The Fiscal Black Holes of Mainstream Economics – Developing Economics

By Jacob Assa and Marc Morgan

“The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”
― Joan Robinson

Recent years have seen a proliferation of debates on the shrinking of fiscal space in both industrialized and developing countries. In the former, the discussion often takes the form of agonizing over fiscal ‘black holes’, whereas in the latter it is usually presented in the context of ‘unaffordable debt’.

In reality, the real black holes, or blind spots, are those found in neoclassical economic models underlying such debates, rather than in the real economy (Table 1). We describe three such neoclassical fiscal black holes, based on our recent paper ‘The General Relativity of Fiscal Space’.

Table 1. Overview of fiscal black holes in the neoclassical paradigm.

Source: Authors’ elaboration. Shaded in black are the black holes of the neoclassical fiscal paradigm.

We show how fiscal space is not the absolute sum of taxes and borrowing, but rather relative in several ways. It depends on macroeconomic conditions, such as unemployment and inflation, countries’ degree of monetary sovereignty, and their level of productive capacity. Furthermore, fiscal space is relative to what governments do with it, expanding or contracting depending on the function of public spending.

Neoclassical Black Hole #1:            A Gilded Cage

Mainstream economic models rely on an anachronistic view of public finances dating back to the gold-standard era, or at least to the quasi-gold-standard post-war period of the Bretton Woods system, when the US dollar was pegged to gold, and all other major currencies were fixed vis-a-vis the US dollar.

In that reality, fiscal space was absolute – the sum of tax revenue and government borrowing. This was the case since, while a country could always issue more of its own currency, the peg to gold or another currency forced it to obtain that external currency to protect the agreed exchange rate, or risk depreciation.

This situation ended in 1971, when the United States forfeited the link to gold, making the US dollar a fiat currency, one whose value is determined by decree (fiat in Latin) rather than being based on its relationship to a commodity like gold or silver. All other major currencies were likewise floated and their exchange rates have since been determined by market dynamics.

In a fiat-money world, nothing limits the ability of a currency-issuing government from creating as much money as it needs. Alan Greenspan, chairman of the US Federal Reserve from 1987 to 2006, said exactly that to a congressional committee. We have seen this in action after the 2007-8 recession, the COVID-19 pandemic, several rounds of quantitative easing, and every time countries go to war.

However, while the public supply of money in a fiat system is infinite, real resources in the economy – labor, capital equipment and nature – are finite. Therefore, how and where the money is spent matters. This leads us to the next two black holes.

Neoclassical Black Hole #2:            The Invisible Private Sector

Mainstream economics is of two minds about the private sector. In theory, it sings its praises as the source of all innovation and growth, positing that the invisible hand of the market can lead to optimal social outcomes. In practice, in modelling fiscal and debt sustainability, it is the private sector itself which is invisible.

This paradox is the result of the twin-deficit theory, which claims that increased public (domestic) deficits lead to larger external deficits, since higher government spending ‘crowds out’ private savings. Public spending in this view has to come at the expense of private spending, since money is seen to be a scarce resource, limited by the fixed amount of currency (e.g. US dollars) or precious metal (in the bygone era) a country has.

In reality, the economy has three institutional sectors – public, private and external. Furthermore, the balances of all three sectors must add up to zero by accounting identity. This has been recognized in the System of National Accounts, the sectoral balances approach of Wynne Godley, as well as by leading investment banks such as JP Morgan and Goldman Sachs.

Looking at the sectoral balances of the US economy (Figure 2) reveals two different aspects of the second black hole of neoclassical theory.

Figure 2. Sectoral balances in the US, 1960-2024

First, holding the external balance constant, the public sector’s deficit is equal to the private sector’s surplus. That is, domestic government spending does not simply disappear into a black hole but is spent into the private sector (hiring teachers, doctors, building bridges and roads, and so forth). Accumulated public deficits constitute the public debt, but that is also by definition the stock of private wealth (held in cash, deposits, bonds, or another form of financial or non-financial asset). Looking at only one side of this is incomplete and misleading.

Second, private deficits are the real danger. In contrast to a currency-issuing government which can never run out of its own money, private households and businesses cannot create money to self-finance. Private banks (under license by the government) create money as loans but the new assets (deposits) are equal to the new liabilities (loans) so there is no increase in the private sector’s net financial position. Private deficits increase private debt and the risk of insolvency. In the lead-up to the 2007-8 crisis this was ignored by most economists (who use neoclassical equilibrium models), except for those using such three-dimensional (3D) accounting models. In fact, reducing fiscal deficits (i.e. increasing private sector deficits and debt ceteris paribus) in the US has led in every single case to a major depression or a recession.

