In my post The Transactions Flow Matrix, I went into how a full transactions flow matrix can be constructed using a simplified national income matrix. Let us reanalyze the latter. The following is the same matrix with some modifications – firms retain earnings and there are interest payments.
FU is the undistributed profits of firms. From the last line we immediately see that
SAVh + FU – If – DEF = 0
or that
FU = If + DEF – SAVh
This is Kalecki’s profit equation which says among other things that firms’ retained earnings is related to the government deficit! The equation appears in pages 82-83 of the following book by Michal Kalecki:
click to view on Google Books
In their book Monetary Economics, Wynne Godley and Marc Lavoie say this in a footnote:
Note that neo-classical economists don’t even get close to this equation, for otherwise, through equation (2.4), they would have been able to rediscover Kalecki’s (1971: 82–3) famous equation which says that profits are the sum of capitalist investment, capitalist consumption expenditures and government deficit, minus workers’ saving. Rewriting equation (2.3), we obtain:
FU = If + DEF − SAVh
which says that the retained earnings of firms are equal to the investment of firms plus the government deficit minus household saving. Thus, in contrast to neo-liberal thinking, the above equation implies that the larger the government deficit, the larger the retained earnings of firms; also the larger the saving of households, the smaller the retained earnings of firms, provided the left-out terms are kept constant. Of course the given equation also features the well-known relationship between investment and profits, whereby actual investment expenditures determine the realized level of retained earnings.
The above can of course also be written as:
I = SAVh + SAVf + SAVg = SAV
if one realized that the retained earning of firms is also their saving:
SAVf = FU
Business accountants know the connection between retained earnings and shareholders’ equity and in our language – which is that of national accountants/2008 SNA – it adds to their net worth just like household saving adds to their net worth.
Assuming away capital gains, we know from many posts that:
Change in Net Worth = Saving
Where do we find the undistributed profits in the Federal Reserve’s Flow of Funds Statistic Z.1?
In Table F.102, there’s an item called “Total Internal Funds”:
For an open economy, we add the current balance of payments to the right of both these equations.
So we have the sectoral balances identity:
NPS = DEF + CAB
for Net Private Saving or Saving Net of Investment. Confusingly, Net Saving is used to mean Saving Net of Consumption of Fixed Capital. Consumption of fixed capital is the national accounting equivalent of depreciation but since there is a different accounting treatment, the former phrase is used.
In addition to Investment by the private sector, there’s also public investment and we need a bookkeeping concept of National Saving.
Just like we consolidated the domestic private sector into one, we could also consolidate the whole nation for specific purposes.
First take a closed economy. Since Income = Expenditure and Saving is defined so that consumption and investment expenditures are treated differently, we have
Gross Saving = Gross Domestic Investment
To get Net Saving, one has to subtract consumption of fixed capital from both sides.
Economies however are open. Hence we need to modify the above equation. Simultaneously taking depreciation into account, we have:
Net Saving = Gross Domestic Investment – Consumption of Fixed Capital + Current Balance of Payments
Remember this Net Saving is different from the other usage which is Saving Net of Investment.
Before verifying that this is indeed the case for the United States, it is worth mentioning that the difference between saving and surplus (or financial balance) applies to the government sector as well. The following is from the Table F.8 of the Z.1 Flow of Funds Accounts of the United States.
(click to expand and click again to expand)
So in green – for the year 2001 for the United States – you see both the gross saving and saving net of consumption of fixed capital of the government sector is positive whereas the government’s budget balance is in deficit.
This shouldn’t be surprising given we saw the same for the private sector.
Back to national saving, we can verify the identity. The current balance of payments is a nation’s income minus expenditure (only in a closed economy, these two are equal). If this is positive, the nation as a whole has a positive net lending. Else, it is a net borrower.
The identity can be seen using the numbers circled in red (and including the statistical discepancy).
The Paradox Of Thrift
The analysis above can mislead one into believing that since “saving” is a positive word, the nation as a whole should save by whatever means – such as by inducing the household sector to increase its propensity to save or aiming for a balanced budget (or worse, aiming to retire the public debt).
Both ideas are vacuous. A spontaneous increase in the propensity to save works by reducing the output and a tight fiscal stance achieves the same i.e., reducing the national saving or private saving as a whichever is the case – as a result of lower demand and output.
The Loanable Funds Fallacy
The simple accounting relations are also used in economics textbooks to promote saving in general because due to the above identity, one can be fooled into believing that a higher saving leads to higher investment. Again such ideas are promoted in public debates to argue against higher government expenditure and to even promote making balanced budget constitutional! The story goes that higher saving allows more investment because supposedly there are more funds to lend for investment.
This is based on the incorrect notion of the exogeneity of money. While this cannot be discussed in a single post, it’s where ideas of endogenous money and Horizontalism are illuminating.
