditions maintain, he argues, other countries will hold substantial amounts in dollars as reserves and that will make the United States run a perpetual trade deficit.

The second step is the implication of that situation in combination with the national income accounting equation of Total Public and Private Deficits = Country's Trade Deficit. Given a trade deficit that will be negative as long as the dollar is the world's only reserve currency, that mean that the the sum of the public and private deficit in a given year will also be negative, i.e., spending more than saving in a given year (paying down debt counts as saving here).

Currently, annual private savings (including debt paydown) in the US are exceeding annual spending. So the private sector has a net surplus. That means the net of all public accounts will have to be negative (spending/borrowing exceeding savings/debt paydown). Since state and local governments are generally required to balance their budgets every years one way or the other, that means the federal deficit is going to be the whole public deficit, more or less.

In years where private spending exceeds private savings, there will be a net private deficit. That means the federal government will go into surplus. Because Total Public and Private Deficits = Country's Trade Deficit, and we have a continuing trade deficit. So far that's also accounting.

I'm not an economist and I don't know how controversial Galbraith's notion is that the US will run a trade deficit as long as the dollar is the world's reserve currency. I don't think most economists would consider it much of a stretch, though. The US has been running trade deficits for many years, confounding the conventional assumption that countries cannot run permanent trade deficits. This is the only explanation I know of how the US has been able to do that.

But even most liberal economists probably aren't ready to endorse the conclusions Galbraith draws from that. He argues that because of the national income accounting equation, the federal government doesn't control whether it runs a deficit or surplus. And also that, as long as the dollar is the world's reserve currency, that the size of federal deficits actually don't matter, whether the economy is depressed or booming.

Still, Baker in the quote above is pointing to how the dollar affects the federal deficit. The large deficits weren't primarily the result of Washington's tax and spending policies, but of what happened with the dollar. The ability of the government to drive the dollar up or down could, I suppose, be used as an argument against the idea that the federal government has no effective control over the deficit.

But it does point to another way in which the current discussion over the alleged menace of the federal deficits in the midst of a weak economy in a liquidity trap is divorced from economic reality. And even from the laws of accounting.

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