...against fictions and other tall tales

Saturday, 26 November 2011

Deficit myths (Part 3): The effect of budget deficits on business profits

Martin Wolf is right in saying that government fiscal tightening will hurt business profits. As Wolf correctly points out: "In order to reduce huge government deficits, surpluses must fall elsewhere".

For the UK, this means that the only way the government can succeed in balancing its budget is if the reduction in the government deficit is offset by a reduction of equivalent magnitude in the surplus of at least one other sector of the economy (i.e. household, corporate or foreign sector). And according to Wolf, the surplus sector that is most likely to be affected by the government's plan to reduce the deficit is the corporate sector because, at the moment, the household sector is not willing to incur additional debt (and fall back into deficit) and UK exporters are unlikely to reverse the flow of wealth currently exiting the UK economy (thereby reducing the surplus of foreigners).*

In a way, Wolf could just easily have argued that, in the UK right now, it is the government deficit that is enabling the corporate sector to run a surplus. And when households are deleveraging and exports are declining, business profits can only be realized if the government runs a deficit. Thus, by cutting the deficit, the government is in effect reducing an important source of business profits.

Proof of this direct, positive relationship between government deficits and business profits is best demonstrated by manipulating the basic national income accounting identity in a manner consistent with the approach of economists John Maynard Keynes and Michal Kalecki. The following arithmetic demonstrates that government deficits have a positive effect on business profits.

Let Y=Total Output; C=Consumption; I=Investment; G=Government Expenditures; X=Exports; M=Imports; T=Taxes; R=Retained Earnings by Firms; Hs=Household Net Savings

Let the combination of the above (X - M) = Current Account Balance or Net Exports; (G - T) = Government Deficit; (Hs + R) = (Y - T - C) = Total Net Private Savings

To start off, here is the basic national income identity, as taught in all macroeconomic textbooks:
Y = C + I + G + (X - M)

Subtract taxes (from both sides of the equation) to achieve an equation "net" of taxes:
Y - T = C + I + G + (X - M) - T

Rearrange the equation to isolate total net private savings on the left side and to subtract taxes from government expenditures:
Y - T - C = I + (G - T) + (X - M)

Since (Y - T - C) can be broken down into household net savings (Hs) and retained earnings by firms (R), the equation can be stated as follows (see Krugman, 1994:313):
(Hs + R) = I + (G + T) + (X - M) 

...and can be rearranged as such:
R = (I - Hs) + (G - T) + (X - M)

In plain English, this translates into:
Firms' Retained Earnings = Investment - Household Savings + Government Deficits + Net Exports

The above equation clearly demonstrates that business profits are positively impacted by government deficits, net exports and private sector investment.* Household net savings, on the other hand, have the effect of reducing firms' retained earnings. Similarly, balanced budgets and government surpluses have either no impact on profits or have the effect of reducing them.

One objection to this line of reasoning often invoked by economists is that government deficits increase the level of private sector savings (as households and businesses reduce consumption in anticipation of future tax increases). This claim is known as the Ricardian Equivalence proposition. However, there is little empirical evidence that this claim holds true and that the impact of government deficits gets neutralized (or offset) by a corresponding increase in private sector savings. As Douglas Bernheim argued in his seminal work on the topic:
...the case for long-run neutrality is extremely weak, in that it depends upon improbable assumptions that are either directly or indirectly falsified through empirical observation...[B]ehavioral evidence weighs heavily against the Ricardian view (1987:213)
To conclude, it should be emphasized that the purpose of economic policy is not to enable firms to realize profits, but to maximize employment and ensure that the product of industry is beneficial to the overall economy. Business profits, by creating an incentive for firms to invest and employ available resources, can help to promote these objectives. In the above analysis, my aim is to show that government deficits cannot be looked at in isolation from the financial positions of other sectors of the economy. Whether it is to stabilize aggregate demand or to provide for much needed public goods, deficits serve an important purpose. Attempting to reduce government deficits without considering its impact on the overall economy is not a sound basis for policy.

* Paul McCulley provided a similar analysis (2010).
** A different, yet equally effective approach to examining the relationship between profits and government deficits is found in Levy et al. (2008:16).


