Not too long ago, on Capital Hill, a Senator representing Michigan waved a piece of paper in the face of Alan Greenspan. The paper apparently listed the current size of overseas holdings of U.S. treasuries. The Senator in question demanded that Greenspan take action to solve this problem. Poor Greenspan has heard many stupid things on Capital Hill, but this one must rank among the classics.
The above is a good example of people attempting to discuss issues without a basic understanding of how the mechanics underlying those same issues actually work. One can, to some extent, forgive politicians. After all, it is their job to speak about things they know little or nothing about.
However, it is more worrying when a large group of commentators seem to ignore certain fundamental principles of economics when they should know better. I am referring to the sometimes incoherent debate regarding the twin deficits in the U.S.
Before I make my points, let’s take another look at the so-called ‘accounting identity’ (and please do not drop out here – this is important):
Government Fiscal Deficit = Balance of Payments Deficit + Private Net Savings
It is important to remember the effect the three components have on GDP. An increase in government deficit is good for GDP, an increase in savings is bad for GDP and an increase in the balance of payments deficit is a/so bad for GDP.
One important lesson from this equation is that you cannot forecast the different components independently. If, for example, the U.S. government takes steps to reduce the fiscal deficit, it is obvious from the accounting identity that it will impact either the balance of payments deficit or private savings (or both).
For instance, the U.S. experienced healthy GDP growth throughout the 1992-2001 period. This happened in spite of a rising balance of payments deficit and an improving government deficit (both bad for GDP). In other words, GDP growth over that period came exclusively from a dramatic deterioration in net savings.
Then, in 2001-03, private savings recovered somewhat, whilst the balance of payments continued to deteriorate, both of which were bad for GDP. Under normal circumstances, this would have set off a recession; however, due to a rapidly growing fiscal deficit, continued economic growth was secured.
Secondly, with virtually no growth in Europe and with certain Asian countries refusing to play even remotely by the rules of free trade (stealing billions of dollars worth of intellectual property and keeping their currencies pegged to the dollar), a U.S. balance of payments deficit appears inevitable.
Thirdly, assuming that we all have an interest in continued U.S. GDP growth (the global economic engine), calling for a reduction in the ‘irresponsible’ U.S. government fiscal deficit is a bit counterintuitive (or outright stupid if you prefer non-diplomatic language). As we now know, GDP growth will decline in the face of an improving fiscal deficit unless the balance of payments deficit shrinks at the same time or private savings decline. The Bush administration has called for a dramatic cut in the fiscal deficit. Because of the accounting identity, this could cause a severe recession. Be careful what you wish for.
By The Absolute Return Team
Absolute Return Partners LLP is a London-based private partnership. They provide independent asset management and investment advisory services globally to institutional as well as private investors, charities, foundations and trusts.
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