Basil Moore had an article titled Saving Is The Accounting Record Of Investment, where he discusses some of the points here – never mind his claim that “total saving on an economy cannot reflect the volitional behavior of savers”. Here’s a Google Books preview from his book Shaking The Invisible Hand:
click to view on Google Books
Mercantilism
The Mercantilists observe the accounting identity about national saving and the fact that it is related to the balance of payments and conclude that foreign trade is highly important in the growth of nations and hence well being and quality of life. The connection is that saving achieved via running a trade surplus with the rest of the world increases a nation’s net worth. To promote less consumption, the same mantra of national saving is used. So it is related to the paradox of thrift.
These ideas are used in public discussions on the problem of the external sector imbalance whether one believes in Mercantilism or not (their idea of rejection of the invisible hand). An increase in the household propensity to save (achieved by whatever means) or an attempt to reduce the budget balance by a tighter fiscal stance improves the current account balance, only because it results in a lower domestic demand and output and hence higher unemployment – all undesirable. That of course does not mean that one can unilaterally relax fiscal policy but just points to a more international effort needed badly right now to solve the problem of global imbalances.
While there is some truth to Mercantilists’ view, it’s for slightly different reasons – it is advantageous so some in one sense and injures others and hence inures everyone in the end.
In the General Theory Keynes introduced open economy considerations in his discussion of Mercantilism. He argued that the Mercantilists had been correct in their belief that a favorable balance of trade was desirable for a country, since increases in foreign investment increase domestic AD exactly like increases in domestic investment:
When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment. … the well-being of a progressive state essentially depends … on the sufficiency of such inducements. They may be found either in home investment or foreign investment … which between them make up aggregate investment. … The opportunities for home investment will be governed in the long run by the domestic rate of interest; whilst the volume of foreign investment is necessarily determined by the size of the favourable balance of trade. …
Mercantilist thought never supposed that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level…
In a society where there is no question of direct investment under the aegis of public authority,… it is reasonable for the government to be preoccupied … [with] the domestic interest rate and the balance of foreign trade. … when nations permit free movement of funds across national boundaries the authorities have no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade [are] the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of precious metals was their only indirect means of reducing the domestic rate of interest, and so increasing the inducement to home investment.
Keynes emphasized that any domestic employment advantage gained by export-led growth was a zero-sum game and “was liable to involve an equal disadvantage to some other country.” He argued that export-led growth aggravates the unemployment problem for the surplus nation’s trading partners, who are forced to engage in “an immoderate policy that (may) lead to a senseless international competition for a favourable balance, which injures all alike.” The traditional approach to improve the trade balance has been to attempt to make the domestic export and import-competing industries more competitive, either by forcing down nominal wages to reduce domestic production costs, or by devaluing the exchange rate. Keynes argued that gaining competitive gains by reducing nominal price variables would tend indirectly to foster a state of global recession. One’s trading partners would be forced to attempt to regain their competitive edge by instituting their own restrictive policies. When nations fail jointly to undertake expansionary policies to raise domestic investment and generate domestic full employment, free international monetary flows create a global environment where each nation has national advantages in a policy of export-led growth. The pursuit of these policies will lead to a race to the bottom, that “injures all alike.”
the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire foundations upon which I was brought up and which for many years I taught—against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time.
These apposite warnings of Keynes have gone virtually unnoticed as mainstream economists have waxed enthusiastic about the benefits of liberalized financial markets and the export-led economic miracles of the Asian “Tigers,” and now the miracle of China. Modern economies have become more open than when Keynes was writing, so it is imperative that Keynes’ open economy analysis becomes better known.
I recently heard from an online commentator that saving is the opposite of borrowing. While there is some “intuition” to this, the following exercise is show it is possible to have a positive saving and incur huge liabilities at the same time.
To complicate the matter the word “Savings” is used. Now, in national accounts, this word is used as a plural of saving and it ought to be given up as a substitute for wealth because it creates more confusions in discussions.
I had recently gone into an example of concepts such Saving, Net Acquisition Of Financial Assets, Net Investment in Nonfinancial Assets, Net Incurrence Of Liabilities and “Net Lending(+)/Net Borrowing(-)”.
The example I wrote in that post was buried in something abstract, so let me extract the most essential paragraphs here and add a few things.
Let us suppose:
A household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75.
He takes a loan of to finance a house purchase near the end of the year whose price is $500.
Assume that the Loan-To-Value (LTV) of the loan is 90% – which means he gets a loan of $450 and has to pay the remaining $50 from his pocket to buy the house. (i.e., he is financing the house mainly by borrowing and partly by sale of assets).
How does the bank lend – assuming the bank does the creditworthiness checks and decides to lend – simply by expanding it’s balance sheet (“loans make deposits”).
Ignoring, interest and principal payments (which we assume to fall in the next accounting period),
His Saving is +$100 – $20 – $75 = +$5.
His Net Investment in Nonfinancial Assets is +$500.
His Net Incurrence of Liabilities is +$450.
His Net Accumulation of Financial Assets is +$5 – $50 = – $45.
His Net Lending is = -$45 – (+$450) = -$495 which is Saving net of Investment ($5 minus $500). i.e., his Net Borrowing is +$495.
