Moving on from the household budget analogy: part 1

Both sides of Australian politics are wedded to an analogy which relates fiscal policy to everyday household budgeting. In this world, “responsible economic management” means the consistent delivery of budget surpluses — or at least “balancing the budget over the business cycle.” Deficit spending is the government “drawing on the nation’s credit card,” and an ever-increasing public deficit is a “burden” to be borne by our grandchildren. Therefore, the government should “tighten its belt” and “live within its means” …

These claims are repeated by mainstream media outlets as though they are supported by reliable evidence. In fact, this view of the economy contradicts empirical evidence and is not shared even by the majority of economists.

In modern monetary theory, there are two fundamental differences between government and household budgets.

  • Governments don’t need to earn before they spend. A household which spends more than it earns will face bankruptcy once its savings and credit limit are exhausted. In contrast, government spending creates currency, and the government can run budget deficits indefinitely — especially when the economy is growing.
  • Governments cannot accumulate savings. Households usually invest their unspent income in the financial sector, because they need to accumulate wealth before they can spend it. When the government taxes more than it spends, the surplus is removed from the economy — unless the government spends it on infrastructure or a sovereign wealth fund. But governments don’t need surpluses to finance investment.

This post is the first in a series. To start with, I’ll describe a model for thinking about macroeconomics that replaces the household budget analogy. In later posts, I’ll use that model and ideas from modern monetary theory to justify the two claims above.

But first, a disclaimer: this discussion applies only to governments, like those in the the US, the UK and Australia, which are monetarily sovereign. Things are different when the government’s ability to spend its own currency is limited by a gold standard, fixed exchange rate or currency union. I discussed this previously in What caused the Eurozone debt crisis?

The pie model: an intuitive way to think about macroeconomics

At the level of the individual household and business, ‘responsible economic management’ means accumulating money, or nominal wealth. Nominal wealth is closely related to real wealth — the subjective value of real land, goods, labor, buildings, machines and experiences. Macroeconomics has a lot to say about how that relationship can change, but at the household level it’s relatively stable (most of the time). Households accumulate nominal wealth by spending less than 100% of their nominal income.

A change of perspective is needed to understand things at the macroeconomic level, because unlike households, governments can create nominal wealth. We need a new definition for ‘responsible economic management.’

Responsible governments should try to maximise the growth and stability of real wealth by controlling the quantity and distribution of nominal wealth.

You can think about the effect of government policy (and private sector behaviour) by using the mental image of a divisible pie that changes in size. The size of the pie represents national (or global, or regional) real wealth. The segments represent units of nominal currency (dollars, or billions or trillions of them circulating in the economy).

This $40b economy experienced real GDP growth of $8b (20%) and inflation of 5%, becoming a $50 billion economy. (Each segment represents $1b.)

Households always want to minimise spending, because it removes segments from their pie. Government spending is different: it increases the total number of segments in the pie (taxation removes segments). The link between the number of segments and the size of the pie is very complicated. A given level of government spending could increase real wealth in some circumstances and decrease it in others.

This is not to say that the government can or should control the economy. The private sector’s behaviour is probably even more important than the government’s in determining the size of the pie and distribution of the segments — and in endogenous money models the private sector can change the number of segments (money supply) too. We focus on the government not because it should control the economy, but because we can control the government.

All government action (and inaction) has some effect on the distribution of wealth. For example, deficit spending increases the number of segments in the pie. Economists who support government stimulus in recession conditions argue that because productive capacity is going unused, increasing the number of segments will increase the size of the pie.

On the other hand, if the behaviour of the private sector is already enlarging the pie as quickly as possible, adding more segments would increase inflation. Everyone has more money, but life isn’t actually any better. If the private sector was allocating spending more productively than the government, this would reduce the rate of growth of the pie, too.

When the government taxes more than it spends (fiscal surplus), some segments are removed from the pie. Since there are fewer dollars chasing after the same quantity of real wealth, we’d expect deflation. And if the private sector allocates spending more productively than the government, the pie should grow even faster.

Even if the budget is always strictly balanced, by deciding who is taxed and who receives the benefits of spending, the government alters the distribution of wealth. And because of feedback loops and changing trends in private sector behaviour, the distribution and growth of real wealth seems to be unstable anyway, meaning that by remaining neutral, the government endorses the changes it allows to go unmitigated.

We can think about the effect of government policy and private sector behaviour by adding ‘layers’ to the pie model which represent the distribution of wealth when the economy is divided into different sectors. We can divide the economy however we like: by industry, by income quintile, or even by gender. We can even define ‘the economy’ differently: usually as real national GDP, but the model applies equally to global GDP, the stock of national wealth, or the share of wages. The important thing is that we don’t mix up stocks and flows, that segments add up to 100%, and that we can find reliable data that measures the quantities we’re interested in. (Mathematically, we must define a partition of the ‘economy’ we have chosen.)

Layers showing the size of Australia's government in 2010-11 (in red, left) and Australia's income distribution by quintile in 2009-10 (right).

The government can use fiscal and monetary policy to change the number of slices the pie is divided into (mainly with monetary policy) and the number of slices controlled by different groups of people or industries (mainly using fiscal policy). Of course, what we really want the government to do is make the pie bigger, but both:

  • the way that government policy affects the number and distribution of slices (nominal GDP and income distribution); and
  • the way the number and distribution of slices affects the rate of growth of the pie (real GDP growth)

are poorly understood by governments and economists. All economic models are incomplete, and in most cases, they are also inconsistent both internally and with empirical data. That is okay, because economics is a complex science in its infancy — but politicians and economists frequently get away with using incomplete and inconsistent arguments to justify controversial policy decisions.

In the next post, I’ll look at why governments don’t need to earn before they spend, and consider when fiscal policy decisions like large budget deficits become unsustainable. If you’d like to jump ahead, you might want to read Bill Mitchell’s introduction to modern monetary theory using the business card analogy at Barnaby, better to walk before we run.

Data sources

  • Size of Australia’s government as proportion of GDP in 2010-11: A perspective on trends in Australian Government spending, Australian Treasury (pdf at p 29).
  • Distribution of Australia’s income by quintile in 2009-10: Household Income and Income Distribution, Australian Bureau of Statistics, 2011 (pdf at p16).

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