The Absorption Problem

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absorption problem:	The absorption problem is summarized by the equation: [G–T] = [S–I] + [M–X]. Thus, any federal government budget deficit (G-T) must be offset by an excess of private saving over private investment (S–I) or by an excess of imports over exports (M–X). This equation is a simplification and rearrangement of an accounting identity for Aggregate Expenditures: Y = C + I + G + (X–M) = C + S + T. If the economy is at its productive capacity, then unless a federal deficit is funded by foreigners (M–X), private investment may be “crowded out” because G–T will equal S–I. Open the file fiscal policy and the great depression for a discussion of an exception to the crowding-out hypothesis. See also aggregate expenditures and crowding in.
crowding-out hypothesis:	The crowding-out hypothesis is the idea that increases in federal spending inevitably cause reductions in private consumption or investment. For example, increases in government borrowing to cover a budget deficit may increase interest rates, reducing investment. The absorption problem is a generalization of the crowding out hypothesis, and summarizes how crowding out may cross international borders. The crowding-out hypothesis assumes that the economy is initially at a full employment level of output. See also crowding-in.
twin deficits problem:	The twin deficits problem is the theory that a national government’s budget deficits (G-T) tend to be offset by balance of trade deficits (M-X), so that e.g., foreigners acquire assets in the United States when our federal government runs a deficit. In the absence of foreign funding of our deficit, if the economy is at full employment levels of output, the budget deficit will “crowd out” private investment (S-I).

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Deriving the Absorption Equation:

National income accounting reveals that Gross Domestic Product (GDP) is the sum of consumption (C), investment (I), government spending (G) and net exports (X—M). Alternatively, GDP is the sum of consumption and saving (S) and taxes (T). Thus:

GDP = C+I+G+(X—M) = C+S+T

Therefore

I+G +(X—M) = S+T

Rearranging terms yields the Absorption Equation

G — T =	S — I +	M — X
Government can be funded through taxes …… OR	by borrowing from domestic savers… OR	by using the savings of foreigners.

If the federal government borrows from savers when the economy is at or near full employment, then there will be either (1) “crowding out” of domestic investment, or (2) transfers to foreigners of ownership in American assets – land, capital, or corporations. During the 1980s, record government budget deficits under President Reagan drove the U.S. from being the world’s largest creditor nation (foreigners owed us) to being the world’s largest debtor nation (we owed them.). Much of this relative indebtedness to foreign interests was eliminated by the smaller deficits and eventual budget surpluses during 1993-2000. Unfortunately, our current twin deficits, fueled by the budget deficits of 2001-2005 [and forecast to continue indefinitely] have reestablished the United States as the all time and uncontested champion of debtor nations.

Do deficits always crowd-out” investment?

Suppose, as was true in the United States at the beginning of World War II, that a nation is significantly underemployed when the central government runs a deficit. In such cases, it is possible for gross domestic product to grow so rapidly that budget deficits neither “crowd-out” investment nor cause positive inflows of foreign saving because C and I and G and S and T may all grow. Open the file fiscal policy and the great depression for a discussion of this exception to the crowding-out hypothesis. See also aggregate expenditures and crowding in.

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Author: Ralph Byrns

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