A Better Way to Think about the “Twin Deficits”

(These remarks will be delivered today at the UBS European Conference in London.)

Q: These questions about deficits are usually cast as problems to be solved. You come from a different way of framing the issue, often referred to as MMT, which—at the risk of oversimplifying—says that we worry far too much about debt issuance. Can you help us understand where fears may be misplaced?

Wray: First let me say that I think the twin deficits argument is based on flawed logic.

It runs something like this: the government decides to spend too much, causing a budget deficit that competes with private borrowers, driving interest rates up. That appreciates the currency and causes a trade deficit.

The budget and trade deficits are unsustainable as both the private sector and the government sector rely on the supply of dollars lent by foreigners. At some point the Chinese and others will demand payment and/or sell out of dollars causing US rates to rise and the dollar to crash.

While that’s a simplified summary, I think it captures the main arguments.

Here’s the way I see it:

1. Overnight rates are set by the central bank; deficits raise them only if the central bank reacts to deficits by raising them.
2. Budget deficits result in net credits to bank reserves and hence put downward (not upward) pressure on overnight rates that is relieved by bond sales by the Fed and Treasury—or by paying interest on reserves. In other words, there’s no crowding out effect on rates. (Inaction lets rates fall.)
3. Budget deficits result from the nongovernment sector’s desire to net save government liabilities. So long as the nongovernment sector wants to net save government debt, the deficit is sustainable.
4. Current account deficits result from the rest of the world’s (ROW’s) desire to net save US dollar assets. So long as the ROW wants to accumulate dollars, the US trade deficit is sustainable. So there is a symmetry to the two deficits, but not the one usually supposed.
5. The US government does not borrow dollars from China. China’s net exports lead to accumulation of dollar reserves that are exchanged for higher earning Treasuries. If China did not run current account surpluses, she would not accumulate many Treasuries. All the dollars China has came from the US.
6. If the US did not run current account deficits, the Chinese and other foreigners would not accumulate many Treasuries. This shows that accumulation of Treasuries abroad has more to do with the trade deficit than with Uncle Sam’s borrowing. (Compare the US with Japan—where virtually all the Treasuries are held domestically.)
7. A sovereign government cannot run out of its own liabilities. All modern governments make and receive payments through their central banks. Government spending takes the form of a credit by the central bank to a private bank’s reserves, and a credit by the receiving bank to the account of the recipient. You cannot run out of balance sheet entries.
8. Affordability is not the question. The problem with too much government spending is that it diverts too many of the nation’s resources to the public sector—which causes inflation and leaves the private sector with too few resources.
9. So, no, I don’t worry about sovereign government debt if it is issued in domestic currency—although I do worry about inflation, and about excessive private sector debt as well as non-sovereign government debt.
10. To conclude: We’ve reversed the twin deficit logic and emphasized quantity adjustments. The twin deficits are the residuals that accommodate the desired net saving of the domestic private sector and the ROW, respectively.
11. Usually the domestic nongovernment sectors want to accumulate dollars so the only sector left to inject dollars is the US government. This means Uncle Sam runs a deficit because others want to accumulate dollars. The government also accommodates the portfolio desires of the nongovernment by swapping dollar reserves and bonds on demand.
12. Finally, if the ROW does not want dollars anymore, it can buy goods and services in the US. That will reduce the external deficit, stimulate domestic demand, and thereby reduce the fiscal deficit.