Some politicians (and economists) pretend that cutting spending and raising taxes will lead to budget balance. The argument is all too familiar in Britain. Indeed, it is the cornerstone of the ‘austerity drive’ and ‘fiscal compact’ that the Euro Area (EA) is currently adopting. In particular, Angela Merkel has promoted the notion that government profligacy is at the root of the EA’s problems. This view betrays near-total ignorance of how economies work.
Budget balance for a national economy is fundamentally different from that of the household or the firm. Why? Because budgetary (or fiscal) balance is one of three interconnected savings balances for the national economy. The other two fundamental economic balances are the current external account balance—or ‘current account’ (CA) for short—and the private sector savings-investment balance. If any one account is out of balance, an equal and opposite imbalance must exist for one or both of the remaining accounts.
An example (and some very simple algebra) will serve to illustrate the above principle. Let the domestic private sector savings balance (ie, private firms and households) be written as savings (S) minus investment (I), or simply (S – I), and government balance be written as tax receipts (T) minus total government spending (G), or (T – G). Let the external current account be written as exports (X) minus imports (M), or simply (X-M). It follows from national account definitions that: 
(S – I) + (T – G) = (X – M)
Current Account Imbalances
Furthermore, suppose that at the prevailing level of national income private domestic savings and investment are in balance—the (S-I) term equals zero—but that the current account is in deficit; ie, (X-M) is negative. It follows that the government account (T-G) must also be negative. The first point then is that:
- For a given level of national income, government cannot balance its own account unless the sum of other accounts is zero.
It is amazing how many politicians seem to be blissfully unaware of this principle.
The second point is nearly as important:
- If government ignores this national income principle and attempts to balance the budget by cutting spending and/or raising taxes, national income must fall.
A cut in government spending, or in private spending because of higher taxes, will cause the economy to shrink. Moreover, as a result of shrinking national income, tax receipts will fall and unemployment spending rise, causing the situation to worsen; ie, the Greek, Portuguese, Irish, Spanish and UK recession experiences. Of course, if national income falls far enough, external equilibrium may be restored through greatly reduced absorption—but half the workforce may be rendered destitute in the process.
The German and Anglo-Saxon Cases
It is useful to use the above ‘savings identity’ framework for thinking about different country experiences. For example, the German and US cases are similar in one sense—both have returned to growth while real wages remain depressed—but quite different in another—- the US has an enormous trade deficit while Germany has a large surplus.
As is generally recognised, well before the great recession of 2008, in the US (as in the UK) domestic private savings was deficient—indeed, in many households savings turned negative as workers—whose real wages had stagnated for decades—sought to maintain their consumption by recourse to cheap credit. Simultaneously, the US ran a large external deficit largely financed by Asian savings, while the UK ran a smaller visible trade deficit partly financed by foreign capital inflows.
In the Anglo-Saxon world, the government balance was negative well before the recession; it is not simply the banking bailout that explains high gross debt-to-GDP ratios in the Anglo-Saxon world.
In the US, instead of cutting public expenditure drastically—what might be called the ‘Tea Party’ strategy—the US administration has tried to escape recession by applying an economic stimulus package. Economists may disagree about whether the stimulus has been large enough, but at least the US economy seems to be growing again—in contrast to the UK which has adopted the ‘European austerity’ approach.
Germany went into the 2008 recession as Europe’s powerhouse, and although output suffered for a time, strong export-led growth allowed the economy to recover. Growth was export-led in part because tight wage discipline restrained domestic demand and in part because the euro has kept its exports more competitive than would have been the case under the DM. Two years ago, however, Ms Merkel’s ‘grand coalition’ government adopted the ‘debt brake’ law, which makes budget balance over the trade cycle legally binding.
Looking at the savings-balances identity set out above provides an important insight into why the ‘debt brake’ has been possible in Germany. Given that (S-I) on left side and (X-M) on the right side are both positive, their near equivalence allows (T-G) to be zero (or even slightly positive) at the given level of output and employment. This of course could not be the case if (X-M) were negative—in reality, the debt-brake constitutionally commits Germany to its export-led growth model.
The Rest of Europe
By extension, it should be apparent that Germany’s debt-brake cannot be good (or even feasible) for the rest of the EA, which is why the ‘Fiscal Compact’, requiring all member states to adopt a similar law, is being so vigorously opposed by the French PS. Why? For three reasons: first, Germany’s exports to the EA are (by definition) another member state’s imports. Secondly, even if all member states could become net exporters to the rest of the world, there is insufficient aggregate demand in the world economy to absorb the extra exports. Thirdly, the debt-brake approach totally ignores private indebtedness; ie, the over-leveraged nature of the banking sector.
With the exception of the Greek case, ‘fiscal irresponsibility’ cannot be blamed for the EA debt crisis. Ireland’s public finances were in good shape before the crisis, but its private banking sector had run up enormous debt—which the government guaranteed in 2008 to save the financial sector causing the public debt ratio to double at a stroke. Spain’s problem was much the same: a huge private property bubble over-stretched its private banks, particularly its caixas.
Portugal’s public deficit in 2008 was only 3.7% of GDP, while Italy’s debt/GDP ratio, traditionally quite high, had not risen for a decade while its private sector was relatively free of debt. But in all these cases, the 2008 recession caused GDP to fall—which by definition raised the public debt/GDP ratio. As Richard Koo has argued in a seminal paper, cutting public expenditure at a time when the private sector is trying to rebuild its balance sheet makes things worse, not better.
The national accounting identities set out above are not Keynesian in themselves. The most important Keynesian argument for present purposes is the one he put forward in 1944 at Bretton Woods. Keynes tried—and failed—to establish an international payments system based on a separate trading currency (bancor), and equally, he envisaged an IMF which would have the power not merely to impose conditionality on countries experiencing external deficits, but equally on those—like Germany and China today—running excessive external surpluses.
Underlying Europe’s private and public financial crisis is a balance of payments crisis. The market has failed to channel trade surpluses into capital flows to the periphery designed to raise their investment in export productivity—any more than it did in the 1920s and 1930s. To address the critical problem of trade imbalances, the EA will require far stronger institutions. Europe needs both growth and trade balance. An ill-considered Fiscal Compact which imposes economic contraction is certainly not the answer—-neither for those EA countries under growing pressure from financial markets nor in the long term for Germany itself.
 An excellent short rebuttal is to be found in a recent speech by Lord Skidelsky to the Lords: see http://www.theyworkforyou.com/lords/?id=2012-04-25a.1834.4&s=speaker%3A13463#g1840.0
 To keep things simple I shall not derive the above identity from first principles—a derivation can be found in any basic macro textbook. Nor shall I consider budget balancing mechanisms ‘over the cycle’.
 This was Obama’s $878bn package in 2009. See Christina Romer’s paper (2011) at: http://elsa.berkeley.edu/~cromer/Written%20Version%20of%20Effects%20of%20Fiscal%20Policy.pdf