Bernheim, D., "Ricardian Equivalence: An Evaluation of Theory and Evidence", NBER Macroeconomics Annual 1987, S. Fischer, ed., Vol. 2, pp. 263-316, (Mass: MIT Press), 1987

Krugman, P., International Economics: Theory and Policy 3rd Ed., (New York:Harper-Collins), 1994

Levy, D., et al., Where Profits come from? Answering the Critical Question that Few Ever Ask, The Jerome Levy Forecasting Center, LLC, 2008

McCulley, P., Facts on the ground, Policy Note, Levy Institute of Bard College, 2010

Monday, 21 November 2011

Crescenzi watch: Public investments boost our standard of living

In a previous post, I criticized Tony Crescenzi, author of PIMCO's Global Central Bank Focus column, for depicting Keynesian-inspired policy remedies as wasteful and ineffective. So I was surprised to discover that the November edition of Crescenzi's column contains one of the most spirited pleas in favor of increased public investment that I have read in recent weeks.

Here is an excerpt from Crescenzi's column,
The vigor and verve with which Franklin Delano fought the Depression today is sorely lacking in Washington, which through its self-aggrandizing and ignorance spits with contempt at fires that rage across the U.S. economic landscape, leading Americans to feel anxious and helpless. This anxiety is present throughout the world, which perceives U.S. leadership to be adrift and intensely polarized. The same goes for European leaders. [...]

U.S. policymakers made one of their first serious blunders in this crisis in 2009 when they crafted an economic stimulus plan targeting consumption rather than investment. The benefits of the stimulus therefore faded rather quickly, which is to say the stimulus had a low or negative fiscal multiplier. The money would have been better spent on investments, which tend to have longer-lasting benefits that boost the national standard of living

Consider this example. When Uncle Sam divvies out stimulus checks to consumers it leads to increased purchases of pants, socks, shoes, a hamburger, a garden hose, you name it, but the purchase of these and other everyday essentials do nothing for America’s long-run growth potential. Investments, on the other hand, have longer-lasting benefits. Consider the benefit of investing in a highway, or an energy grid – it lasts years. In other words, an investment of this sort has a relatively high fiscal multiplier – it is the gift that keeps on giving. (emphasis added)
I agree entirely with this view of public investment. In fact, the papers by economists David Aschauer and Alicia Munnell linked to my previous post support the claim that public investment results in a net benefit to society in the long-run.

That said, I am a somewhat puzzled by Crescenzi's contention that the recent US federal stimulus did not significantly enhance the level of public investment. As you can see from the charts below, whether you look at total (federal, state and local) nondefense public investment as a percentage of gross domestic product (Chart 1) or public investment as a percentage of private nonresidential investment (Chart 2), the US federal stimulus initiated at the onset of the last recession resulted in a very large increase in public investment.

Chart 1: Public investment as a percentage of GDP, Source: St. Louis Fed

Chart 2: Public investment as a percent of private investment, Source: St. Louis Fed

Finally, in regard to Crescenzi's point about public investment being more effective than measures that boost private consumption, one could argue that government intervention aimed at increasing private consumption is not necessarily detrimental if it is accompanied by a decline in household indebtedness (see Chart 3). As the great economist and disciple of Keynes, Lorie Tarshis, once wrote in relation to remedies for recession (or Depression):
The general objective is clear: to increase employment, we must either increase the propensity to consume or increase investment. And, as a matter of fact, there is no reason why we should not try to increase both. (1947:570) (emphasis added)
But, on the whole, I am willing to agree with Crescenzi that, given the current state of US public infrastructure, increasing public investment would be more beneficial than measures aimed at increasing consumption.

Chart 3: Financial Obligations and Debt service to income, Source: St. Louis Fed


Tarshis, L., The Elements of Economics (Riverside Press: Cambridge), 1947

Wednesday, 16 November 2011

Inflation-targeting: Still the BoC's top priority

It's a shame this sort of discussion didn't occur during the last federal election. A debate on the renewal of the Bank of Canada's inflation-control target would have added much substance to what I thought was a particularly lame election. But what is even more regretful is that this discussion, it now turns out, got to take place only after the renewal of the five-year agreement became a fait accompli

That said, yesterday's session of the House of Commons Standing Committee on Finance aimed at discussing the merits of the renewal of the BoC's inflation target contained some good exchanges. The economists who were invited to present their views included Mario Seccareccia of the University of Ottawa, Scott Sumner of Bentley University, Jim Stanford of the Canadian Auto Workers Union, Chris Ragan of McGill University and Craig Alexander of TD Bank.

