Each quarter, the Federal Reserve publishes the “Flow of Funds” accounts, which provide a summary of the conditions of the consolidated balance sheet of the United States and its constituent parts: households, nonfinancial businesses, financial intermediaries, and government. The U.S. national balance sheet continues to deteriorate, with a record $56.3 trillion in gross debt outstanding relative to $15.8 trillion in national income (GDP). At 357% of GDP, gross debt continues to set records relative to the size of the economy. Although this negative news is offset somewhat by the increased value of stocks and homes, the basic message to be drawn from the Fed data is that the economy is drowning in debt, nearly all of the recent increase of which has come from the Federal government.
Basic Keynesian models focus on expenditures rather than production as the key driver of economic activity. These models suggest that the basic problem with the current economy is excess savings. Yet, what’s been most interesting about the Obama years has been the way net national savings not only turned negative during the recession, but has remained negative since (see Figure 1). Gross national savings is the sum of household savings, the retained earnings of businesses, and the consolidated government (federal, state, and local) budget balance. In 2012, gross national savings totaled $1.98 trillion. During the same year, the depreciation of the existing capital stock was estimated to be $2.01 trillion. As a result, net savings (gross savings – depreciation) was -$31 billion. This means that the U.S. had to import $31 billion of capital from abroad simply to raise the funds necessary to replace depreciated assets and keep the capital stock from contracting.
Figure 1: U.S. Net Savings as a % of GDP
Keynes popularized the theory of the “paradox of thrift,” which argues that an increase in desired savings in excess of investment demand can lead to a reduction in income, which causes total savings to fall. The basic premise is that since economic activity is determined by expenditure, a fall in expenditures from an increase in desired savings reduces income, which, in turn, reduces the total amount of savings in the economy. Surely, households were overleveraged in 2008, when household debt reached an all-time record of 97% of GDP. As a result, it is perfectly understandable that the household current account balance (income relative to spending) shifted into positive territory in 2008 and has remained there since. Thanks to savings in excess of spending (and record defaults on mortgage debt), household debt is down to 80% of GDP, the lowest level since 2003.
Figure 2:U.S. Household Current Account Balance
But it’s not clear why this required household deleveraging could not be accommodated by other sectors of the economy. Ideally, nonfinancial businesses would use the extra savings generated by the household sector to make productivity-enhancing investment. This investment channel is all but ruled out by the pure Keynesian models, which assume that the business sector simply responds passively to households’ expenditures; each period, the amount produced by businesses is exactly the amount demanded. The problem is that businesses must invest and hire to have the capital necessary to meet household demand. The rate of this investment is generally determined by the financial condition of businesses, corporate profits, and the relationship between the expected return on capital and borrowing costs. The rate of business investment also determines payroll employment growth (see Figure 3).
Businesses’ balance sheets were healthy entering the crisis, with debt levels close to historical averages as share of GDP. After the initial shock of 2008-2009, it would have been reasonable to expect businesses to increase investment in both physical and human capital (i.e. hiring) substantially to take advantage of solid balance sheets, record low borrowing costs, and record profits. This could have been expected to create a virtuous cycle, as increased business spending and hiring boosts incomes, increases employment, and leads to growth in household demand. Instead, this virtuous cycle never materialized, as businesses simply either retained their profits and cash flow, or increased dividends and stock buybacks. As shown in Figure 4, nonfinancial businesses continue to run current account surpluses averaging 2% of GDP, as businesses hoard cash instead of hiring and investing.
Figure 3: Relationship Between Business Investment and Job Growth (JEC)
Figure 4:U.S. Nonfinancial Businesses Current Account Balance
Businesses reluctance to invest is understandable given the huge increase in government indebtedness during the Obama years. When the government issues debt, it creates future tax liabilities that must be financed by the private sector. The doubling of the publicly-held debt over the past four years to $12 trillion has increased the present value of future tax liabilities by $6 trillion. This increase comes in addition to the surge in future entitlement spending, which will create trillions of dollars in additional future tax liabilities. The problem is not only the size of the future tax burden, but the fact that the Obama Administration has not provided a plan to explain who is going to bear it. Until Washington reduces the size of the future burden through entitlement reform and determines what specific households and businesses are going to bear it through tax reform, investment and hiring are likely to remain muted.
