- Using the national savings and investment identity, we can determine if public consumption or private investment will suffer as a result of larger budget deficits.
- The quantity of financial capital supplied must equal the quantity of financial capital demanded.
- Private sector savings + inflows of capital (trade deficit) must equal private investment + the budget deficit.
- By running massive budget deficits, the government is locking in one of three options: enormous trade deficits, collapsing consumption, or plummeting private investment.
- The Federal Reserve cannot change this equation.
Theories can be proven true or false. Identities must always hold true.
The national savings and investment identity provides a critical framework to understand the flow of financial capital and determine the possible implications of increasing budget deficits.
Currently, many market participants are worried about the implications of massive government spending financed by debt. While this is a significant cause for concern based on the concepts outlined by the national savings and investment identity, using the well-studied formula, we can “game-out” all the various possibilities. Given that identities must hold, we know that re-arranging the equation below will set the stage for all the possible outcomes.
Starting with the conclusion first, by the government running massive budget deficits, we know one of three possible outcomes must come true. First, the trade deficit with other countries can rise massively, and those countries will recycle their trade surplus into US assets. Second, private sector savings can rise, which would lead to a decline in consumption. More savings equals less consumption. Lastly, private investment would have to plummet if option one and two do not come true.
In short, we need the foreign sector to continue yielding the United States their savings. Otherwise, we’ll need to compensate for a significant increase in the demand for financial capital with much lower domestic consumption or domestic investment, both of which are bad for real GDP growth.
National Savings & Investment Identity
The national savings and investment identity states that the supply of financial capital must equal the demand for financial capital.
A country’s total savings equals the savings of domestic households and domestic businesses plus government savings. If the government runs a budget deficit, this is dissavings. If a country runs a trade deficit, like the United States, that money flows back into the United States and is considered part of the supply of financial capital. Other countries are essentially yielding the United States their savings.
The demand for financial capital is the group borrowing money. The supply of financial capital comes from the group saving money.
Private businesses need to borrow capital for investment in plant, equipment, and other uses. The government can run a surplus, but this note is about the massive deficits run by the government, therefore putting the government in the camp of demanding financial capital.
The supply of financial capital comes from the private sector (household & business) savings as well as the savings of the foreign sector that flows back into the United States in the form of a trade deficit.
The image below shows the equation we need to follow.
Domestic savings + inflows = domestic investment + government borrowing.
We can rewrite the equation above to focus on government borrowing.
Government borrowing = domestic savings + inflows (trade deficit) – domestic investment.
We know that government borrowing is exploding, so, therefore, for the identity to hold, something on the right-hand side of the equation must change: savings (up), the trade deficit (up), or investment (down).
There is a growing fear that foreigners will stop buying US Treasury bonds. What does that mean? Well, it means the inflows of financial capital will drop, leading to either a surge in private savings (collapse in consumption) or a decline in private investment. Either outcome is negative for GDP because we cannot circumvent the concept that borrowing is stealing future consumption for current consumption.
The chart of net national savings below shows private sector savings + government savings (dissavings). The fact that net national savings as a percentage of GDP is likely to turn negative upon the release of full-year 2020 data must mean that investment will decline so that the supply of financial capital will equal the demand for financial capital. We can also see ballooning trade deficits to steal savings from other countries.
Net National Savings As A % of GDP:
Less domestic investment has long-run implications for productivity growth. By foregoing domestic investment in structures and equipment, productivity will assuredly slump for years to come, unless offset by some revolutionary technological breakthrough.
By running massive budget deficits, we are locking ourselves into massive trade deficits unless we want declining consumption (higher savings) or a lack of domestic investment. This identity must hold.
During World War II, government budget deficits were massive, but net national savings rose to compensate for the government’s dissavings.
Net National Savings As A % of GDP:
It was the private sector (household savings) that rose north of 25% that compensated for the decline in government savings or the rise in government dissavings.
Personal Savings Rate:
The national savings and investment identity must hold. The supply of financial capital must equal the demand for financial capital.
The Federal Reserve does not impact this equation, and thus QE has shown no impact on economic growth nor interest rates.
Quantitative Easing “QE” Does Not Impact The National Savings & Investment Identity
Let’s suppose the Federal Reserve engages in QE and buys a significant portion of Treasury bonds from the private sector. Will this change the national savings and investment identity and allow economic growth to continue without sufficient savings? No.
We know that private savings + foreign inflows must equal the budget deficit + private investment.
Let’s suppose foreign inflows were zero for the sake of this example.
That means that private savings must equal the budget deficit plus private investment.
We can rewrite this formula to say:
Private savings – Domestic investment = budget deficit.
If the budget deficit was $100 and private savings was $120, that means domestic investment equals $20.
The private sector has to save for both the government and for domestic investment, two sources of demand for financial capital.
If we double the budget deficit, now $200, private savings have to rise massively, which lowers consumption or investment has to decline.
Given that Treasury bonds are auctioned to the private sector, not the Federal Reserve directly, this process takes place before the Fed buys a bond in the open market.
Let’s say the private sector savings rises enough to compensate for the budget deficit and private investment.
So the budget deficit is now $200, savings is $220, and investment is $20.
The Federal Reserve now comes into the market and buys $200 worth of bonds from the private sector.
The private sector does not have a new $200 to increase consumption that was foregone for savings.
The Federal Reserve pays for these bonds with reserves, not money, which sits idle in the banking system and cannot leave. These are not spendable dollars that can be used back in the economy to offset the savings that needed to occur to absorb the budget deficits.
Consumption does not rise because the Federal Reserve swapped a bond for an overnight deposit (reserve).
Thus, QE has no impact on economic growth and cannot offset large budget deficits. The result in the real economy of the upcoming and lasting massive budget deficits will be a ballooning of the trade deficit, a collapse in consumption (increase in savings), or a decline in investment.
The latter two options are both detrimental to GDP in the short run. A rise in private savings is bad for the economy today (lower consumption) but good for the economy in the long-run (higher savings).
A decline in investment is bad for the economy today and in the future, as productivity growth is meaningfully impacted by strong and efficient investment.
This identity is generally why the net national savings rate tracks the rate of private investment in structures & equipment in the economy.
Note how this relationship was not meaningfully altered upon the introduction of QE.
Net National Savings Rate | Private Nonresidential Fixed Investment: Structures & Equipment As A % of GDP:
As net national savings turns lower and moves into negative territory, this shows us that private sector savings are insufficient to absorb the budget deficits.
We either have to rely on the foreign sector to cover our budget deficits or physical investment in the economy will plummet and impact productivity for years to come.
With governments around the world running massive deficits to fend off the impact of COIVD, and with world trade volume slowing, it is unclear that the foreign sector will supply enough capital and thus, the most likely outcome is we see a material decline in the rate of investment in structures and equipment.
Private Nonresidential Fixed Investment: Structures & Equipment As A % of GDP:
Interest rates will continue to fluctuate and have volatility depending on the expectations of inflation, tied to the movements in industrial commodity prices.
Over the long run, the lack of real economic growth and investment will weigh on total employment and total disposable income per capita. Productivity will be stuck in a sub-optimal range.
QE from the Fed does not eliminate the negative impact of growing budget deficits.
We cannot solve a debt problem with more debt, and the Federal Reserve cannot serve a free lunch.
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