Paul Krugman Does S=I+(S-I)

One of the core understandings of Monetary Realism is understanding how private investment is the backbone of private sector equity (we MR nerds use S=I+(S-I).   It’s not as complex as some might think (and certainly not as overly simplistic as some others think).  The identity essentially states that understanding private saving is about understanding how private saving is made up of private Investment plus the non-government’s surplus/deficit.  So, our saving is not just the government’s deficit position (like t-bonds), but is also comprised of other assets that include claims against private sector entities.

Understanding this balance is crucial for understanding the drivers of growth.  For instance, I often post the chart showing the drivers of corporate profits over the last 50 years (see figure 1 below).  It clearly shows that private investment drives corporate profits most of the time.   And since the vast majority of private sector net worth is derived from claims against entities inside the private sector (like stocks, corporate debt, etc), well, you do the math.

The key point is, private investment is hugely important in driving the private sector’s health.   And the key to understanding the environment of the last few years and the cause of the crisis has been largely about understanding this relationship.  Those of us who understood it knew that the collapse in private investment was devastating.  But we also knew that the surge in the government’s deficit (those bright red bars) would offset the decline in investment to a large degree. As I like to say, when the private sector’s “flow” turned off, the public sector’s “flow” turned on and kept spending, income and revenues higher than they otherwise would have been.

Knowing this, it’s nice to see this bit from Paul Krugman this afternoon where he essentially does S=I+(S-I):

“The blue line is government saving, roughly speaking (leaving some public investment aside) the public sector surplus or deficit; the red line is the private sector surplus, the difference between private saving and private investment. So yes, the budget deficit has soared — but it’s just offsetting a surge in the private sector surplus.

Now, this is almost an accounting identity, so by itself the figure doesn’t tell you which side is driving the action. But we know the answer to that question from other evidence. For one thing, we know that most of that surge in the private sector surplus reflects the collapse of the housing bubble, and that most of the surge in the public deficit reflected automatic stabilizers. For another, we know that if government deficits were crowding out private spending, we should have seen rising interest rates; what we actually saw was falling rates.”

Outside of a balance sheet recession, the private sector drives growth.  But in this once in a lifetime debt based collapse, the public sector picked up the slack and drove growth.  Understanding all of this is not just about understanding accounting identities, but about understanding how the different pieces of the money system all come together to generate a particular flow of funds in the system.  Those who understood this did a vastly better job predicting the environment of the last 5 years than those who didn’t….

(Figure 1 – Corporate Profits as % of GDP)


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Great chart. It really drives home the point that the private sector drives profits. But could this be a sustained problem going forward? Also, any chance you can let us in on how you produced that?

  2. Cullen, I just read the MR paper on SSRN. The new edits are fantastic and add a level of clarity that was previously missing. Thanks for your hardwork on it. It’s like a small book at this point!

  3. Thanks. I’ve worked really hard on that and I am pleased with what I hope is a final copy though that’s probably wishful thinking as it’s turned into a living document of sorts. But this version is really clean and has some good additions including the moneyness scale, banking examples, a glossary and lots of other good little MR insights.

  4. Ya, the new version is f-ing awesome, especially the new stuff on what is money. I think you should create an e-version of your paper so that we can keep it on our persons (our smartphones) at all times :)

  5. I haven’t read it yet. Is it definitely worth taking a look at? Much new that MRists won’t already know? Thanks.

  6. Nothing you won’t already know if you’ve been reading this site, but it’s still cool to see it all laid out in context. Sorry, but I’m a money geek who gets excited about this stuff.

  7. Yeah, there’s not a whole lot new that regulars won’t already understand, but it really ties everything together into one concise paper. The format and presentation is much improved. I basically just added sections clarifying what is money, why it matters, why banking matters so much, how govt is mostly a facilitating entity, a glossary, updated references, etc.

    It’s just really clean and clear now. I think you get as much out of that 40 page paper as you get out of most undergrad (maybe even some graduate) econ classes. Plus, the presentation is very unique and there’s a lot of original thought that’s gone into MR by now.

  8. I’d say your paper is 10 times better than most undergrad Econ classes, which are typically neoclassical.

  9. I agree. I have a masters in economics and a CFA and I learned more from reading Cullen’s MR paper than I did in all of those courses combined.

    In 10 years I wouldn’t be surprised to see Cullen’s work as the benchmark for how macroeconomics is taught.

  10. CR – seriously, I keep telling you to lecture more and get out from behind the internet. You’re made for the speaking circuit. You just need to get your name out there a bit more. I noticed the MR paper is 5th overall in downloads on SSRN. You need to pump that and get it out there more. You’ve written THE seminal paper on the monetary system for crying out loud!!!!

  11. Sorry, just one more comment. Can you think of any other economists who describe the system the way you do? The facts that the government doesn’t print money was mind blowing to me. And to think of outside money as facilitating money totally altered the way I view everything. Did you get these concepts from somewhere else or are they totally original? I can’t recall having seen these concepts anywhere else.

  12. SS, it takes a very open mind and a humble spirit to unlearn a Masters of Economics. Kudos!

  13. Check out this app called “pocket”. Lets you save web pages and documents in an e-reader format to view whenever. No cell or wifi connection needed.

  14. Sorry that message was for Geoff didn’t think it would end up all the way down the thread and look like spam.

  15. I don’t know of any who describe it this way. Maybe I am wrong though. A lot of our work is built on the ideas of other economists thought so it’s by no means completely unique. It’s part Adam Smith, part Wynne Godley, part Warren Mosler, part Kaldor, Part Kalecki, part Keynes, part Schumpeter, part Fisher, etc. I don’t think anyone can claim that any theory of the system is totally unique, but this approach (purely descriptive with an operational and institutional focus) is unusual. I don’t know of any modern economists who describe the system as I do with outside money being a pure facilitating money. Almost all economists I can think of believe outside money sits atop a hierarchy of money. And they usually use that to justify some sort of policy agenda. MR is totally different. No policy agenda, no bull shit govt centric presentation.

  16. The chart is great ! It explain more than 10 books. Excellent. But where we go from here ? Is the private sector ready to step in again ? How much longer and deeper can the US run a huge deficit spending ? Is the balance sheet recession over and, if not, when it will be ? Personally I stand with the latest Koo’s comment (and Shilling’s too), the balance sheet recession is not over, personal savings are sending the wrong message and healing will need 3 to 5 more years of 10% deficit spending. If there will be no other external shocks (like Europe or Japan or a war in the middle east) we should be out around 2016 – 2018 with a US public debt in the range 130% – 150%. And deficit spending must be much better qualified spending, more for instruction and much more for the necessary infrastructures like the rebuilding of an obsolete electrical network. In the past, in any country, were the goverments that funded the infrastuctures which ensured prosperity and wealth.

  17. I also believe that this paper does a better job than many undergrad courses. Thanks for that CR it changed a lot the way I see the macro enviroment.
    It’s important stuff and it’s simple. I would just change the example of Sexual favor as a form of money so first readers dont get distracted.