Why the rating agency needs a lesson in basic accounting — and how its REAL message is anti-private savings.
It took an accountant to take down Al Capone. Perhaps the accountants will be the ones who finally take down the deficit terrorists? They seem to be the only ones who understand that policy makers cannot coherently examine fiscal policy options without analyzing their implications for the financial balances of other sectors. For all of the talk about Greek “rescues”, or the US reducing its “structural fiscal deficits”, few seem to understand that imposing an arbitrary fiscal deficit to GDP ratio (or fixing an exchange at an arbitrary level) reduces the room available to achieve private sector net saving.
Deficit Hysteria Ignores Basic Accounting
Basically, it all comes down to Accounting 101. Those who continue to rail about “fiscal sustainability” or terrorize us with deficit hysteria are demonstrating phobias relating to private savings (if they truly considered the logic of their position).
And this includes our esteemed ratings agencies, which today issued another blast against both the US and UK. According to Moody’s (MCO), both countries have moved “substantially” closer to losing their AAA credit ratings and must bring down their debt. Somehow, the countries are supposed to do this without damaging growth, despite the fact that the very expansionary policies which Moody’s now decries have provided a floor under what could have been a collapse in income and employment similar to that of the 1930s.
Well, to paraphrase the famous baseball Hall of Famer, Yogi Berra, we have a sense of “déjà vu all over again”. The same thing happened to Japan in the late 1990s. In November 1998, the day after the Japanese government announced a large-scale fiscal stimulus to its ailing economy, Moody’s Investors Service began the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. The next major Moody’s downgrade occurred on September 8, 2000.
Then, in December 2001, Moody’s further downgraded the Japan Government's yen-denominated bond rating to Aa3 from Aa2. On May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana, Chile and Hungary.
Big deal. Japan today still borrows 10 year money at around 1.3%. Fortunately, deficit hysteria doesn’t translate very well in Japanese.
If our ratings agencies (and the vast majority of economists and market commentators) had a basic understanding of accounting, they might stop embarrassing themselves. To be sure, many do get it. Dean Baker, Rob Parenteau, Scott Fullwiler, Randy Wray, and Bill Mitchell, are conspicuous amongst the profession of those who adopt a coherent stock-flow analysis to macroeconomics.
Most, however, are reluctant to embrace this approach. And not just economists: Politicians and the media often argue that the government must balance its books, just like a household. If a household were to continually spend more than its income, it would eventually face insolvency; it is thus claimed that government is in a similar situation. Randy Wray has demolished this line of reasoning.
Part of the problem is ideological. At the most basic level, the combined income of all three sectors of an economy - the domestic private sector (including households and businesses), the government sector, and the foreign sector – must equal its expenditures. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis. But the neoliberals hate the idea of placing the government sector on par with the private and external sectors. They view it as an unwanted appendage which adversely afflicts the operation of the private sector in a “free market” economy.
Having established this notional balance sheet, there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income). Historically, for example, the US private sector has spent less than its income. Another way of expressing this is that the government’s budget deficits have accommodated the private sector’s traditional proclivity to save. When the latter formulation is used, it helps to understand how irrational is the hysteria surrounding government deficits. As paradoxical as it seems, Professor Jan Kregel’s observation holds true here:
The government can intervene to make private vices into public virtue by encouraging prodigality when the private sector desires to be frugal. Government prodigality is the equivalent of supporting public virtue! This is the fiscal policy of a responsible government, responsible to insure that private sector decisions can be achieved rather thwarted by the law of unintended consequences. (”Fiscal Responsibility: What Exactly Does It Mean?” — Draft of remarks prepared by Jan Kregel for the Will Lyons Inaugural Lecture, Franklin and Marshall College, 23rd February, 2010.)
And the corollary applies as well: during the Clinton years the federal government acted in a manner which would have pleased the greatest Victorian scolds amongst us, running the biggest budget surpluses the government has ever run. This was celebrated by virtually every mainstream economist (much as most decry today’s “explosive” deficits), because it meant that the government’s outstanding debt was being reduced. Of course, in reality what these economists were celebrating was history’s greatest private sector debt binge. Naturally, they didn’t see it this way because they failed to understand the accounting implications of these budget surpluses, which meant by identity that the private sector was running a deficit. Households and firms were going ever farther into debt, and they were losing their net wealth of government bonds, which were being liquidated to offset the resultant loss of private sector savings.