This means even though the person has a Saving of $5, he has incurred liability of $450 and due to sale of assets worth $45, he is a net borrower of $495 from other sectors (i.e., his net lending is -$495).
That can be confusing since Net Borrowing is $495 even though the person actually borrowed $450 from the bank.
As I have mentioned before, an alternative terminology exists where Net Acquisition of Financial Assets is used instead of Net Lending and Net Lending (to a sector) is used instead of Net Incurrence of Liabilities.
Table F.10
The Table F.10 of the Federal Reserve’s Statistical Release Z.1: Flow Of Funds Accounts Of The United States is below:
(click to expand and click again to expand)
The Flow of Funds Table F.10 may lead one to suppose that “Net Investment in Nonfinancial Assets” is Saving. Or to put it more simply one may suppose that “purchasing a house is saving”. Or worse “purchasing a house is dissaving”.
This is “Monetarist Intuition”. Here the house was purchased by incurring liabilities and sale of assets.
As we saw above – for the personal sector,
Saving = Disposable Income – Consumption.
NIPA accountants calculate it this way. But we also saw that
Saving = Net Acquisition of Financial Assets + Net Investment in Nonfinancial Assets – Net Incurrence of Liabilities
which can be verified from the table. This method is used by the Flow of Funds accountants.
As an aside, apart from definitional issues between Flow of Funds and NIPA, there can discrepancies and the following link discusses this without giving any conclusion.
Economists worry too much about the government’s deficit although they seem to not know about the private sector deficit.
Goldman Sachs’ chief economist Jan Hatzius came to know about the sectoral balances approach and called the difference between United States’ private expenditure and income in “The Un-Godley Private Sector Deficit”. He later included the sectoral balances approach in his forecasting models.
Here’s the sectoral balances for the United States using data from the Federal Reserve’s Z.1 Flow Of Funds Accounts Of The United States:
GDP appears in Table F.6 and sectoral balances in Table F.8 – as “Net Lending(+)/Net Borrowing(-)”. The above is using quarterly seasonally adjusted data. Easy work. Excel data is available at the Federal Reserve’s page here
It can be verified that
Private Sector Balance = Government Deficit + Current Balance of Payments
The red line is the private sector balance and is the difference between the private sector income and expenditure. When positive, the private sector is in surplus and when negative, it is in deficit.
For most of history having been positive (and back to being positive now), the private sector balance made a dramatic shift in the mid-1990s reaching as low as as -5.8% in Q1 2000 (and hence “private sector deficit”). This implied that before the recession, growth in the United States was driven by higher private expenditure relative to income. The flip side of this growth was that due to the Un-Godley private sector deficits, the budget went into a surplus while private indebtedness continued to rise.
This was enough to cause a recession in the early 2000s and the US government had to provide a massive fiscal stimulus to prevent a severe recession. The Federal Reserve also provided stimulus by keeping interest rates low but the private sector went into a deficit again – rushing to participate in a boom. The result of all this was the increase in the current account deficit of the United States to about 6.43% of GDP at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale and cracks started to appear in the foundations of growth – as warned by a series of articles from the Levy Institute.
This appears a bit like Scenario 4 in a Levy Institute paper Debt And Lending – A Cri De Coeur by Wynne Godley and Gennaro Zezza from April 2006 – the “gloomiest variant” according to the authors – where a drastic fall in private expenditure relative to income induces a recession in the United States, reducing the current account balance dramatically and increasing the budget deficit (to eventually enough to become the central debate in US politics).
And it turned out that the private sector deficit quickly went into a surplus – faster than the scenario presented above because the private sector could not handle the rise in indebtedness. The fall in private expenditure relative to income also meant – as mentioned above – that the United States went into a deep recession – from which it is still recovering.
But this is mixing up saving for saving net of investment.
Now, “saving net of investment” is sometimes called “net private saving”, although the originators such as Wynne Godley always specified this.
I guess the the root of the confusion on the part of those who have inherited this terminology from the originators is to treat the “net” in net private saving as a result of netting due to aggregation alone, and take the sectoral balances identity – whereas the “net” is crucially net of investment.
In a recent post Income And Expenditure Flows And Financing Flows, I went into concepts such as saving, saving net of investment, net acquisition of financial assets, net incurrence of liabilities, and “net lending(+)/net borrowing(-)” and you may read the example there on the calculation of these flows. I also went into clarifying this by an example but let’s just check this for the case of the United States with actual data from the Federal Reserve Z.1 Statistical Release Flow Of Funds Accounts Of The United States from the historical data from 1995-2004 available here. In particular the table F.8.
In the above, the data highlighted in blue is the current account balance. With the whole nation’s expenditure higher than income, it’s net lending was negative – i.e., it was a net borrower (from the rest of the world).
Also, the government budget was in surplus in the years (line 49 highlighted in red).
Also, here’s the part which has the potential to create more confusions. The Net Saving defined by the flow of funds accountants is Saving net of Consumption of Fixed Capital (i.e., depreciation). So this can be checked from items highlighted in yellow.
So, the private sector had a positive saving even though the budget was in surplus and the current balance of payments in deficit!
