Fiscal Constraints & the Economy:

4 Politically Incorrect Questions

Rob Parenteau, CFA

M
MacroStrategy
St t Ed
Edge
Levy Economics Institute
April 14, 2011

1
Fiscal Constraints & the Economy
 What
Wh t is
i the
th reall governmentt budget
b d t constraint?
t i t?

 How do fiscal constraints restrict the range

g of possible
p
outcomes for other sector financial balances?

 Does financialization lead to lower corporate

reinvestment rates (and hence larger fiscal deficits)?

 Why can “expansionary

expansionary fiscal consolidations”
consolidations prove to be
so elusive?

2
The Government Budget Constraint

G = T + d(
d(D)) + d(M)
d( )

G = Government Expenditures
T = Tax Revenues
D = Government Debt Outstanding
M = Money Stock

Solvency defined:
PV of future (T-
(T-G) = or > initial D

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Government Budget Finance
T
Taxes +B
Bond
dPPurchases
h

Domestic
D ti PPrivate
i t Governmentt
G
Sector Sector

Expenditures

 Tax payments and bond purchases require money

 Households and firms cannot create money
 Where does the money come from then?
4
Money Creation and Fiscal Budgets
 Banks
B k create
t money when
h ththey credit
dit a d
deposit
it accountt
as they make loans, buy securities

 But this is not a net financial asset of the private sector

 Central bank debits Treasury account, credits a bank
account when it buys goods, services from private sector

 This is a liquid net financial asset of the private sector

that can be used to buy government bonds, pay taxes

 Governments with a sovereign currency have to first

create the money they collect as taxes, bond revenues
5
The Government Budget Constraint
 Tax
T obligations
bli ti force
f the
th private
i t sector
t tot sellll goods,
d
services, assets to the government for money

 A government with a sovereign currency can never “run

out of money”: it creates the money it collects

 Government constraint is not financial (unless self

imposed as with debt ceilings, etc.) but rather real

 Fiscal balance needs to be set with regard to real

capacity constraints in labor, P&E, resources

 Rating agencies should be assessing inflation risk, not

default risk, for sovereign currency nations 6
Fiscal Constraints on Other Sector
Financial Balances
T l Saving
Total S i = Total
T l Investment
I
(or Total Income=Total Expenditures)

3 Sector Financial Balances (FB) in 3 Possible States (+

(+,=, -):
 Government FB = T – G
 Foreign FB = M – X, (or inverse of Current Account Balance)
 Domestic Private Sector FB = (Sh + Sb) – (Ir + Inr)
DPSFB + GFB + FFB = 0 (as financial balances must net to zero)

DPSFB + GFB – CUB = 0

Change in one sector financial balance implies changes to other two

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The Financial Balance Approach
E
Expenditures
dit Exports

Domestic Domestic
Governmentt
G Foreign
F i
Private Private
Sector Sector
Sector Sector

Taxes Imports

 Changing
Ch i the
th FB for
f one sector
t will
ill have
h implications
i li ti for
f
the remaining sectors (range of possible outcomes)

 For DPSS to net save, needd a)) fiscal

f l deficit,
d f or b) trade
d
surplus, or more generally, CUB > GFB
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 3 Sector Financial Balances Map
p
Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance

Fiscal Surplus

DPS Deficit DPS Deficit DPS Surplus

Current Account Current Account

Deficit Surplus

DPS Deficit
DPS Surplus
Domestic Private Sector
Financial Balance = 0% DPS Surplus

Fiscal Deficit
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 Balanced Budget Constraint
Fiscal Surplus

DPS Deficit DPS Deficit DPS Surplus

Current Account Current Account

Deficit Surplus

DPS Deficit
DPS Surplus
Domestic Private Sector
Financial Balance = 0%
DPS Surplus

Fiscal Deficit
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The EMU Triangle
Fiscal Surplus

Current Account Current Account

Deficit Surplus

Very little room to achieve

a Domestic Private Sector Surplus
Domestic Private Sector
Financial Balance = 0 Fiscal Deficit = -3% of GDP

Fiscal Deficit
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Fiscal Deficit > Current Account Deficit =
Large Private Sector Financial Surplus
C u r r e n t A c c o u n t B a la n c e a s a S h a r e o f G D P

G o v e r n m e n t F i n a n c i a l B a la n c e a s a S h a r e o f G D P

2 .5 2 .5

0 .0 0 .0

-2 .5 -2 .5

-5 .0 -5 .0

-7 .5 -7 .5

-1 0 .0 -1 0 .0

-1 2 .5 -1 2 .5
70 75 80 85 90 95 00 05 10
Source: Haver Analytics

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US Households in a Net Saving Mode

Ho u s e h o ld F i n a n c i a l B a la n c e a s a S h a r e o f G D P

8 8

6 6

4 4

2 2

0 0

-2 -2

-4 -4
60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics

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Business Sector Net Saving
N o n f a r m N o n f i n a n c i a l B u s i n e s s F i n a n c i a l B a la n c e a s a S h a r e o f G D P
4 - q t r M o v in g A v e r a g e

