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					April 10, 2012


Economics Group

Special Commentary


                                                                                                 Jay Bryson, Global Economist
                                                                                         jay.bryson@wellsfargo.com ● (704) 383-3518
                                                                                                   Joe Seydl, Economic Analyst
                                                                                        joseph.seydl@wellsfargo.com ● (704) 715-1488



Fiscal Consolidation in a Flow-of-Funds Framework
Executive Summary
As the U.S. economy continues to gain momentum, attention has shifted among policymakers
toward reducing deficits in the public sector. Indeed, both President Obama’s and Representative
Paul Ryan’s recent budget blueprints call for significant deficit reduction this decade. In the first
of two special reports on deficit reduction, we assess the evolution of public sector deficits from
the perspective of a flow-of-funds accounting framework. By definition, deficit reduction in the
public sector must be offset by less saving from some combination of U.S. households, U.S.
businesses and the rest of the world.
During “normal” times, changes in private-sector behavior and in prices, interest rates and
exchange rates facilitate the required changes that must take place in saving flows among sectors.
However, there may currently be some impediments that could retard adjustment. Households
may desire to keep their saving rates elevated to repair battered balance sheets, and businesses
may choose to remain in cash-hoarding mode. The adjustment toward a smaller current account
deficit, which implies fewer capital inflows from abroad, could be hampered by attempts of
foreign governments to prevent their currencies from appreciating against the dollar. The
U.S. economy could then become trapped in a vicious cycle of fiscal consolidation that leads to
private-sector retrenchment and weak export growth, which is followed by further fiscal
consolidation and then by further retrenchment and even weaker export growth.
Will fiscal tightening in the United States lead to such a vicious cycle? In a subsequent report, we
will examine the fiscal consolidation that is currently underway in the United Kingdom to
ascertain what lessons that experience may hold for the United States.
Public Sector Deficits in a Flow-of-Funds Framework
The proposed budget for fiscal year 2013 as well as for future years that President Obama recently
released projects red ink in the federal government’s accounts as far as the eye can see. For
example, the federal deficit, which will likely exceed 8 percent of GDP in the current fiscal year, is
expected to total more than 5 percent of GDP in FY 2013 (Figure 1). Although the budget                     The federal deficit
blueprint projects that deficits will recede to 3 percent of GDP in the latter years of the current         will likely exceed
decade, the shortfall of revenues from expenditures at the federal level will still total hundreds of       8 percent of GDP in
billions of dollars each year. Congressman Paul Ryan’s fiscal year 2013 budget proposal, which              the current fiscal
was released in March, goes even further. Ryan would cut the federal budget deficit to around               year.
one percent of GDP by the end of the decade, although the means by which he would achieve
deficit reduction differ sharply from the spending reductions and revenue increases that President
Obama would employ. At the state level of government, budget gaps are expected to improve
noticeably over the next few years, but shortfalls will likely still persist through fiscal year 2014
(Figure 2).




 This report is available on wellsfargo.com/economics and on Bloomberg WFEC.
 Fiscal Consolidation in a Flow-of-Funds Framework                                                                  WELLS FARGO SECURITIES, LLC
 April 10, 2012                                                                                                              ECONOMICS GROUP


Dissaving in one       While there are numerous political and economic reasons why fiscal deficits in the public sector
sector of the          have persisted as long as they have, it is useful to think of public sector deficits within the context
economy must be        of a basic flow-of-funds accounting framework. That is, dissaving in one sector of the
met by saving in       economy—the federal government is currently a dissaver because it spends more than it collects
another sector of      in revenue—must be met by net positive saving in another sector of the economy.
the economy.
                       Figure 1                                                                         Figure 2
                                       Federal Budget Deficit Projections                                                 Cumulative State Budget Gaps
                                                 Deficit as a Percentage of GDP                                                      Fiscal Years, Billions of Dollars
                       10%                                                                        10%   $200                                                                                 $200
                                                                      Fiscal Year 2013 Budget                            Cumulative State Budget Gaps: 2011 @ $91.0 B
                           9%                                         Fiscal Year 2012 Budget     9%    $180                                                                                 $180

                           8%                                                                     8%    $160                                                                                 $160

                           7%                                                                     7%    $140                                                                                 $140

                           6%                                                                     6%    $120                                                                                 $120

                           5%                                                                     5%    $100                                                                                 $100

