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Imbalances Looking For A Policy

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… and not Infernal Muddles

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)

Closing Stocks = Opening Stocks + Flows + Revaluations

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 article A 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:

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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.

Income And Expenditure Flows And Financing Flows

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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:

  1. Income and Expenditure Flows
  2. 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:

Closing Stocks = Opening Stocks + Flows + Revaluations

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.

In an article Peering Over The Edge Of The Short Period – The Keynesian Roots Of Stock-Flow Consistent Macroeconomic Models, the authors Antonio C. Macedo e Silva and Claudio H. Dos Santos say:

… 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.

Sources And Uses Of Funds

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In a recent post, I went into what is called the Transactions Flow Matrix. This is used heavily in Stock-Flow Consistent Modeling of the whole economy. The underlying theme is “everything comes from somewhere and goes somewhere, and there are no black holes”.

I also mentioned about a Balance Sheet Matrix. What is it?

Sectors in an economy have assets and liabilities. Assets can be both financial as well as nonfinancial. Since nonfinancial assets are nobody’s liability, liabilities are financial. Very quickly, a balance sheet matrix is created by assigning a + sign to assets and a (-) sign to liabilities.

As per the System of National Accounts, all assets and liabilities are to be evaluated at market prices. According to 2008 SNA,

So a corporation or the government may have issued bonds at $100 but since the value fluctuates everyday and even during the day, it is possible that the bond price may reach $103. If it is the last day of the period for which the balance sheet is compiled, then the liability should be entered as $103, not $100.

We will have more to see in another post but let us just have a cursory look at an item called net worth. Since balance sheets should balance, we include this item in liabilities or rather call the right hand side of a balance sheet “Liabilities and Net Worth”. The term Net Worth has an intuitive appeal. If I have assets worth $100 and owe someone (say a bank) $10 and nothing more or less, my net worth is $90.

So let us quickly jump into the balance sheet matrix of a model economy.

In the previous post on the Transactions Flow Matrix, I had amalgamated the sectors Government and Central Bank into one, but now I have separated them so that there is higher clarity.

The reason I am writing this post is to stress the importance of signs. So in the above you will notice that households have a liability of L_{h} and hence appears with a negative sign. We shall see below however, that since loans are a source of funds, it will appear as a positive sign in the transactions flow matrix!

So households hold currency notes, deposits, bills and equities and these have counterpart in some other sector. And this should be the case because every financial asset is someone else’s liability. Also, from the matrix, the sum of net worths of all sectors (for a closed economy, at any rate) is equal to the value of the nonfinancial assets. This result isn’t surprising since financial assets cancel out with their counterpart liabilities.

We now jump to the transactions flow matrix – which I remade and added a lot of complications as compared to the previously related post The Transactions Flow Matrix

(Click to enlarge in a new tab)

These matrices are almost exactly similar to what appears in Wynne Godley and Marc Lavoie’s book Monetary Economics. 

The difference between the two matrices is that the balance sheet matrix records assets and liabilities at the beginning or the end of a period, whereas the transactions flow matrix records transactions during an accounting period.

In the previous post I had briefly stressed the importance of signs but now we have the balance sheet matrix as well ready, let me stress this again using a few lines from G&L’s book on the transaction flow matrix (page 40):

The best way to take it in is by first running down each column to ascertain that it is a comprehensive account of the sources and uses of all flows to and from the sector and then reading across each row to find the counterpart of each transaction by one sector in that of another. Note that all sources of funds in a sectoral account take a plus sign, while the uses of these funds take a minus sign. Any transaction involving an incoming flow, the proceeds of a sale or the receipts of some monetary flow, thus takes a positive sign; a transaction involving an outgoing flow must take a negative sign. Uses of funds, outlays, can be either the purchase of consumption goods or the purchase (or acquisition) of a financial asset. The signs attached to the ‘flow of funds’ entries which appear below the horizontal bold line are strongly counter-intuitive since the acquisition of a financial asset that would add to the existing stock of asset, say, money, by the household sector, is described with a negative sign. But all is made clear so soon as one recalls that this acquisition of money balances constitutes an outgoing transaction flow, that is, a use of funds.

So the government expenditure G has a minus sign because it is a use of funds and its sources are taxes, net issuance of bills and central bank profits.

The sources of funds for the production sector (abbreviated “firms”) is retained earnings (or undistributed profits, called FU), loans from banks and the issuance of equities and also sales (the consumption by households), government purchase of goods and investment itself because producers create tangible capital for themselves as a whole.

Now compare signs in the two matrices – equities are a source of funds for firms and hence has a positive sign in the transactions flow matrix but equities are also liabilities and hence the stock of equities appears with a negative sign in the balance sheet matrix.