N o n f a r m N o n f i n a n c i a l B u s i n e s s F i n a n c i a l B a la n c e a s a S h a r e o f G D P

4 4

2 2

0 0

-2 -2

-4 -4
55 60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics

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Profit Margins Soar,
Soar Investment Share Low
P r e ta x C o r p o r a te P r o f i ts a s a S h a r e o f G D P

C a p i ta l E q u i p m e n t a n d S o f tw a r e a s a S h a r e o f G D P

14 14

12 12

10 10

8 8

6 6
80 85 90 95 00 05 10
Source: Haver Analytics

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US Capital
p Stock on a Diet:
Financial Incentive Constraint?
N e t S to c k : P r i va te S tr u c tu r e s : Q u a n ti ty I n d e x
% Ch a n g e - Y e a r t o Y e a r 2005=100

N e t S to c k : P r i va te E q u i p m e n t & S o f tw a r e : Q u a n ti ty I n d e x
% Ch a n g e - Y e a r t o Y e a r 2005=100

16 16

12 12

8 8

4 4

0 0

-4 -4

-8 -8
25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05
Sources: Bureau of Economic Analysis /Haver Analytics

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US Business Financial Balance and the
Unemployment Rate
U n e m p lo y m e n t R a te
1 2 - mo n t h Mo v in g A v e r a g e SA , %

D o m e s ti c B u s i n e s s F i n a n c i a l B a la n c e
4 - q t r M o v in g A v e r a g e

12 4

10 2

8 0

6 -2

4 -4

2 -6
55 60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics

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Tobin
Tobin’ss Q: Signal to Reinvest,
Reinvest not M&A

N o n f a r m N o n f i n a n c i a l C o r p o r a te B u s i n e s s: M a r k e t V a lu e o f E q u i ti e s / N e t W o r th
%

200 2 00

160 1 60

120 1 20

80 80

40 40

0 0
55 60 65 70 75 80 85 90 95 00 05 10
Source: Federal Reserve Board /Haver Analytics

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Corporate Reinvestment Rates
 Incentive
I ti structures
t t ffor managers and
d iinvestors
t h
have
shifted over 30 years toward short term financial gains

 With exception of the New Economy Bubble,

reinvestment of profits in US capital stock has been low

 US job growth (and tax revenue growth) are dampened

if firms fail to reinvest profits in tangible capital stock

 Changing incentive structures (and public/private

investment) may be required to revive secular growth

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Expansionary Fiscal Consolidations
 Tax
T hikes
hik and
d governmentt expenditure
dit cuts
t drain
d i
domestic private sector cash flow

 Growth then requires DPS to spend more out of its

income flows (higher corporate reinvestment, for eg.)

 Or requires trade balance to improve

 Or combination of both in sufficient size

 No automatic price adjustment (dollar, interest rate)

insures sufficient offsetting DPS and/or CUB shift

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Fiscal Consolidation…or rediscovering
g
the Paradox of Public Thrift?
U . K . : P u b li c S e c t o r B u d g e t S u r p lu s / D e f i c i t a s a % o f S A G D P ( S A , % )
I r e la n d : C e n t r a l G o v e r n m e n t B u d g e t S u r p lu s / D e f i c i t a s a % o f S A G D P ( S A , % )
S p a i n : C e n t r a l G o v e r n m e n t B u d g e t S u r p lu s / D e f i c i t a s a % o f S A / W D A G D P ( S A , % )

5 5

0 0

-5 -5

-1 0 -1 0

-1 5 -1 5

-2 0 -2 0

-2 5 -2 5
00 01 02 03 04 05 06 07 08 09 10
Sources: ONS, ICSO, SPBDEH /Haver

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Expansionary or Double Dip?
Expansionary…or
UK Real GD P (Y oY % C hange)
I r e la n d R e a l G D P
S pain Real GD P

20 20

15 15

10 10

5 5

0 0

-5 -5

-1 0 -1 0
00 01 02 03 04 05 06 07 08 09 10
Sources: ONS, ICSO, SPENE /Haver

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EU Trade Balances Not Helping
E u r o A r e a 1 6 : T r a d e B a la n c e : T o ta l
S A / W D A , M il. EU R

12000 1 20 0 0

8000 8 00 0

4000 4 00 0

0 0

-4 0 0 0 -4 0 0 0

-8 0 0 0 -8 0 0 0

-1 2 0 0 0 -1 2 0 0 0
00 01 02 03 04 05 06 07 08 09 10
S o u r c e : S t a t i s t i c a l O f f i c e o f t h e E u r o p e a n C o m m u n i t i e s / H a v e r A n al y t i c s

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Conclusions
 The true government budget constraint for nations with sovereign
currencies is not financial
financial, but one of real productive capacity

 Constraining fiscal deficits will reduce the capacity for private sector
to spend less than it earns (net save
save, reduce private debt)

 The business sector will be hesitant to reduce its net saving without
incentive structures less driven by short term financial returns

 Expansionary fiscal consolidations require current account balances

to improve or the domestic private sector to reduce its net saving

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