More Austerity Advice From the Very Rich: Buffett On Deficits!

Warren Buffett's recent op-ed [1] in the New York Times is making a stir because it calls for a minimum tax on high incomes above $One million annually. But I was much more interested in some deficit targeting he proposes which exposes his ignorance about the sectoral financial balances model of macro-economics, and reveals him as a deficit hawk whose advice, if followed would be unsustainable and lead the United States into another deep recession. I'll comment on a couple of paragraphs in Buffett's op-ed.

Our government’s goal should be to bring in revenues of 18.5 percent of G.D.P. and spend about 21 percent of G.D.P. — levels that have been attained over extended periods in the past and can clearly be reached again. As the math makes clear, this won’t stem our budget deficits; in fact, it will continue them. But assuming even conservative projections about inflation and economic growth, this ratio of revenue to spending will keep America’s debt stable in relation to the country’s economic output.

So, our goal ought to be running deficits of 2.5% and this is Warren Buffett's idea of fiscal responsibility. Now here's an accounting identity from macroeconomics, [2] called the Sectoral Financial Balances (SFB) model in which the economy is divided into three sectors, and in all the balances are financial flows over a period of time:

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0.

There's plenty of empirical evidence [3] showing that the real world interpretation of this identity works. But, there's NO negative evidence refuting it.

Now, let's say that the income of the private sector exceeds the amount it pays to the other two sectors by 6% of GDP, so that the private sector has a surplus. And let's say that the income of the foreign sector in dollars exceeds what it spends on US goods and services by 4% of US GDP, leaving it with a surplus, and the US with a current account (trade) deficit, then what does the formula say [4] MUST happen to the Government balance?

Government spending will have to exceed its income from taxation by 10%. That is, it will have to run a deficit of 10% to support the foreign surplus and the domestic savings. i.e. 6% + 4% + (-10%) = 0.

Now, what happens if we refuse to let the deficit be 10% of GDP, and that we either cut Gov spending or raise taxes to make that happen? Let's say we want to hit Warren Buffett's target, so that we try to force that -10% to become Buffett's - 2.5% of GDP. Then we have choices.

We can force a zero trade balance, by refusing to import more than we export. But that still leaves us with the need to DECREASE the private balance surplus from 6% to 2.5% of GDP to get the Federal budget to a deficit 2.5%. This is a decline of 3.5% of GDP in savings the private sector might have had, if Mr. Buffett's deficit target was, say, - 6% of GDP.

There are other options here of course. We could leave the foreign sector balance where it is at 4% of GDP, and decrease the private sector balance to -1.5%, of GDP, actually increasing the private sector's debt by 1.5% of GDP. But, do we really want to do either of these first two options or anything in between?

I really don't think so. Do you? Why would we want a policy that would impoverish the private sector over time, or minimize its accumulation of nominal wealth? Is this really consistent with the public purpose?

So, is there any way we can retain those private sector savings of 6% and keep Buffett's recommended budget deficit of 2.5% of GDP? Yes, there is. We can decrease our imports and increase our exports so that the foreign sector has a negative trade balance. That is, we can get more income from trade than we spend on it by 3.5% of GDP, a shift of 7.5% of GDP from that -4% trade balance, placing the rest of the world in a trade deficit with us, provided we can increase our foreign sales (exports) by that much.

Of course, it would be very difficult for us to do that without engaging in a trade war since our attempt to decrease the foreign trade sector's balance so drastically and quickly would trigger such a war with all our major trading partners, who rely on trade surpluses with the US. There would be an international race to the bottom, which, for us to win, would require US companies to cut prices and costs to the bone in order to export more. This would be likely to result in lower wages, which, in turn, would be likely to reduce domestic sales, and tax revenues, leading a to a higher Government deficit which would work against Buffett's goal of a 2.5% budget deficit.

But getting back to eliminating the positive foreign sector balance through greater exports, the Government can neither do this for the private sector, nor maintain control over such a process once it starts. And, in any case, a change like this isn't beneficial in terms of adding to the real wealth of Americans, since even though imports cost money, they increase real benefits/wealth, as opposed to financial wealth. But that's a story for another time. [5]

For now the important thing is that the SFB model, tells us that trying to enforce a Federal Budget of 2.5% of GDP, would be a negative for the private balance, and a disaster for private sector accumulation of financial wealth over a period of years, unless we could develop a foreign sector balance surplus by selling more than we import.

Even more, if you think about it, you can see that if we want to save 6% in the private sector and import more than we export by 4%, then the Government would have to allow at least a 1.6T deficit in the coming fiscal year, and even better would not target the budget deficit at all, but just let it float against private savings and import desires.

However, assuming the President and Congress compromise on a deficit reduction plan, we may end up with a plan for this fiscal year that is $700 - $800 billion smaller than the Government deficit we ought to have if we want to support our savings and desires for more in imports than we can export. That's too bad, because it's likely that if Congress and the President passed a full payroll tax cut, a State Revenue sharing plan and a Federal Job Guarantee Program [6], then this could produce the additional $700 - $800 billion Government deficit [7] we need, given our current savings desires and import levels, to create a full employment economy.

The programs would cost more than that, of course, but we'd be spending a lot less in unemployment insurance, income support programs, Medicaid, and other welfare programs than we are now because of the effects of these other initiatives. So for an additional $700 - $800 billion in deficit spending we could have complete recovery from the crash and full employment, at last. We're crazy, and maybe evil, for not going for this, and letting more than 28 million people [8] looking for full-time jobs hang out there, instead.

Buffett adds:

All of America is waiting for Congress to offer a realistic and concrete plan for getting back to this fiscally sound path. Nothing less is acceptable.

And, he clearly thinks that his 2.5% deficit target is that more realistic and concrete plan for getting us to fiscal responsibility. But, unfortunately for him and all of us, it is a profoundly unrealistic plan, because it adopts a deficit target based on Buffett's expectations about reasonable growth in US GDP over time, and his belief that the debt-to-GDP ratio must go down and not up over time, which is what would happen if his deficit target of 2.5% was met.

However, the debt-to-GDP ratio is just a number. It has no causal relationship to government solvency in nations like the US, that have a non-convertible fiat currency, a floating exchange rate, and no debts in a currency not its own. So, fiscal responsibility in deficit spending has nothing to with the debt-to-GDP ratio, and nothing to do a 2.5% deficit target.

It depends, instead, completely on the impact of deficit spending on real things like employment, price stability, economic inequality, economic growth, and many other societal outcomes that are aspects of public purpose. To achieve good results in these areas we need, in our present rather stagnant economic state, much larger deficit spending than we currently have. And the advice that Mr. Buffett should be giving is that we ought to enact the MMT-based fiscal policy program mentioned above, and let the budget deficit float until we reach full employment.

At that point, when the private sector economy is strong enough to have hired away most people working for the job guarantee program, or receiving unemployment benefits, we can cut back government spending, further to avoid demand-pull inflation if, as expected, private sector savings desires, and the current account balance in the foreign sector both have declined as a percent of GDP. And, if they haven't, then we can just keep the deficit spending where it needs to be for full employment, without worrying about either government insolvency or demand-pull inflation, Mr Buffett and other austerians, notwithstanding.

(Cross-posted from New Economic Perspectives [9].)