Just ten years ago, the British economist Wynne Godley, distinguished scholar at the Levy Institute at the time, published a short policy note entitled “Some Unpleasant American Arithmetic”, which addressed the problems the American economy was going to face in the near future (for a more in-depth discussion, see this report he co-authored the same year with some Levy scholars). It is worth quoting one of the paragraphs in full:
The private sector balance was negative 2.2 percent in the first quarter of 2005 – some 4 percent below its long-term average – mainly because there has been a furious housing boom financed by exceptionally high borrowing. It is noteworthy that between 1952 and 1997, there was not a single whole year during which the private sector balance was negative. If, during the next four years, the private sector balance were to recover halfway to normal (i.e., to zero), implying a large fall in private expenditure relative to income, and if the deficit in the current account remains at 6 percent, the general government deficit must rise to equal the current account deficit, that is, it must rise to 6 percent. This number follows arithmetically because, as already pointed out, the budget deficit is equal, by definition, to the current account deficit plus the private sector balance. If the private sector balance were to return to its long-term average (plus 1.8 percent), as might easily happen if the housing boom were to collapse, the government deficit would have to rise to nearly 8 percent of GDP.
For readers not accustomed to financial balances language, remember that by definition the balances of the three main sectors of the economy (private, government and foreign) have to add up to zero. What Godley was saying then is that with a 2.2% deficit (as a percentage of GDP) in the private sector and a 6.0% deficit in the current account, then the government was at the time running a deficit of around 3.8%. Nothing surprising so far. But Godley’s point was that government budget forecasts, which were projecting to “cut the federal deficit in half during the next four years”, were simply untenable: as the previous paragraph shows, Godley was expecting something closer to a deficit of 8%, otherwise “United States will, at best, encounter a prolonged growth recession under the (conservative) stated assumptions about international trade and the private sector balance.” The balance of payments was a powerful constraint on the ability of government to cut its deficits, if a recession had to be avoided. And, as it happens, he was quite right about the gloomy prospects for the US, especially at a time when apparently the “state of macro” was good and depressions were supposed to be a thing of the past. Continue reading