Teaching the Fallacy of Composition:
The Federal Budget Deficit
by L. Randall Wray
One of the
most important concepts to be taught in economics is the notion of the fallacy
of composition: what might be true for individuals is probably not true for
society as a whole. The most common example is the paradox of thrift: while an
individual can save more by reducing spending (on consumption), society can save
more only by spending more (for example, on investment). Another useful and very
topical example involves the federal government’s budget deficit. Politicians
and the media often argue that the government must balance its books, just like
a household. If a household were to continually spend more than its income, it
would eventually face insolvency; it is thus claimed that government is in a
similar situation. However, careful examination of macroeconomic relations will
show that this analogy is incorrect, and that it would lead to improper
budgetary policy. This example can drive home the fallacy of composition.
One of the most important concepts we
teach in economics, and most importantly in macroeconomics, is the notion of the
fallacy of composition.
Students and others who haven’t been
exposed to macroeconomics naturally extrapolate from their own individual
situation to society and the economy as a whole.
This often leads to the problem of the
fallacy of composition. Of course, that isn’t just restricted to economics.
While a few people could exit the doors of a crowded movie theatre, all of us
The macroeconomics example of the
fallacy of composition most often used is the paradox of thrift. Any individual
can increase her saving by reducing her spending—on consumption goods. So long
as her decision does not affect her income—and there is no reason to assume that
it would—she ends up with less consumption and more saving.
The example I always use involves Mary
who usually eats a hamburger at Macdonald’s every day. She decides to forego one
hamburger per week, to accumulate savings. Of course, so long as she sticks to
her plan, she will add to her savings (and financial wealth) every week.
The question is this: what if everyone
did the same thing as Mary—would the reduction of the consumption of hamburgers
raise aggregate (national) saving (and financial wealth)?
The answer is that it will not. Why
not? Because Macdonald’s will not sell as many hamburgers, it will begin to
lay-off workers and reduce its orders for bread, meat, catsup, pickles, and so
All those workers who lose their jobs
will have lower incomes, and will have to reduce their own saving. You can use
the notion of the multiplier to show that this process comes to a stop when the
lower saving by all those who lost their jobs equals the higher saving of all
those who cut their hamburger consumption. At the aggregate level, there is no
accumulation of savings (financial wealth).
Of course that is a simple and even
silly example. But the underlying explanation is that when we look at the
individual’s increase of saving, we can safely ignore any macro effects because
they are so small that they have only an infinitely small impact on the economy
as a whole.
But if everyone tries to increase
saving, we cannot ignore the effects of lower spending on the economy as a
whole. That is the point that has to be driven home.
We can then again return to the notion
of the multiplier, and show that the way to increase aggregate saving is by
increasing spending, specifically, nonconsumption spending—spending on
investment, spending by government, or spending by foreigners on our exports.
I don’t want to go into that particular
example any further. Another example that is less frequently used concerns
The view shared by most of my
undergraduate students is that unemployment is caused by laziness or lack of
training. The argument they often use is that “I can get a job, therefore all
the unemployed could get jobs if only they tried harder, or got better education
The way I go about demonstrating that
fallacy is a dogs and bones example. Say we have 10 dogs and we bury 9 bones in
the backyard. We send the dogs out to find bones. At least one dog will come
back without a bone.
We decide that the problem is lack of
training. We put that dog through rigorous training in the latest bone finding
techniques. We bury 9 bones and send the 10 dogs out again. The trained dog ends
up with a bone, but some other dog comes back without a bone (empty-mouthed, so
The problem, of course, is that there
are not enough bones and jobs to go around. It is certainly true that a
well-trained and highly motivated jobseeker can usually find a job. But that is
no evidence that aggregate unemployment is caused by laziness or lack of
We could also go into the common belief
that minimum wages cause unemployment. It is at least partly true that for an
individual firm, higher wages reduce the number of workers hired. But we cannot
extrapolate that to the economy as a whole. Higher wages mean higher income and
thus higher consumption spending, which induces firms to employ more labor. So
the truth is that economic theory does not tell us that raising minimum wages
will lead to more unemployment, indeed, theory tells us it can go the other
way—raising the minimum wage could increase employment.
Again, the reason we can reach the
wrong conclusion in all of these cases when we aggregate up from the micro level
to the macro is because we ignore the impacts that behavior of individuals or
firms has on other individuals or firms. That can be OK for the case of the
individual firm or household, but is almost certainly incorrect for firms and
households taken as a whole.
Let me move on to a more important
fallacy of composition. We hear politicians and the media arguing that the
current federal budget deficit is unsustainable. I have heard numerous
politicians refer to their own household situation: if my household continually
spent more than its income year after year, it would go bankrupt. Hence, the
federal government is on a path to insolvency, and by implication, the budget
deficit is bankrupting the nation.
That is another type of fallacy of
composition. It ignores the impact that the budget deficit has on other sectors
of the economy. Let me go through this in some detail, as it is more complicated
than the other examples.
We can divide the economy into 3
sectors. Let’s keep this as simple as possible: there is a private sector that
includes both households and firms. There is a government sector that includes
both the federal government as well as all levels of state and local
governments. And there is a foreign sector that includes imports and exports;
(in the simplest model, we can summarize that as net exports—the difference
between imports and exports—although to be entirely accurate, we use the current
account balance as the measure of the impact of the foreign sector on the
balance of income and spending).
