Buffett is Wrong about Government Borrowing

Warren Buffett wrote an article for Tuesday’s New York Times, in which he speculated about how the federal government is going to finance its huge deficit. His conclusion? Private sector sources won’t provide enough money to finance the deficit, so the Federal Reserve will have to step in and print money. I never thought I’d see the day, but Buffett is way off base here.

Here’s a summary of Buffett’s analysis: The federal deficit is projected to hit $1.8 trillion this year. Buffett estimates that around $400 billion of that will come from foreigners, and that another $500 billion will be made available through the saving activities of American citizens. That leaves a shortfall of at least $900 billion, which Buffett claims must be provided by the Federal Reserve in the form of freshly printed money.

This analysis is wrong on several levels. For starters, it appears that Buffett considered only one source of domestic savings, namely households, and neglected saving activities undertaken by businesses. More importantly, he ignored private investment, which draws from the same savings pool as federal borrowing. Buffett actually alluded to this fact in his article, but suggested that if private investment were factored into the analysis, it would make the savings shortfall even worse. On the contrary, the problem largely disappears when private investment is included.

The discussion will be more illuminating if we focus on changes in saving and investment, rather than absolute levels. I’ll use 2007 as a base year (the recession didn’t start until December of that year), and discuss changes between then and the first quarter of 2009 (i.e., the latest quarter for which I have data). Take a look at the table, below, which shows Buffett’s numbers for the two periods.

These figures come from the Saving and Investment table of the National Income and Product Accounts, provided by the Bureau of Economic Analysis. The Q1 2009 figures are annualized. They are different from Buffett’s more recent estimates, but the differences won’t affect my conclusions.

Household savings have increased significantly since 2007, but the increase was more than offset by a reduction in savings provided by foreigners. Meanwhile, the federal deficit increased by more than $900 billion. According to Buffett’s logic, this implies a savings shortfall of roughly $1 trillion, which the Federal Reserve must have covered by printing money.

The first problem with this analysis is that it neglects business savings. That’s an important oversight, because businesses actually save more money than households. The second problem is that Buffett’s calculation ignores private investment, which must be subtracted from private savings in order to determine how much money is leftover to finance the deficit. Take a look at the table, below, which shows gross business saving and gross private investment.

These figures were obtained from the same NIPA table as before. Gross private investment includes residential construction, which is primarily a household investment, not a business investment. Unfortunately, the NIPA tables don’t provide separate estimates for household and business investment. We’re mainly interested in the consolidated figure anyway.

There has been a huge decline in private investment. The causes are easy to identify. Residential construction has been falling for several years, following the bursting of the housing bubble. Business investment remained strong until the financial crisis began, but has fallen steeply since then, as the outlook for profits has dimmed. The result has been a $703 billion contraction in private investment spending. Throw in a $60 billion increase in business saving, and we’ve covered 75% of the savings shortfall identified in the first table above.

This is not a numerical coincidence. The economic definitions of ‘saving’ and ‘investment’ imply that the two are always equal when aggregated at the national level. I neglected several smaller entries in the NIPA table (such as borrowing by state and local governments), otherwise we would have found that the total savings shortfall was zero (within statistical bounds). In other words, there is no mystery about how the government is going to finance its additional deficit this year. The extra savings will mainly come from domestic households and businesses, both of which are scaling back expenditures and paying down debt in response to the recession.

There’s a deeper lesson to be found here. Buffett wonders where the additional savings will come from to finance the government’s extraordinary deficits. The question itself indicates a lack of understanding about how the economy works. The right question is, how much money does the government need to spend in order to soak up the extraordinary amount of savings that the private sector is currently generating?

There is no way for the public collectively to create a savings account of unused haircuts. If everyone decides to scale back on haircuts, barbers simply make less money. The same observation applies to the rest of the economy. We can’t collectively ‘save’ output (except by running a current account surplus, which doesn’t appear to be in our immediate future). If everyone decides to spend less money, the end result is that everyone works less. That’s the definition of a recession.

The budget deficit didn’t just happen to come along at the same time as households and businesses were ramping up their savings. The government is ramping up spending in order to offset private sector spending cutbacks, which are the root-cause of the recession. The government needs to run higher deficits only so long as the private sector insists on spending (or investing) less than it earns.

In other words, Buffett has it backwards: The government doesn’t need the private sector to save heavily in order to finance extraordinary deficits. The private sector needs the government to spend heavily if it wants to save extraordinary amounts of money.