                           4%                                                                     4%    $80                                                                                  $80

                           3%                                                                     3%    $60                                                                                  $60

                           2%                                                                     2%    $40                                                                                  $40

                           1%                                                                     1%    $20                                  No                                              $20
                                                                                                                                            Data
                           0%                                                                     0%     $0                                                                                  $0
                                2012      2013         2014        2015           2016     2017                02   03     04   05     06    07     08    09    10       11   12   13   14



                       Source: Office of Mgmt. and Budget, National Conf. of State Legislatures and Wells Fargo Securities, LLC

                       Consider a simple two-person economy. If person A wants to spend more than (s)he earns, then
                       (s)he must borrow from person B. Total net saving in this simple two-person economy must
                       always equal zero: the borrowing (i.e., the dissaving) of person A must be exactly offset by the
                       saving of person B. This same logic applies to an infinitely more complex economy such as the
                       U.S. economy. That is, if the federal government decides to incur a fiscal deficit (i.e., dissave),
                       then it must borrow the shortfall of its revenues from its expenditures from some combination of
                       U.S. households, U.S. businesses and the rest of the world.
                       The experience of the past decade is a useful illustration of how the accounting identity for saving
The experience of      flows in the U.S. economy works in reality and over time. The U.S. household sector entered the
the past decade is a   new millennium as a dissaver (Figure 3). 1 That is, the rather low personal saving rate at the time
useful illustration    in conjunction with fairly robust residential investment made American households net
of how the             borrowers. 2 Due to the robust rate of capital investment at that time, the business sector was also
accounting identity    a net borrower. This net borrowing by the household and business sectors was financed by capital
for saving flows in    inflows from the rest of the world—the United States incurred a current account deficit that was
the U.S. economy       equivalent to 4.3 percent of GDP in 2000—and by the budget surplus of the public sector that
works.                 made the public sector a net saver. 3 However, as the economy slid into recession in 2001 and as
                       the Bush tax cuts kicked in, the surplus of the federal government quickly disappeared, leading
                       the public sector to become a large dissaver by 2003.
                       Initially, the red ink in the public sector’s accounts in the early years of the past decade was
                       financed largely by the business sector, which became a net saver in late-2001. Although business



                       1 Net saving in each sector in Figure 3 is calculated by subtracting capital transfers and capital
                       consumption from gross saving. Saving in the U.S. private business sector is simply the sum of saving in
                       the U.S. nonfinancial business sector and the U.S. domestic financial sector. The U.S. public sector
                       includes saving at the federal, state and local levels of government.
                       2 The personal saving rate fell from about 7 percent at the beginning of the 1990s to about 3 percent in
                       1999. Housing starts trended up from 1.0 million units in 1991 to more than 1.6 million in 1999.
                       3 The astute reader will notice that the sum of net saving in each sector shown in Figure 3 does not equal
                       zero. This is because of a statistical discrepancy, which is evident each quarter. This statistical
                       discrepancy, however, is small and averages only 0.26 percent of GDP when considering data back to
                       1960.




  2
Fiscal Consolidation in a Flow-of-Funds Framework                                  WELLS FARGO SECURITIES, LLC
April 10, 2012                                                                              ECONOMICS GROUP


profits weakened significantly during the 2001 recession, capital investment plunged. 4 Beginning
in 2004, the government’s fiscal situation stabilized and started to improve gradually, but by then
the housing bubble was beginning to inflate and residential investment was skyrocketing. This
increased demand for financing by the U.S. household sector was financed, at least in part, by the
rest of the world. Net capital inflows from abroad rose to 6 percent in 2006 from about 4 percent
of GDP in 2003.
Figure 3

                         Net Saving By Sector - Identity
                                  Balance, Percent of Nominal GDP
         8%                                                                           8%




         4%                                                                           4%




         0%                                                                           0%




        -4%                                                                           -4%




        -8%         U.S. Private Business Sector: Q4 @ 2.96%                          -8%
                    U.S. Households & Nonprofits: Q4 @ 2.90%
                    Rest of World: Q4 @ 2.71%
                    U.S. Public Sector: Q4 @ -8.10%
       -12%                                                                           -12%
           1990       1993     1996      1999     2002      2005     2008      2011

