Government Deficits and the Private Sector Balance

In an important series of columns in the Financial Times, economics editor Martin Wolf has been making the argument that – to avoid a relapse into recession – governments must run deficits so long as the private sector is running large surpluses of savings over spending.

“Jumps in fiscal deficits are the mirror image of retrenchment by battered private sectors. In the US, the financial balance of the private sector (the gap between income and expenditure) shifted from minus 2.1 per cent of GDP in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter of 2009, a swing of 8.8 per cent of GDP (see chart). This massive swing occurred despite the Federal Reserve’s efforts to sustain lending and spending. Similar shifts occurred in other crisis-hit countries.

If these governments had decided to balance their budgets, as many conservatives demand, two possible outcomes can be envisaged: the plausible one is that we would now be in the Great Depression redux; the fanciful one is that, despite huge increases in taxation or vast cuts in spending, the private sector would have borrowed and spent as if no crisis at all had happened. In other words, a massive fiscal tightening would actually expand the economy. This is to believe in magic.

….a massive fiscal tightening today would be a grave error. There is a huge risk – in my view, a certainty – that this would tip much of the world back into recession. The private sector must heal. That, not fiscal retrenchment, is the priority.”

What does this mean for Canada? A Chart in a later column by Wolf shows that we are at the low end of the OECD spectrum in terms of the shift in the private sector balance, but this swing is is still about 2% of GDP, 2007 to 2010, based on an OECD estimate.

Notwithstanding a recent surge in mortgage loans – which is likely to peak quite soon – the Canadian personal savings rate has doubled from 2.5% of disposable income in 2007 to about 5% in 2009 (4.9% in Q1; 5.5% in QII and 4.8% in QIII .)  Data from the financial flow accounts show that net borrowing by persons is running about $40 Billion below 2008 levels on an annualized basis. Corporations are running a somewhat smaller surplus, but are still major net lenders rather than borrowers. In short, if it were not for the sharp swing of the government sector from surplus to deficit, the recession would have been a good deal worse. Continuing to run deficits remains essential to recovery.

Hopefully Mr. Flaherty will use his Budget Speech to tell Canadians about the necessity of deficits when the private sector become net savers.


  • I fear the conservatives are much like their republican counterparts. The idea is to create a massive tax shortfall in-order to force a cut in “size of government.”

    The opposition parties need to stop being so timid and explain that tax increases and spending increasing are a necessity. But it would take a lot of air time to undo thirty years of preaching about the responsibility of tax and program spending cuts.

  • Andrew,

    Households are savers because of deficit spending — that’s the important causality insight from the Godley-Lavoie-inspired models and modern-monetary theories (MMT).

    For a nice counterpoint (critique) of a recent Wolf piece, see Bill Mitchell’s excellent blog post today:


  • Andrew, your third paragraph presents two extremes with no happy medium. I highly doubt we’d have seen an outcome as bad as the Great Depression without an extensive stimulus package. However, I also don’t think “a massive fiscal tightening would actually expand the economy.”

    I think deficits are more of an intertemporal problem. Sure, the spending helps us recover in the short run. The question is whether the short-term gain from running a deficit is worth the long-term pain of paying back our debt, or whether it’s easier to endure the short-term pain of running a balanced budget when the markets are doing poorly.

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