Imagine you and are the only two people in an economy. For the sake of argument, say we use sea shells as a currency and we trade with no one else but each other. So when we do trade, we exchange goods and services with each other for the amount of sea shells these goods and services are worth. From an accounting perspective, it’s a wash; if you buy my goods, I get the sea shells and lose the goods of equivalent value and if I buy from you, you get the shells and I get the goods of equivalent value. So far, so good.
Now, let’s bring a third person into the mix, Harry. Harry is a foreigner with whom who we agree to do business. Where he’s from, he uses silver as his currency. No matter; in trading with Harry, we agree to an exchange rate between our sea shells and his silver and we are ready to go. Now, we can trade with each other and with Harry. If Harry buys from either of us, we get silver and he gets an equivalent value of goods. If we buy from Harry, he gets sea shells and we get the goods, also equivalent in value to the shells.
Notice that in both examples there is no value ‘leakage’ in the system. Everyone gets a fair deal, goods for a currency amount equivalent in value to those goods. So, from an accounting perspective, we can trade as much as we want with each other and with Harry and all that is being done is a transfer of goods, services and currency between us. That’s Econ 101.
Now, let’s introduce some deficits and debt into the scenario. For the sake of argument, let’s say that year in, year out we produce the same amount, the same value of stuff. However, in one particular year, you produce a lot of stuff – and I want to buy it.? The problem is that I produce less stuff that you want to buy.? What do we do?? I could issue you an I.O.U. and tell you I will pay you back sometime later. You accept the deal and now I have received the goods and services and you have received an equivalent value from the two sources, currency and the I.O.U.? Again, it is a wash from an accounting perspective. I have a deficit in this particular year and you have a surplus.
Now, even if we add Harry and his silver and foreign goods into the mix, it’s pretty much the same.? For example, if you bought some of Harry’s services but didn’t have enough sea shells to pay for it, you could issue an I.O.U. to him for the shortfall. You would have a deficit with Harry for the year and Harry would have a surplus with you for the year. So, even when we introduce debt and deficits into an economy, the accounting is the same; there is no value leakage.
The government, the private sector and the foreign sector
What holds in my little example for three people also holds for three groups of people too.? You could have 100 million people in a group that you represent that does trade with my group and Harry’s group and the accounting would be identical. So, let’s give our groups names. I am the government, you are the non-government sector and Harry is the foreign sector. The sea shells are the domestic currency and the silver represents foreign currencies.
- Me – government
- You – non-government sector
- Harry – foreign sector
- Sea Shells – domestic currency
- Silver – foreign currency
What should be clear from my example is that when the government has a deficit in any period, by definition the non-government sector (foreign plus private) must have a surplus of exactly the same amount.
Conclusion: the financial sectors must balance
Notice I haven’t talked about government as the creator of currency and the private sector as the user of currency. I haven’t focused on any misallocation of resource or malinvestment issues. I haven’t raised the spectre of inflation or currency depreciation. I have simply presented the economics and accounting of budget deficits.?
The other stuff is where the politics and the ideology come into play but the accounting of federal government deficits is clear. When the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. Draw your own conclusions about what this means in an era of government fiscal austerity.