Macroeconomic accounting models thus allow us to go beyond the market/state dichotomy, since public deficits fund private surpluses (as long as public spending is not feeding the external account directly), which then translate into profits, investment and growth.

Let us illustrate this black hole with an example. An absolute approach would likely evaluate a 5% public deficit as too big, passing targets conventionally believed to be good practice such as a balance at 0% or a deficit limit of 3% of GDP. By contrast, the fact that the private sector cannot run a deficit for long determines the minimum public sector deficit as being equal to or greater than the external sector balance (at least over a medium term horizon and conditional on public socio-economic objectives). In other words:

Absolute fiscal space: public deficit 5% > (0% ¦ 3%) – too big

Relative fiscal space: public deficit 5% too small

This is true not just for the advanced economies but also for developing economies. A neoclassical twin-deficit view would struggle to explain how China, a country running public deficits in 26 of the last 27 years (Figure 3), could become the workshop of the world. The 3D view of sectoral balances, however, shows the massive benefits to China’s private sector of these productive public deficits, which increased after the current account surplus declined precipitously following the 2007-8 global financial crisis.

Figure 3. Sectoral balances in China, 1997-2024.

Source: IMF World Economic Outlook.

Public deficits do only help to create private surpluses, but also affect real economic activities such as production. Thus they impact the general utilization of real resources, affecting the unemployment rate and the rate of inflation. When there are more unemployed (or underemployed) resources, public deficits can stimulate their employment without stoking inflation, compared to an economy with fully employed resources.

Repeating the example above:

Absolute fiscal space: public deficit 5% > (0% ¦ 3%) – too big

Relative fiscal space: public deficit 5% too small

Relative fiscal space: public deficit 6% >= 6 % external deficit and low unemployment – sufficient

Relative fiscal space: public deficit 6% >= 6 % external deficit and high unemployment – too small

These were the key insights of John Maynard Keynes and Abba Lerner, among others. However, as they were based in and writing about industrialized economies (the UK and US, respectively), we consider this a special case of fiscal relativity, applying only to developed countries. To examine fiscal space in developing countries, we need to generalize the theory to account for their lower levels of productive capacity and monetary sovereignty.

Neoclassical Black Hole #3:            Monetary Sovereignty and Productive Capacity

Compared to the world before World War II, most countries today are politically sovereign having achieved their independence through the process of decolonization in the post-war decades. However, many former colonies are still economically dependent on advanced economies, for several reasons.

First, they have low productive capacity and typically export low-value added raw materials and minerals, while importing high-value added machinery. This leads to negative terms of trade, persistent trade deficits, and high external (foreign-currency) debt.

Second, and related to this, indebtedness in foreign currency is far more complex than domestic currency debt. The former requires the borrowing country to have sufficient foreign exchange reserves, and also exposes it to exchange-rate volatility. If its currency depreciates against the foreign currency of its debt (e.g. dollar or Euro), it owes more in local currency terms. Default in foreign currency is possible and not infrequent.

In contrast, domestic public ‘debt’, as seen above, is the same as domestic wealth. Where the government sells bonds to private investors, it can always pay the principal and interest without default or exchange rate risks. Most of the more successful developing countries have thus reduced the share of foreign currency debt in their total borrowing over time (Figure 4).

Figure 4. Foreign currency public debt as a share of total public debt.

Source: IMF World Economic Outlook.

Other factors reducing the monetary sovereignty of countries include not having their own currency at all (e.g. the CFA countries in Africa or Euro countries in Europe), fixed exchange rates, a high degree of inelastic imports (e.g. food and fuel imports), and not having a liquid currency. The following chart ranks regions by our Monetary Sovereignty Index.

Figure 5. Monetary Sovereignty Index Across World Regions.

Source: Assa and Morgan (2025).

One notable finding in this graph is that Euro countries are ranked third from the bottom, below non-CFA African countries. The latter have more monetary sovereignty than the former, since they issue their own currency. The former rely on an external issuer (the ECB) for money creation.

However, European countries have higher productive capacity than African countries, and can thus absorb more public spending before inflation starts to kick in. And again, the level of unemployment in each country matters too. Combining these four elements together we arrive at a general relativity of fiscal space, applicable for all countries, and operationalized in our Fiscal Space Index. Figure 6 shows the five countries with the highest index of fiscal space, and its decomposition.