Source: U.S. Department of Commerce, Federal Reserve Board and Wells Fargo Securities, LLC
As is well known, the subsequent bursting of the U.S. housing bubble ultimately contributed to        At the federal level,
the financial collapse of 2008. As the economy plunged into a very deep recession in 2008-2009,       revenues as a
the revenues of the public sector dried up, leading to large fiscal deficits. At the federal level,   percentage of GDP
revenues as a percentage of GDP dropped to 14.7 percent in 2009 from 18.5 percent of GDP in           dropped to
2007. In addition, the American Recovery and Reinvestment Act of 2009 (i.e., the stimulus             14.7 percent in
program) added to the red ink in the federal government’s accounts. States were also struggling       2009 from 18.5
with combined budget shortfalls that shot up to more than $100 billion in FY 2009 and nearly          percent of GDP in
$200 billion in FY 2010 (Figure 2).                                                                   2007.
How did the public sector finance its dissaving? Net capital inflows from abroad weakened a bit in
2009, but they remained positive. However, the bulk of the government’s financing needs were
taken up by the business and household sectors. Not only did the deep recession cause the
personal saving rate of the household sector to shoot up to 5.4 percent of disposable income in
2008 from 2.4 percent in 2007, but the collapse of the housing bubble also led to a collapse in
residential investment, which tumbled 24 percent over the same period. By early 2008, the
American household sector had become a net saver for the first time since 1998. In addition, the
business sector slashed capital spending again and started to build cash reserves on its collective


4 Corporate profits fell 8 percent between 1999 and 2001, and business fixed investment spending
tumbled nearly 15 percent between its peak in late-2000 and its trough in early 2003.




                                                                                                                       3
 Fiscal Consolidation in a Flow-of-Funds Framework                                                                    WELLS FARGO SECURITIES, LLC
 April 10, 2012                                                                                                                ECONOMICS GROUP


                       balance sheet. Today, the gaping budget deficits of the public sector continue to be financed by a
                       combination of saving from the rest of the world and saving from the U.S. private sector.
                       Fiscal Consolidation: Sectoral Adjustment in Theory
The red ink in the     Most reasonable people agree that the federal government needs to shrink its fiscal deficits in the
public sector’s        coming years. Indeed, the red ink in the public sector’s accounts will likely recede somewhat,
accounts will likely   either by default or by choice. 5 Although the government is not likely to become a net saver
recede somewhat in     anytime soon, its rate of dissaving will drop, as the deficits recede. Keeping the flow-of-funds
the coming years,      accounting framework in mind, a decline in the rate of dissaving by the public sector must be
either by default or   offset by a decline in the saving rate of at least one other sector. Which sector is likely to save less
by choice.             in the coming years?
                       Consider a “normal” adjustment scenario. Spending cuts and/or revenue increases by the public
                       sector would impart a slowing effect on the economy, at least in the short term. Profit growth
                       likely would slow, which would make it more difficult for the business sector to save. In addition,
                       slower economic growth would be associated with slower growth in personal income, which
                       would lead households to save less in order to smooth their consumption expenditures. If, as
                       seems likely, the Federal Reserve responded to the slowdown by easing monetary policy, the
                       resulting decline in interest rates would discourage saving by the private sector as well as
                       encourage investment spending. In other words, the net saving of both the household and
                       business sectors would decline.
                       The rest of the world would also play a role in the adjustment mechanism. Policy easing by the
                       Federal Reserve would probably lead to a weaker dollar. Currency depreciation in conjunction
The rest of the        with slower U.S. economic growth would lead to a deceleration in imports as well as an
world plays a role     acceleration in exports. The resulting reduction in the current account deficit would necessitate
in the adjustment      less financing via capital inflows from abroad. As the flow-of-funds accounting framework
mechanism.             dictates, less public sector dissaving would be balanced by less saving by some combination of the
                       business, household and foreign sectors. Therefore, the negative hit to economic activity that
                       fiscal consolidation would impart would be offset, at least in part, by adjustments in other sectors
                       of the economy, at least in theory.
                       Figure 4                                                                       Figure 5
                                                Personal Saving Rate                                                                 Household Net Worth
                                   Disp. Personal Income Less Spending as a % of Disp. Income                                               Trillions of Dollars
                       15%                                                                      15%   $70                                                                                         $70


                                                                                                      $60                                                                                         $60
                       12%                                                                      12%

                                                                                                      $50                                                                                         $50


