Martin Wolf wrote a blog post yesterday on FT: Understanding sectoral balances for the UK where he compares the sectoral balances for the United Kingdom and the United States.
To me both the similarities and differences are interesting. The following charts are from his post:
The OECD released its Economic Outlook recently. The preview is available here but download is for subscribers. Else if you are an FT subscriber, you can get it from FT Alphaville’s Long Room.
A few interesting charts (at least for me):
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Most Economists (except a few good ones), following the work of Mundell, Fleming and Friedman believed that in floating exchange rate regimes, the invisible hand will work to remove imbalances. Unfortunately, this has not happened and it has taken the crisis for them (most of them actually!) to realize that there is no mechanism and it is still unclear if they understand this.
There are some dissenters among Post Keynesians, such as Randall Wray, who do not consider current account deficits as an imbalance. See this blog post. Also see Reserve Bank of Australia’s Guy Dibelle’s speech In Defense of Current Account Deficits from July 2011.
An intuition I see often displayed in blogs is that these numbers are small and hence not problematic! My view is that these imbalances are kept low by keeping demand low. More importantly, these imbalances (deficits) add to the stock of external debt (because a deficit in the current account increases net indebtedness to foreigners) and this gets out of control sometimes leading to deflation of demand and/or seeking help from the IMF. So “low” imbalances accumulate to a huge net indebtedness.
There is an informative graph on the financing needs of Greece, Ireland and Portugal:
The report also charts sectoral balances for the Euro Area!
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The Euro Area as a whole seems healthy, and it is imbalances within that are causing the troubles.
It seems Italy’s current account is worsening:
Turkey’s current account attracts a lot of attention and challenges look like this:
Turkey’s currency Lira has depreciated a lot recently
In Post Keynesian theory, the exchange rate is determined in a beauty contest in addition to demand and supply for financial assets. Sudden movements can be very painful and hence nations face a balance of payments constraint – success of nations depends on how producers do in international markets. In words of Wynne Godley,
For growth to be sustainable, it is essential that the management of domestic demand be complemented by the management of foreign trade (by whatever policies) in such a way that the net balance of exports less imports contributes in parallel to the expansion of demand for home production.
At the global level, since not everyone can be net exporting, the problem of global imbalances affects everyone, and new changes are required on how the global economy is run.
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)
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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.
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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.
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James Tobin et al. had something similar – almost but not quite in A Model Of US Financial And Nonfinancial Economic Behavior :
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The International Monetary Fund, IMF has one full chapter devoted to the subject of “twin deficits” in their latest issue of World Economic Outlook. The subject of “twin deficits” is full of complications and can invoke the deepest emotions from economists. Naively, the argument goes as follows: The “three financial balances” identity can be written as
NAFA = DEF + BP
where NAFA, DEF and BP stand for the Net Acquisition of Financial Assets of the private sector, Government Deficit, and the current Balance of International Payments. From the above, if the government deficit increases, for a constant NAFA (rather a constant NAFA/GDP), an increase in DEF causes BP to reduce, i.e., reduces the current account balance or causes the current account deficit to increase.
Now, this is hardly the best way to put it – because it is mistaking an accounting identity for a behavioural relationship. For example, in conjecturing, one is implicitly assuming that the budget deficit is exogenous or fixed by the government. It is then argued that to reduce the current account deficit (or BP with a minus sign), the government should cut its budget deficit.
There is some truth to “twin deficits”, in my opinion. A lot actually! However, conclusions from any analysis need to be studied in a proper framework and stock-flow coherent macroeconomics is the only way to do this. Money is automatically endogenous in “SFC” models – it cannot be otherwise.
The government sets its fiscal policy or fiscal stance. This can be approximated to be G/θ, where G is for government expenditures and θ is the tax rate (as opposed to total taxes). The budget deficit is out of the control of the government and is dependent among other things, the private sector propensity to consume, the exports and imports. Assuming exports remain constant, relaxing the fiscal stance (i.e., an increase of G/θ) leads to an increase in domestic demand, ceteris paribus. An increase in demand leads to an increase in imports. (If people have higher incomes, they will purchase more imported products). This leads to the widening of the current account deficit and hence through the sectoral balances identity a widening of the budget deficit.
Various things can be said about what is written in the last paragraph. Take the case when ceteris is not paribus. An increase in the propensity to save (i.e., a decrease in propensity to consume) can lead to a higher NAFA and DEF and increasing BP (as a result of lower domestic demand and hence lower imports).
Come back to ceteris paribus: assume that demand abroad has increased for some reason. This could be due to an increase in the fiscal stance of the foreign government or a private sector led credit expansion abroad. This will lead to an increase in exports for the country we are discussing. So in such a scenario, an increase in the fiscal stance – up to some limit – will not lead to a widening of CAD, i.e., decrease in BP.
Wynne Godley put it best in a Levy article in 1995 (always perfect with his wording):
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.
How is protectionism related to all this? When nations face severe balance of payments issues, they are forced to deflate demand in order to bring the balance of payments at sustainable levels. If that doesn’t work either, nations may try to directly reduce imports. This works via reducing the propensity to import and hence imports. However, it is difficult to take such a step because it can lead to retaliation. As John Maynard Keynes once put it:
During most of the period in which the modern world has been evolved … the failure to solve this problem has been a major cause of impoverishment and social discontent and even of wars and revolutions.
i.e., the failure to resolve the balance of payments problem. The only way to peacefully resolve this issue is by working toward a solution which is good for all. Even the Bank of England (and Mervyn King) has realized this. Else we will just have a long period of low demand and high unemployment, leading to social unrest. More on that some other time.
[Update, 3 Jan 2012: Fixed some errors]
Martin Wolf used the three financial balances approach in his blog recently. Here’s the chart from that post:
I am reading Dani Rodrik’s The Globalization Paradox and borrowed the title for this post.
