Discussions of the U.S. public debt and fiscal deficits curiously miss on the connection with the external sector. Even the Congressional Budget Office (CBO)’s The Budget And Economic Outlook report misses this connection when projecting the public debt over many scenarios.
Last week the President of the Federal Reserve Bank of New York, William Dudley gave a speech at a “Panel Discussion on Fiscal Challenges” and the two topic discussed by him were: the interest expense of the US government on its debt and the U.S. sectoral balances.
According to him, “we are in an unusual period in which net interest expense is temporarily depressed”. You can read about it at the FRBNY web page of the speech.
Which brings me to his discussion on sectoral balances. This is not the first time he has talked on this and the public debate on the public debt and fiscal deficit of the United States almost always miss the important connection of this with the external sector imbalance. But Dudley knows the importance of this in policy making, even though he begins his talk by saying that discussion of fiscal policy “for central bankers [is] always dangerous waters to swim in”.
Here’s Dudley’s chart:
Let’s just say Dudley is less dogmatic about fiscal policy than his colleagues because he says:
Fiscal adjustments require offsetting changes in private-sector spending and saving behavior, and in the trade sector. Prudent economic policies and international coordination can help ensure that such adjustments take place in ways that support economic activity (and, by extension also support government revenue).
and
On one hand, the U.S. economy must be reoriented toward global demand and stronger net exports. On the other hand, there will have to be offsetting adjustments elsewhere in the world. After all, on a global basis, the current account balance—properly measured—must sum to zero. This means that countries with significant trade surpluses will need to reorient their economies over time toward increasing domestic demand and running smaller trade surpluses.
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.
Readers of this blog may be aware of my fanhood for Wynne Godley and the title of this post is from a paper by him from 2004, although it was US-centric. This post is on imbalances in the Euro Area.
Wynne had not only always foreseen crises, but also knew about the muddle in the public debate and in academia both before and after the crises and the policy space available to resolve the crisis. Here’s from the short paper:
The public discussion is fractured. There are vacuous suggestions coming from sections of Wall Street that Goldilocks has been reincarnated and everything is fine. There are right-wing voices calling unconditionally for cuts in the budget deficit. The Bush administration seems complacent and, thank goodness, is not being convinced about cutting the federal budget deficit any time soon. Many are concerned about the current account deficit. Some of them fear a big and “disorderly” devaluation of the dollar while others think the dollar isn’t falling enough. No one has a clear idea about what can actually be done, by whom, and when. I have no sense that anyone who pontificates on these matters (outside the Levy Institute!) does so with the benefit of a comprehensive stock-flow model—the indispensable basis for competent strategic thinking.
In his 1983 book Macroeconomics, with Francis Cripps, he wrote:
… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do not know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.
Eurostat, the statistical office of the European Union published for the first time today the indicators of the “Macroeconomic Imbalances Procedure Scoreboard”.
The Headline Indicators Statistical Information release provides detailed data (since 1995) for current account imbalances, the net international investment position, share of world exports, private credit flow (net incurrence of liabilities discussed in the previous post), private debt and the general government debt for the EU27 countries not just EA17. People a bit familiar about Post Keynesian Stock-flow coherent macro models will be aware of the connection between these.
The flow accounting identity
NL = PSBR + BP
where NL is the Net Lending of the private sector to the rest of the world, PSBR is the Public Sector Borrowing Requirement, equal to the government’s deficit and BP is the current balance of payments (or simply the current account balance) adds to stocks of assets and liabilities via the short-hand equation (also mentioned in the previous post)
and hence the connection between the stocks and flows mentioned by Eurostat. The report also provides data for Real Effective Exchange Rates, Normal Unit Labour Costs, evolution of House Prices (which rise faster in booms and do the opposite in busts) relative to prices of final consumption expenditure of households.
The Euro Area was formed with the “intuition” that by having a single currency, among other advantages – the nations would not have balance-of-payments problems at all.
Wynne Godley saw this muddle as early as 1991:
(click to expand in a new tab)
Writing for The Observer where he said:
… But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.
Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.
and that:
… If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.
The Eurostat is a statistical organization and its job is to report and maybe suggest some policies to the policy makers. It has rightly identified the imbalances which are looking for a policy. Unfortunately, these imbalances are typically brought to a balance (or at least attempted to) by deflating demand and hence reducing output and increasing unemployment. The recent treaty changes with a new “fiscal compact” shows what the policy makers are trying to do. But they do not realize its implications!