                        9%                                                                      9%
                                                                                                      $40                                                                                         $40


                                                                                                      $30                                                                                         $30
                        6%                                                                      6%


                                                                                                      $20                                                                                         $20

                        3%                                                                      3%
                                                                                                      $10                                                                                         $10
                                  Personal Saving Rate: Feb @ 3.7%
                                  Personal Saving Rate, 12-Month M.A.: Feb @ 4.6%                                     Net Worth: Q4 @ $58.5 Trillion
                        0%                                                                      0%    $0                                                                                          $0
                             60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11                          80   82   84   86   88    90   92   94   96   98   00   02   04   06   08   10   12



                       Source: U.S. Department of Commerce, Federal Reserve Board and Wells Fargo Securities, LLC




                       5 By default, we mean deficit reduction steps that have already been legislated. Not only are the Bush tax
                       cuts set to expire at the end of 2012, but cuts to military as well as to discretionary spending that were
                       negotiated between the U.S. Congress and President Obama in August will also start to take effect early
                       next year. By choice, we mean any further deficit reduction steps that the government undertakes in the
                       future.




  4
Fiscal Consolidation in a Flow-of-Funds Framework                                                                                                  WELLS FARGO SECURITIES, LLC
April 10, 2012                                                                                                                                              ECONOMICS GROUP



Fiscal Consolidation: Potential Impediments to Effective Adjustment
In the current environment, however, there could be some impediments to a “normal”
adjustment. Let’s start with the household sector. As discussed previously, the personal saving
                                                                                                                                                                            In the current
rate has risen to 3.7 percent at present from 2.4 percent in 2007 (Figure 4). Not only is it likely
                                                                                                                                                                            environment, there
that the financial meltdown of 2008 caused an increase in precautionary saving among
                                                                                                                                                                            could be some
consumers, but it is also likely that the destruction of wealth that occurred from the housing bust
                                                                                                                                                                            impediments to a
has caused consumers to increase their saving rates in order to repair battered balance sheets
                                                                                                                                                                            “normal”
(Figure 5). Nevertheless, will the household sector reduce its saving rate when fiscal
                                                                                                                                                                            adjustment.
consolidation gets underway, as the “normal” adjustment process would predict? Perhaps not.
Because household wealth remains more than 10 percent below its previous peak, households
may opt to continue saving at the same rate as that witnessed over the past few years.
If interest rates did decline significantly, perhaps households would then be inclined to save less.
However, short-term interest rates are already near zero percent, and long-term rates have
dropped to their lowest level in decades. Therefore, the desire of many households to repair their
balance sheets in conjunction with the inability of interest rates to decline much further may keep
personal saving rates elevated. Rather than reduce their saving rates to smooth consumption as
fiscal consolidation kicks in, households may choose to cut back on consumption expenditures,
which would tend to depress the overall rate of GDP growth further.
Would the business sector choose to save less? Perhaps, but Figure 3 makes it clear that the net
saving rate of the business sector remains elevated with respect to historical levels. Building liquid
reserves became the foremost priority for many businesses during the previous recession, and                                                                                Given the recent
businesses continue to keep plenty of cash on their balance sheets today (Figure 6). If fiscal                                                                              desire among many
consolidation were to cause real GDP growth to slow, would businesses run down liquid reserves                                                                              businesses to keep
to maintain current rates of investment spending or would they revert to cash-hoarding mode to                                                                              plenty of cash on
guarantee survival? Given the recent desire among many businesses to keep plenty of cash on                                                                                 hand, further cash
hand, further cash hoarding cannot be ruled out. In addition, as we have written previously, so                                                                             hoarding cannot be
long as the U.S. economy remains in a liquidity trap state and short-term interest rates are                                                                                ruled out.
pressed against their lower bound, there may be a persistent incentive for the business sector to
continue to accumulate cash reserves, especially when inflation expectations remain well-
anchored. 6
Figure 6                                                                                            Figure 7
                 U.S. Nonfin. Corporate Cash Holdings                                                                 Chinese Exchange Rate
                  Total Assets Market Value, U.S. Nonfinancial Corporations                                                       CNY per USD
6.5%                                                                                         6.5%   8.50                                                             8.50
                  Cash Ratio: Q4 @ 6.1%
6.0%              4-Q Moving Average: Q4 @ 5.8%                                              6.0%

