Sunday, January 04, 2009

Private Savings is the Federal Deficit

Jesse has a very nice post explaining the different kinds of money, and I recommend people read it. However, (s)he ends on an error, which I was prey to until recently also.
Are credit cards or loans Money? No,those are all forms of borrowing something that is not yours that you promise to return with conditions. You are receiving money that was not yours.

Credit Is Not Money.

Credit, or debt, is the 'potential' for money, a way of receiving it.

Whether water is held in a canteen, a well, a cistern, or a private lake, it is still water and it is yours if you own it. So too money is still money if it is yours, no matter under what conditions you hold it or save it for your use.

The cloud of credit, or debt depending on your perspective, is the potential for money as it is defined in our economy. It is a source of money. At a given point in time, you either have the money as your property or you do not.

But the source is not the money itself, and the source can be different and can change over time. In our society borrowing is so common and so technologically convenient that there is little difference in most people's mind between credit and money.
I used to believe the same thing, but I was wrong. Money is not a store of value. Credit is money. It is more useful to think of money as "points" than anything with intrinsic worth, and credit is points in an asset column, and debts are points in a liability column, but the points themselves, those are money and they are money no matter which column they go in.

I tried to explain this on Marginal Revolution, but they banned me from the comments there. Both Brad DeLong and Tyler Cowen ban people they do not agree with in their comments. I prefer Greg Mankiw's approach, which is not to allow comments at all. It's honest, and it avoids echo chambers.

I recommend spending time at Mosler Economics which is really difficult to get into, but really changed my perspective on this stuff. I don't agree with everything, but the "points" mental model for money is much more accurate to reality than the "store of value/gold" model we instinctively carry in our heads.

Here's a pure derivation:

The real (inflation-adjusted) national income, Y, is defined as
Y = G + X – M + PX + I

G = Govt' spending
X = exports + foreign transfers + property income
M = imports
PX = Private spending
I = Private investment (note, I left this out by mistake the first time. Sorry!)

Subtract T from each side, where T is taxes and government transfers we get

Y – T – PX - I = [G – T] + [X – M]

Private Net Savings = [G – T] + [X – M]

Private Net Savings is GNP - taxes - private spending (PNS is private disposable income less taxes less private spending on consumption less private investment).

So, by identity, PNS equals the Federal deficit (G-T) + the current account surplus (X-M). The current account surplus is the $ value of exports minus the $ value of imports. The US runs a large current account deficit ($ value of imports >> $ value of exports) which is, contrary to popular opinion, a *good* thing. Swapping real goods and services for shiny baubles is always a good trade for those receiving the real goods and services. So, as [X-M] is negative, and we would prefer to keep it good, the [G-T] must grow to support higher demand for PNS. The alternative would be for [X-M] to switch and become positive (US starts exporting, stops importing) which means we are now trading real stuff for foreigners shiny baubles. That day may still
come, but there is no need to hasten it.

Arguments against the above:

1. It just ain't so

It is so. This is all true and straightforward as accounting identities.

2. You can't just define savings as a residual, what you have left over to make the national income equations balance!

Yes you can. Brad DeLong answers that Walras' Law says you can. My response is that there is no such thing as "active savings" because no vehicle exists that is an actual store of value over time. So people may think they are "actively saving" but in fact all they are doing is increasing the residual left over after everything else, which will drive by the Federal deficit or current account surplus by identity. Sucks to be you.

3. It's not fair that there is one set of rules for currency issuers and another set for currency users.

Fairness does not come into it, the same way fairness does not come into discussions of whether a referee should follow the same rules as the players. The job of a ref is to be a good ref. The job of the players is to play the game. Both have different roles, and both should strive to do a good job in their role. Arguing that refs should pick a team and try to score baskets too blocks the discussion of what makes a good ref, and does not display good understanding of how the Federal banking system actually works.

4. This is just a static model, tells us nothing about how booms and busts happen, or how to run an economy.

Totally true. And incredibly important to remember.

4a. You are wrong about imports being good and exports being bad.

Quite possibly, and there is a good argument for this. Nevertheless, the US is largely a closed economy and I end up ignoring the capital account term below.

5. It just makes no sense. This would then lay the fault of our current depression on surpluses run under Clinton/Rubin in the 90s!

Yes. This blows my mind also.

It helps a little, but not much, to take a balance sheet perspective on the world. When we think about our own household balance sheets, we add up our liabilities (debts) and our assets (checking account etc.) and hope that our assets are greater than our liabilities. If all of our liabilities vanished with a stroke of a pen, then we'd be happy because all we would have is pluses. This would be wrong -- balance sheets always have to balance, and assets always have to equal liabilities. Personal equity sits under the liabilities column.

When it's pointed out to gold bugs that the Fed can print money at will, they like to analogize it to the Fed having a monopoly on an infinite gold mine. This is almost true, but misses one important detail -- the Fed needs to account for each ounce of gold that leaves the mine, not because it is in any danger of running out, but because it wants to keep its books in balance and not pump out too much gold. Counting how much gold is out there in circulation is done via an entry called the "Federal deficit" (G-T). The term is misleading because it makes you think that the Government is somehow in debt, and you worry about whether it will be able to pay everyone back. This is wrong, the Fed can print money, and therefore everyone can get paid.

