Accounting identities are not behavioural rules

Chris Dillow says that there may be:
...a structural dearth of investment opportunities; even in the boom of 2007, firms had a large surplus. If this is the case, then a permanent large corporate surplus means permanent large government borrowing...government borrowing is - to a large extent - out of the government’s hands.
But this is an odd argument. It starts from the premise that:
government borrowing + corporate borrowing + household borrowing - net foreign lending = 0
Which is true, because by definition these things must add up.

From this, Chris infers that the government has no control over its borrowing, because after corporates, households and foreign investors have made their choices, the government will be stuck with whatever's left over.

This is untrue, however. It implies that all other actors have free choice and the government has none. In fact, the levels of borrowing are a negotiation between all the four parties in the above equation.

Imagine a simpler economy, with the only actors you and me. In just the same way, your net borrowing from me, plus my net borrowing from you, must also add to zero. If I lend you a tenner (-10), you've borrowed a tenner (+10).

This does not mean that if I want to lend, you have no choice but to borrow. What it means is, if you don't want to borrow, I'll have to reduce the interest rate I'm asking. Perhaps all the way to zero. Perhaps I'll even have to pay you a few pence to hold onto my money. Or perhaps, if you won't take it at any price, I'll just have to keep the tenner in my pocket.

In exactly the same way, if the government does not want to borrow, nobody can force it to. If companies want to save and there are not enough borrowers at current interest rates, those interest rates will just have to fall.

If market interest rates are at zero, and banks still can't lend the money out, companies will have to keep their money in deposit accounts instead. Or under the mattress.

If we do end up in such an extreme situation, it won't be much good for the economy. Money velocity will fall precipitously. This is Keynes's paradox of thrift, and is a reasonable argument for the government to keep borrowing and spending. But there are two alternatives to the situation we're now in:

  1. First, if the government has to spend money it could choose to spend on investment instead of consumption. This would have the same effect on circulation of money but would build a lasting wealth-creating asset base for the future.
  2. Second, as an alternative to borrowing at zero interest rates, the government could create higher inflation. This would force the real interest rate below zero, reducing the incentives for companies to hoard money and, eventually, stimulating private investment.
I'm not saying I particularly disagree with the UK (and US) government's current fiscal policy, which is largely based on deficit consumption spending. Just that they do have a choice in the matter, despite the apparent constraint of the accounting identity. Although they do create a constraint on prices (in this case interest rates), accounting identities do not control behaviour.


Min said…
I agree with your headline. However, I am not sure about your interpretation of what Dillow is saying.

Dillow: "The pessimistic reading is that the corporate sector’s reluctance to invest is not merely a temporary cyclical artefact but rather a sign of a structural dearth of investment opportunities;"

That may be so, in a sense, but puts the matter strangely. There may be plenty of opportunities that are simply not being taken advantage of. Better to say that there may be a structural reduction in investment, without assuming why.

Dillow: "even in the boom of 2007, firms had a large surplus. If this is the case, then a permanent large corporate surplus means permanent large government borrowing."

There are some unstated assumptions there, but that is more or less so.

Dillow: "I’m not at all sure which of these is right. But I know two things. One is that people are under-estimating the significance of the latter possibility. The other is that government borrowing is - to a large extent - out of the government’s hands."

He says, "I know two things." To me that suggests that these are not conclusions so much as assumptions.

In regard to government borrowing, I hope that he does not mean that corporate surpluses keep money out of government hands, so that the government has to borrow to finance its spending. As we know, the British government is the source of its money. Rather, the question is political. For the corporate sector to retain surpluses, the government has to run deficits, given the other assumptions he is making. A democratic government, as a government of and for the people, serves their interests, more or less. A capitalist democracy accommodates capitalists. (Not in the sense of capital vs. labour, but in a systemic sense.) The government is not an independent entity. It does not compete with the private sector for funding, but serves their needs. In that sense it is not in control of its borrowing.
chris said…
I don't think we differ here.
I am NOT saying that accounting identities are descriptions of behaviour. In principle, it could be that the corporate sector is running a surplus because government is borrowing. It just seems to me more plausible - and more consistent with other facts (eg low interest rates) that the causality is the other way round.
You are certainly correct that the government could run a surplus if it wanted. But as you say, its efforts to do so would be catastrophic for the economy; in terms of the accounting identity, they'd lead to a current account surplus (ie foreign net borrowing from us) because the economy would fall so far as to slash demand for imports.
When I say that the corporate surplus has caused the government deficit, I mean that this alternative is so horrific that government has preferred to borrow.
What's wrong with that?
Leigh Caldwell said…
Fair enough Chris. I must admit that, by the time I finished writing the post, I realised that was essentially what you meant.

However, do you agree that greater monetary stimulus would be an alternative way out of the situation, if the government didn't have other policy-based reasons to run a deficit?

Or equivalently, do you think there is any other way in which the corporate sector could be induced to borrow and invest? Presumably if companies would do that, then not only would it give government more freedom of movement, but also we'd probably get enough GDP growth to cure the cyclical deficit anyway.
Buen Post Sobre El Decline Estructural Economico.
chris said…
Yes - loose monetary policy (both price and access to finance) would help reduce the deficit, insofar as it encourages firms to invest.
My concern, thought is that capital spending responds only a little to interest rates in the narrow sense, as it is much more dependent upon animal spirits.
Where monetary policy might work is in influencing the latter. A long period of loose monetary policy might stimulate investment by fuelling hopes of a boom.

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