                                                                                                    8.00                                                             8.00
5.5%                                                                                         5.5%


5.0%                                                                                         5.0%
                                                                                                    7.50                                                             7.50
4.5%                                                                                         4.5%


4.0%                                                                                         4.0%
                                                                                                    7.00                                                             7.00
3.5%                                                                                         3.5%


3.0%                                                                                         3.0%
                                                                                                    6.50                                                             6.50

2.5%                                                                                         2.5%
                                                                                                              CNY per USD: Apr @ 6.29
2.0%                                                                                         2.0%   6.00                                                             6.00
       80   82    84   86   88   90   92   94   96   98   00   02   04   06   08   10   12             2005   2006    2007      2008    2009    2010   2011   2012



Source: Federal Reserve Board, IHS Global Insight and Wells Fargo Securities, LLC

Will the net saving that continues to flow into the United States from the foreign sector decline?
That is, will the current account deficit get smaller, thereby necessitating fewer net capital inflows


6 See, “The Direction of Treasury Rates: A Japanese Story?” (September 9, 2011), which is available on
request.




                                                                                                                                                                                           5
 Fiscal Consolidation in a Flow-of-Funds Framework                                  WELLS FARGO SECURITIES, LLC
 April 10, 2012                                                                              ECONOMICS GROUP


                      from abroad? Slower economic growth in the United States surely would lead to a downshift in
                      import growth. But would exports strengthen? Currency depreciation would help to strengthen
                      exports, but there are credible reasons to question the amount of dollar depreciation that may
                      occur over the next few years. The U.S. dollar has depreciated about 25 percent versus the
Net saving from the   Chinese renminbi since mid-2005 (Figure 7). However, during periods of slow global growth,
rest of the world     such as the period from late-2007 through 2009, Chinese authorities have halted the renminbi’s
would not recede      slow rate of appreciation. If the United States, which is China’s largest trading partner, were to
much if the current   enter a prolonged period of subdued economic growth due to fiscal consolidation, would Chinese
account deficit is    authorities allow the renminbi to strengthen significantly further? Probably not. Policymakers in
not allowed to        the Eurozone and Japan, which both are suffering from anemic economic growth at present, may
decline.              also take steps to prevent their currencies from strengthening against the greenback. In other
                      words, export growth may not strengthen much if other major economies prevent the U.S. dollar
                      exchange rate from adjusting. In sum, net saving from the rest of the world would not recede
                      much if the current account deficit is not allowed to decline markedly due to currency
                      manipulation by foreign governments.
                      Conclusion
                      Flow-of-funds accounting necessitates that dissaving in one sector of the economy must be
                      balanced by saving in at least one other sector. If the U.S. federal government is to embark on a
                      journey of fiscal consolidation (i.e., if it is to reduce its rate of dissaving), then some other sector,
                      by definition, must save less. Usually, changes in private-sector behavior and changes in prices,
                      interest rates and exchange rates facilitate the required adjustments in saving flows among
                      sectors.
                      In the wake of the global financial crisis, however, there may be some impediments that could
                      retard the “normal” adjustment process. Households may desire to keep their saving rates
                      elevated in order to repair battered balance sheets, and the business sector may choose to
                      increase its record cash holdings even further. Policymakers in China, the Eurozone and Japan
                      may prevent their currencies from appreciating against the dollar in order to support their own
                      export growth. In other words, the contractionary impulse imparted to the U.S. economy by fiscal
                      consolidation could be reinforced by the behavior of the household, business and foreign sectors.
                      Anemic growth in the United States, not to mention a renewed recession, would weigh on tax
                      revenue growth that would make deficit reduction even more difficult to achieve. The
                      U.S. economy could then become trapped in a vicious cycle of fiscal consolidation that leads to
                      private-sector retrenching and to weak export growth, which is followed by further fiscal
                      consolidation and then by further retrenchment and even weaker export growth.
                      If the United States had a real world example to study, it might be able to gain some insights into
                      how significant fiscal consolidation operates in practice. Does such an example exist? Yes. The
                      United Kingdom, which saw its own fiscal deficit explode in the wake of the global financial crisis,
                      embarked on a path of significant fiscal consolidation more than a year ago. In the second of our
                      two reports, which we will release shortly, we will delve deeply into the recent British experience
                      to ascertain what lessons that example may hold for the United States.




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