Of course, this meant that the private sector financial balance is negative and this you can see in line 43 highlighted in Red.
A commenter on my post on Net Worth asked me if I could do an example.
Here it goes.
First I do it as done by national accountants as per 2008 SNA – the System of National Accounts and then by the method used by the Federal Reserve’s Z.1 Flow of Funds Accounts.
The example is from a Levy Institute working paper by Antonio C. Macedo e Silva and Claudio Dos Santos with tables created more neatly here.
Let us assume that a single firm starts with the following balance sheet.
Opening Stocks: 2011
$
Assets
900
Nonfinancial Assets Financial Assets
600 300
Liabilities and Net Worth
900
Securities Other Than Shares Loans Shares and Other Equity Net Worth
150 250 450 50
In the above Net Worth is defined as we did earlier by treating equities as liabilities of a corporation. As we saw in the table Transactions Flow Matrix in the post Sources And Uses Of Funds, firms finance investment by retained earnings, and incurring liabilities. It was a simplified matrix of course and firms may also by sale of assets they hold.
An important point in the analysis is that this is for a single firm not the consolidated corporate sector as I am going to assume it will purchase physical capital from another firm for which it is a part of current receipts and hence a source of funds for the latter. That is, in the Transactions Flow Matrix, “I” appears both in the current and capital account of the consolidated production firms sector but here we are interested in a single firm.
Let us assume in an accounting period the firm retains $90 of earnings and finances a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans, issuing $40 of equities in the markets and selling existing financial assets worth $70.
The closing balance sheet will be as follows:
Closing Stocks: 2011
$
Assets
1,230
Nonfinancial Assets Financial Assets
1000 230
Liabilities and Net Worth
1,230
Securities Other Than Shares Loans Shares and Other Equity Net Worth
200 400 490 140
We assume away capital gains i.e., asset prices haven’t changed for the sake of clarity. As you see, net worth has increased from $50 to $140 and this is due to the firm’s saving – undistributed profits of $90. In general, asset prices change all the time and there will be holding gains and/or losses in both assets and liabilities.
What about flows such as the financial balance?
Here Saving = +$90
Net Incurrence of Liabilities = (+$50) + (+$150) + (+$40) = +$240
Net Acquisition (or Accumulation) of Financial Assets = (-$70)
because of the sale of assets and hence
Net Lending by the firm = (-$70) – (+$240) = (-$310)
(This is also called NAFA in old terminology, instead of splitting Net Lending into Net Accumulation of Financial Assets and Net Incurrence of Liabilities.)
To check: this is equal to Saving Minus Investment which is +$90 – $400 which is equal to -$310 – the “financial balance” of the firm.
So even though we have a negative financial balance, the firm’s net worth has increased. However note that by doing so, the firm’s financial assets/liabilities ratio has reduced – increasing its fragility somewhat.
As mentioned earlier, the purchase of physical capital was from another firm and we have not consolidated the corporate sector and hence the above balance sheets are for a single firm only.
Alternative Approach
The Federal Reserve will do this differently because equities issued by corporations are treated as if they are not liabilities in its Z.1 Flow of Funds Accounts of the United States and accordingly the example will need to be modified to look like this:
Opening Stocks: 2011
$
Assets
900
Nonfinancial Assets Financial Assets
600 300
Liabilities and Net Worth
900
Securities Other Than Shares Loans Net Worth Memo: Shares and Other Equity
150 250 500 450
I have added Equities in “Memo” as per the Federal Reserve’s practice and the Net Worth at the beginning of the period is $500. With the same set of transactions – a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans, issuing $40 of equities in the markets and selling existing financial assets worth $70, while retaining earnings of $90 in the period, the closing stocks will be as below:
Closing Stocks: 2011
$
Assets
1,230
Nonfinancial Assets Financial Assets
1000 230
Liabilities and Net Worth
1,230
Securities Other Than Shares Loans Net Worth Memo: Shares and Other Equity
200 400 630 490
Here Net Worth increased by $130 from $500 to $630 because of retained earnings of $90 and issuance of equities of $40 in the period.
The second approach is more like an “own funds” approach.
In the previous two posts, I went into a description of the transactions flow matrix and the balance sheet matrix as tools for an analytic study of a dynamical study of an economy.
During an accounting period, sectors in an economy are making all kinds of transactions. These can be divided into two kinds:
Income and Expenditure Flows
Financing Flows
Let’s have the transactions flow matrix as ready reference for the discussion below.
(Click for a nicer view in a new tab)
The matrix can easily be split into two – on top we have rows such as consumption, government expenditure and so on and in the bottom, we have items which have a “Δ” such as “Δ Loans” or “change in loans”. We shall call the former income and expenditure flows and the latter financing flows.
To get a better grip on the concept, let us describe household behaviour in an economy. Households receive wages (+WB) and dividends from production firms (called “firms” in the table) and banks (+FD_{f} and +FD_{b}) respectively) on their holdings of stock market equities. They also receive interest income from their bank deposits and government bills. These are sources of households’ income. While receiving income, they are paying taxes and consuming a part of their income (and wealth). They may also make other expenditure such as buying a house or a car. We call these income and expenditure flows.
