In my recent ZeroHedge debate against MMT co-creator Randall Wray, there was a point where Wray invoked the “sectoral balance” approach to financial flows to argue that it was foolish to insist on a balanced government budget. Wray’s argument seemed airtight on the surface, but I want to spend the present post walking through its serious shortcomings. Although Wray’s national income tautologies are correct, they were extremely misleading (I assume unintentionally) in the way Wray deployed them. As we will see, it is perfectly reasonable for economists like me to warn about the dangers of government budget deficits; the sectoral balance accounting doesn’t prove me wrong.
Wray’s Argument
The relevant portion of the debate occurred from 1:01:00 through 1:06:30. Rather than quoting him verbatim, I will paraphrase Wray’s argument here, including a diagram. I assure the reader that this is a steelman (not a strawman) of Wray’s position, but by all means I encourage everyone to click the link and watch it to be sure.
Wray’s Step 1: Derive Sectoral Balance Identity From National Income
Using MMTer Bill Mitchell as a guide, we start with the two fundamental definitions of GDP, and show they together imply the sectoral balance identity.
GDP as expenditure (what is purchased):
Y = C + I + G + (X − M)
where Y is national output, C is private consumption, I is private investment, G is government spending, X is exports, and M is imports.
GDP as income (what is earned):
Y = C + S + T
where S is private saving and T is net taxes (taxes minus transfers).
Since both equal Y, set them equal:
C + I + G + (X − M) = C + S + T
Cancel C from both sides and rearrange to yield:
(S − I) + (T − G) + (M − X) = 0
This is the three-sector identity in surplus form. Each term is a sector’s financial surplus (receipts minus expenditures). They must sum to zero because every dollar of financial saving by one sector is a dollar of financial dissaving by another. An MMTer might interpret this identity as saying: “The domestic private sector surplus plus the government budget surplus plus the foreign sector surplus must sum to zero.”
Wray’s Step 2: Rearrange Terms to Isolate the Domestic Private Sector
Now we rearrange the identity to put the private sector balance on the left-hand side, and express it as a function of the other two sectors:
(S − I) = (G − T) + (X − M)
An MMTer might interpret the equation like this: “The private sector’s net financial surplus is equal to the government’s budget deficit (how much higher government spending G is than government taxes T) plus the US current account surplus (how much US exports X exceed US imports M).
(Incidentally, a quick note for purists: The letters (X-M) in these equations, as used in macroeconomics, would refer to a trade surplus, whereas strictly speaking they have to refer to a current account surplus for the sectoral balance argument to work. I’m not going to worry about that complication anymore in this blog post, but I did want to note it.)
Wray’s Step 3: Appeal to History to Pin Down the Alleged Danger of Government Frugality
After establishing the sectoral balance framework, Wray then appealed to history to say that the US was going to run a current account deficit for the foreseeable future. After all, we’ve had one since the Reagan Administration, and even Trump’s tariffs didn’t give us balanced trade.
So if we stipulate that the US will have a financial deficit with the rest of the world, then the only way the US private sector can itself have a financial surplus is if Uncle Sam runs a big enough budget deficit. In contrast, if we continue to assume that the US will run a current account deficit with foreigners, then if the federal government balanced its budget, it would mean the US private sector would necessarily have to spend more than it earned, i.e. it would have to experience a net financial deficit.
We can summarize Wray’s argument with this diagram:
To reiterate Wray’s punchline, using the colored boxes above: Unless the US somehow begins running a trade surplus (which Wray thinks is impossible in the near term), we need a government deficit in order to make the right-hand side positive. If instead the government balances the budget (or even worse, runs a surplus), then the green box on the left would have to itself be negative. That would mean net private financial saving was negative, or (as Wray put it in the ZeroHedge debate) the private sector in the aggregate would be spending more than it earned in income.
The apparent strength of Wray’s argument is that it’s independent of particular macroeconomic theories or “Keynesian multipliers.” No, the above conclusions result from basic accounting tautologies. This is why some MMT fans are so strident in online arguments; they think their fiscal hawk opponents are refusing to heed arithmetic.
Despite its ostensibly airtight foundation, Wray’s rhetorical demonstration suffers from two serious problems.
Problem #1 for Wray: A Balanced Government Budget Would Reduce the US Trade Deficit
In the first place, Wray wondering aloud how America could reduce its trade deficit is ironic, because in the textbook theory—that he no doubt derides—we would expect the US government balancing its budget (especially if done so via huge spending cuts) to lead to a sharp fall in the trade deficit.
