There's loads of money left

Michael Burke: The FT’s Martin Wolf has an interesting piece in yesterday's paper. He discusses the latest EU summit and highlights the impossibility of achieving the state objective of reducing fiscal deficits using the stated means, further cuts in government spending. This is because the government’s net lending or borrowing is simply the counterpart to all the other net lending or borrowing by the other sectors in the economy.

This point is illustrated in the graphic below (click image to enlarge), which shows three components: the net lending/borrowing of the private sector, the overseas sector and the governments in selected Euro Area economies. These are based on IMF data and projections. These must always sum to zero- there is no other sector that can lend or borrow to/from the rest of the economy. This argument has been made elsewhere.

The situation in relation to the Irish economy is stark. Despite much bluster about corners turned, roads to recovery, etc., Ireland still has the largest fiscal deficit in the whole of the Euro Area economies listed (third graphic on the right). Yet since the external sector is a net borrower Ireland, that is, there is a current account surplus (middle graphic) , along with government, then there must be a large surplus in the private sector. This is exactly what is shown in the first graphic, where Ireland has the largest private sector balance as a proportion of GDP, over 10%.

According to the CSO the gross savings of the domestic sector were over €18bn in 2010, and are €8bn in the first half of 2011. These totals include the government deficits.

But the net lending/borrowing of the private sector can by subdivided as between the corporate sector and the household sector. In any normally functioning market economy the household sectors designated role is as a net saver. The exception was in the run-up to the last bubble when it became a net borrower. The designated role of the corporate sector is as a net borrower, for the purposes of investment. (Banks are supposed to distribute these savings in an efficient manner to the most productive borrowers).

However, only the household sector is performing its role, saving €5.2bn in the first half of this year. The corporate is not performing as it should. It too is saving, €2bn so far this year and nearly €43bn in 2010.

It is this failure of the private sector to borrow to invest which shows up in the national accounts and the investment strike which is the cause of the slump. And, since one sector’s surplus must be recorded as another’s deficit, it is this borrowing and investment strike which leads to the public sector deficit.

The effect of government policy is to transfer incomes for the household sector by cutting benefits and raising taxes (and from the corporate sector by cutting the government’s own investment). This reduces the spending power of both the household sector and the corporate sector and provides an encouragement to the latter to increase its saving, precisely the opposite of what is required.

Instead, government could increase the incomes of both the household and corporate sectors by increasing its own investment (while also stopping any further cuts in their incomes via personal incomes taxes, levies like the USC and benefits cuts). It could take some of those savings from the corporate sector and investment them on its behalf. The consequent increase in economic activity would then oblige the corporate sector to gear up for recovery, by investing and borrowing on its own account. The resulting increase in employment/reduction in the welfare bill would see the public sector deficit decline. The degree to which that occurred would be entirely a function of how much idle savings were transferred into productive investment by government intervention.