Similarly, borrowing via loans are a source of funds for households and hence the positive sign in Table 2 while in Table 1 it appears with a minus sign.

For banks, making loans is a use of funds and taking deposits a source of funds. Hence minus and plus respectively in Table 2.

Also, the equities and loans in Table 2 are flows whereas in Table 1 they are stocks. Hence in Table 2, we have “Δ Loans” or change in loans, whereas in Table 1 its simply “Loans”.

Once we have a beginning of period balance sheet matrix and the transactions flow matrix, how do we construct the end of the period balance sheet matrix? I will leave this question for another post because I will have to introduce capital/holding gains and something called a full integration matrix. Before that I will have another post on real numbers taken from statistical releases to get more a intuitive feel for the balance sheet matrix.

The three matrices (the transactions flow matrix, the balance sheet matrix and the full integration matrix) go into the heart of “how money is created”. For this to be seen in detail, I will have to go into “monetary circuits” using transaction flows and that is the topic of yet another post. If you really understand how loans make deposits, the two tables should set you into a dynamical view of the whole process – a description completely different than the chimerical money multiplier model.

S&P Takes Rating Actions On Euro Area Governments

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On 5 December 2011, S&P put ratings of EA17 governments on rating watch negative. See my post S&P And EA17 National Governments for link to the S&P report. Today it concluded its review and downgraded several governments.

click to view  the tweet on Twitter

According to the report, which can be obtained from S&P’s Tweet:

We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches; lowered the long-term ratings on Austria, France, Malta, Slovakia, and Slovenia, by one notch; and affirmed the long-term ratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands. All ratings have been removed from CreditWatch, where they were placed with negative implications on Dec. 5, 2011 (except for Cyprus, which was first placed on CreditWatch on Aug. 12, 2011).

The outlooks on the long-term ratings on Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain are negative, indicating that we believe that there is at least a one-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizon for issuers with investment-grade ratings is up to two years, and for issuers with speculative-grade ratings up to one year. The outlooks on the long-term ratings on Germany and Slovakia are stable.

We assigned recovery ratings of `4′ to both Cyprus and Portugal, in accordance with our practice to assign recovery ratings to issuers rated in the speculative-grade category, indicating an expected recovery of 30%-50% should a default occur in the future.

S&P also cites that “an open and prolonged dispute among European policymakers over the proper approach to address challenges” as one of the reasons to take the rating actions.

How can the Euro Area solve its problems?

One of my favourite papers is A Simple Model Of Three Economies With Two Currencies (link) written by Wynne Godley and Marc Lavoie. The paper was written about 7-8 years back and was published in 2006 in the Cambridge Journal of Economics.

The paper’s abstract:

This paper presents a Keynesian model which describes three countries trading merchandise and financial assets with one another. It is initially assumed that all three countries have independent fiscal policies but that two of the countries share a currency, hence the model can be used to make a preliminary analysis of the conduct of economic policy in ‘the eurozone’ vis-a`-vis the rest of the world—‘the USA’. The main conclusion will be that, if all three countries do indeed operate independent fiscal policies, the system will work under a floating currency regime, but only so long as the European central bank is prepared to modify the structure of its assets by accumulating an ever rising proportion of bills issued by any ‘weak’ euro country.

G&L make an interesting remark about a possible ECB behaviour:

… If the ECB is forbidden from accommodating market-driven changes in the composition of its assets, or if the ECB rules that it will not accumulate additional stocks of securities issued by governments that have excessively large debts according to rating agencies, then fiscal policy in the ‘weak’ countries must be endogenous for stability to prevail, for otherwise it would seem that the only alternative is to let interest rates on euro bills to diverge from country to country in an unsustainable way.

Now this would seem to be a rather dismal state of affairs, from a progressive standpoint. However, it should be noted that balanced fiscal and external positions for all could as well be reached if the euro country benefiting from a (quasi) twin surplus as a result of the negative external shock on the other euro country decided to increase its government expenditures, in an effort to get rid of its budget surplus …

i.e., Euro Area nations with a weak external sector will have to deflate fiscal policy to attempt to keep the external deficit, net indebtedness to the rest of the world and interest rate in check, if surplus nations in the Euro Area do not wish to engage in fiscal expansion. Else, as G&L conclude:

Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

In my opinion, this is the only way the Euro Area can come out of the mess because it is the only way the net indebtedness of an EA nation (or a group of nations) can be prevented from exploding relative to its domestic output .

For an earlier take on the Maastricht Treaty by Wynne Godley see the article Maastricht And All That published in the London Review of Books in 1992.

The Transactions Flow Matrix

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Why is GDP defined as C+I+G+… and how is it related to national income, expenditure etc and that of each sector of an economy such as that of households?

