Modern Money Theory – Part 2. Government budget deficits are largely Non-Discretionary: The case of the Great Recession of 2007 – L Randall Wray.

The sum of deficits and surpluses across the three sectors (domestic private, government, and foreign) must be zero. 

While household income largely determines spending at the individual level,

At the level of the economy as a whole spending (demand) determines income.(Reversing that causation.) 

Individual households can certainly decide to spend less in order to save more. But if all households were to try to spend less, this would reduce aggregate consumption and national income. Firms would reduce output, thus would lay off workers, cut the wage bill, and thereby lower household income.

This is Keynes’s well-known “paradox of thrift”: Trying to save more by cutting aggregate consumption will not increase saving.

The national conversation, in the United States, the United Kingdom, and Europe presumes that government budget deficits are discretionary. If only the government were to try hard enough, it could slash its deficit.

In the aftermath of the Great Recession of 2008, many government budgets moved sharply to large deficits.

While observers attributed this to various fiscal stimulus packages (including bailouts of the auto industry and Wall Street in the United States, and bank bailouts in Ireland), The largest portion of the increase in the deficit after 2008 in most countries came from automatic stabilizers and not from discretionary spending.

The automatic stabilizer – and not the bailouts or stimulus – is the main reason why the economy did not go into a freefall as it had in the Great Depression of the 1930s. As the economy slowed, the budget automatically went into a deficit, putting a floor on aggregate demand.

With counter-cyclical spending and pro-cyclical taxes, the government’s budget acts as a powerful automatic stabilizer: deficits increase sharply in a downturn.

Slow growth has been the major cause of the rapidly growing budget deficit, and the slow growth, in turn, is due to a high propensity to save by the retrenching household sector.

Given loss of jobs, and stagnant or falling incomes for most Americans, the likelihood that the household propensity to spend will reverse course soon seems unlikely.

Summary if the main points.

1: The three balances must balance to zero.

(Domestic private + Government + Foreign.) 

This implies it is impossible to change one of the balances without having a change in at least one other.

2: At the aggregate level, spending determines income.

A sector can spend more than its income, but that means another spends less.

3: Government Income is Non-discretionary. 

While we can take government spending as more-or-less discretionary, government tax revenue depends largely on economic performance. Tax receipt growth is highly variable, moving procyclically (growing rapidly in boom and collapsing in slump). Government can always decide to spend more (although it is politically constrained), and it can always decide to raise tax rates (again, given political constraints), but it cannot decide what its tax revenue will be because we apply a tax rate to variables like income and wealth that are outside government control. And that means the budgetary outcome – whether surplus, balanced, or deficit – is not really discretionary.

4: Foreign Income is Non-Discretionary.

Turning to the foreign sector, exports are largely outside control of a nation (we say they are “exogenous” or “autonomous to domestic income”). They depend on lots of factors, including growth in the rest of the world, exchange rates, trade policy, and relative prices and wages (efforts to increase exports will likely lead to responses abroad). It is true that domestic economic outcomes can influence exports – but impacts of policy on exports are loose (as discussed, slower growth by a large importer like the United States can slow global growth). On the other hand, imports depend largely on domestic income (plus exchange rates, relative wages and prices, and trade policy; again, if the United States tried to reduce imports this would almost certainly lead to responses by trading partners that are pursuing trade-led growth). Imports are largely pro-cyclical, too. Again, the current account outcome – whether deficit, surplus, or balanced – is also largely nondiscretionary.

(Hans: Private Sector positive Income is made possible at the aggregate level by government spending. 

Government Deficit/Surplus + Foreign Deficit /Surplus Private Income/Surplus must equal 0.

Therefore: The Government in setting spending and tax policies influences Private Sector Income and thereby demand in the economy. 

Contrary to what Neoliberal economic theory proclaims it is the Government which ‘makes the market’ by way of it’s spending, tax and interest rate policies, thereby influencing the Private Sector Income level and it’s spending capacity. Without government there is no Market.

The best domestic policy is to pursue full employment and price stability – not to target arbitrary government deficit or debt limits, which are mostly nondiscretionary anyway.

What is discretionary?

Domestic spending – by households, firms, and government – is largely discretionary. And spending largely determines our income.

L Randall Wray

From his book: Modern Money Theory, a primer on Macroeconomics for Sovereign Montary Systems. 

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