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Policy Shifts Towards Reducing Deficits In Public Sector

 April 10, 2012 03:03 PM


Now that the U.S. economy is gaining momentum, the focus among policy makers seems to have shifted towards cutting deficits in the public sector. It was quite evident from the way U.S. President Barrack Obama's and Representative Paul Ryan's latest budget proposals called for reducing the deficit in this decade.

By definition, reducing the deficit in the public sector should be compensated by reduced savings from the U.S. households, businesses and the rest of the world. Usually, change in prices, behavior of private sector, interest and exchange rates make the expected changes provide savings flow among sectors. However, there could be some obstructions to retard adjustments.

Households may want to keep their saving rates higher than usual to fix their balance sheets. While businesses will likely remain in cash-hoarding mode. The adjustment towards a smaller current account deficit could be hampered by attempts by foreign governments to prevent their currencies from appreciating against the US dollar, Wells Fargo wrote in a research note to clients.

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In such a situation, the U.S. economy could enter a vicious cycle of fiscal consolidation leading to retrenchment in the private sector besides weak export growth. This will further aggravate retrenchment and weaker export growth.

The fiscal deficit is estimated to top 8 percent of GDP in the current fiscal year, although proposals call for deficits to recede to 3 percent of GDP in the latter years of the current decade. In fact, Congressman Paul Ryan's fiscal year 2013 budget proposal goes beyond this calling for a federal budget deficit of around one percent of GDP by the close of the decade. However, the methodology in achieving the deficit reduction differs from Obama's. At the State level, budget gaps are predicted to show improvements during the next few years, but shortfalls may still persist through fiscal year 2014, Wells Fargo believes.

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Currently, the budget deficits of the public sector continued to be funded by a combination of saving from the U.S. private sector and the rest of the world. The public sector red ink could possibly recede to some extent in the coming years either by choice or by default. As the deficit recedes, the government's rate of dis-saving would fall. In any case, government is not likely to be the net saver anytime soon. The fall in the rate of public sector dis-saving should be compensated by a drop in the saving rate of a minimum one other sector. This is in keeping with the funds flow accounting framework in mind.

The reduction in the public sector could create other problems, such as slower economic growth and reduced personal income that could potentially force lower household savings. The Fed could respond to a slowdown by easing monetary policy, which could result in a fall in interest rates. This, in turn, would discourage savings by the private sector and encourage investment spending. In a nutshell, housing and business sectors saving would fall in such a scenario.

Other parts of the world also play a role in the adjustment mechanisms. Policy easing could threaten the dollar to weaken. A weaker currency and slower economic growth would lead to a deceleration of imports and also acceleration of exports. The resulting current account deficit reduction would require lower financing from capital inflows from foreign nations.

It is quite clear that if the U.S. wants to embark on a fiscal consolidation, then some or other sector must save less. The question remains as to which sectors will face the situation. Policy makers will have a tough time handling the situation arising out of planned deficit reductions within the current decade.

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