I am curious as to what Barry Eichengreen has to say in his talk at the Federal Reserve’s annual forum at Jackson Hole, Wyoming. He is the author of the book Exorbitant Privilege: The Rise And Fall Of The Dollar And The Future Of The International Monetary System – one of the books I want to read soon. The phrase Exhorbitant Privilege was coined in the 1960s by the then French Finance Minster Valéry Giscard d’Estaing. The term refers to the high ability of the United States (and directly and indirectly, the United States government) to borrow in US$ to finance its balance of payments deficit.
To some extent, the scale and timing of the Federal Reserve’s emergency operations during the credit crisis which started around 2007 has helped maintaining the hegemony of the US$ for a while and Barry Eichengreen knows that. This United States Government Accountability Office (GAO) report Federal Reserve System – Opportunities Exist To Strengthen Policies And Processes For Managing Emergency Assistance is a nice reference for the kind of operations done by the Fed, especially international swap lines. Many central banks made use of the swap lines and lent large quantities of US$ to the banking system because banks were facing funding issues in dollars.
Back to the Jackson Hole Symposium. Everyone is waiting for the ECB Chairman Jean-Claude Trichet’s talk. Meanwhile Christine Lagarde, IMF’s chief touched on some issues about imbalances in her speech. She rightly points out that
… risks have been aggravated further by a deterioration in confidence and a growing sense that policymakers do not have the conviction, or simply are not willing, to take the decisions that are needed.
which is quite right, IMO because this crisis needs coordination at a scale never seen before. She also points out that
As we all know, a major cause of the crisis was too much debt and leverage in key advanced economies. Financial institutions engaged in practices that magnified, disguised and fragmented risk, while households borrowed too much. Experience tells us that these excesses (combining both housing and financial crises) take a long time to work off—and require decisive action. We have made some progress, but not enough to unshackle growth.
I am by no means downplaying what has been done. In 2008, governments took bold action to prevent a calamitous collapse in demand. They offset private contraction with fiscal expansion and used public resources to recapitalize financial institutions. They strengthened financial regulation, and reinforced the capacity and resources of international institutions. And monetary authorities did their part as well.
But today, it is public sector balance sheets themselves that are in the firing line. Today, the headline problems are sovereigns in most advanced economies, banks in Europe, and households in the United States. Adding to this—global growth is also being held back by policies that slow demand in some key emerging market economies while balance sheet risks are increasing in others.
The fundamental problem is that in these advanced economies, weak growth and weak balance sheets—of governments, financial institutions, and households—are feeding negatively on each other. If growth continues to lose momentum, balance sheet problems will worsen, fiscal sustainability will be threatened, and policy instruments will lose their ability to sustain the recovery.
which is quite right. Fiscal expansion has helped nations recover from the private sector imbalance but fiscal policy alone cannot achieve everything. However, somewhere her message won’t work well because she mentions earlier in her speech that
Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties. On the first, the idea was that strengthened private sector finances would allow the engine of growth to switch back from the public to the private sector. On the second, the idea was that higher demand in surplus countries would make up for a lower spending path in deficit countries. But the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing.
implying thereby that coordinated fiscal policy (expansion) has no role in the long run, at least giving the impression to the reader/listener. However, she is right in stressing that surplus nations need to take up the task of rebalancing.
While talking of “urgent recapitalization” banks in Europe require, Lagarde also talks of a common vision for Europe:
Third, Europe needs a common vision for its future. The current economic turmoil has exposed some serious flaws in the architecture of the eurozone, flaws that threaten the sustainability of the entire project. In such an atmosphere, there is no room for ambivalence about its future direction. An unclear or confused message will add to market uncertainty and magnify the eurozone’s economic tensions. So Europe must recommit credibly to a common vision, and it needs to be built on solid foundations—including, for example, fiscal rules that actually work.
but no mention of a fiscal union! Most people – economists at least – would take the above to mean a plan to work toward achieving targets for deficits and public debt – an impossible dream.
Lagarde’s conclusions are right
There is a clear implication: we must act now, act boldly, and act together.
but this comes only by at least and not limited to coordinating fiscal policies not by “fiscal consolidation” – a phrase which literally suggests a fiscal contraction.
Conclusion
The IMF is a part of the problem but Christine Lagarde’s heart is in the right place – she needs to carefully think about how fiscal policy really matters and convey to others some of the ideas she has thought of, since they are slightly different from the IMF’s traditional beliefs. How far she goes will be interesting to see.
The sectoral balances identity
NAFA = PSBR + BP
(where NAFA is the private sector net accumulation of financial assets, PSBR is the public sector borrowing requirement to finance its deficit and BP is the current balance of payments) and the approach which is built around this, implies that if the public sector wants more saving, the government has no choice but to accommodate this demand unless it is prepared to run the economy at less than full employment. However, it doesn’t mean that the government has the ability to fully relax its fiscal stance up to constraints from the supply side, because if domestic demand starts expanding faster than domestic output, the nation’s balance of payments situation will suffer and this can be resolved only by correctly negotiated international policies which is good for all. The IMF should look at it that way instead of recommending fiscal expansion as a temporary measure.
Update
For a different take on Lagarde’s speech check Zero Hedge
Update 2:
Financial Times has a post Lagarde calls for urgent action on banks on this. The writer points out that
On fiscal policy, she continued the IMF’s change of emphasis away from immediate fiscal tightening, and towards fiscal programmes that reduce deficits over the long-term but which allow spending to continue while economies stay weak.
Today the Bank of England was out with its quarterly Inflation Report and I happened to find a graph which tracks the sectoral balances. Here it is
Not sure why it leaves out financial corporations though.