Here’s from a 1995 articleA Critical Imbalance in U.S. Trade written by Godley:
Refuting the “Saving is Too Low” Argument
It is sometimes held that, in the words of the Economist (May 27. 1995, p. 18), “America’s current account deficit is enormous because its citizens save so little and its government spends too much.” The basis for this proposition is the accounting identity that says that the private sector’s surplus of saving over investment is always equal to the government’s deficit plus (or minus) the current account surplus (or deficit). As this relationship invariably holds by the laws of logic, it can be said with certainty that if private saving were to increase given the budget deficit or if the budget deficit were to be reduced given private saving, the current account balance would be found to have improved by an exactly equal amount. But an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.
and also in The United States And Her Creditors: Can The Symbiosis Last? (link) from 2005:
A well-known accounting identity says that the current account balance is equal, by definition, to the gap between national saving and investment. (The current account balance is exports minus imports, plus net flows of certain types of cross-border income.) All too often, the conclusion is drawn that a current account deficit can be cured by raising national saving—and therefore that the government should cut its budget deficit. This conclusion is illegitimate, because any improvement in the current account balance would only come about if the fiscal restriction caused a recession. But in any case, the balance between saving and investment in the economy as a whole is not a satisfactory operational concept because it aggregates two sectors (government and private) that are separately motivated and behave in entirely different ways.
The European Commission has taken the report and produced another titled “Alert Mechanism Report” which has this table called “MIP Scoreboard” which highlights the imbalances in grey:
(click to expand in a new tab)
and makes observations on many individual nations – e.g., for Spain:
Spain: the economy is currently going through an adjustment period, following the build-up of large external and internal imbalances during the extended housing and credit boom in the years prior to the crisis. The current account has shown significant deficits, which have started to decrease recently in the context of the severe economic slowdown and on the back of an improving export performance, but remain above the indicative threshold. Since 2008 losses in price and cost competitiveness have partially reversed. While the adjustment of imbalances is on-going, the absorption of the large stocks of internal and external debt and the reallocation of the resources freed from the construction sector will take time to restore more balanced conditions. The contraction in employment linked to the downsizing of the construction sector and the economic recession has been aggravated by a sluggish adjustment of wages, fuelling rising unemployment.
The above is reminiscent of the Monetarist experiments of the 70s and the 80s where wages are squeezed by deflating demand (resulting in reducing employment instead of increasing it). No suggestion is made on how wages are to be negotiated. While I do not yet the best way to say the following, here it is: while wages are cost to firms, they are incomes to households and this strategy puts higher pressure on the fall in demand and creates a more recessionary scenario.
The Euro Area had no central government which is responsible for demand management in the broadest sense and individual nations having forgotten Keynesian principles, had haphazard policies from the start. In some nations, governments had a more relaxed fiscal stance but it was not seen in their budget balances because the domestic private sectors were happily involved in having its expenditure higher than income – adding to stronger growth and hence higher tax revenues. Thus the budget balance was seen under control. In others, this may have been the result of the private sector itself contributing to most of the increase in domestic demand by high net borrowing. The high growth in private sector incomes also led to deterioration in external balances of the weaker nations and the whole process was allowed to go due to irresponsible behaviour of the financial sector which was underpricing risk. Everyone was acting as if there was no balance-of-payments constraint (sectoral imbalances in general) which will hit hard someday.
When the crisis hit, governments realized that they had given up the ultimate protection (and simultaneously the lenders to governments) – making a draft at their home central bank.
Let me offer an intuition on sectoral balances in general and not just for the Euro Area. While it is true that a “good” sectoral balance is one in which all the “three financial balances” are near zero, it is important that policy be designed (and bargained at an international level) so that these balances are brought to their preferred paths of staying near zero in the medium term without affecting the aim of full employment.
So imagine a closed economy. Most economists would suggest that – under certain conditions – the government should design policy to aim to reach a budget surplus (or a primary surplus) but this comes at the cost of lower demand and higher employment and hence a poor strategy. A higher fiscal stance – as opposed to targeting a balanced budget – will automatically lead to primary surpluses in the medium term because of the increase in demand and national income leading to increases in the government’s tax receipts. In open economies this gets complicated. Under the current arrangement a unilateral fiscal expansion by a nation such as Spain is ruled out because this will bring about a return to high current account deficits because of a faster rise in domestic demand than domestic output putting the nation on a different unsustainable path.