At the aggregate level, the dollar
spending of all three sectors combined must equal the income received by the
three sectors combined. Aggregate spending equals aggregate income. But there is
no reason why any one sector must spend an amount exactly equal to its income.
One sector can run a surplus (spend less than its income) so long as another
runs a deficit (spends more than its income).
Historically the US private sector
spends less than its income—that is it runs a surplus. Another way of saying
that is that the private sector saves. In the past, on average the private
sector spent about 97 cents for every dollar of income.
Historically, the US on average ran a
balanced current account—our imports were just about equal to our exports. (As
discussed below, that has changed in recent years, so that today the US runs a
huge current account deficit.)
Now, if the foreign sector is balanced
and the private sector runs a surplus, this means by identity that the
government sector runs a deficit. And, in fact, historically the government
sector taken as a whole averaged a deficit: it spent about $1.03 for every
dollar of national income.
Note that that budget deficit exactly
offsets the private sector’s surplus—which was about 3 cents of every dollar of
income. In fact, if we have a balanced foreign sector, there is no way for the
private sector as a whole to save unless the government runs a deficit. Without
a government deficit, there would be no private saving. Sure, one individual can
spend less than her income, but another would have to spend more than his
While it is commonly believed that
continual budget deficits will bankrupt the nation, in reality, those budget
deficits are the only way that our private sector can save and accumulate net
Budget deficits represent private
sector savings. Or another way of putting it: every time the government runs a
deficit and issues a bond, adding to the financial wealth of the private sector.
(Technically, the sum of the private sector surpluses equal the sum of the
government sector deficits, which equals the outstanding government debt—so long
as the foreign sector is balanced.)
Of course, the opposite would also be
true. Assume we have a balanced foreign sector and that the government runs a
surplus—meaning its tax revenues are greater than government spending. By
identity this means the private sector is spending more than its income, in
other words, it is deficit spending. The deficit spending means it is going into
debt, and at the aggregate level it is reducing its net financial wealth.
At the same time, the government budget
surplus means the government is reducing its debt. Effectively what happens is
that the private sector returns government bonds to the government for
retirement—the reduction of private sector wealth equals the government
reduction of debt.
Now let us return to the Clinton years
when the federal government was running the biggest budget surpluses the
government has ever run. Everyone thought this was great because it meant that
the government’s outstanding debt was being reduced. Clinton even went on TV and
predicted that the budget surpluses would last for at least 15 years and that
every dollar of government debt would be retired.
Everyone celebrated this
accomplishment, and claimed the budget surplus was great for the economy.
In the middle of 2000, I wrote a
contrary opinion (“Implications of a budget surplus at mid-year 2000, CFEPS
Policy Note 2000/1). I made several arguments. First, I pointed out that the
budget surplus meant by identity that the private sector was running a deficit.
Households and firms were going ever farther into debt, and they were losing
their net wealth of government bonds.
Second, I argued that this would
eventually cause a recession because the private sector would become too
indebted and thus would cut back spending. In fact, the economy went into
recession within half a year.
Third, I argued that the budget
surpluses would not last 15 years, as Clinton claimed. Indeed, I expected they
would not last more than a couple of years. In fact, the budget turned around to
large and growing deficits almost immediately as soon as the economy went into
And of course we still have large
budget deficits. No one talks any more about achieving budget surpluses this
decade; almost everyone agrees that we will not see budget surpluses again in
our lifetimes—if ever.
The question is whether the US
government can run deficits forever. The answer is emphatically “yes”, and that
it had better do so. If you look back to 1776, the federal budget has run a
continuous deficit except for 7 short periods. The first 6 of those were
followed by depressions—the last time was in 1929 which was followed by the
Great Depression. The one exception was the Clinton budget surplus, which was
followed (so far) only by a recession.
Why is that? By identity, budget
surpluses suck income and wealth out of the private sector. This causes private
spending to fall, leading to downsizing and unemployment. The only way around
that is to run a trade or current account surplus.
The problem is that it is hard to see
how the US can do that—in fact, our current account deficit is now rising toward
7% of GDP. All things equal, that means our budget deficit has to be even larger
to allow our private sector to save. Given our current account balance, the
budget deficit would have to reach 9% of GDP to allow our private sector to have
a surplus of 2% of GDP.
I don’t want to give the impression
that government deficits are always good, or that the bigger the deficit, the
better. The point I am making is that we have to recognize the macro relations
among the sectors.
If we say that a government deficit is
burdening our future children with debt, we are ignoring the fact that this is
offset by their saving and accumulation of financial wealth in the form of
government debt. It is hard to see why households would be better off if they
did not have that wealth.
If we say that the government can run
budget surpluses for 15 years, what we are ignoring is that this means the
private sector will have to run deficits for 15 years—going into debt that
totals trillions of dollars in order to allow the government to retire its debt.
Again it is hard to see why households would be better off if they owed more
debt, just so that the government would owe them less.
There are other differences between the
federal government and an individual household. The government is the issuer of
our currency, while households are users of the currency. That makes a big
difference, and one explored in many other CFEPS publications. However, the
purpose of this particular note is to explain why we cannot aggregate up from
the individual household situation to the economy as a whole. The US
government’s situation is not in any way similar to that of a household because
its deficit spending is exactly offset by private sector surpluses; its debt
creates equivalent net financial wealth for the private sector.