There are two ways of seeing this. For a purely mechanical explanation, consider: If the Treasury slashes spending to the level of tax receipts, then the budget deficit drops to $0. The Treasury then has to issue no new bonds going forward. This huge reduction in the demand for loanable funds (denominated in USD) would lead to a drop in US interest rates, particularly Treasury yields. Other things equal, lower yields would make Treasury securities less attractive to foreign investors, and so they wouldn’t try to add as much to their portfolios. An investor in Japan, say, would no longer try to add $100 million in 10-year Treasuries to his portfolio, and so the yen he would have used to obtain the USD (and then the Treasuries) will instead try to fetch, say, euros. Hence the USD would fall against the yen, compared to the counterfactual where the US Treasury continued to issue trillions in new debt year after year. With a weaker USD, American exports would be more attractive to foreigners, and foreign imports would be less attractive to Americans. Hence the US trade deficit would fall.
Instead of the mechanical approach, we can also understand this outcome holistically. If the Treasury were to balance its budget, then foreigners would stop receiving a flow of new Treasury debt to add to their portfolios. If Americans aren’t giving them as many assets as before, then the rest of the world wouldn’t willing to send as many cars, TVs, and sweaters as before. To account for the sudden cessation of new Treasury debt flowing onto foreign balance sheets, Americans would need to send foreigners more exports (wheat, jet engines, software) than before, and foreigners would need to scale back how many cars, TVs, and sweaters they sent. In other words, the US trade deficit would shrink.
Thus we see that in a scenario where the US government slashed spending and balanced its budget, natural “textbook” forces would produce the move toward balanced trade that Wray finds implausible under current conditions.
Problem #2 for Wray: “Net Financial Saving” Isn’t Equivalent to Net Saving
However, the more fundamental problem with Wray’s analysis is the implicit assumption that the “Private Saving” green box in the diagram above is equivalent to people in the private sector “getting ahead” financially. As Stephanie Kelton provocatively put it on Twitter: “Their red ink makes our black ink possible.”
Let me dwell on this mindset for a moment, to make sure the reader understands how Wray (and Kelton) have fallen into a trap. Imagine Prudent Paula is trying to save for her retirement. She earns $100,000 a year but spends only $80,000 on her lifestyle. She dutifully sets aside $20,000 each year in savings. However, at the same time Spendthrift Sam earns $100,000 a year but takes a loan from Paula in order to spend $120,000 on his lifestyle. He sinks deeper into debt every year. Now it’s clear that the community of “Paula and Sam” are collectively treading water. Paula’s financial assets grow over time while Sam’s shrink.
Yet something similar happens even if every worker in the community tries to behave like Paula. If, for example, all of the workers put their savings into commercial banks, then their assets (i.e. their bank balances) are counterbalanced by the banks’ liabilities. If they instead lend money to corporations by buying bonds, the same pattern holds: the households’ assets are the corporations’ liabilities. Even if Paula uses her $20,000 annual savings to buy shares of corporate stock (i.e. an equity not a debt instrument), even so, in the standard accounting the private sector as a whole would have “zero net financial assets.”
In contrast, suppose the government runs a budget deficit, by spending more than it taxes, with the difference covered by floating new bonds. So for example, Paula can now use her $20,000 in saving to buy newly-issued Treasury notes. Paula’s gain in financial assets would be counterbalanced by the government’s increased liability, but the private sector as a whole can now accumulate net financial assets, since the debtor would lie outside the system. It is because of this accounting framework that Wray (and Kelton) think a balanced government budget would spell disaster for private sector households and firms.
But this is all nonsense, stemming from a confusion of financial assets versus real assets. For example, suppose Paula, Sam, and every other worker in the community saves $20,000 annually, and uses it to buy more corporate stock. The corporations then take the influx of cash and spend it on investment in more equipment, more factories, more trucks and planes, more oil wells, etc. Even if we ignore the government and foreign sectors completely, we can still have a bustling economy with high real GDP growth, fueled by private-sector saving and investment.
Yes, the accounting tautologies show that a pure domestic private sector would have to obey S=I (because the other two sectors would have a zero balance), but so what? The accounting doesn’t hold back private saving; it just insists that high private saving be exactly matched by high private investment. Since when is that a scary thing? How does this impede workers’ ability to provide for their retirement?
The quick answer is that it doesn’t. Wray (and Kelton) are earnestly misleading their fans by focusing on irrelevant details of accounting, while ignoring the underlying economic realities.
Conclusion
You don’t make an economy richer by having the government siphon real resources into political projects via deficit spending. The sectoral balance approach is correct—it’s based on accounting tautologies, after all—but in the hands of MMTers like Randall Wray, it can be extremely misleading. Our recent ZeroHedge debate showcased the danger.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together the dependability of Whole Life insurance policies with the benefits of blockchain-based finance.
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