The global economy is endlessly complex – a professor’s traditional introduction on the first day of macroeconomics 101 is a description of how a pencil is made. Sourcing and refining the lead, timber, rubber, the yellow paint, and the little metal piece that affixes the eraser to the pencil, transporting the raw materials, manufacturing the pencil itself, packaging, marketing and distributing the now-ancient writing utensil – all require unimaginable levels of coordination across the globe. Adam Smith’s invisible hand at work. It is quite remarkable. I remember listening to that lecture in class 14 years ago while every student had laptops open on their desk. I wonder if the professors have moved onto a different subject for their story. Perhaps now they discuss the complexity of creating a semiconductor, though that misses the point – we all already know semiconductors are endlessly complex. The lesson is the production and distribution of ostensibly simple goods is wildly sophisticated.
A good macroeconomics professor simplifies the complex, and the simplest way to conceive of the global economy is to divide it into three sectors: the domestic public sector (government), the domestic private sector (all domestic households and businesses), and the foreign sector (every government, household, and business outside of the domestic sector). Every player in the global macroeconomy falls neatly into one of these three buckets.
We know from considerations of the local economy that one person’s spending is another’s income. I spend every month at grocery stores, gas stations, restaurants - those transactions show up as expenses on the Cawley family income statement, while they are recorded as income for Trader Joe’s, Shell, and the local sushi restaurants. Now that we’ve divided the entire global economy into three sectors, the same concept applies: one sector’s spending is another’s income. Every dollar (or Euro, yen, renminbi, zloty, etc.) that is spent by one sector shows up as income in another sector. There is no escape for any unit of currency. Each must land either in the government’s coffers, on the balance sheet of domestic firms and households, or on a foreign economy’s balance sheet.
As these three sectors interact, dollars (well, all currencies via the foreign exchange markets, but for simplicity’s sake we’ll think in dollars here) are constantly flowing between them. The government takes dollars in from the other two sectors (taxes and tariffs) and spends dollars (Big Beautiful Bill). The domestic private sector takes dollars in (saving, activities accretive to balance sheets) and spends dollars (taxes to the government, purchasing imports from the foreign sector). The foreign sector takes dollars in (selling exports to the domestic private sector) and spends dollars (importing from the domestic private sector, paying foreign taxes). One sector’s spending is another’s income, and every dollar must end up in one of these three sectors. The macroeconomic lingo for for this concept is sectoral balances. Every unit of currency must be accounted for. There is no interstellar trade.
One important factor before we proceed is the US Dollar as the global reserve currency. It is the reserve currency not due to sovereign fiat but because the individual constituents of the domestic and foreign sectors choose to transact in dollars. The US economy alone accounts for over one quarter of global GDP, and the US dollar is the ticket required to participate in the world’s foremost economic engine. A popular topic to fearmonger about is the dollar losing its reserve currency status – usually propagated by someone trying to sell you something. The US dollar is involved in 88% (!!) of foreign exchange trades worldwide, with the Chinese yuan coming in second at… 7%. The greenback also accounts for 58% of global foreign exchange reserves; the second closest is the Euro at 20%. The Chinese yuan? 2.12%. But the dollar’s reserve status is eroding! the (salesmen) holler. In 1995 the US dollar’s share of global forex reserves was… 59%. “Gradually then suddenly” only sounds smart when Hemingway says it. Capital flows where it is treated best, and the US dollar trades in the deepest and most liquid capital markets (by an unfathomably wide margin), is governed with strong rule of law, retains freedom from capital controls, and enjoys vast network effects. The dollar is not only the global reserve currency; there is no close second.
America’s status as the reserve currency issuer has been dubbed her privilège exorbitant (the economist who coined the term was French). When times are good and the global economy is expanding, everyone wants US dollars. When times are bad, and the global economy is contracting… everyone wants US dollars even more. When the US singularly initiated a global financial crisis in 2008 – largely due to very bad decisions by members of its own financial sector (creating and selling opaque derivative financial products neither the buyer nor the seller understood), the global economy’s demand for US dollars increased. The US can create the worst financial crisis in a century, and individuals, institutions, and governments across the world will increase their demand for US dollars. If that is not an exorbitant privilege, I do not know what is. Look at any period of global financial uncertainty and you will see US Treasury yields declining (buyers demand more dollars as a safe haven, they buy US Treasurys, demand for Treasurys increases, the yield on Treasurys decreases). Thus, during periods of economic hardship, the US finds her borrowing costs falling. An exorbitant privilege, indeed.