Due to these decisions, they are either left with a surplus of funds or a deficit. Since we have clubbed all households into one sector, it is possible that some households are left with a surplus of funds and others are in deficit. Those who are in surplus, will allocate their funds into deposits, government bills and equities of production firms and banks. Those who are in deficit, will need funds and finance this by borrowing from the banking system. In addition, they may finance it by selling their existing holding of deposits, bills and equities. The rows with a “Δ” in the bottom part of transactions flow matrix capture these transactions. These flows will be called financing flows.
How do banks provide credit to households? Remember “loans make deposits”. See this thread Horizontalism for more on this.
This can be seen easily with the help of the transactions flow matrix!
The two tables are some modified version of tables from the book Monetary Economics by Wynne Godley and Marc Lavoie.
It is useful to define the flows NAFA, NIL and NL – Net Accumulation of Financial Assets, Net Incurrence of Liabilities and Net Lending, respectively.
If households’ income is higher than expenditure, they are net lenders to the rest of the world. The difference between income and expenditure is called Net Lending. If it is the other way around, they are net borrowers. We can use net borrowing or simply say that net lending is negative. Now, it’s possible and typically the case that if households are acquiring financial assets and incurring liabilities. So if their net lending is $10, it is possible they acquire financial assets worth $15 and borrow $5.
So the the identity relating the three flows is:
NL = NAFA – NIL
I have an example on this toward the end of this post.
I have kept the phrase “net” loosely defined, because it can be used in two senses. Also, some authors use NAFA when they actually mean NL – because previous system of accounts used this terminology as clarified by Claudio Dos Santos. I prefer old NAFA over NL, because it is suggestive of a dynamic, though the example at the end uses the 2008 SNA terminology.
While households acquire financial assets and incur liabilities, their balance sheets are changing. At the same time, they also see holding gains or losses in their portfolio of assets. What was still missing was a full integration matrix but that will be a topic for a post later. Since, it is important however, let me write a brief mnemonic:
where revaluations denotes holding gains or losses.
This is needed for all assets and liabilities and for all sectors and hence we need a full matrix.
We will discuss more on the behaviour of banks (and the financial system) and production firms some other time but let us briefly look at the government’s finances.
As we saw in the post Sources And Uses Of Funds, government’s expenditure is use of funds and the sources for funds is taxes, the central bank’s profits, and issue of bills (and bonds). Unlike households, however, the government is in a supreme position in the process of “money creation”. Except with notable exceptions such as in the Euro Area, the government has the power to make a draft at the central bank under extreme emergency, though ordinarily it is restricted. Wynne Godley and Francis Cripps described it as follows in their 1983 book Macroeconomics:
Our closed economy has a ‘central bank’ with two principle functions – to manage the government’s debt and to administer monetary policy. [Footnote: The central bank has to fund the government’s operations but this in itself presents no problems. Government cheques are universally accepted. When deposited with commercial banks the cheque become ‘reserve assets’ in the first instance; banks may immediately get rid of excess reserve assets by buying bonds.]. The only instrument of monetary policy available to the central bank in our simple system is the buying and selling of government bonds in the bond market. These operations are called open market operations. We assume that the central bank does not have the right to directly intervene directly in the affairs of commercial banks (e.g., to prescribe interest rates or quantitative lending limits) or to change the 10% minimum reserve requirement. But the central bank is in a very strong position in the bond market since it can sell or buy back bonds virtually without limit. This gives it the power, if it chooses, to fix bond prices and yields unilaterally at any level [Footnote: But speculation based on expectations of future yields may oblige the central bank to deal on a very large scale to achieve this objective.] and thereby (as we shall soon see) determine the general level of interest rates in the commercial banking system.
Given such powers, we can assume in many descriptions that the government’s expenditure and the tax rate is exogenous. However, many times, there are many constraints such as price and wage rises, high capacity utilization and low production capacity and also constraints brought about from the external sector due to which fiscal policy has to give in and become endogenous.
While I haven’t introduced open economy macroeconomics in this blog in a stock-flow coherent framework, we can make some general observations:
For a closed economy as a whole, income = expenditure. While it is true for the whole economy (worth stressing again: closed), it is not true for individual sectors. The household sector, for example, typically has its income higher than expenditure. In the last 15-20 years, even this has not been the case. If one sector has it’s income higher than expenditure, some sectors in the rest of the world will have its income lower than its expenditure. Many times, the government has its income lower than expenditure and we see misleading public debates on why the government should aim to achieve a balanced budget. When a sector has its income lesser than expenditure, it’s net lending is negative and hence is a net borrower from the rest of the world. It can finance this by borrowing or sale of assets. A region or a whole nation can have its expenditure higher than income and this is financed by borrowing from the rest of the world. A negative flow of net lending implies a net incurrence of liabilities – thus adding to the stock of net indebtedness which can run into an unsustainable territory. Stock-flow coherent Keynesian models have the power to go beyond short-run Keynesian analysis and study sustainable and unsustainable processes.