Now this may sound like TINA – but it is not if one thinks of alternative strategies which are aimed at bring the three financial balances from getting out of hand but with a coordinated fiscal reflation. However, this is difficult without there being institutional means of achieving the desired outcome and hence there is an urgent need for a more integrated Europe with higher spending and taxing powers for the European Parliament (unlike the 2% budget rule of Charles Goodhart) which will be induced in substantial fiscal transfers. Competitiveness also needs to be addressed but the powers of the government go beyond fiscal policy alone and policies need to be designed in a more integrated Europe which reduce transfer addiction such as a common wages policy as suggested by George Irvin and Alex Izurieta in their article Fundamental Flaws In The European Project (August 2011):
Policy action is necessary if these trade imbalances are gradually to disappear. Crucially, labour productivity must increase faster in the deficit countries than in the surplus countries, an aim difficult to achieve unless proactive fiscal policy and infrastructure investment trigger a modernising wave of “crowding in” private investment. This means that Europe must redistribute investment resources from rich to poor regions. In addition, if higher labour productivity growth is to be achieved in the periphery, a “common wages policy” (not to be confused with a common wage) must be adopted which better aligns wage and productivity growth and sustains aggregate demand. This will not be achieved with wage disparities exercising a deflationary impact on the union. In the absence of national exchange rate realignment, adjustment must take place through a regional wage bargaining process.
Update: The European Commission background paper “Scoreboard For The Surveillance Of Macroeconomic Imbalances” is available at here.
In yesterday’s post Spain’s Sectoral Balances, I briefly discussed the sectoral balances of Spain and its connection with demand, income and output. Here’s the original graph from the Banco de España again with my viewpoints in the previous post.
I learned some GIMP from a friend some time ago and thought I’ll use it for some fun.
I consider two scenarios:
Suppose the Spanish government relaxes its fiscal policy (independent of other Euro Area governments’ policies) or does not tighten it. How do the sectoral balances look? Here’s a likely scenario:
(may not sum to zero because of drawing discrepancies)
The “projection” – not to scale since I had limited availability for space – implies the government deficit keeps rising and this is the result of the rising current account deficit. A higher fiscal stance leads to a slightly higher income and employment but the flip side of this is a rising indebtedness to the rest of the world caused due to the current account deficits. The public sector is incurring almost all the change in net indebtedness – i.e., its contribution to net borrowing from the rest of the world is the highest.
Of course, this process cannot go on forever as a rising indebtedness implies foreigners have to be attracted by hook or crook and interest rate paid on government debt and consequently all private sector debts will also keep rising leading to a deflationary bust at some stage.
Also note, the causality here is a bit opposite of what was described in the previous post! The causalities between the balances of the “three sectors” is complex and not so straightforward. Here a higher fiscal stance leads to a higher income and expenditure and a widening of the current account deficit which in turn widens the budget deficit.
To prevent such possible instabilities – at least their smell of such instabilities – the European leaders have imposed the “fiscal compact” on nations.
What do they aim to achieve? The following “projection” is a possible answer:
The above describes the possible outcome of a tight fiscal stance of the Spanish government. A tight fiscal policy leads to lower income and hence a lower current account deficit – because of lower expenditure on foreign products – but it is achieved via lower output and employment.
The above projections are not based on a specific model for the Spanish economy but some analysis based on familiarity with SFC modelling.
Macroeconomics is not so easy – there are so many constraints – and governments have to strive to achieve the best optimal outcome. “Market forces” do not do that.
The second scenario can also be achieved by a coordinated fiscal expansion by the Euro Area nations. The sectoral balances may behave similar to the second scenario but in the expansionary scenario, output and hence employment is higher. Unfortunately there is no mechanism or institutional means by which fiscal policies are coordinated within the Euro Area (the exception is the recent “fiscal compact” which unfortunately misses the point). Even if there is an agreement on fiscal expansion, there is nothing to make sure that there is a constant management of the whole process – i.e., there are chances of failure.
There are various ideas one sees on proposing a solution to end the Euro crisis but almost none appreciate the real problems. In my opinion, there is no alternative to moving ahead with a European integration and granting more fiscal powers to the European powers – making it a central government – which is involved in fiscal transfers and a mandate to achieve full employment.
The Banco de España released its Quarterly Economic Bulletin today and it had an interesting chart on the sectoral balances of the Spanish economy.
With a net indebtedness of €994.5bn – i.e., close to €1 trillion – as compared to the gross domestic product of €1.06tn (2010 figure) Spain has limited choices. Except via the possibility of expanding by another private sector led credit expansion which is highly unlikely, the Spanish economy faces the prospects of low output and demand. Increasing exports is another option but with all Euro Area nations’ governments being forced by a “fiscal compact” to contract, this is unlikely because of low demand in the rest of Europe.
