The starting point is the budget identity: the sum of all budget positions in a country, public and private combined, is equal to the current account surplus or deficit. Separate out public and private and you get
Private budgets + Public budgets ≡ Current account
As a mental exercise, suppose the CA is fixed. In that case, if the public budget position increases by $1B (either a smaller deficit or larger surplus), the private budget position must fall by the same amount. Of course, no single component is fixed; they all change simultaneously in order to maintain the identity.
“Identity” is an important word here. What you see above is not an equation (with an equal sign), but an identity with an extra little bar. This means it is not a behavioral relationship, one which may or may not be true depending on how agents behave. It is an identity: it’s always true at every moment of every day, brought to you by the gods of accounting.
Since it has no behavioral content, it tells you nothing about what adjusts to what, or how. Nevertheless, it is a useful starting point—the most useful starting point.
Consider a first problem, adjustment. This arises when a deficit country (this refers to a CA deficit) is no longer sustainable. A crisis could take the form of a run on foreign exchange, or a sudden stop in external lending. A deficit country, by virtue of the budget identity, is a net borrower: its households, firms and government borrow more than domestic savers can finance. This exposes the country to the risk that external capital markets will shut down or become too expensive to access. Adjustment means that a country must do two things, which according to the identity are actually one thing: rapidly reduce the sum of public and private borrowing and reduce the current account deficit. Surplus countries don’t have to adjust; they are net lenders. They face default risk, but that can’t be remedied by changes in their own policies, at least not to a first approximation. (At a detailed level it depends on how large and connected they are.)
Keynes didn’t like this asymmetry of adjustment; he thought it lent a deflationary bias to the global economy. He was right, but there wasn’t anything he could do about it. This asymmetry is the dominant fact about the international financial system today as it was in his time.
Adjustment is what Greece and Hungary are going through right now, and what the other peripheral European countries are staring at.
Additional governments who are not threatened by adjustment are nevertheless planning to cut public (fiscal) deficits in the near term. Some of these are deficit countries like Britain, which is not completely crazy to worry about abandonment by international markets. Some are surplus countries like Germany, which is completely crazy (in this respect).
That brings us to the second problem. Recall that, if the CA is unchanged, any reduction in fiscal deficits must be offset by an increase in private deficits. There is no plausible mechanism for this, however. In fact, the most probable adjustment to preserve the identity will be the CA itself. If private borrowers do not change their behavior, or if they actually continue to deleverage, the logical sequence is that fiscal tightening will lead to a decline in national income and therefore a surplus or reduced deficit on the CA. In other words, the more elastic component of this identity is the external position, due to contractionary fiscal policy. But reductions in national income will also reduce public revenue, which means that the achieved reduction in the fiscal deficit will turn out to be less than the intended. To summarize, unless you can tell me why fiscal tightening (government spending cuts and tax increases) will cause households and businesses to become greater net borrowers, the tightening is offset instantaneously and unavoidably (this is an accounting identity after all) by some combination of automatic stabilizers and reduced imports, both due to a shrinking economy.
What does this mean for intelligent policy? First, Keynes was right: if the private sector has stopped borrowing, the public sector must leap in and take its place, and this must continue as long as the private sector remains skittish. If that imperative leads countries into the maw of adjustment—well, we need international institutions that spread adjustment across surplus and deficit countries alike, so that the contractionary impact on the latter is offset by the stimulative impact of the former.
Second, if lots of bad debts have been incurred, and if the amount of time it will take to wind them down and return to healthier levels of consumption and investment is too long, it is better that there be an orderly writeoff of a large chunk of the debt overhang. Alas, this was not central to the bailouts of the last two years as it should have been, even though the financial system had accumulated trillions of dollars in bad debt. Either we do this in a rational, civilized way, or the economy will sputter until default breaks out chaotically.
Unfortunately, the creditors are in command across the world economy and can think only of squeezing out every last cent of their assets.