Let's Ignore the current account (imports/exports) for now, and imagine a God like currency creator, with a celestial t-table.

In the beginning, there was nothing.

And then God said, let there be credit and debit of $100. And it was so.

And then God lent that credit to Man, who now has a debit of $100 to the Government, and a credit of $100 in his bank account. The Government has $100 debit (which he created originally) and a $100 credit (in accounts receivable) to the man. The $100 in the Government's debit column -- also know as the Federal deficit -- equals the amount of money in the man's bank account, also known as Private Savings. The Federal deficit must always equal net private savings.

The picture is complicated a little by banks, because banks act as intermediaries between the Fiat God and lowly Man. Banks can borrow from the Fed, and lend to Man in FDIC insured accounts, which as equivalent to Man borrowing directly from the Fed because the credit risk Man takes on by putting his money in these accounts is the credit risk of the Government, not the bank. Banks can create debt too, in the same way as the Fed, except they borrow from the Fed directly and lend out to Man. When banks stop doing this, then bank debt creation stops and the Fed needs to step in an increase the Federal deficit if it wants to keep aggregate money supply from contracting. This should be the goal of any stimulus.

On the left hand side of the equation, Y – T – PX, PX is falling. To keep the same size, Y has to fall too. Alternatively, you could increase G on the right hand side, or reduce T on both sides to support a larger PX. If you do nothing, that T will fall the hard way, though people losing income which reduced income tax, and so bring the equation into balance that way, but this requires a large increase in unemployment just to support the desire for higher net private savings and that just seems stupid.

So there you have the ugly and stupid math behind recession economics. The demand for net private savings goes up, probably for very good reasons, and the Federal Deficit MUST INCREASE to meet this demand for net private savings. It can increase in two ways: higher government spending, or lower taxes, or both.

Taxes can go down in two ways. People can lose their jobs so they stop having income to tax. Or the government can just cut taxes. Given that it's better to have people employed than not, this seems like a no brainer to me.

If the deficit goes too large, then there is more money available for net private savings than is required, and this extra money is not saved, it's spent. Too many dollars chasing too few goods creates inflation, and that is bad also. It's important to note that money in bank accounts does not contribute to inflation, although it can if everyone decides they no longer want money in the bank.

The problem with increasing G is that it's proven impossible to decrease it again when the times comes, while T bounces up and down like a yo-yo. Big Government advocates, like Paul Krugman, support larger G no matter what the consequences. Increasing G is slow. "Shovel ready" projects cannot be implicated as quickly, or at the scale, of a payroll tax holiday, and are essentially impossible to shut down. Larger G also slows the long run productive capacity of the country, as, by definition, Government is after things other than sheer efficiency and productivity.

So, a larger G solution will 1) increase the deficit by reducing T the hard way -- driving up unemployment, and 2) will then start to increase the deficit in a way that cannot be stopped after the deficit has already reached its new, optimum size, driving up inflation. This inflicts large economic costs on current workers (who will lose their jobs), future workers (who are now in an economy with lower productive capacity) and current and future savers (who will see the value of their "savings" be inflated away).

Whenever you hear anyone say there should be a fiscal stimulus, ask them why it wouldn't be better implemented as an immediate payroll tax holiday, to be ended once CPI picks up, instead of paying government contractors to build bridges to nowhere beginning next summer.


Blogger Rodger Malcolm Mitchell said...

Nice article. I even reference it at: Saving = deficit.

There are a few details with which I disagree, but perhaps the most important one involves your recommendation about increasing the deficit by reducing taxes.

You say, "Increasing G is slow." Actually, increasing G can be almost instantaneous. Remember the very first stimulus attempt, where the government mailed out those $500 checks to taxpayers?

By contrast, reducing taxes usually involves extended Congressional debate, while all the special interests distribute their bribes.

That said, I do agree with the FICA holiday. With the assistance of Warren Mosler and Randy Wray, I wrote this post:

Ten Reasons to Eliminate FICA

Good job.

Rodger Malcolm Mitchell

6:43 AM  
Blogger Blog Admin said...

The formula assumes both time is stopped and there's no mal-investment. Or more over all money spent will equal the same increase in overall wealth. Thats just.. crazy.

So for that instant in time, yes the accounting is correct.

If you allowed real time to flow you'd quickly see it doesn't really work out that way.

Here's an example.

Lets say the gov took all it's money, and paid one guy to dig a small hole. In the time it took him to do that, nothing was generated. Now this very rich man would take his money (which is now technically back in the economy) and spend it on something innane. And so would the next and the next etc.

Now although the amount of money would be the same, at each link in the chain time has passed and actual wealth was lost, not generated.

So food was consumed, materials rot, etc. With less of these goods, the cost to buy more goes up. But no one is producing anything. Or apparently all spending has the same value.

And there's your problem.

The dollar amount stays static, but loses it's value.
While you've let your fields rot, you don't have any food and a ton of money. But now you are pleading your kingdom for an orange.

The formula is incredibly misleading. Its a little like using the conservation of energy formula as a reason for wasting untold amounts of power.

8:25 AM  

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