As was pointed out in the comment by Ralph Musgrave, there are negative connotations associated with the word “debt”; hence the political appeal of reducing government debt. But one of the basic principles of Stock-Flow Consistent modelling (and hence Modern Monetary Theory (MMT)) is that financial instruments end up on two entities’ balance sheets. Government debt is the flip side to the “net financial assets” of the non-government sector; and so attempts to reduce government debt if the private sector is attempting to increase savings is likely to end badly.
The chart above shows the “cash” holdings of the household business and sectors in my simulated economy. (All of the charts in this article are for the case where the “debt
limit” is non-binding.) The recession in year “0001” in the model was induced
by the household sector increasing its desire to save out of current income. I
do not think that this is the most typical cause of recessions, but it does
generate post-recession conditions similar to what is seen currently in the
United States. The stock of household sector savings rises steadily towards a new steady
state level. Since there are no other assets available within the model, the
implication is that government debt (the sum of household and
business sector “cash”) has to march higher. In other words, the demand for
financial assets forces the government to run a deficit to supply those
savings; absent a tax cut, the only way to provide those deficits is a
recession and then a period of too-high unemployment.
The cause of the recession is probably non-intuitive for
many people. It is often noted that “Savings = Investment” is an identity (a relationship that holds by definition), and so the
standard story runs:
Higher Household Savings -> Higher Investment -> Higher Future Growth.
This is often explained by “Robinson Crusoe” economies
involving one or two people who barter amongst themselves, and have to invest
to increase their productivity.
My model is very non-mainstream in this respect, and rising
personal savings is associated with weaker growth (and in fact causes the
recession). In a modern industrial economy, most
investment is undertaken by the business sector. The upward spike in personal savings does
imply increased investment initially – involuntary inventory investment, as seen in the above chart. In other words,
business have increasing amounts of unsold goods piling up on their shelves. (As
seen in the previous article, the inventory/sales ratio rises above the target
level, forcing cutbacks in production. There is no fixed investment within the model, just inventory investment.)
In mainstream models, there is
typically an assumption made that markets clear ("Y=C"), and such involuntary inventory
investment is by definition impossible. Since inventory investment is often
observed to be a contributor to recessions, this assumption appears to generate
unrealistic model behaviour.
Finally, my model does not attempt to deal with changes in
the prices of labour or goods (price levels are assumed to be constant). This
is probably too simplistic, but it represents the extreme end of the
Post-Keynesian modelling bias which argues that activity volumes are the major
source of adjustment to shocks, not changing prices. If the model incorporated
price changes in a more realistic fashion, my expectation is that the modelled
cash flows would not be changed by a large amount. This article by “circuit” at Fictional Reserve Barking
explains in more detail why the “Pigou effect” (deflation causing an increase
in activity) is viewed to have a limited impact on real activity.
(c) Brian Romanchuk 2013
On the effect of price changes, open economy implications may be more relevant, but then you get into the difficult question of how the exchange rate responds to price changes, i.e. will it tend to neutralise any price change or not.
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