Economics 101: Government deficits and national accounting identities

Okay, what follows is slightly wonkish, but it’s Economics 101—something which our politicians sometimes appear to ignore.

One of the first things an economic student learns is the basic national income definitions.  The best known simple definition of the aggregate components of national income is: Y = C+I+G+(X-M) and the disposition of income is Y=C+S+T. I shan’t bore you with the specific meanings since you can look them up in any basic macro textbook. Suffice to say that simple substitution yields:
(S-I) + (T-G) = (X-M)

This definition really is important!  (S-I) is the ‘private savings balance’ or the difference between private sector savings (S) and investment (I); (T-G) is the ‘government balance’ or the difference between tax receipts (T) and all government expenditure (G); (X-M) is the difference between exports (X) and imports (M) and is usually called the simple ‘current account balance’. Why is the above bit of mumbo-jumbo so important? Because it shows the inter-related nature of the government deficit and other key components of national income.

To understand the principle involved, let’s suppose that at the current level of national income and employment the current account is in balance; ie, (X-M) = 0. Let’s assume too that there’s a private sector savings surplus of 10 units, or (S-I) = 10. Substituting into the above, the ‘government balance’ must be negative, or (T-G) = -10. If the private savings balance increases to 15, ceteris paribus the government balance or ‘the deficit’ must also widen to -15; this is precisely what happens when firms and households try to rebuild their savings after over-leveraging. But if simultaneously the external account improves by 5 units, or (X-M) = 5, the government account (T-G) can remain at -10.

In short, the ‘deficit’ cannot be cured simply by cutting expenditure (G) and raising taxes (T) as some politicians would have us believe. Any attempt to do so will have repercussions on other variables—including on the level of national income itself. This in not ‘Keynesian economics’; rather, it follows from basic national accounting principles.

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  • Andrew Watt

    George, you are right that we need to hammer this simple but key point. I have responded on my blog:

    George Irvin is right to emphasise the importance of sectoral (im)balances in understanding the current debate on fiscal consolidation and austerity. It may seem evident that cutting spending and raising taxes reduces a government deficit, but the extent to which that actually happens – indeed, under certain circumstances, whether it does so at all – depend on a number of other factors, particularly the behaviour of the private sector and that of foreign trading partners (as mediated by the exchange rate).

    Interested readers may wish to look at the analysis here (especially from p.16). It takes the same national accounting framework that George uses and provides the relevant figures for the most important current-account surplus and deficit countries in the euro area – Germany and Spain. The upshot of the analysis is that the fiscal consolidation programmes envisaged by governments and the European authorities are unlikely to work (in terms of achieving rapid fiscal consolidation) or will be very costly in terms of lost output. This is because the plans implicitly make assumptions about the behaviour of the other sectoral balances which are not plausible. The inexhorable need to achieve the overall sectoral balance (which is a definitional or mathematic, and not a mere political, requirement) comes about via lower-than-forecast output or growth.