David McWilliams discusses the Irish version of the ‘Gavyn Davies’ sector financial balances graph in the Irish Independent today. He makes two points. The first is to highlight the restoration of the foreign sector balance in recent years, which he interprets as meaning that, absent the banking crisis, the government would not have needed to seek EU/IMF funding given the availability of sufficient domestic savings to fund the government deficit.
His second point is that the chart shows that austerity will not work because, if the private sector keeps saving, then either the government deficit remains high (as a result of a further contraction of the economy) or there is a build up in the current account surplus on the balance of payments, which he also sees as undesirable because it means that “we will export capital to the rest of the world for them to use, while projects in Ireland are starved of capital”.
While the first point may be true in the sense that the state would not have faced the downgrade on its sovereign debt in the absence of the banking crisis, I think the second conclusion is wrong.
To help the discussion, I reproduce the chart here which I had earlier created in a comment on Brendan Walsh’s post below. Two caveats are in order. First, although in principle the financial balances are equal to the net borrowing or lending of each sector as shown in the institutional non-financial accounts, there is a sizeable discrepancy due to errors and omissions. More important, these figures only show the flow of funds for any year, and need to be complemented by the balance sheet figures showing the stock of financial assets and liabilities held by each sector if we are to assess these flows correctly.
The stock figures (not shown here) show how private sector debt increased in an unsustainable fashion and that the private sector now needs to deleverage, i.e. to reduce its liabilities relative to its income. The government is currently unable to borrow because of the size of the bank liablities, but even if this constraint were not there there are dangers in allowing the public debt to build up with the consequent knock-on debt service costs. So if the government deficit is to be reduced given high private savings without causing a further serious contraction in the economy, we need the foreign sector balance to take up the slack. In other words, given the various objectives which macro policy must keep in mind, exporting more to pay off our foreign creditors is the least painful way of resolving the various dilemmas that now face the Irish economy.