As you read this, the final version of the $789 billion economic stimulus package has likely cleared Congress and has been signed by President Obama. You might be wondering where this money will come from.
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The national savings and investment identity helps us understand where the government gets the money it borrows. It tells us that government borrowing + private sector investment = private domestic savings + foreign investment. When we consider this, we find the money, if borrowed, can come from only three possible places.
The first possibility, on the right side of the equation, is that private domestic savings will increase. This is a legitimate possibility since fear over the duration and severity of the recession is likely to lead U.S. households to favor saving over spending. In fact, over the past year while the economy has been in recession, the U.S. savings rate has increased to its highest level since 2004.
When households deposit money into savings accounts, financial institutions make that money available for government borrowing through the purchase of government securities, and for private sector investment through loans and stock purchases. It’s unlikely, however, that private domestic savings will increase to the levels necessary to generate the money needed to finance the bailout and stimulus packages.
Part of the problem is that, during recessions, income levels tend to fall. While the savings rate may increase, there may be less actual dollars in savings. Moreover, those who lose their jobs may have to use savings to meet basic living expenses.
The second possibility, also on the right side of the equation, is that foreign investment might increase. The United States has run consistent trade deficits over the past few decades. You might wonder what happens to all that money we send overseas. The answer is it comes back in the form of foreign investment.
In 2007, the United States had a $739 billion trade deficit (with trade broadly defined) but a $741 billion surplus in its financial account. This means the value of goods and services imported into the United States (along with adjustments for net investment income and transfers) exceeded the value exported by $739 billion, but foreign investment in the United States exceeded U.S. investment in other nations by $741 billion. The $2 billion gap between these figures is explained by debt forgiveness.
Foreign investment refers to the purchase, by foreign individuals or entities, of U.S. government securities, stocks and bonds, or capital assets such as plants and equipment located in the United States. The portion of foreign investment that goes to government securities helps finance the U.S. budget deficit and national debt. A budget deficit occurs when the government spends more than it takes in, within a single year; the national debt is the accumulation of the annual budget deficits. The government gets the money to fund deficits by selling U.S. Treasury bills, bonds, and notes.
About 25 percent of the national debt is financed through foreign investment. The other 75 percent is held by U.S. individuals and entities. If you’ve ever owned a U.S. savings bond—congratulations, you owned a piece of the national debt. Your retirement account likely holds a good deal of the national debt, as well.
It’s unlikely that foreign investment will increase to the levels necessary to fund the bailout and stimulus packages. The U.S. government has run especially high budget deficits in recent years as a result of tax cuts implemented in the early 2000s; higher levels of spending on defense, including the wars in Iraq and Afghanistan; and increased spending on domestic programs. These have been financed by unusually high levels of foreign investment.
Since the current recession is worldwide, it’s unlikely that foreign investors will be willing and able to increase their investment in the United States significantly. Moreover, as income levels in the United States decline as a result of the recession, Americans will likely purchase fewer imported goods and services, meaning less money will be sent abroad to fund the foreign purchase of U.S. assets.
The third possibility comes from the left side of the savings and investment identity equation. Recall that government borrowing + private sector investment = private domestic savings + foreign investment. If private sector investment decreases, then government borrowing can increase by an equal amount without increasing either private domestic savings or foreign investment.
Most economists dismiss emotional arguments surrounding government borrowing, such as claims it will bankrupt future generations, because such arguments lack economic merit. But a legitimate concern recognized by most economists is that increased government borrowing could crowd out private sector investment
There is a finite amount of money available for combined government borrowing and private sector investment. An increase in resources allocated to one will result in a decrease in resources available to the other. So, government borrowing undertaken to lift the economy out of recession could actually make matters worse by cutting off funds available for private sector investment, thereby slowing economic growth.
There is another possibility outside the savings and investment identity: The government could simply print more money. This is quite probable, given that increased private domestic savings and foreign investment won’t likely produce the levels of funding necessary to finance the bailout and stimulus packages.
The problem is that printing more money—the classic definition of inflation—devalues it meaning prices go up and private domestic savings and foreign investment are discouraged. Despite the fears some economists have over price deflation, the current situation may in fact lead to higher levels of inflation and higher interest rates as banks begin to price risk and government and the private sector compete for scarce savings and investment funding.
If you have any questions on the economy, please contact the CER at (520) 515-5486 or email us at cer@cochise.edu. Be sure to check out the CER’s website at www.cochise.edu/cer.
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