… it is important to have in mind that it is possible to get three kinds of trajectories with SFC models:
trajectories toward a sustainable steady state;
trajectories toward a steady state over certain limits;
explosive trajectories.
The analysis of SFC models’ dynamic trajectories and steady states is useful, first because it makes clear to the analyst whether the regime described in the model is sustainable or whether it leads to some kind of rupture—either because the trajectory is explosive or because it leads to politically unacceptable configurations. In these cases, as Keynes would say in the Tract, the analyst can conclude that something will have to change and even get clues about (i) what will probably change (since the sensitivity of the system dynamics to changes in different behavioural parameters is not the same); and (ii) when this change will occur (since the system may converge or diverge more or less rapidly).
Example
Note that Net Lending is different from “saving”. Say, a household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75 and takes a loan of to finance a house purchase near the end of the year whose price is $500. Assume that the Loan-To-Value (LTV) of the loan is 90% – which means he gets a loan of $450 and has to pay the remaining $50 from his pocket to buy the house. (i.e., he is financing the house mainly by borrowing and partly by sale of assets). How does the bank lending – simply by expanding it’s balance sheet (“loans make deposits”). Ignoring, interest and principal payments (which we assume to fall in the next accounting period),
His saving is +$100 – $20 – $75 = +$5.
His Investment is +$500.
His Net Incurrence of Liabilities is +$450.
His Net Accumulation of Financial Assets is +$5 – $50 = – $45.
His Net Lending is = -$45 – (+$450) = -$495 which is Saving net of Investment ($5 minus $500).
This means even though the person has “saved” $5, he has incurred an additional liability of $450 and due to sale of assets worth $45, he is a net borrower of $495 from other sectors (i.e., his net lending is -$495).
Assume he started with a net worth of $200.
Opening Stocks: 2010
$
Assets
200
Nonfinancial Assets Deposits Equities
0 30 170
Liabilities and Net Worth
200
Loans Net Worth
0 200
Now as per our description above, the person has a saving of $5 and he purchases a house worth $500 by taking a loan of $450 and selling assets worth $50. We saw that the person’s Net Accumulation of financial assets is minus $45. How does he allocate this? (Or unallocate $45)? We assume a withdrawal of $10 of deposits and equities worth $35. At the same time, during the period, assume he had a holding gain of $20 in his equities due to a rise in stock markets.
Hence his deposits reduce by $10 from $30 to $20. His holding of equities decreases by $15 (-$35 + $20 = -$15)
How does his end of period balance sheet look like? (We assume as mentioned before that the purchase of the house occurred near the end of the accounting period, so that principal and interest payments complications appear in the next quarter.)
Closing Stocks: 2010
$
Assets
675
Nonfinancial Assets Deposits Equities
500 20 155
Liabilities and Net Worth
675
Loans Net Worth
450 225
Just to check: Saving and capital gains added $5 and $20 to his net worth and hence his net worth increased to $225 from $200.
Of course, from the analysis which was mainly to establish the connections between stocks and flows seems insufficient to address what can go wrong if anything can go wrong. In the above example, the household’s net worth gained even though he was incurring a huge liability. What role does fiscal policy have? The above is not sufficient to answer this. Hence a more behavioural analysis for the whole economy is needed which is what stock-flow consistent modeling is about.
One immediate answer that may satisfy the reader now is that the households’ financial assets versus liabilities has somewhat deteriorated and hence increased his financial fragility. By running a deficit of $495 i.e., 495% of his income, the person and his lender has contributed to risk. Of course, this is just one time for the person – he may be highly creditworthy and his deficit spending is an injection of demand which is good for the whole economy. After all, economies run on credit. While this person is a huge deficit spender, there are other households who are in surplus and this can cancel out. In the last 15 years or so, however (before the financial crisis hit), households (as a sector) in many advanced economies ran deficits of the order of a few percentage of GDP. If the whole household sector continues to be a net borrower for many periods, then this process can turn unsustainable as the financial crisis in the US proved.
Now to the title of the post. Flows such as consumption, taxes, investment are income/expenditure flows. Flows such as “Δ Loans”, “Δ Deposits”, “Δ Equities” are financing flows. Income/expenditure flows affect financing flows which then affect balance sheets, as we see in the example.
The Flow of Funds Accounts provides one of the best snapshot of an economy. In an article appropriately titled ‘No one saw this coming’ – or did they? (see the full paper here), Dirk Bezemer correctly recognizes that the Economics profession’s ignorance of Flow of Funds had a big role to play in its inability to see a crisis coming. Bezemer says
We economists – and the policymakers who rely on us – ignore balance sheets and the flow of funds at our peril.
Of course, as Bezemer points out, there were exceptions. Post Keynesians were always aware of the flow of funds because monetary economy is a natural starting point in their theory. Wynne Godley and Marc Lavoie wrote a book (my favourite!) Monetary Economics: An Integrated Approach To Credit, Money, Income, Production and Wealth, Palgrave Macmillan, 2007, to unify Post Keynesian theory and the flow of funds approach, perhaps improving the presentation of the latter using something called the “transactions flow matrix”.
