Yesterday I linked to Dillow’s piece which argued that the government doesn’t choose its deficit; the deficit is chosen for it by the decisions of the private sector to save.
You will be familiar from earlier posts of his (e.g. this one) that GDP can be disaggregated into expenditure components (consumption and investment and net exports), and also income components (wages, taxes, profits, others). Ultimately, the weird and counterintuitive magic of macroeconomics is that these two need to be brought to equal one another. (Though note: the two are often far apart – see the Economist). It is this sort of insight that causes Nick Rowe to rant* with some justification about the misplaced use of microeconomic techniques in macro. Certain homespun wisdoms of micro-thinking just don’t work on a macro level. A classic example is: if you want to have higher savings, then have lower consumption. It don’t always work that way.
A (very bright) friend noticed that blogpost, and questioned the theory that ‘the government does not control how much it borrows’. Without being snarky and saying “if they get to choose this, they have made some rather uncontrolled choices in the last 2 years”, I tried to summon the logic of a naive Keynesian like me into a sentence, and made a hash of it. So I have tried drawing pictures instead.
This is for my own education as much as anything; I often blurt things out without seeing them through. It does not constitute a prediction about what will happen if the government cuts now; as a model, it is grossly oversimplified, leaving out prices and the variable behaviour of the various actors (state, households, businesses) in the picture. It can be extended.
The basic point I have been trying to explain to myself is that GDP as determined by expenditure needs to be brought to equal GDP as determined by income. This is a picture of how it might happen in equilibrium:
(updated; thanks Ben and Luis below)
In this simple world, I leave out the transfers that government sends straight back to households; I just net them out (see this report). Government consumption tends to be 20% of so of GDP, not the same as government spending. For simplification, I assume that businesses reinvest all their profits. The savings relationship is therefore between households and government: the households save 50, and the government has a deficit of 50.
Now, let’s see what happens in disequilibrium. The government decides to run no deficit at all.
Now we have a problem: the GDP demanded is now insufficient. A demand shock: the government has lowered what it wants to spend, and nothing has risen to take its place. Please note: in that single sentence is buried and second-guessed all of the macro argument, including the possibility of non-Keynesian effects. If business was investing too little because something about that government spending of 200 was bothering it (it was taking too many resources, bidding up wages, threatening future insolvency, raise interest rates), then the equalization would come through, say, investment increasing. But in a slump the presumption from a hardline Keynesian is that this does not happen.**
So how is this disequilibrium resolved? In the Keynesian-depressive account, by GDP falling, household incomes falling, probably unemployment rising and government revenues falling, so the government is forced to run a deficit. Like this:
Now things match up again. Household spending has fallen, in order to keep their desired level of savings at 50. Taxation has fallen – like it does in a recession, much harder than the GDP fall. Government spending has risen – driven by the GDP fall. So the government is forced to run a deficit of …. 50, the very deficit it tried not to run. The situation is just like the first picture – but GDP is 5% lower.
Again, let me reiterate: this is not a prediction about what will happen, just an explanation for my own edification and hopefully some of yours of the logic behind the Keynesian insight. All of the real macroeconomic meat is in the arrows, not the numbers; how particular relationships make those numbers go up and down. If I steal a moment tonight, I will post some alternative possibilities.
Does it makes sense?
*I mean rant as nothing but a compliment. Please read his post.
**And, anyway, even if it did, it would return the same result: what the government chooses is not the point; it is the private sector’s decisions that determine the outcome.