I was particularly pleased by the fact that the discussions were not limited to the renewal of the inflation target. Topics also touched upon included the role of fiscal policy, the current slowdown in the global economy, the actions of the Bank of Canada in recent years, as well as the state of Canada's manufacturing sector.

My views on the BoC's inflation target can be found here and here. Given that this type of conversation only occurs once every five years, I thought it might be appropriate to post it here (click on Play to hear the session) Enjoy.

Friday, 11 November 2011

Deficit myths (Part 2): The effect of deficits on macroeconomic stability

Paul Krugman is right in saying that the crisis in Europe has absolutely nothing to do with Europeans' preference for an extensive welfare state. As Krugman demonstrates, there is simply no reason to believe that the deterioration in the public finances of European nations now affected by the debt crisis was caused by the financial cost of welfare policies in those nations.

Indeed, I would add that the claim that welfare policies are somehow responsible for the current debt crisis in Europe is particularly implausible in the case of the Spanish government, which, prior to the financial crisis and ensuing recession, was actually running sizeable fiscal surpluses (see Chart 1). This fact alone should be sufficient to dispel the myth that the current European crisis was the result of uncontrolled and unsustainable government spending. (See Addendum below for data on Ireland and Iceland)

Chart 1: Cash Surplus/Deficit for Spain, Source: St. Louis Fed

In fact, in regard to the causes of macroeconomic instability, there is very little empirical evidence to support the view that public sector debt and deficits cause debt crises or have any significant impact on macroeconomic stability. This was demonstrated recently by the research staff of the International Monetary Fund (IMF) in the May 2010 edition of the IMF Fiscal Monitor (2010:67).

As you can see from the chart contained in the Fiscal Monitor (see below), the relationship between government debt as a percentage of GDP and macroeconomic volatility is extremely weak.* The reason for this is that financial crises can afflict nations with either small or large debt burdens. Examples of nations with relatively small debt burdens that were impacted by a financial crisis include those nations affected by the East Asian crisis in the late 90s.

Chart 2: Macroeconomic volatility and debt level, Source: IMF

* The purpose of the red horizontal line in the chart is to show that the level of volatility is more or less the same at any ratio of debt.


IMF, Fiscal Monitor: Navigating the fiscal challenges ahead, World Economic and Financial Surveys, May 2010

See here to read Part 1 of this series on deficit myths: The effect of deficits on interest rates

Addendum (added on November 11, 2011)

Central government debt: Ireland, Spain, Iceland, Source: St. Louis Fed

Central government surplus: Ireland, Spain, Iceland, Source: St. Louis Fed

Thursday, 10 November 2011

Bank reserves and credit creation

I agree with Joseph Laliberté, a French-speaking blogger out of Canada dedicated to MMT: there isn't much difference between Treasury bonds and commercial banks' reserves with the central bank. Other than the fact that one can be used as collateral, both share similar properties.

Also, more importantly, Laliberté makes a good observation when arguing that bank reserves aren't inherently inflationary. The reason for this is simple: in a modern banking system, contrary to what most students are taught in economics courses, the level of reserves held at commercial banks does not have a significant influence on the level of credit creation. This point was well described recently by economists Claudio Borio and Piti Disnyatat:
The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple...in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively. [...]
By the same token...an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. (2009:19) (original emphasis)
The point here is that lending decisions by banks are not based on the amount of reserves. Rather, bank lending depends in large part on whether banks can find a creditworthy borrower.


Borio, C and P. Disnyatat (2009): “Unconventional monetary policies: an appraisal” Bank for International Settlements Working Papers, No. 292.