In my opinion, nobody even came close to Wynne Godley in not only predicting the crisis but the warning about the difficulties in resolving it.
One notable highlight of today’s Z.1 release was that
Household net worth—the difference between the value of assets and liabilities—was $57.4 trillion at the end of the third quarter, about $2.4 trillion less than at the end of the previous quarter.
A lot of readers will know about sectoral balances. How do we get that from Z.1? Table F.8 gives “Net Lending” of each sector of the economy. The difference in a sector’s income and expenditure is it’s “Net Lending”.
(click to expand, and click again to expand)
Before the crisis, the private sector had its income lower than expenditure and was financing the difference by borrowing from the other sectors. As the crisis hit, private sector expenditure retrenched – so you can see how the private sector has become a net lender from being a net borrower before the crisis. Because of this, the government’s borrowing increased from (line 49) $408.1bn in 2007 to $1,471.7bn in Q3 2011 (annualized). It was also due to a relaxation of fiscal policy during the crisis, in order to stimulate demand. The expenditure of the United States as a whole is higher than its income, and the difference is the current account deficit. This is financed by net borrowing from foreigners (line 42) – which was $446.7bn in Q3 2011 (annualized). This deficit was $715.9bn in 2007, bleeding demand at a massive scale from the US economy.
There are two more tables I see closely. The first is the net income payments from the rest of the world, which surprisingly remains positive, leading to a lot of literature about “dark matter”. (More on that some other time). This, according to the Z.1 is the “net receipts from foreigners of interest, corporate profits, and employee compensation”.
The Levy Institute has been tracking this since 1994. Here’s a latest graph (from their March 2011 analysis)
There are discrepancies between BEA and Fed data. The other table which I rush to check, whenever the flow of funds data is released is the United States’ net indebtedness to the rest of the world – L.107:
which at the end of Q3 was $3,616bn, or 24% of GDP.
There’s a new table – L.108, Financial Business – which actually appeared first time in the previous release (Q2). This sector had $64,299bn in assets and $60,457bn of liabilities at the end of Q3!
Of course, I look at all the tables at some time or the other. Highly recommended.
Marc Lavoie forwarded me the European Central Bank’s Monthly Bulletin, October 2011 which has a section on TARGET2 and the European monetary system. I have had good discussions with him on emails to nail the TARGET2 operations so it is good to see the conclusions being verified in publications. I am waiting to write a long blog post on TARGET2 and trying to collect sources I can quote/link and I came across a section on flow of funds in the same article. It appears on page 99 (page 100 of the pdf) and is titled The Financial Crisis In The Light Of Euro Area Accounts: A Flow-Of-Funds Perspective.
The article has this chart which will be very familiar to readers because it has been in the Levy Institute’s Strategic Prospects since many years.
There are some differences in terminologies. Wynne Godley (and Francis Cripps) started using NAFA (Net Accumulation/Acquisition of Financial Assets) to denote a sector’s surplus in the 1970s and Levy Institute has continued using this. Modern national accountants use Net Lending (by a sector) and split this into Net Acquisition of Financial Assets and Net Incurrence/Acquisition/Increase of/of/in Liabilities and take the difference. Levy’s authors also use Net Lending but as Net Lending to a Sector – e.g., Net Lending to Households.
The article also presents this table (termed Transactions Flow Matrix by Wynne Godley – his greatest trick)
(click to enlarge)
and has this description:
The sectoral accounts present the accounts of institutional sectors in a coherent and integrated way, linking – similar to the way in which profit and loss, cash flows and balance sheet statements are linked in business accounting – uses/expenditure, resources/revenue, financial flows and their accumulation into balance sheets from one period to the next.To this effect, all units in the economy are classified in one of the four institutional sectors (i.e. households, non-financial corporations, financial corporations and general government). Their accounts are presented using identical classifications and accounting rules (those of ESA 95), in a manner such that each transaction/asset reported by one unit will be symmetrically reported by the counterpart unit (at least in principle). Accordingly, the sectoral accounts present the data with three constraints: each sector must be in balance vertically (e.g. the excess of expenditure on revenue must be equal to financing); all sectors must add up horizontally (e.g. all wages paid by sectors must be earned by households); and transactions in assets/liabilities plus holding gains/losses and other changes in the volume of assets/liabilities must be consistent with changes in balance sheets (stock-flow consistency). The sectoral accounts are commonly presented in a matrix form, with sectors in columns and transactions/instruments in rows, with horizontal and vertical totals adding up (see the example in the table).
The first five rows of the table show the expenditure and revenues of each of the sectors (broken down into types of expenditure/revenue). In row 6, the difference between revenue and expenditure (the surplus/deficit) is shown.
The notions of revenue and expenditure are close to, but generally less encompassing than, the more traditional national account concepts of resources and uses. Income can then be defined as revenue (except capital transfers received) minus expenditure other than final consumption and capital expenditure (capital formation and capital transfers paid). For corporations, income corresponds to retained earnings. Savings is the excess of income over final consumption.