Figure 6. Fiscal Space Index in the top 5 countries, 2022.

Source: Assa and Morgan (2025).

An important implication of the relativity of fiscal space is not how much a country has at any particular moment. It is the fact that it can contract or expand its fiscal space depending on what it spends on. This can be seen in several counterintuitive general examples.

In the mainstream interpretation, public deficits are thought to create ‘black holes’ by increasing the public debt to supposedly unsustainable levels. But targeting public spending on utilizing unemployed resources can lead to economic growth which is faster than the growth rate of debt. This in fact would reduce the economy’s debt burden.

Deficits are also expected to increase inflation in the twin-deficit view. But if the spending is directed to creating more productive capacity, especially of food and energy, this would reduce the need to import these strategic inputs. Since global commodity prices of food and energy are volatile, and tend to rise during global crises, such ‘productive deficits’ would reduce the potential for pass-through inflation from abroad, thus enhancing fiscal space for the future.

Another example is choosing to finance infrastructure projects with domestic (deficit) spending rather than with borrowed foreign debt. After spending, the government can sell bonds to drain the additional liquidity created through its spending. This requires a sufficiently developed domestic financial market. Alternatively, the government could just spend and tax the additional liquidity instead of issuing bonds. The newly created domestic ‘debt’ is also newly created private sector wealth in the form of differently held assets and additionally has no exchange rate risk or default risk. By increasing its monetary sovereignty, the country has increased its future fiscal space, despite (or because of) functional deficit spending.

To take a concrete example, let’s look at China. As Figure 6 shows, China is the country with the fifth highest fiscal space according to our estimates (for 2022). Table 2 breaks China’s record down further, showing how it scores highly on components that positively impact fiscal space and lowly for components that negatively impact fiscal space. The country has recognized the importance of exercising its sovereignty over domestic policy, meaning it has made institutional choices that has given it the fiscal space to attain its economic objectives – it issues its own currency, it operates a (managed) flexible exchange rate (aided by a tightly regulated capital account), it prioritizes issuing public debt in its domestic currency, it targets a high utilization of resources and a high domestic productive capacity that forgoes excessive dependence on food and fuel imports. There is a blueprint in this record, one in which all the determinants of fiscal space are taken seriously.^[1]

There is also the consideration of international sovereignty over domestic policy, in which institutional choices made collectively by the global community impinge on national fiscal space. Among the variables included in our analysis, this concerns the convention of foreign exchange reserves (dependent on foreign demand for the country’s production and on the international monetary system more generally – for example the existence of an international central bank operating a global unit of account), and currency liquidity (dependent on foreign demand to hold the country’s currency, which would be aided by requiring payment of trade in the currency of the importing country or by requiring foreign direct investment into the importing country’s economy, subject to transparent legal frameworks). China has been acutely aware of these asymmetric interdependencies, hence its strategic moves to not be subject to their worst side-effects (e.g. currency and balance of payments crises). An increasing cohort of smaller developing countries are seeing eye to eye on this, demanding reform to the international monetary system in these directions to better aid their chances at development. 

Table 2. Decomposition of fiscal space in China, 2022.

Source: Assa and Morgan (2025). Shown are the four components of our fiscal space index by the positive or negative impact each has on the overall index, the Chinese values of each component, and how the Chinese values rank compared to other countries, as well as the global weights of each component in the principal component analysis (PCA) for the 150 countries.

These ideas may seem to go against the current of mainstream economic policy, which encourages countries, both developed and developing, to balance their budgets, borrow in global capital markets, and hope for their private sector to fund the public sphere.

This approach is not just cautious; it is incoherent and reckless given the framework presented above. Keeping in mind the three-dimensionality of sectoral balances, their link to the real economy’s productive capacity, and the global dimensions of monetary sovereignty, the opposite approach – strategic, targeted public spending to achieve concrete developmental objectives – is what should become the new conventional wisdom.

Audentes fortuna iuvat

Jacob Assa holds a PhD in Economics from The New School for Social Research.

Marc Morgan is a Research and Teaching Fellow in the Department of History, Economics and Society and the Paul Bairoch Institute of Economic History at the University of Geneva (UNIGE).

Notes

^[1] For comparison, South Africa’s high fiscal space estimate in Figure 6 is predominantly the result of its excessive unemployment rate of between one quarter and one third of the labour force.