One the most popular narratives of the past four years is that government spending is directly responsible for the massive size of the deficit. While this is true to a point, it is an explanation that fails to account for the role of revenue.
There is much more evidence to show that the currently large deficits are caused by reduced revenue as a result of the private sector's lack of willingness to invest and spend.
Martin Wolf in the Financial Times looks at the recent economic downturn through the lens of a balance sheet recession: a recession where the economic actors are paying off debts and are actively deleveraging as opposed to investing.
This perspective helps to confirm what many have argued: as private sector spending decreases because of economic downturns, government revenues drop and deficits explode:
What does this picture tell us? First, the US has been a consistent net importer of capital, via its current account deficit. The foreign financial surplus has fallen since the crisis, but not that much. It looks baked into the structure of the US economy. Meanwhile, by definition, the private and government sectors have, in aggregate, been running a financial deficit. But the components of this aggregate domestic financial deficit have oscillated with the state of the economy.
In the recession of the early 1990s, the mild recession of the early 2000s and the “great recession” since 2007, the private sector has run either small or (in the last case) very large financial surpluses. The government’s position has been the mirror image: when the private sector has boomed, the government has been in financial surplus (as in the later 1990s). When the private sector spends more, relative to its income, the economy booms, the government’s revenue surges and its counter-cyclical spending shrinks; when the private sector spends less, the government’s revenue shrinks and its counter-cyclical spending rises. This happens without any deliberate government decisions. It is essentially automatic.
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The government’s deficit then exploded, almost without any decisions being taken (this being well before the impact of the Obama administration’s negligible stimulus package, of about 6 per cent of GDP over three years). The idea that the huge fiscal deficits of recent years have been the result of decisions taken by the current administration is nonsense. No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust.