The following table (redrawn by myself) taken from the book Monetary Economics by Wynne Godley and Marc Lavoie gives an idea on how to go about measuring national income, product etc. The sample chapter (Contents, Chapter 1 & Index) from the publisher’s website has an introduction to the authors’ approach of studying Macroeconomics from a stock-flow consistent approach.

The table describes income and expenditures flows within an economy. Of course, as mentioned this is simplified and complications have to be added one by one. For example, there is no inventories, no external sector and households do not purchase a house etc. However, the above construction shows an easy way of building up and thinking about how funds flow between different ‘sectors’ of an economy. The reader who is new to this way of thinking should pay attention to the signs attached to each entry. For example, households receive wages and it is a source of funds for them and hence the positive sign. When they are consuming, they use funds and hence the first row in the table with the item consumption has a negative sign for households. For businesses, this a source of funds and hence positive. Another item which may be unfamiliar is the capital account of businesses. Firms purchase capital goods for their production and the sale of these goods comes from the same sector and hence one need for this column.

Even at this simplified form, there are a lot which are not known from the above table. What form does saving take? How does the government finance its excess of expenditure over income (i.e., deficit)? How do firms pay for wages and get funds to do the investment etc. To see this, we need a transactions flow matrix which I had discussed previously in my post Financial Crisis And Flow Of Funds from a not-so-pedagogic perspective. It is a foxy trick.

A few things before going into this. First notice that from the matrix,

C + I + G = Y = WB + F

So in our simplified example, gross domestic product is the sum of expenditures on goods and services and at the same time the sum of incomes paid for the production of goods and services.

Second, if you want the actual numbers (for the United States), the place to get this from the Federal Reserve Statistical Release Z.1. In particular, tables F.6 and F.7 and the hyperlink directly takes you to the table.

Back to our question on what form does saving take and how do firms finance their activities etc. Below is the table I made using TeX (and taken from the same book, Chapter 1)

The questions asked also lead us naturally to the introduction of the banking sector and its importance in the process of production, and this sector was missing in Table 1. So we can now clearly see what form saving takes. For households, this is in the form of currency notes, bank deposits, government T-bills and firms’ equities. Apart from various complications added, you may have noticed that profits are assumed to be part distributed and part retained. Firms hence finance investment by retained earnings, loans from banks and by issuance of equities, here. The government finances its deficit (i.e., excess of outlays over receipts) by issuing currency notes and T-bills. We have merged the Central Bank and the Federal Government into one sector “Govt”, for simplicity (which is also the case for Table 1). The behavioural aspects are something different and it should not be assumed that the government can “control” its deficit and that it can choose the proportion of financing in the form of currency notes and bills.

Needless to say, the above transactions flow matrix is a simplified one. For example, you may immediately notice that there is no interest payments on loans and bills yet.

It should be noted here that the entries in the table are flows and hence you may see a lot of Δs. The reader who is relatively new to this should not fail to observe the signs attaching each entry. The negative sign in the entry for deposits for households may be confusing at first, but the self-consistency of the whole construction forces the signs on these entries.

It is worth emphasizing that the fact that all rows and columns sum to zero and this makes the whole construction very appealing. When I was trying to get myself introduced to economics about 3 years back, I browsed around the internet and quickly came across the transactions flow matrix – exactly what I was looking for!

This construction greatly simplifies visualizing flow of funds as compared to the Blue Book way of doing it. The following is the 2008 SNA way of maintaining national accounts and there is some additional effort one needs to visualize this without the usage of a transactions flow matrix!

(click to enlarge)

Books In Honour Of Wynne Godley

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There are two new books in honour of Wynne Godley and they are out now

The first one – edited by Marc Lavoie and Gennaro Zezza – has selected articles and papers by Wynne Godley, and carefully chosen.

It’s available at amazon.co.uk, but not yet on amazon.com

Here’s the book’s website on Palgrave Macmillan. The book also contains the full bibliography of Godley’s papers, books, working papers, memoranda (such as to the UK expenditure committee), magazine/newspaper articles, letters to the editor etc.

Here’s a picture I took of Marc at Levy Institute in May when he was deciding on the cover.

The is second book written in honour of Wynne Godley contains proceeding of the conference held in May at the Levy Institute (the same place the above photograph was taken)

The publisher’s website for the book is here.

