The government deficit is an addition of funds to the private sector.
Net financial assets in the private sector grew by $90 billion in June 2017.
The government's deficit is the private sector's surplus and vice verse.
Why is this good news?
The first question that comes to most people's mind is: why is this bad news? Deficits are bad, are they not? In a household or business, yes, they are, as it means you are losing money. 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 creating its own money. The U.S. government can create 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 and has the same relationship with money as a referee does with game points.
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 added $90B to the private sector. The private sector grew by that much as this money was added to the circular flow of income.
If the government had run a surplus, it would have reduced the circular flow of income by the amount of the surplus. 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 money is, in effect, "unprinted". It is like returning sea water to the sea.
The government traditionally issues a bond to match its spending; now, there are $90 billion more 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.
Another source of funds for the economy is private credit creation by commercial banks.
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:
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 adds all three sectors together, it equals the GDP for that year. One sector's loss is the other's gain, and if they all go down, so does GDP.
The following chart shows the interplay of the three sectors over time.
From the chart, one sees that the government flows mirror the flows of the private sector and external sector with the symmetry of butterfly wings. Note how when the government runs low deficits or a surplus the flows in the private sector are reduced. Note too how reduced deficits and surpluses always precede a recession.
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.
The chart below shows the long-term picture:
Long term, the picture is of an overall add to the private sector from the government. 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:
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 below illustrates the big picture. M3 would be better than M2. However, it is not published and would be higher and have the same trend.
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".
The following table is a summary of household debt.
Households have some debt, though, as the table below shows.
Domestic credit to private sector (% of GDP World Bank 2015)
Household debt to GDP
Household debt total, % of net disposable income, 2015 (OECD)
(Sources: World Bank, OECD, Trading Economics as marked)
Professor Steve Keen, an expert on private debt, posits that 150% of income is the level at which private debt becomes unsustainable and sets the economy up for a fall if and when aggregate demand sags and a recession starts.
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, the NINJAs (no income, no job, no assets)
To borrow money and invest in businesses, 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 macro economic 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 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 reserves 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-1970s 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.
So, with an external sector net drain and a heavily indebted consumer, aggregate demand can only be held up by government spending, and that is a fact of sectoral balance accounting. There is no way around it.
The balance of accounts equation for America is better this month by $90B as the formula below shows.
[P] = [G]+[X] is an accounting statement of fact.
This month, the statement looks like this:
[P] = [$90B]+[-X]
The sector flows at present and for the GFC boom-bust are shown in the table below.
Private Sector Credit Creation
2009 GFC Trough
2007 GFC Peak
(Source: Trading Economics, FRED and Author calculations based on same)
One can see the government budget makes a critical difference to the private domestic sector flow results. This is important as private credit flows are determined by the general population and international flows by overseas players and are market driven. Government expenditure flows are a planned choice and not driven by market forces. Government expenditure can be used to guide the overall outcome to an intended result.
The government deficit is offsetting the current account deficit and allowing just under one percent for additional growth in GDP for the year. This is good news for financial assets, such as stocks, bonds, and real estate, as all these sectors have fiscal space within which to increase in value. The distribution across the various financial sectors will not be even, and some will benefit more than others and vice versa. The main message is that the economic pie will be getting bigger next year providing fertile ground for investment.
Past trends show the US economy can tolerate negative flows of up to -2.83% before tipping over into a recession and stock market panic and we are thankfully not there yet. With wise economic management of the sector fiscal flows, there is no need for any recession or related stock market panic.
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SPDR Dividend ETF (NYSEARCA: SDY)
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.