Sunday, 6 November 2011

Canada needs a National Industrial Policy

The unemployment figures released by Statistics Canada this week are a huge disappointment. With employment in Canada declining by 54,000, all in full-time, and the national unemployment rate climbing by 0.2 percent to 7.3%, it is now clear that Canada was not able to avoid the current slowdown affecting the global economy.

But the most alarming part of October's Labour Force Survey are the figures relating to changes in employment in Ontario, one of Canada's most important industrial regions.

To put it bluntly, the figures are simply devastating. The loss of over 75,000 full-time jobs in Ontario, approximately half the amount of full-time jobs created during the last year in the province, represents a massive blow to Canada's economy. As a matter of comparison, even during the worst of the 2008-2009 downturn, full-time employment in Ontario did not once decline by this much within a single month. And the fact that part-time employment increased by 36,000 jobs in the province does nothing to attenuate the significance of October's decline in full-time positions.

There are two reasons why this turn of events should be of concern to Canadian policymakers. The first is that a rise in part-time jobs without at least some growth in full-time employment does little to improve the economy during a recovery. This is the case because part-time work is often temporary and usually not as high-paying as full-time work.

Another reason to be concerned about the sharp drop in full-time employment in Ontario is because of what it means for the province's manufacturing sector. Given that most of the losses in full-time work originated in the manufacturing sector, it is possible that the job losses are indicative of an acceleration in the decline of Canada's manufacturing sector. While the decline in manufacturing is nothing new (note: Canadian manufacturing has been losing jobs for six years straight, leaving its total employment for the last decade down 22 percent), there are reasons to believe that this trend has accelerated in recent years due to the strength of the Canadian dollar, which makes other nations' exports more competitive, and the drop in demand for Canadian manufactured goods such as automobiles, machinery and equipment. (Cross, 2011)

From a public policy standpoint, the decline in manufacturing has an important downside given that a nation's economy and productivity depends in large part on its manufacturing capacity. However, many policymakers erroneously believe that economies can thrive solely on their services sector. According to economist Ha-Joon Chang, this view is wrong because it disregards the link that exists between a nation's manufacturing capacity and productivity growth. Chang sums up the problem succinctly in the following excerpt of his most recent book:
...the shrinkage of the relative weight of the manufacturing sector has a negative impact on productivity growth. As the economy becomes dominated by the service sector, where productivity growth is slower, productivity growth for the whole economy will slow down. Unless we believe (as some do) that the countries experiencing de-industrialization are now rich enough not to need more productivity growth, productivity slowdown is something that countries should get worried about - or at least reconcile themselves to. (2010:97)
Given that productivity growth plays a critical part in improving our standard of living and quality of life, it would be wise for Canadian policymakers to view seriously any possible acceleration in manufacturing's decline.

One way to address this possibility and help counter any acceleration in the decline of Canada's manufacturing sector would be to put forth a national industrial policy. While some readers may recall that the federal government implemented a policy called Advantage Canada in 2007 to help promote Canadian industry, it should be mentioned that this strategy was abandoned when the federal government put forth the Canada Economic Action Plan, the stimulus package aimed at boosting the economy during the last recession.

To be sure, a national industrial policy should not aim at replacing the current Economic Action Plan. On the contrary, it would be appropriate for the policy to build on the combined success of the federal and provincial governments' stimulus measures, all of which made Canada's response to the recession one of the most effective countercyclical economic policies implemented by a major nation during the last recession. As shown in the chart below, as a result of these stimulus measures, Canada's ratio of fixed public investment as a percentage of gross domestic product now stands at the highest level in over three decades. The fact that Canadian unemployment did not rise too sharply during the last downturn is in good part a consequence of the significant increase in fixed public investment.

Therefore, instead of winding up the current Economic Action Plan, as the federal government appears to be doing as part of its strategy to reduce the deficit, the government should rather be shifting the focus from investing in public infrastructure to implementing measures that will enhance the competitiveness of Canadian industry and, more specifically, its manufacturing sector. Such a measure would be consistent with the approach taken by Canadian governments in recent years and an appropriate transitional policy at this stage in the recovery.


Chang, H-J., "23 things you didn't know about capitalism", (Bloomsbury Press, London), 2010

Cross, P.,  "2010 in review", Statistics Canada, Section 3, Canadian Economic Observer, April 2011