Chart of the Day: Public deficits and private savings in the euro zone

In May I wrote a post asking "Why can’t people understand national accounting?" and I was heartened that the post seemed to get a lot of traction. Most people don’t get it. In fact, I didn’t get it until a few years ago.

I asked the question because in this post-crisis world, some people seem to act like cutting budget deficits has no effect on the private sector whatsoever. Or worse, they act like George Osborne does, thinking that confidence fairies will magically fly in to prop up the private sector when deficits get cut and all will be well. It doesn’t work that way at all. When the government’s balance changes, the balances for businesses and households change too. We need to know how changes in the government’s balance will affect the rest of the economy before we go off half-cocked and start talking about cutting deficits.

Here’s a chart that gets to what I am driving at. I got it from Warren Mosler who spied it on an Italian finance blog.

Here’s what I am seeing: when the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. So, to reduce the government deficit in any period, the private balance and the capital balance must increase by the exact same amount in that period.

What this means in effect is that when you say that you want to reduce government budget deficits, you are automatically saying you want to reduce non-government surpluses. Go ahead and just say it straight out:

The non-government surplus is too large, we need to reduce it now before it gets out of control.

If that’s not a statement you feel comfortable making, then you have to look at government deficits in a different way.

My view: Budget deficits are what results ex-post from an accounting identity between the sectoral balances and should not be a primary goal of public policy. What we want to do is target the cause of the deficits, insufficient demand which I believe is the result of the overhang of debt after a period of excess private sector credit growth. What you want to do is eliminate that debt overhang by reducing the debt or increasing private sector incomes to support the debt. That’s getting at root causes.

I know I’ve stripped this down at the risk of being simplistic but I don’t want to get into a discussion about how you increase private sector incomes or reduce private debt. I just want to put it out there that that’s what you want to do rather than just focusing on the government deficit. Focusing on the deficit is what Europe’s doing – and it doesn’t work.

  1. Jayarava says

    This is great. I also read the May thing about about national accounting, very helpful. I can follow the argument about debt overhang causing reduced demand – this is quite consistent with what other people are saying. And it’s quite clear that tackling deficits is not working, and seems to be making things worse.

    This might be a stupid question but is the upshot of this that cash is being saved/hoarded by business and consumers? That in fact there is both a huge private sector debt (450% of GDP in the UK) and a large pot of savings? Is there data on savings in the UK? (rhetorical  – I’ll for looking for it)

    Would it be right to say, for arguments sake, that if the confidence fairies did fly in and make people more confident that they’d have money to spend if they wanted to? 

    1. Edward Harrison says

      Hi Jayarava, that is a good question because the private/trade sector is not one monolithic block. What we do know is that in aggregate the private sector is indebted. 

      If you disaggregated the sectors, you would separate the non-government sectors into four broad categories: household, non-financial business, financial, and external.

      My concern is mostly in the household sector because that’s where the lion’s share of demand and growth comes from. That sector is still very indebted in the UK and the US. So what households in aggregate wish to do is minimise that debt or the associated interest as a percentage of income. They can do that by paying lower interest rates, reducing the stock of debt or increasing income. But i am just speaking in aggregate here – some households are just fine while others are sinking.

      The bottom line is that there is no savings to draw from to maintain (excess?)  consumption in aggregate if the goal is to reduce debt unless the government runs a larger deficit to accommodate this – and targets that deficit through increased transfers to exactly those folks that will consume more. I think people want  to concentrate on getting the debt ratios down as best they can and trying to gin up more consumption stops this from happening.

      That’s why the focus on jobs instead of gov’t deficits makes sense because you attack not just the numerator (the debt) but also the denominator (the income).

      1. Jayarava says

        Thanks. It does make sense. I don’t know economics but I can follow a logical argument and this makes sense to me. So why is no government in the world doing what you say? If that is a question that can be answered…

        1. Edward Harrison says

          Two things stand out for me. One is special interests. Politicians want to reward their political money donors with perks and favours. That often means doing things that favour special interests at the expense of the broader economy. The second thing that comes to mind is the process of deficits. Most people see high deficits and think that’s a sign of irresponsibility and spending beyond one’s means. That will always be the case.

    2. David_Lazarus says

      If the confidence fairies did arrive only some would have the capability to spend more, and what is more likely is that they would invest in sectors likely to benefit from such improvements rather than spend more. The best way to get spending to increase is to increase incomes for those at the very bottom of the income distribution as they have a very high marginal propensity to spend. Though that is unlikely with the attacks on the low paid and benefit claimants. 

      The distribution who has surpluses is not even either. Large corporates are very solvent but smaller businesses are struggling to get credit. Same for individuals. The rich are very solvent but the middle classes are struggling, most only being a paycheque from bankruptcy or close to it. As Edward mentioned the real problem is debt, and many are struggling even with interest rates close to zero, because banks needing to rebuild their capital base have raise rates on loans and debts, so any benefits of low interest rates have gone to the banks not consumers, unless they are on tracker mortgages. 

