What Should We Do?

Yesterday's post outlined the problem: demand deficiency and private debt overhang. So what should we do? The obvious answers: increase demand and reduce debt. I understand that the political case for either of these actions ranges from difficult to impossible; but I want to make the best case I can for both. Having put this down on paper, will step back and consider what might be doable politically. In this post, will focus on building a case for increasing demand through government deficit spending.

Increasing Demand


With consumers retrenching, businesses not investing, and the US not likely to give up its pattern of a negative trade balance, the only actor left is the Government. Remember:

                                        GDP = C + I + G + (X - M)

C is the consumer; I is business; and (X - M) is our trade balance, invariably negative, and therefore not contributing to GDP growth. So if C and I are stuck, then G must go up; and assuming Taxes stay the same, this means deficits go up. We all know the arguments against increased government spending and deficits: It won't work, as in the "stimulus did not work". Conservatives and their economists argue that the private sector will exactly offset this increase in G by reducing I, and to a lesser extent C, because they will calculate forward the future tax liability they will have, and they will withdraw just that amount of money, add it to savings, allowing themselves to be "crowded out of the market" by the Government. There is almost no empirical proof for this position, but that seems to make little difference,

The next attack on deficits is that they are inflationary. And the final "take no prisoners - all out war approach" is that deficits create an added debt burden, and that at some point (very soon) the nation will go broke; no one will buy our debt; we will face sovereign default and simply shut down as a going concern.

These arguments are all demonstrably wrong. That won't make much if any difference in the political arena, but I think it's good, occasionally, to be exposed to the facts.

The chart below shows the Sectoral Balances for the US from 1952 through 2010. The Private Sector is in blue and represents Savings - Investment. When the blue bar is above the line, the private sector is net saving, which has been the pattern, except in the 1990s' in the run-up to the dot.com bust, and then in the 2000s', in the run-up to the housing bust. In both periods, the private sector was "dissaving", i.e., borrowing. Net saving (the blue bar above the line) is a use of funds. The green bars are the foreign balance (M - X). Since the 1970s' oil shock, imports have consistently exceeded exports; which puts the green bars mostly above the line, and are also a use of funds. So since uses must be equal to sources, then we know the Government Sector (G - T, or Government Spending minus Taxes) must be below the line sourcing the funds for Private Saving and our Negative Trade Balance.

There are very few years since 1952 when we have not had a budget deficit. The late Clinton years is one brief period; but the only way this was achieved was to turn our nation of savers into a nation of heavy borrowers (blue bars below the line). This led first to the dot.com bust, and then to the much more significant housing bust. the deep deficits we are running now essentially allow us to significantly increase our saving, helping to repair our wounded private balance sheets.

The next question in the attack on deficits: they are inflationary, and in addition, they will lead us to pile up sovereign debt, to the point where no one will buy our Treasuries, and we will have to default, or, just as bad, we will print so much money we will have a Weimar like runaway inflation. Let's take a look at a Sectoral Balances chart for Japan:

Since their 1991 crisis, Japan has run consistent, significant deficits, which have been the primary source of funding the private sector's desire to save and rebuild their balance sheets (in this case, their corporate balance sheets). Inflation has stayed well below 2%. 10 Year Bonds have sold consistently in the 1% range over the period. Sovereign Japanese debt is now well over 200% (more than twice the US ratio) with no ill effects.

I do not hold up Japan as an example of what we should do. They molly-coddled their banks and did not insist on bankruptcy for many insolvent firms, resulting in over cautious banks and too much capacity in the economy. I hold them up to support my argument that deficits are not necessarily inflationary; and that death or disaster is not automatic with an increase in the debt/GDP levels.

So there is a strong case for deficits, and using those deficits to support the private sector's desire to repair balance sheets, but also to engage in serious demand building and job creating. More on this tomorrow, when I present some thoughts on helping the consumer deleverage.