Offsetting private sector financial balances with fiscal policy

Although I used this post from Chris Dillow as an excuse to talk about a particular problem with looking at ex post estimates of cyclically adjusted budget deficits, I did not address the main issue of his post, which is how the government budget deficit should respond to private sector financial imbalances. As Rich Clayton points out in comments, the issue raised by Chris is important, and it has been raised by others [1], but I’m not sure there are any simple answers.

Suppose the private sector runs a surplus or deficit, which has nothing to do with the business cycle (i.e. it runs a cyclically adjusted surplus or deficit). Should the public sector attempt to match this by running a deficit or surplus (so the national surplus or deficit is much smaller), or should it focus on doing the right thing in relation to the stock of government debt. If the government has a fixed debt to GDP target, for example, should it try to keep to that target, even though the private sector is running a surplus or deficit? This is equivalent to the question of whether the government should worry about current account surpluses or deficits that have nothing to do with the business cycle.[2][3]

There are examples where it would not be appropriate for fiscal policy to respond to private sector surpluses or deficits, which come from what is sometimes called the intertemporal approach to the current account. Suppose, for example, that the economy discovers a finite natural resource, which will temporarily boost output and incomes. Before the resource is extracted, the private sector (and therefore the current account) is likely to go into deficit because of any investment required for extraction, and because consumers will anticipate the income gains and borrow to smooth consumption. When the resource is extracted, the private sector should be in surplus as it builds up assets to prepare for when the resource runs out. In both cases it would make no sense for the government to try and offset these private sector financial imbalances, because they represent the optimal response to the resource discovery.

Now consider the same example, but while the resource is being extracted the private sector does not run a surplus. Perhaps it wrongly believes the resource will last forever, or it is just very myopic. In this case you could argue that the public sector could compensate for the private sector’s ignorance or short-sightedness, and run surpluses on their behalf by raising taxes (or not cutting taxes with the revenue raised by taxing the resource industry).[4] You could think North Sea oil and contrast Norway and the UK here. You could also think this involved the government being rather paternalistic, or alternatively wanting to pass on some of the benefits of the resource to future generations.

Coming more up to date, consider this example. The financial sector for some reason becomes highly risk averse, making it very difficult for firms and consumers to borrow. Monetary policy succeeds in preventing any downturn in economic activity (by, for example, encouraging savers to save less), but the overall scale of credit constraints in the economy remains elevated. Fiscal policy could relax these constraints by cutting taxes. These tax cuts might have little impact on savers if they were fairly Ricardian, but they would help those who were credit constrained spend more. If we viewed the risk aversion by the financial sector as a distortion, then fiscal policy would be reducing the distortion, and thereby increasing social welfare.


Now think about a situation where there is a housing bubble. Despite the best advice of economists and politicians, the private sector borrows to buy real estate because they believe prices can only go up. There is only modest inflationary pressure (house prices are not in the CPI), and the monetary authorities successfully deal with it with small increases in interest rates, but these do not prick the bubble. There are no macroprudential controls. Should the fiscal authority run surpluses in this case? There is a large literature on whether monetary policy should deviate from the inflation target to try and prick the bubble (I discussed a recent contribution here), but it generally takes fiscal policy as given. Should it be?

There is a general consensus that in stabilising the business cycle, monetary policy should take the lead, if it is available (we are not in a monetary union) and unconstrained (we are not at the zero lower bound). We can think of aggregate excess demand as arising because sticky prices mean real interest rates are inappropriate, and monetary policy is the obvious instrument to fix that. But if the distortion is not sticky prices, but irrational exuberance interacting with some financial market friction, does monetary policy have any superiority over fiscal instruments? In particular, if the problem is largely confined to the housing market, would some change in housing taxation not get closer to undoing the distortion than a generalised increase in interest rates. (A change in some macroprudential control might do better still.)

