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One + One = Two (Not Too Wonkish)

letsgetitdone's picture

After reading one of my rants about the stupidity of policies aiming at a balanced budget, somebody in my Facebook environment, commented by saying: “1 + 1 = 2.” Here's my answer.

Yes, 1+1 = 2.

Now here's an accounting identity from macroeconomics, called the Sectoral Financial Balances (SFB) model:

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0.

It's like 1 + 1 = 2. But just slightly more "wonkish."

There's plenty of empirical evidence showing that the real world interpretation of this identity works. But, there's NO negative evidence refuting it.

Now, let's say that the income of the private sector exceeds the amount it pays to the other two sectors by 5% of GDP. And let's say that the income of the foreign sector exceeds what it spends on US goods and services by 4%, then what does the formula say will happen to the Government balance?

Government spending will have to exceed its income by 9%, that is it will have to run a deficit of 9% to support the foreign surplus and the domestic savings. i.e. 1+1=2; or in this case 5% + 4% + (-9%) = 0.

Now, what happens if we refuse to let the deficit be 9% and that we either cut Gov spending or raise taxes to make that happen? Let's say we want to balance the budget, so that we force that -9% to become 0 (Ron Paul's idea).

Then we have choices. We can force a zero trade balance, by refusing to import more than we export. But that still leaves us with the need to INCREASE private sector debt by 5% to get the Federal budget to balance without decreasing economic activity. There are other options here of course. We could leave the foreign sector balance where it is and increase private sector debt by 9%. But, do we really want to do either of these first two options or anything in between?

I really don't think so. Do you? Is there any way we can retain those private sector savings of 5% and keep a balanced budget? Yes, there is. We can decrease our imports and increase our exports so that the foreign sector has a negative trade balance. That is, we can get more income from trade than we spend on it by 5% of GDP, a shift of 9% from our current trade balance, provided we can increase our foreign sales (exports) by that much.

Of course, it would be very difficult for us to do that without engaging in a trade war since our attempt to decrease the foreign trade sector's balance so drastically and quickly would trigger a trade war with all our major trading partners. There would be an international race to the bottom, which, for us to win, would require US companies to cut prices and costs to the bone in order to export more. This however, would be likely to result in layoffs or lower wages or both, which in turn would be likely to reduce sales, tax revenues and GDP, leading a to a higher Government deficit which would defeat our goal of a balanced budget.

But getting back to eliminating the positive foreign sector balance through greater exports, the Government can neither do this for the private sector, nor maintain control over such a process once it starts. And, in any case, a change like this isn't beneficial in terms of adding to the real wealth of Americans, since even though imports cost money, they increase real, as opposed to, financial, wealth. But that's a story for later on.

For now the important thing is that 1+1=2, or, if you like 1+1 – 2 = 0, tells us that trying to balance the Federal Budget would be a disaster for the private sector unless we could develop a negative foreign sector balance by selling more than we import.

Even more, if you think about it, you can see that if we want to save 5% in in the private sector and import more than we export by 4%, then the Government would have to plan for a 1.44T deficit in the coming fiscal year. However, the President is only planning for a .9T deficit, about $500B short of the Government deficit we ought to have if we want to support our savings and desires for more in imports than we can export. That's too bad, because it's likely that if Congress and the President passed a full payroll tax cut, a State Revenue sharing plan and a Federal Job Guarantee Program, then this could produce the needed additional $500 B Government deficit we need given our current savings desires and import levels.

The programs would cost more than that, of course, but we'd be spending a lot less in unemployment insurance, income support programs, Medicaid, and other welfare programs than we are now because of the effects of these other initiatives. So for an additional $500 B we could have complete recovery from the crash and full employment. We're crazy, and maybe evil, for not going for this, and letting 30 million people looking for full-time jobs hang out there, instead.

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