Dimitri says:

The death of Wynne Godley silences a forceful and very often critical voice in macroeconomics. Wynne’s own strong view, that although his work was representative of the non-mainstream Keynesian approach to economics and especially economic policy was important nevertheless, has been confirmed time and time again as evidenced in the fortunes of the UK, US and Eurozone economies. His writings, reflecting the sharpness of his mind and intellectual integrity, have had a considerable impact on macroeconomics and have aroused the interest of scholars, economic journalists and policymakers in both mainstream and alternative thought. In a review of Wynne’s last book with Marc Lavoie (2007), Lance Taylor had this to say: ‘Wynne’s important contributions are foxy – brilliant innovations… that feed into the architecture of his models’

I also like Wynne’s stand on the current account imbalance of the United States:

Bibow finds that Godley’s diagnosis of the looming economic and financial difficulties ahead of their occurrence was prescient with regard to US domestic developments – a theme that came up in the chapters by Wray and Galbraith. But Bibow takes issue with Wynne’s assessment of the US external balance being unsustainable. He notes that the US investment position and income flows are more or less in balance and he attributes this phenomenon to the safety of the US Treasury securities and the dollar functioning as the reserve currency.

Dimitri then says

Even if this is so, it cannot continue indefinitely, Wynne would have replied.

The conference page is here

Macdougall Report

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Charles Goodhart and Dirk Schoenmaker just released their article on a game plan for saving the Euro, which is approaching its endgame. According to them,

An EZ Minister of Finance without money is like an emperor without clothes. There are proposals to have tax capacity capable of funding a budget of about 2% of European GDP (Marzinotto et al 2011; Goodhart 2011). This 2% should cover most eventualities, including effective stabilisation policies. Yet there may be exceptional circumstances, for example, relating to banking resolution where more is needed (the deep pockets of government).

Given the severe imbalances in the Euro Area, this looks too low. Really 2%? A recent empirical study done by The Economist for the United States suggests otherwise.

What is wrong with the Euro Area? Wynne Godley said this best in an article (written in 1991) in The Observer titled “Commonsense Route To A Common Europe”. Scan here

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.

All of this was recognised in the Macdougall Report of 1977 which correctly argued that if a monetary union were not later to fly apart it would be necessary to have a Community budget at least seven times larger than existed then, with most of the increase going into the social and regional fund. The object of having a greatly enlarged budget would, of course, be to carry out the kind of fiscal equalisation that is at present performed by national budgets, and which is essential if a minimum standard of living is to be maintained throughout the Community.

[emphasis added ;-)]

The Macdougall Report is available from the European Commission website: Part 1 and Part 2. Haven’t read it, so my knowledge is restricted to the above quote, and it adds to my huge list of things to do.

At the time of writing, I believe the situation was much different. The imbalances in the “three sectors” (public, private and external) is now severe in the Euro Area. (Three for each country, so actually 17 x 3)

Sir Donald Macdougall died in 2004 and according to The Guardian‘s obituary:

His career – as an Oxford don, a London “special adviser”, a mover and shaker in Whitehall and Westminster – started before the second world war, and wound down with skilful “letters to the editor” against the euro.

There have been so many proposals on attempts to rescue the Euro Area. Ideas termed “monetary financing” by the European Central Bank carry tremendous risks of exacerbating imbalances within the Euro Area, because nations will keep relying on the Eurosystem’s financing and is a potential political time-bomb. And, there are those simpletons, who argue that nations should just walk away! As if …

To me, it looks as if the European leaders know that the size of the central government and the fiscal transfers would be substantial given Macdougall’s estimations were done when the situation was much different and a redoing may prove this. It is the political unacceptability of this, which will finally lead to Eurocalypse.

Z.1, Q3-2011

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The Federal Reserve released the Flow of Funds Accounts of the United States today.

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.

Same Old, Same Old

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John Cassidy of The New Yorker comments on the failed austerity policies in the UK:

During the past eighteen months, a callow and arrogant Chancellor of the Exchequer, empowered by a hands-off Prime Minister and backed by the bulk of the country’s financial and media establishment, has needlessly brought Britain to the brink of another recession by embracing draconian spending cuts that hark back to the early nineteen-thirties. Rather than changing course and taking measures to boost growth, the Conservative-Liberal coalition is doubling down on austerity. On Tuesday, it announced plans to extend its cuts for two more years, until 2016-2017. “Until now, we had been thinking of four years of cuts as unprecedented in modern times,” Paul Johnson, the director of the non-partisan Institute for Fiscal Studies, said. “Six years looks even more extraordinary.”

The following was written in The Guardian in early 1981. Click to enlarge. And click again to enlarge.

According to FT,

In the early 1980s, when recovery from global recession was slow, the jobless rate more than doubled, soaring from 5.3 per cent in August 1979 to 11.9 per cent in 1984.

13 quarters were required to recover the output drop, according to the BoE Inflation Report, February 2009

Seems nothing has changed in the last 30 years! Although, the Bank of England has dropped the bank rate to 0.5%, the present budget policies of the UK Government is a hangover of Thatcherism.

Charts From OECD’s Economic Outlook

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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):

(click to enlarge)

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!

(click to enlarge)

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.