June 29, 2012

Frank Newman's Six Myths - #4: If the deficit is reduced, then national saving and investment will increase

Charles Perrottet
Partner

Today we examine the fourth “myth” from Frank Newman’s book Six Myths That Are Holding Back America – the presumption that increased saving will drive increased investment.

By definition, the government will reduce the deficit when it spends less than it receives.  Everything that the government receives comes from the private sector (either from taxes or the sale of Treasuries) and everything that it spends eventually finds its way back to the private sector.  If the government collects more than it spends it creates “Government Savings”.   On the other side of the equation, “Private Savings” will mirror this amount with a reduction equal to the increase in the government.  Thus a reduction in the deficit must lower the GDP and reduce private disposable income.  This is a good thing if the economy is in danger of overheating, which can happen in times of strong growth with full employment.  It will not, however, cause an increase in investment.

Let’s follow the money.  The government can reduce the deficit by reducing the amount of outstanding Treasuries.  It uses money received from taxes to buy back Treasuries without replacing them with new issues.  Since the money used to buy back the Treasuries has gone back to the public, the total amount of money in the system is unchanged.  Since the private sector has financed this, however, the amount of disposable money left available for investment has dropped.

(Incidentally, there is a widely reported “fact” that saving in the U.S. is comparatively low.  Some of the difference between saving rates in the U.S. and other countries is due to technical reasons in the way savings are computed in various countries.  Capital gains are excluded from “income” here, but taxes on those gains are included.  Also, imputed rent on owned housing is used rather than actual cash flows such as mortgage interest, real estate taxes and maintenance.  This is different in other countries.  After adjusting for these anomalies savings in 2009 would have been 15.5% compared to the 5.1% reported.  Further adjusting for the dissaving of retirees, it is estimated that American workers save over 20%.)

In summary, decreases in the deficit cannot cause investment.  Only perceived opportunities will drive investment, which will, in its turn, as we saw in the previous post, create savings.  During recessions, when the private sector is reducing its spending, the government can increase its deficit to stabilize the economy.  America does, however, need to avoid deficits during strong economies with full employment to avoid inflationary pressure.  But since nobody has created an accurate crystal ball,  organizations probably should use a tool that might look a whole lot like scenario planning to help them deal with future uncertainties. 

Next myth: “Deficits create great burdens of repayment and taxes for our children.”

Thoughts?