The chart is really interesting as it illustrates some of the many causalities associated with the financial balances identity
NAFA = PSBR + BP
where NAFA is the Net Accumulation of Financial Assets of the domestic private sector, PSBR is the Public Sector Borrowing Requirement or the deficit and BP is the current balance of payments.
When the domestic private sector tries to increase its saving, there is a contraction of demand, income and output (unless exports increase). As a result imports too reduce (because income is lower). The higher propensity to save also leads to an increase in the government’s budget balance.
So in the chart you see a dramatic fall in the current account deficit and a huge increase in the government’s budget deficit. (The term “Nation” is used in the chart because the current balance of payments is the difference between the incomes and expenditures of all domestic sectors of a nation).
The situation is not atypical of recent (post crisis) behaviour of other nations’ sectoral balances but the fall in the external sector balance in this case is striking, though the same could be said for various deficit nations in the Euro Area.
The Banco de España – whose short-term projections are usually accurate – also said today that unemployment will hit 23.4% in 2012!
S&P released another document yesterday in connection with the rating action of Eurozone governments yesterday which you can get via it’s Tweet:
click to view the tweet on Twitter
On the political agreements, the release says:
We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.
Two points.
First – yes, fiscal profligacy is not the only source of the crisis. It is typical to give the example of Spain and Ireland – and done by S&P itself – to justify this:
This to us is supported by the examples of Spain and Ireland, which ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany), while reducing significantly their public debt ratio during that period.
There is a risk in making such an argument and even progressives sometimes do so. The error is assuming that the public sector deficit is a proxy for the fiscal stance of the government! Macroeconomists using stock flow coherent macro modeling have shown that the budget balance is just an endogenous outcome and the more appropriate proxy for the fiscal stance is G/θ, where G is the government expenditure and θ is the average tax rate.
To me it seems both Spain and Ireland governments (and local governments) were actually lavish in their spending. The private sector was even more lavish in its expenditure and rising incomes led to higher tax revenues which improved the government’s budget balance before the crisis. The whole process was allowed to continue by market forces, domestic and foreign lenders who (not surprisingly) underpriced risk. Needless to say the lack of a central government overseeing demand management and the ignorance of Keynesian principles contributed to the haphazardness.
Second, most commentators – including the S&P – pay too much attention to price competitiveness. So typically one sees a graph of unit labour costs of individual nations in almost all analysis. One even does not need to take innovations in the export sector to explain the crisis.
The EA17 nations had different levels of non-price competitiveness to begin with and faster growth of income/expenditure in the “periphery” as a result of the boom as compared to slower growth in the “core” nations led to exploding current account deficits. Here’s the data from the IMF’s latest World Economic Outlook published in September 2011 on the current account balances:
With different non-price competitiveness (or income elasticity of imports) (to begin with at the formation of the monetary union rather than innovations during the last ten years) combined with fast rising income/expenditure in the periphery, this led to a dramatic increase in net indebtedness of the periphery as a straightforward consequence. To emphasize the point, even if non-price competitiveness was similar between the core and the periphery, this would have resulted in rising net indebtedness.
It is surprising how international finance contributes to unsustainable processes from continuing as if they can continue forever!
Update
Paul Krugman has a new post on his NY Times Blog on the same comment from S&P from its FAQs but with a different viewpoint.
In a recent post, I quoted Kaldor and got a lot of response on what I quoted. So a post on more from the book The Scourge Of Monetarism from the early 80s.
In the following PSBR is Public Sector Borrowing Requirement – the term used often in the UK for net market borrowing of the UK Treasury for a given period such as a month/quarter/year.
The following appears in the Part II of the book. The Select Committee of the House of Commons on the Treasury and the Civil Service ordered an enquiry into monetary policy and Kaldor was invited to write on this in 1980. The whole text appears in the book and the following appears on pages 48-50:
In the Green Paper on Monetary Control of March 1980 it is asserted that ‘it is sometimes helpful to examine how a particular control will affect items on the asset side of the banking system’. The Paper then proceeds to state an accounting identity which shows the change in the money stock (£M3) in a given period as the sum of five separately identified items, of which PSBR is one (though it is not claimed that the five items are mutually invariant).
In my view it may be more helpful to view the effects of the PSBR on the asset side of the non-banking private sector, both at home and overseas. The PSBR in any year can be defined as the public sector’s net de-cumulation of financial assets (net dissaving) which by accounting identity must be equal to the net acquisition of financial assets (net saving) of the private sector, home and overseas; which in turn can be broken down to the net acquisition of financial assets of the personal sector, of the company sector, and the overseas sector (the latter is the negative of the balance of payments on current account). Ignoring capital flows of existing wealth to and from the country, the change in liabilities of the banking system is thus equal to that part of the net saving (or the net increment of financial assets) of the home and overseas private sector which persons and companies wish to hold in the form of sterling bank deposits as against other financial assets (such as ‘bonds’ or ‘gilts’) and which in turn is equal to that part of the PSBR which is financed by the addition of the banking system’s holding of the public sector debt.