  2. Modelpriceguy says

    Sorry Edward, however I totally disagree with your
    logic.  As a Canadian, our Federal
    government we went through this process – of paying down debt in 1995 to
    2002.  As Canadians, we had a housing
    bubble bust in 1988, recession from 1990 to 1991 and Federal government debt of
    100% of GDP with weak economic performance. 
    In 1994, we were broke!  The
    Liberal government, at the time, did the hard work of paying down our national
    debt.  Taxes increased significantly
    (including a national sales tax), inflation was mandated at 2%, and our
    currency fell to $0.61 cents to the US dollar. 
    With an export led economy and private sector spending (yes, demand
    picked up as the federal government debt decreased). As a small businessman I
    can tell you these were hard times however, look at us now.  I believe you will find many other countries
    did the same thing.  Australia and Sweden
    (which had a banking crises) come to mind in the late 1990’s.


    UK is following this example – I believe
    correctly, however Europe is “gumming up” the process.  Like your post I had to simplify my response,
    however you and your readers would do well by talking to people who have lived
    and experienced austerity and ultimately its benefits.

    1. Edward Harrison says

      Modelpriceguy, I have seen how austerity works in Canada and elsewhere. To be clear, I never said austerity won’t eliminate the deficit. It will that’s why people do it. But it will work in a deflationary way. It “doesn’t work” if the goal is avoiding recession.

      See here: 
      “People like Hugh Hendry get it. He is not advocating fiscal contraction because he believes it will immediately be expansionary. Instead, he argues there is no policy remedy for debt deflation. Rather than allow the government’s debt levels to climb and fill in the missing private sector demand as Richard Koo advocates, Hendry recommends just letting aggregate demand fall and starting anew. That leads to Depression of course. ”

      But more importantly, your example is too simplistic because the macro environment is different today than in 1990. The UK, Sweden and Finland also experienced the same housing bust and recovery that Canada did. The recovery that Canada and these other nations experienced was aided greatly by a number of factors including a benign global economic backdrop, lower interest rates and in some cases exchange rate depreciation.

      In today’s environment, with rates already at record lows and the global macro picture very cloudy indeed, austerity can lead to debt deflation. Will it work? It might do in Britain but at great cost.

      P.S. In 1994, Canada was not broke. the government prints money. It can never run out: 

    2. David_Lazarus says

      There are huge differences between Canada and the UK, then and now. When Canada was doing its austerity there was a growing world market and Canada is a major resource exporter which helped. The UK has a trade deficit and while devaluation has helped exports to some extent it has not lead to a fall in the trade deficit. The world economy also had a rare recession and is now slowing again. So the ability of the UK to export its way out of trouble is limited. As a nation we only managed because Financial services brought so much in, but that is becoming a liability as the debtors are struggling to pay back. Austerity in the UK will not work and we are already back in recession with the small government cuts so far. 

        1. David_Lazarus says

          It is interesting that they have changed their minds because the circumstances had changed. Rubbish I was against the austerity from the start, now others are slowly coming around to the same conclusion as I have. The only way for the UK to get out of trouble is to create a new green market for wind and energy conservation. This would require deficit spending but employing people is only marginally more expensive than leaving them to fester on the dole queue. The UK also needs significant banking reform and political finance reform. Neither likely with the Tories very dependant on the City for funding.

          1. Edward Harrison says

            Also see here for why Canada is not the model here:


            That spells it out. Austerity will cut long-term deficits. After all, you are spending less. But the short-term pain could be so overwhelming in getting there that it does more harm than good. You have to look at it case by case. And clearly, the euro zone is the worst example, a small country like Australia might be a better one. Even so, in this macro environment, the results are always going to disappoint.

          2. David_Lazarus says

            There has also been talk of whether Greece will achieve its austerity targets. I am beginning to think that any such targets will be unachievable because the Greek economy has been so throughly cratered by austerity that it will be ineffective, so it is no longer a case of unwilling but simply asking the impossible. Greece needs a type of Marshall Plan to rebuild the economy. It also needs time, which it is not being given. The fact that all the pressure is being applied to wage rates will mean that the Greeks will not be able to own homes in their own country as they will simply not have the income to pay the rents or prices demanded. That is becoming true of America, While you can buy a home in Detroit for a dollar there is no work there.

    3. Edward Harrison says

      By the way, I was a diplomat at the time this occurred in Canada and a friend of mine worked in Canada as a diplomat and was friends with Chretien’s son. I visited Ottawa and got a good look around. I would say I know the situation rather well. And what I have been saying here is that Canada is not a very good model. David does a good job on this as well but here is a link that puts it together well:

  3. Modelpriceguy says

    I think we both agree austerity alone will NOT
    do the job.  However, austerity + tax
    increases (national sales tax) + inflation + currency devaluation is the proper
    response.  Europe is trying austerity and
    tax increases without inflation and currency devaluation (though its
    interesting the Euro hit a new low today) and that’s why Europe is such a
    mess.  The UK at least is doing all four-policy
    options, which will work overtime.  My
    main point is once the national government lays out its plan to eliminate its
    deficits over time and is credible the private sector which is hoarding cash
    will loosen its’ purse strings again over time.

    1. Edward Harrison says

      That’s the problem for Europe. There can be no devaluation for Spain. (That and an inability to print money means they can run out of money unlike Canada). Sweden and Canada in particular were greatly aided by currency depreciation and as relatively small nations in the global context.

      Spain can’t depreciate the currency but the euro can depreciate. However, the game of competitive currency depreciation would end in an ugly trade war if major currency areas started to try this. Bottom line: Europe is in a world of hurt that Britain and the US are not.

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