Why is this bad news?
The first question that comes to most people's mind is: why is this bad news? Surpluses are good, are they not? In a household or business, yes, they are, as it means you are saving money or making a profit. The government is, however, not a household or a business; it is a unique creature that can issue currency. No other entity can legally do this. It is another ball game altogether and not well understood.
The government of a currency-issuing sovereign nation, such as the U.S., has the privilege of printing its own money. The U.S. government can print money and buy anything that is for sale in USD. The government is like a referee at a soccer match and can never run out of points to reward goals.
The U.S government is the monopoly issuer of the USD. It is the referee at the soccer match, and we in the private sector are the players and want to win as many points as possible. These cost the referee nothing to award - that referee should award as many as we deserve, and then some.
A referee does not take points from one team to give them to another. A team does not need to wait for another team to lose points in order to be able to obtain more points from the referee.
The government's deficit is the private sector's surplus, and that is a simple fact of accounting. If GDP is $20T, it is because $20T of business was transacted in that year and that the government has $20T of money in circulation.
Last month the government sector drained the private sector of $51B. The private sector shrank by that much as this money was removed from the circular flow of income.
If the government had run a deficit, it would have enlarged the circular flow of income by the amount of the deficit. When the government runs a surplus the money is not "saved" in the same way as it is in the private sector. The Treasury simply lowers the amount in a column on a spreadsheet and the money ceases to exist. The GDP in that year falls by exactly that amount.
The government traditionally issues a bond to match its spending; now, there are $51b fewer bonds in circulation. Government bonds are bought with money from the private sector and are a record of how much private wealth is held as term deposits at the Fed. The return is low but risk-free.
In the presence of a net drain from the government sector one must look to the external sector to offset and alleviate this drain with a net add to the private sector. Otherwise, overall the private sector must shrink.
To understand the macroeconomic picture one must turn to sectoral balance of accounting analysis.
A nation's balance of accounts can be expressed by the following formula:
Private Sector [P] = Government Sector [G] + External Sector [X]
The community, business, and the stock market are located in P.
For P to expand it needs the balance of inputs from G and X to be positive. A negative balance causes P to contract.
When one makes a sectoral analysis of the U.S. one finds the following:
The chart below shows the near term income flows to the private sector from the government sector.
One notices that the budget has been net adding to the private sector, but that the net add is declining. This is not a good trend for the private sector. Last month, just like in January 2016, a monthly budget surplus $51B was seen (not yet shown in the chart).
The chart below shows the long-term picture:
Long term the image is almost a reflection of itself with periods of rising and falling deficits. Note how net surpluses preceded the dot-com crash of 2000 and then the GFC of 2008. At present one sees that the trend is a declining level of deficit spending as less money is injected into the economy each year by the government sector. What the government does not put in the private sector cannot hold as an asset or circulate as income. Will the current declining deficit cycle end in recession and return to deficit spending? Certainly in the absence of a compensating inflow from the external sector.
For the private sector to expand in the face of a net drain of funds from it to the government sector over time, it needs a net add from the external sector to make up the difference and grow.
The current account is a measure of the net flows within the external sector - from trade, capital flows, and direct foreign investment. The long-term picture is shown in the chart below:
The chart clearly shows a large and continuous outflow of funds overseas.
On a strategic level, this means that the U.S. has swapped paper for finite resources. Foreigners are happy to hold U.S. paper while we are happy to have their resources and products. Nonetheless financially the dollars have left the circular flow of income and contracted the private sector even if the private sector is materially better off.
The Big Picture
Comparing GDP with the amount of money in circulation shown in the charts and tables below illustrates the big picture.
"The deceleration in real GDP in the fourth quarter reflected a downturn in exports, an acceleration in imports, a deceleration in PCE, and a downturn in federal government spending that were partly offset by an upturn in residential fixed investment, an acceleration in private inventory investment, an upturn in state and local government spending, and an acceleration in nonresidential fixed investment. Current-dollar GDP increased 4.0 percent, or $185.5 billion, in the fourth quarter to a level of $18,860.8 billion. In the third quarter, current dollar GDP increased 5.0 percent, or $225.2 billion"
These numbers added together match the national debt almost dollar for dollar as the table below shows:
The bottom line is that a country with a negative external balance of accounts cannot long run a government surplus budget, as it would further contract the private sector and lead to a recession. This contraction of the private sector is reflected in business decline, stock market decline, unemployment, crumbling infrastructure and a less educated and less healthy population. This is not a good base going forward.
A nation with an external deficit must run a government deficit that at the very least makes up for the net drain from the external sector. To move forward and expand the private sector such a government needs to match the external deficit PLUS inject enough money into the economy to provide for full employment and thereby a strong aggregate demand.
One might ask how America has gotten this far since the GFC in the face of a continuing net drain on the private sector from the external sector and a declining expansionary spend from the government sector.
The answer is: private debt and persisting unemployment.
The chart below shows the level of household debt to GDP in America:
The chart shows that the average American household has an increasing debt load. The debt peaked in 2007 at near 100% and has since declined to around 80%. It is no wonder that despite low-interest rates credit issue rates are flat to declining. Most people are already "all loaned up".
No matter how cheap you make loans by means of monetary policy, if the market is saturated then you will not sell any more loans just because they are cheap. Credit creation is only limited by the number of creditworthy borrowers who are ready, willing and able to go to the bank and apply for a loan. The GFC was caused by a lack of such people and was on extended time for extending credit to borrowers who were not creditworthy but were made to appear so.
To borrow money and invest businesses and people need confidence and the belief that in the future they will have the income to pay the loan and that the investment will be worth more in the future than it is now. On average the numbers show that rational individuals are not of this opinion.
It makes no macroeconomic sense for the FOMC to raise interest rates in the face of the high level of household debt AND falling credit demand. Lifting the price of loanable funds will not lift the demand for it. Such a move is counter-intuitive. What lifting the interest does do is lift the income to the Fed that is derived from buying the government's bonds at interest.
In contrast to government debt, which is a record of how much money the government has put into circulation, private debt matters, as it kills aggregate demand stone dead. We are in a protracted balance-sheet recession.
The spending gap created by external deficits and government surpluses has been made good by the private sector through debt. The problem is that this transaction nets to zero over the long term when the debt is repaid. Loans create deposits and generate reserves at the Fed. Repaid loans extinguish deposits and destroy financial assets at the Fed. The process is now rolling back the other way after having topped out in the GFC.
Personal saving rates are also in long-term decline, as the chart below shows:
Savings have been in a steady decline since the mid-1970's and reached an all-time low in the mid-2000s. After that there was a change in trend and a small rise in savings as people sought to deleverage after the GFC experience. This mirrors the decline in consumer debt shown in the consumer debt to GDP chart above.
The chart below shows unemployment. More recently trending back up.
So with an external net drain and a heavily indebted consumer, aggregate demand can only be held up by government spending, and that is a fact of sector balance accounting. There is no way around it.
The balance of accounts equation for America is not healthy, and the private sector must contract.
[P] = [G]+[X] is an accounting statement of fact.
This month the statement looks like this:
[P] = [-$51B]+[-X]
The private sector must get smaller or take on more private debt in the absence of a compensating income flow from the government sector. Aggregate demand falls, meaning lower sales, less production, less investment, less income and fewer jobs.
Let us hope that President Trump and Congress can get together to enact some large tax cuts and productive fiscal policy to inject income into the private sector and that this, in turn, will lift the stock market in the private sector - for us investors to profit from.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.