There are even clearer theoretical examples where fiscal policy is the appropriate tool, although they are of less obvious practical relevance. A shift in the monopoly markup of prices over costs (a ‘cost push’ shock) can be exactly offset by changes in tax rates or subsidies (zero additional social costs), whereas monetary policy can only balance additional social costs between inflation and output. Of course varying some particular fiscal instrument is not the same as changing the budget deficit. However if the distortion was temporary (e.g. a housing bubble), and some tax was changed temporarily to counteract it, then there are good tax smoothing reasons why you would not want to change other taxes (or raise spending) to offset the impact on the public accounts.

So there seem to be examples of where it might make sense to run fiscal deficits (surpluses) to partially offset private sector surpluses (deficits), but also examples where it does not. To sort out which is which we need to ask what the distortion or friction is (if any) that is giving rise to the private sector imbalance, and whether there are appropriate fiscal instruments that act on similar margins that could offset the distortion. In other words, we need to think about the microeconomics behind the macro.

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[1] In both cases in response to the large corporate sector surplus that has emerged in the UK since around 2002.
[2] If the private sector runs a surplus, but the government is in balance, then the current account must be in surplus by identity.
[3] I must stress that no business cycle issues are involved. Forget the zero lower bound, and assume the central bank successfully moves interest rates such that the output gap is zero, and inflation is on target. This will be the case whatever fiscal policy does, so there is no traditional business cycle motive for any particular fiscal policy stance.
[4] Short sighted consumers will not be Ricardian.

Sector Financial Balances as a Diagnostic Check

                Martin Wolf has a nice post explaining the financial crisis using sector financial balances. He rightly attributes this way of looking at things to Wynn Godley. It goes way back – I remember using them as a cross-check on forecasts in the UK Treasury in the 1970s, but it was probably Godley’s influence that helped that happen too. They are not a substitute for thinking about macroeconomic behaviour, but they can often be a very useful check on whether your thoughts (or forecasts) make sense.

                Take the example of a balanced budget temporary increase in government spending, which I used recently as a challenge to heterodox economists to come up with an alternative analysis that did not use either representative agents or rational expectations. (I’ve had plenty of responses telling me of all the defects of rational expectations, but no one has as yet given me an alternative account of the impact of this particular policy measure. As Godley is respected among heterodox economists, I thought maybe retelling my analysis using sector balances might help.)

The policy itself does not directly change the government sector’s financial balance (by definition). Theory tells us that consumers will smooth the impact of temporarily higher taxes, so their sector will move into deficit. But if we were foolish enough to think the story stopped there, thinking about financial balances tells us that has to be wrong. Consumers are in deficit, and no sector has moved into surplus. Keynesian theory then tells us what happens to put things right: output and incomes increase until the point that the consumer sector is no longer in deficit. If you think about it (and given consumption would always fall by less than post-tax income because of smoothing), this has to be the point at which income has increased by an amount equal to the tax increase i.e. a balanced budget multiplier of one. We could talk about this as a dynamic multiplier process, or we could talk about rational consumers working this out, and so not bothering to reduce their consumption in the first place.

As Martin Wolf and others have pointed out many times, thinking about financial balances also tells us the foolishness of cutting government deficits when the private sector has moved into surplus to restore their asset/liability position. In a global economy, if governments are successful in cutting deficits then the private sector surplus has to diminish. That makes the idea that nothing will happen to output as a result of deficit reduction rather improbable. With interest rates stuck at zero, real interest rates cannot move to persuade the private sector that they no longer need to correct their financial position. So the only possibility left is that output falls until they no longer want to do so. (Because of consumption smoothing higher short term income would imply a rising, not falling, private sector surplus.)

Looking at sector balances are not a substitute for thinking about behaviour, but they can and should demand that we are able to tell stories about them that make sense. Where I think criticism of the mainstream macroeconomic profession is correct is that there were not enough people telling convincing stories about why the household sector balance was evolving the way it did over the two decades before the recession. (I talk more about this here.) What was I doing? The answer is writing papers looking at the impact of fiscal policy in DSGE models, and not looking at this kind of data at all. In that sense I was definitely part of the problem, although it did kind of come in useful later on.