Why Governments Can’t Choose to Run Balanced Budgets #2

I’ve been banging on recently about the importance of a country’s trade balance, which is usually overlooked, in any discussion about the government’s budget balance. If we look at countries who do have a strong trade surplus, like Germany, Norway and China,  then invariably they have a government budget surplus too.

So, it could be argued that Governments can choose to be like Germany and China if not Norway. However, I would argue that the economic composition of any country is not entirely within governmental control. Conceivably it would be possible for the US or UK governments to end the sale of their treasury bonds , to overseas buyers, but it certainly is not realistic. Neither would it be realistic for either the British or US Governments to impose trading restrictions in contravention of international agreements.

I did receive this comment:

“But your point  {the link between the trade  and budget balance} is nonsense anyway.  Y=C+I+G-T+X-M. You are not accounting for C and I in your comment. You learn this in A Level economics -which is pretty basic.”

Anyone can Google this equation to establish its validity. It is OK

(Y=national income , C=domestic household consumption of goods and services , I=domestic real investment, G=government spending, T= Taxation, X, = exports of goods and services , M= import of goods and services)

I must say that it’s not immediately apparent, at least to me,  why this equation settles the argument one way or the other, but let’s see:

We can define S=Y-C where S is the level of savings
Then rearrange the terms to give

(I – S) + (G – T) + (X – M) = 0

or by multiplying throughout by -1 we get:

(S-I) +(T-G) + (M-X) =0

This now makes the equation much easier to understand. We can now say:

Domestic Private Balance + Government Balance + Rest Of World Balance = 0

This relationship holds for any time period, and it may help to think of changes during a one year span. So the word balance can be read as either deficit or surplus.

For the UK we can say:
The second term is negative (the Govt have a deficit)
The third term is positive  (the ROW sell more than they buy)

For countries like Germany and Norway:
The second term is positive (Govts have a surplus)
The third term is negative ( ROW buy more than they sell)

Of course the Government and ROW surpluses don’t have to be exactly equal and opposite, Slight out of balance amounts can be accounted for by the private sector increasing or decreasing their balance.

So we can say that the second and third terms when added together have to produce a small number which is within the capabilities of the private sector to correct. If it is too large a negative number the private sector accumulates financial assets but that leads to high inflation.

If too large a positive number, which it would be if the UK tried to run a budget surplus, or even too small a budget deficit, without addressing the trade imbalance, the private sector would quickly become impoverished leading to recession.

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