One caveat of issuing the global reserve currency is the issuing country must always run a trade deficit. Other nations – the foreign sector – must continually accumulate units of the reserve currency to engage in international trade and bolster their reserves, so the reserve currency issuer will always be sending out more units of its currency abroad than it takes in, which is another way of saying her imports must exceed her exports. This is the structural reason behind the United States’ persistent trade deficit (the world gets lots of dollars, we get lots of stuff, everyone is happy). It has been said America’s most valuable export is the US dollar. In theory, America could retool her economy to run a trade surplus, but she would have to sacrifice the dollar to do so. This would (a) be exceedingly difficult to do, (b) take a long time and require massive global economic disruption, and (c) result in the American economy resembling China’s.*
Back to the global macroeconomy – remember every player falls into either the public, private, or foreign sectors. One sector’s spending is another’s income, and every dollar must end up in one of those three sectors. This accounting identity yields important implications. Namely, all three sectors cannot run a surplus. If two of the three sectors are running a surplus (taking in more dollars than they are spending), the remaining sector must be running a deficit. As already discussed, the dollar’s role as reserve currency means the foreign sector will always run a surplus (as the US, the issuer of the dollar, runs a trade deficit). That leaves two sectors – the domestic private sector and the US government – at least one of which must run a deficit. The macroeconomic balance sheet must balance. Just as an electron moving faster than the speed of light violates the laws of physics, all three macroeconomic sectors running a surplus violates the laws of accounting.
Would anyone really prefer the private sector run a deficit and the government run a surplus? Maybe the Communists? Please do not misunderstand me. Washington, DC emits a tsunami of wasteful spending, and I am as angry as anyone about the nonsensical, wasteful spending of my hard-earned tax dollars. I am not saying government spending is inherently good – all else equal I prefer smaller government! But I am examining things from an accounting perspective, and two things can be true at the same time: (a) the government engages in considerable wasteful spending that drives us all absolutely nuts and (b) I would much rather the government run a deficit than the private sector. This is the uncomfortable world we find ourselves in: for the government to run a surplus and pay down its debt (running a surplus is the necessary precondition for paying down the national debt), either the private sector must run a deficit, or we relinquish the dollar as the global reserve currency, her privilège exorbitant. That is not the same thing as saying all government spending is good (it’s not) or that the government should spend into oblivion (too much spending can create inflation, which is in no one’s interest). But it is a pretty good argument for why you should spend less time worrying about the national debt and the level of Uncle Sam’s deficit spending. On the list of concerns you ought to harbor regarding the economy and your own balance sheet and portfolio, I estimate the government’s debt and deficit should be near the bottom. But I sense those fears are misplaced near the top of the list for many.
Given a government deficit and trade deficit means private balance sheets must expand, what is the optimal level of government spending? Is it infinite? Absolutely not, too much government spending creates inflation, and we all have experience with how miserable a state of affairs that is. In historical context, the recent period of elevated inflation was relatively moderate. Moderate inflation will ruin your year but hyperinflation will ruin your life, so the government ought to be cautious with the level of deficit spending. Annual deficit spending exceeded $1 trillion for the first time in 2009 and remained elevated through 2019 (fluctuating between $1.4 trillion and ~$500 billion annually). Meanwhile, the private sector underwent massive expansion while inflation averaged a mere 1.57%/yr. Then the government ballooned the deficit in excess of $3 trillion in 2020 and $2 trillion in 2021 and inflation spiked. That is what too much spending looks like.
We are citizens of the greatest economic powerhouse the world has ever known. The US has 4% of the world’s population but is responsible for 27% of the global economy and 50% of the global stock market. We issue the world reserve currency, which enables us to buy from abroad far in excess of what we sell and serves as a bulwark during economic crises. Due to natural accounting mathematics, our government perpetually runs a deficit as the wealthiest private sector in the world relentlessly expands its balance sheet. The government issues debt to finance that deficit in an attempt to satiate the insatiable global demand among governments, institutions, and individuals to own Uncle Sam’s debt. Yet this is supposedly... bad? People look at this state of affairs and bemoan an impending apocalypse. $35 trillion dollars in debt! How will we ever repay it? Well, we won’t. Unless we prefer the private sector run a deficit so the government can run a surplus. Also, as it relates to the national debt, just as it is axiomatic one sector’s expense is another’s income, so is one sector’s liability another’s asset. If the US government paid off its $35 trillion in debt, precisely $35 trillion of assets would disappear from the private and foreign sectors. The US government did not force any member of the private or foreign sectors to buy its debt. Each Treasury purchase was the result of capital’s natural flow to its highest and best use, the free decision of the millions of individuals, corporations, pensions, endowments, charities, and governments worldwide. Would wiping $35 trillion from their balance sheets be a net positive for the global economy?
We live in an uncertain world with plenty of things to worry about. Focus on things you can control and please don’t waste your mental space worrying about government debt and deficits.**
Sean Cawley, CFP®
*China’s economy is built on a trade surplus. The PBOC (Chinese central bank) artificially devalues the yuan against the dollar to make its exports more competitive in global markets to support its export-dependent manufacturing sector. The Chinese economy is built to import dollars and export goods. GDP per capita in China is $13,303. It is $85,810 in America. We do not want to trade economies with China.
**Unless policymaking becomes so unhinged we enter a hyperinflationary cycle, then you should definitely worry.
Sources:
https://data.imf.org/en/Dashboards/COFER%20Dashboard
https://www.jpmorgan.com/insights/global-research/currencies/de-dollarization
https://data.worldbank.org/indicator/NY.GDP.PCAP.CD
https://www.optimisticallie.com/p/relentless-optimism
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