As was pointed out in the comment by Ralph Musgrave, there are negative connotations associated with the word “debt”; hence the political appeal of reducing government debt. But one of the basic principles of Stock-Flow Consistent modelling (and hence Modern Monetary Theory (MMT)) is that financial instruments end up on two entities’ balance sheets. Government debt is the flip side to the “net financial assets” of the non-government sector; and so attempts to reduce government debt if the private sector is attempting to increase savings is likely to end badly.
The chart above shows the “cash” holdings of the household business and sectors in my simulated economy. (All of the charts in this article are for the case where the “debt limit” is non-binding.) The recession in year “0001” in the model was induced by the household sector increasing its desire to save out of current income. I do not think that this is the most typical cause of recessions, but it does generate post-recession conditions similar to what is seen currently in the United States. The stock of household sector savings rises steadily towards a new steady state level. Since there are no other assets available within the model, the implication is that government debt (the sum of household and business sector “cash”) has to march higher. In other words, the demand for financial assets forces the government to run a deficit to supply those savings; absent a tax cut, the only way to provide those deficits is a recession and then a period of too-high unemployment.
The cause of the recession is probably non-intuitive for many people. It is often noted that “Savings = Investment” is an identity (a relationship that holds by definition), and so the standard story runs:
Higher Household Savings -> Higher Investment -> Higher Future Growth.
This is often explained by “Robinson Crusoe” economies involving one or two people who barter amongst themselves, and have to invest to increase their productivity.
My model is very non-mainstream in this respect, and rising personal savings is associated with weaker growth (and in fact causes the recession). In a modern industrial economy, most investment is undertaken by the business sector. The upward spike in personal savings does imply increased investment initially – involuntary inventory investment, as seen in the above chart. In other words, business have increasing amounts of unsold goods piling up on their shelves. (As seen in the previous article, the inventory/sales ratio rises above the target level, forcing cutbacks in production. There is no fixed investment within the model, just inventory investment.)
In mainstream models, there is typically an assumption made that markets clear ("Y=C"), and such involuntary inventory investment is by definition impossible. Since inventory investment is often observed to be a contributor to recessions, this assumption appears to generate unrealistic model behaviour.
Finally, my model does not attempt to deal with changes in the prices of labour or goods (price levels are assumed to be constant). This is probably too simplistic, but it represents the extreme end of the Post-Keynesian modelling bias which argues that activity volumes are the major source of adjustment to shocks, not changing prices. If the model incorporated price changes in a more realistic fashion, my expectation is that the modelled cash flows would not be changed by a large amount. This article by “circuit” at Fictional Reserve Barking explains in more detail why the “Pigou effect” (deflation causing an increase in activity) is viewed to have a limited impact on real activity.
(c) Brian Romanchuk 2013