With a few brief exceptions, the US federal government has been in debt every year since 1776. And the cumulative stock of debt which eventuated was not a Sword of Damocles hanging over the heads of future generations of taxpayers which in some way constrained their future freedom of action (or else how did the US become the wealthiest economy on the planet?). Rather this stock of debt issuance simply reflected an accounting expression of the aggregate budget deficits that have been run by the government in past years. The “intergenerational theft” line now trotted out with nauseating regularity is completely bogus. As Kregel notes in the remarks cited above, we cannot simply engage Doc Brown to allow Marty McFly to fly “back to the future” to make the required payments on behalf of the prodigal grandparents. On the contrary:
If the debt is incurred today, but it is to be resolved in the future, the future resources to pay off the debt would have to be transmitted back to the present in order for there to be any burden in terms of lost consumption by the future generation! If it cannot be time-transmitted then it stays in the future, unless our grandchildren decide to engage in a gigantic potlatch and burn the resources and declare the debt to be extinguished.
In fact, talk of “trillions of dollars of unfunded liabilities” due to retirements of the baby-boomers is meaningless unless it is compared to the cumulative size of GDP over the same length of time — another instance where our deficit terrorists compare apples with oranges.
Government Budgets and Political Priorities
A government budget, then, does not simply set in stone government expenditures and tax receipts. It is a document that sets out the political and spending priorities of our policy makers to mobilize national resources for broader public purpose. In essence, a budget is a political statement, which reflects priorities and preferences, not the economic equivalent of a straitjacket which, for example, arbitrarily decrees that government spending shall not exceed a certain percentage of GDP. By definition, a budget cannot do this, because all budget surpluses, or deficits, are largely “endogenous”, or non-discretionary. A government can set out its spending plans, and its taxation plans via legislative fiat, but it cannot determine in advance the level of the deficit (or surplus). The macroeconomic linkages which ultimately establish the budget position are largely determined by the interplay between government and non-government spending. The deficit is as much a reflection of this interplay, as a cause.
Which again brings us back to the government’s fiscal spending and the notion of “fiscal sustainability”: In our view, the only truly “fiscally sustainable” policy is one that delivers full employment at or near current price levels. The notion of government offering a Job Guarantee program, is a very compelling fiscal policy option, but one which has generally been eschewed in response to our growing deficit hysteria. Given that “fiscally responsible” governments which continue to cut spending and try to run surpluses risk locking a generation of their youth into a lifetime of disadvantage, job creation programs are required now which will require further stimulus. That is the only responsible course of action. A Job Guarantee program is vastly preferable to more transfer programs to banks and federal agencies to keep households limping along in their current impaired state.
The real key toward a substantial US recovery, then, is not restrained fiscal activism (which will actually make things worse), but some combination of substantially more government spending and/or tax cuts to offset the implosion of private sector demand. Once the government honestly addresses the solvency issue of a government spending and borrowing in its own currency, there is nothing that could in theory prevent the US Government from offering a job to anyone who applies, at a fixed rate of pay, and let the deficit float. This would result in substantially higher rates of employment, by definition, as well as mitigating the need for such legislation as unemployment compensation and a minimum wage (since the Job Guarantee program would, by definition, constitute the minimum wage).
The federal government’s spending is not constrained by revenues or borrowing. This fact is non-controversial, but very poorly understood, as evidenced by the persistent criticism of the government’s fiscal profligacy. The real question that needs to be addressed is: what constitutes “fiscal responsibility” on the part of the government and on the part of economists? We need to proceed boldly, but can only do so by disposing of a number of traditional bogeymen that no longer apply in a post-gold standard world: public debt burdens, national solvency, and “crowding out”. Above all, it is crucial to understand that the global desire for private sector deleveraging is not going to go away and that government must play a role in accommodating this process. Ironically, the more fiscal austerity is being imposed intentionally, often with conditionality requirements along the way that reinforce the fiscal austerity measures in the transition period -as we are now seeing in Greece (and which is unlikely to end in Greece) — the worse will be the very budget deficits now decried by deficit hawks.
The private sector’s ability to spend less than its income depends on another sector to do the opposite. For one sector to run a surplus, another must run a deficit. This is not high Keynesian theory, but a basic accounting identity that seems to have been lost by the vast majority of economists and pundits. In principle, there is no reason why one sector cannot run perpetual deficits, so long as at least one other sector wants to run surpluses. But certainly for the current environment there is nothing, nor should there be anything, which should stop any government from running large deficits so that the private sector can happily build up its savings again, as was the case in the US in the aftermath of World War II.