Surpluses/deficits are then associated with transactions in financial assets and liabilities in each sector. This is shown in rows 7 to 10. The bottom part of the table shows the stocks of assets and liabilities, which result from the accumulation of transactions and other flows. This table is extremely simplified (e.g. omitting an explicit presentation of the stock of non-financial assets).
The excess of revenue over expenditure is the net lending/net borrowing (i.e. financial surplus/ deficit), a key indicator of the sectoral accounts. Typically, a household’s revenue will exceed its expenditure. Households are thus providers of net lending to the rest of the economy. Non-financial corporations typically do not cover their expenditure by revenue, as they finance at least part of their non-financial investments by funds from other sectors in addition to internal funds. Non-financial corporations are thus typically net borrowers. Governments are also often net borrowers. If the net lending provided by households is not sufficient to cover the net borrowing of the other sectors, the economy as a whole has a net borrowing position vis-à-vis the rest of the world. Deviations from this typical constellation were apparent in several euro area countries before the crisis, in particular, with extremely elevated residential investment that resulted in households becoming net borrowers (as has been the case in the United States).
The adding-up constraints in the accounts require that any (ex ante) increase in the financial balance of one sector is matched by a reduction in the financial balances of other sectors. The accounting framework does not, however, indicate by which mechanism this reduction will be brought about, or which mechanisms are at play. The EAA makes it possible to track changes in net lending in the different sectors of the economy. It also specifies the financial instruments affected and shows how the transactions and valuation changes leave a lasting effect on the balance sheets of the sectors.
The article is worth a read.
The Bank of England also had a similar article recently but before: Growing Fragilities – Balance Sheets In The Great Moderation by Richard Barwell and Oliver Burrows and quotes the work of G&L (Godley and Lavoie). It also has a similar matrix as the ECB’s article.
(click to enlarge)
Godley and Lavoie build a series of closed accounting frameworks based on the system of National Accounts, which encompass: the standard national income flows, such as wages and consumption; the counterpart financing flows, such as bank loans and deposits; and stocks of physical and financial assets and liabilities. This framework lends itself to representation in a set of matrices. The first matrix captures flow variables (Table A.1). The columns represent the sectors of the economy and the rows represent the markets in which they interact. The matrix has two important properties. Each sector’s resources and uses columns provide their budget constraint — the sums must equal to ensure that all funds they receive are accounted for. And each row must also sum to zero, to ensure that each market clears — that is, the supply of a particular asset must be matched by purchases of that asset, to ensure that no funds go astray.
The table can usefully be split in two, with the top half covering the standard income and expenditure flows and the bottom half covering financing flows. The two halves of the table are linked together by each sector’s ‘net lending balance’, or ‘financial surplus’. The net lending balance can be used to summarise each sector’s income and expenditure flows as the difference between the amount the sector spends on consumption and physical investment and the amount that it receives in income. This difference must be met by financing flows — either borrowing or the sale of financial assets. In national accounts terminology, a sector’s net lending balance (NL) must equal its net acquisition of financial assets (NAFA) less its net acquisition of liabilities (NAFL). Across sectors, the net lending balances have to sum to zero, as all funds borrowed by one sector must ultimately come from another.
While it is useful to split the table for accounting purposes into income and expenditure flows and financing flows, it is important to note that the acquisition of financial assets and liabilities is not necessarily determined purely by imbalances between income and desired expenditure. Sectoral balance sheets can adjust for other reasons. Agents may want to borrow money to purchase assets, simultaneously acquiring financial assets and liabilities. And on occasion agents may want to shrink the size of their balance sheets, selling off financial assets to pay off financial liabilities. Finally, some agents may default on their debt obligations, which will involve a revision in the financial assets and liabilities of both debtor and creditor. At an aggregate level, simultaneous expansion of a sector’s assets and liabilities invariably represents one set of underlying agents taking on assets whilst the other takes on liabilities. The household sector provides an important example. If a young household takes a mortgage to buy a house from an old household, the sector in aggregate simultaneously acquires a liability (the young household’s mortgage) and an asset (the deposit created for the young household to pay to the old household).
All of these activities — leveraging up, deleveraging and default — involve NAFA and NAFL moving in lockstep. The net lending identity still holds: the gap between income and expenditure determines the difference between NAFA and NAFL. But the absolute size of the NAFA and NAFL flows is determined by agents’ actions in financial markets. The second table captures the balance sheet positions of each sector. The balance sheet matrix is updated over time using data on the acquisition of assets and liabilities from the transaction flows matrix, and revaluation effects to asset positions. Proceeding in this manner, balance sheets always balance across sectors, flows of funds are always accounted for over time and the impact of flows of funds on balance sheets is always recorded.
Again, good article!
The first time a proper transactions flow matrix appeared was in a 1996 Levy institute paper by Wynne Godley: Money, Finance And National Income Determination – An Integrated Approach.
