It is like living in a dream—a very bad dream. Everything seems at once real and imaginary, serious and deliriously impossible. The language is familiar and incomprehensible. And it seems there is no waking up, ever.
I’m talking about the “debate” over America’s fiscal deficits, which is what I stumbled into after a night of much happier visions. Now, according to this morning’s New York Times, the left has weighed in with its own plans to achieve deficit stability. Of course, it is more reasonable than the pronunciamenti of the Simpson-Bowles cabal, with a wiser assortment of cuts and more progressive tax adjustments. Still, it is part of the same bizarre trance, disconnected from the basic laws of income accounting.
All you need to know is the fundamental identity. In its financial balance form, it appears as
Private Deficits + Public Deficits ≡ Current Account Balance
If the US runs, say, a 4% CA deficit, the sum of its net public and private deficits must equal 4%. You can’t alter this no matter how you juggle budgets.
Add to this one more piece of wisdom, which we should have learned from the past three years, even if we were blind to everything else: private debts matter as much as public ones. The indebtedness of households, corporations and financial entities can bring down the economy as readily as the profligacy of the public sector. In fact, in the grip of a crisis (which we have not yet escaped), private deficits are far harder to finance because of their greater default risk. That’s why governments slathered themselves with red ink: they borrowed to assume the debts that private parties could no longer bear.
So what does this mean for US fiscal deficits? Isn’t it obvious? Public deficits can be brought down only to the extent that the private willingness and capacity to borrow increases and current account (mostly trade) deficits shrink. There is still an important discussion to be had over the size and composition of revenues and expenditures, of course, but this is only about how, not how much. To put it differently, if private deficits and the external position of the US economy remain as they are, planned deficit reduction by the government cannot be realized. Revenues will fall along with spending, the economy will take a dive, and actual fiscal deficits will be unmoved. This is guaranteed by the laws of arithmetic, and you can see such a process happening in real time in the peripheral Eurozone countries.
What can break this fall? The current account constraint can be relaxed as falling incomes drive falling imports, but this entails an economic catastrophe unless devaluation can do the job instead. Or the borrowing capacity of the private sector can rise, but this is inconceivable in a collapsing economy. Or, facing the abyss, those who run the show can dispense with all the nonsense about fiscal prudence in isolation from surrounding economic conditions, and open the spigots once again.
My prediction: if there is deficit-cutting in the US of any sort before the private sector is prepared to take on more debt and, especially, approximate trade balance is restored, we will see exactly this third scenario. The economy will take a dive, political leaders (whether of the latté or tea persuasion) will spend like crazy, and fiscal deficits will be larger than ever. The deficit-cutting debate is delusional.