The main monetarist thesis is that the net dissaving of the public sector is ‘inflationary’ in so far as it is ‘financed’ by the banking system and not by the sale of debt (bonds or gilts) to the public. But this view ignores the fact that the net saving, or net acquisition of financial assets of the private sector will be the same irrespective of whether it is held in the form of bank deposits or of bonds. The part of the current borrowing of the public sector which is directly financed by net purchases of public debt by the banking system – and which has its counterpart in a corresponding increase in bank deposits held by the non-banking private sector – is as much part of the net saving of the private sector as the part which is financed by the sale of gilts to the private sector. When the public sector’s de-cumulation of financial assets increases (i.e. the PSBR increases) there must be an equivalent increase in the net savings of the non-bank private sector (home and overseas) as compared with what net savings would have been with an unchanged PSBR which will be the same irrespective of how much that saving takes the form of purchases of gilts and how much takes the form of an increase in deposits with the banking system. The decision of how much of the increment in private wealth is held in one form or another is a portfolio decision depending on relative yields, the expectation of future changes in interest rates (long and short), and the premium which the owners are willing to pay for ‘liquidity’ – i.e. the possession of command over resources in a form that can be directly applied to extinguish debts or to meet financial commitments.
But it is a mistake to think that an individual’s spending plans (whether in a business or in a personal capacity) are significantly affected by the decision of how much of his wealth he decides to keep in the form of ‘money’ (broadly or narrowly defined) as against other financial assets that are readily convertible into money (including available overdraft facilities). It is equally mistaken (in my view) to assume that the part of current private saving which is held in the form of additional bank deposits gives rise to additional lending by the banks to the private sector, whereas the part which is held in the form of bonds does not. In the former case, the increase in the bank’s liabilities to depositors is matched by a corresponding increase in the banks’ holding of public sector debt.
Excellent analysis of the EU Summit by Martin Wolf on FT using the sectoral balances approach:
…
Let me make this point by turning last week’s analysis of the balance of payments into one of foreign, private and government financial balances in eurozone members (see charts). To remind readers: these have to add up to zero, by definition. But how they go about adding up is revealing.
As I noted last week, fiscal imbalances were modest before the crisis, but the current account imbalances were huge. Surplus private funds in some countries (notably Germany and the Netherlands) were intermediated by the financial system to fund private deficits in others (notably Greece, Ireland, Portugal and Spain). When crisis hit, these flows ceased. Deficits of private sectors collapsed (most turning into surpluses), while fiscal deficits exploded. Now, says Germany, the latter must be slashed.
By definition, the sum of private and current account deficits must also fall towards zero. The private sectors of erstwhile capital-importing countries have moved towards surpluses, for a good reason: they are trying to reduce their debts, not least because their assets are falling in value. Thus the external deficit needs to fall. That can occur in a good or a bad way. The good way would be via increased output of exports and import substitutes; the bad would be via a deeper recession. The good way requires far higher imports in the core of the eurozone or far greater competitiveness for the eurozone as a whole. But little chance of either of these exists, under plausible expectations for demand and activity. That leaves the bad way: deep recessions, in which the government reduces its deficit by deflating the private sector yet more.
In brief, it is extremely difficult to eliminate fiscal deficits in the structural capital-importing countries, without prolonged recessions or huge improvements in their external competitiveness. But the latter is relative, so the needed improvements in the external performance of weak eurozone countries imply a deterioration in that of eurozone capital-exporters, or radically improved external performance for the eurozone as a whole. The former means that Germany becomes far less German. The latter implies that the eurozone becomes a mega-Germany. Who can believe either outcome is plausible?
This leaves much the most plausible outcome of the orgy of fiscal austerity: long-term structural recessions in vulnerable countries. To put it bluntly, the single currency will come to stand for wage falls, debt deflation and prolonged economic slumps. Can this stand, however big the costs of a break-up?
The eurozone has no credible plan to fix the flaws of the eurozone, apart from greater fiscal austerity: there is to be no fiscal, financial or political union; and there is to be no balanced mechanism for economic adjustment on both sides of the creditor-debtor divide. The decision is, instead, to try still harder with a stability and growth pact whose failures have been both predictable and persistent.
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.
