Understanding the Modern Monetary System – Part 6

Part 6 is the final section in our series on understanding the modern monetary system and Monetary Realism.  This section dives into some accounting identities behind the sector balances and the ways the private sector and public sector interact and drive economic growth.  For a more complete discussion please review the entire paper here.

Part VI – Understanding Sectoral Balance Economics & S = I + (S-I)

It’s very important to understand the sectoral relationship within an economy and the ways in which growth is produced by the various sectors and their interdependence.  Contributors to Monetary Realism find much relevance in the Sectoral Financial Balance approach as developed by Wynne Godley. It is a useful lens to help conceptualize the macro economy and to understand how the government budget relates to the current account balance and private sector saving-investment decisions. The approach is an ex-post accounting identity derived by rearranging the components of aggregate demand and it is typically presented as a three-sector model comprising the private, public and foreign sectors. It is a fundamental identity that links aggregate demand (i.e. the total amount of final goods and services purchased by agents over a given time period) with changes in sectoral net financial asset positions.

The Sectoral Financial Balance approach measures the income of the three sectors net of spending over a given time period. When any sector spends more than its income it runs a deficit and, vice versa, when a sector spends less than its income it runs surplus. It is vital to recognize that amongst the three main sectors it is the public sector (and the federal government in particular) that is most able to run large deficits over a prolonged period. This is because the budget constraint of the US federal government is not similar to that of an individual, household, business or even a state or local government.

The deficit of the entire government (federal, state, and local) is always equal (by definition) to the current account deficit plus the private sector balance (excess of private saving over investment). To be more precise: net household financial income = current account surplus + government deficit + Δbusiness non-financial assets. The private sector surplus represents the net saving of the private sector (households and businesses) from income after spending, while the public sector deficit is the government’s deficit. This is the essence of the sectoral balances approach made famous by the late great Wynne Godley. It can be visualized with the following diagram:

(Figure 3 – Sectoral Balances)

The sectoral balances can be broken down according to GDP:

GDP = C + I + G + (X – M)

Where C = consumption, I = investment, G = government spending, X = exports &M = imports

Or stated differently;

GDP = C + S + T

Where C = consumption, S = saving, T = taxes

From there we can conclude:

C + S + T = GDP = C+ I + G + (X – M)

If rearranged we can see that these sectors must net to zero:

(I – S) + (G – T) + (X – M) = 0

Where (I – S) = private sector balance, (G – T) = public sector balance & (X – M) = foreign sector balance.

The three main sectoral balances must as an accounting identity add to zero. In Figure 4 what stands out is that the US government has run budget deficits for the majority of the last 60 years (in fact well over 200 years). Equally important is that the domestic private sector balance remained in surplus until 1997 where it remained in deficit on annual basis through to the end of 2007. So why was the private sector running a deficit from 1997-2007 an ominous development? It meant that the private sector was in aggregate getting less liquid and more fragile. Disaggregation of the private sector into its subcomponent sectors (e.g. households, nonfinancial business and financial business) is needed to understand precisely how these deficits impacted on the composition of balance sheets. It remains that the negative financial balance run by the US private sector during 1997-2007 was a pointer to growing financial fragility with the crisis that began in 2007 a testament to the merits of this conceptual framework.

You can see this different version of the above chart in visual form by viewing the sectoral balances in the USA going back to 1952:

(Figure 4 – Sectoral Balances part 2)

The SFB approach underlines that when the federal government spends more than it collects in revenues the deficit spending creates net financial assets for the private sector in the form of government bonds. Private agents benefit from these net financial assets in various ways. There are investors who get a ‘safe’ interest-bearing asset for their investment portfolios. There are also the thankful recipients of the Treasury’s deficit spending who get paid for doing their business or receive a social security payment that enables them to meet their bills and survive.  It’s important to note that these saving bonds are an asset of the private sector and a liability of the government.  So to “pay off the national debt” would, by accounting identity, involve the elimination of an important private sector financial asset.  This does not mean the government can make the private sector wealthy by providing us with government bonds, but at mentioned previously, the public sector’s constraint is different than the private sector’s constraint (solvency versus inflation) so the notion of paying off the national debt must be placed in the proper context.

The Importance of Understanding S = I + (S-I)

It’s important to take the private sector component in the sectoral balances one step further or the reader might confuse the true driver of economic growth as being the government and not the private sector.  Although government can help to drive economic growth (if used properly) we should not forget that investment is the backbone of private sector equity.  This simple rearrangement of the private sector component highlights this fact and helps to avoid thinking that I>S might be a negative for the economy when the reality is that a high level of Investment is generally good for the economy.   

If we rearrange the above sectoral balances equation we can arrive at a very important identity:

(S – I) = (G – T) + (X – M)

S = I + (G – T) + (X – M)

Which rearranges to:

S = I + (S – I)

We can also think of this from the National Income Accounting equation:

C + I + G + (X – M) = C + S + T

Which rearranges to:

(S-I) + (T-G) + (M-X) = 0

Which rearranges to:

I = S + (T-G) + (M-X)

This helps to show the reader that wealth creation is not just achieved through government deficit spending, but largely occurs independent of government.  On this point it’s important to understand the difference between real wealth and financial wealth.  A good way to think about all of this is to understand that the private sector can create real wealth entirely independent of the government.  A farmer does not need the government to turn 2 cows into 10.  The farmer has achieved real wealth creation regardless of the government’s spending position.  What the government must generally do over time is help to facilitate the wealth accumulation process by providing the net financial assets to help the private sector monetize this real wealth and sustain its demand for saving.  It’s important not to put the cart before the horse here.  It’s best to think of government as being a facilitator of wealth creation and not the driver.  Hence, our focus on S=I+(S-I) with the emphasis on the idea that “the backbone of private sector equity is I, not Net Financial Assets.”   The idea is not novel, but simply clarifies the understanding of the private sector component.

Turning quickly to the data, the US general government deficit averaged around one-sixth of gross private domestic investment during the period 1960-2007, and fourth-fifths during 2008-2010. It should not be controversial at all that the main driver of private saving is usually private investment but that during economic downturns the role of general government deficit-spending becomes more important.

MR understands that consumption and production are two sides of the same coin, but it is through production that we grow the coin.  We highlight this point by expanding on the sectoral balances equation and showing that S = I + (S-I) in order to emphasize that I>S does not mean the private sector financial position is necessarily deteriorating or experiencing a “net loss”.  So while the sectoral balances equation is useful in understanding the dynamic of the system it should not be used to imply that the private sector’s financial position is necessarily deteriorating because I>S .  When one takes this perspective you bring a more balanced understanding of the way our monetary system actually works.

Private sector saving can be decomposed into the amount of saving created by investment “I” and the amount of net financial assets transferred from other sectors (S – I). That is the focus of the equation S = I + (S – I) as it highlights the fact that the private sector is the primary driver of economic prosperity while government is a powerful facilitator.

It’s important not to overstate the idea of “net financial assets”.  “Net financial assets” (NFA) as a source of savings and vehicle for private agents to accumulate wealth is more at the margins than the center. There is no debate that T-bonds play a crucial role enabling deficit-spending and providing ‘safe’ collateral for private agents; however, the importance of financial claims issued by the public sector and held by private agents is drastically elevated when focusing on net positions instead of gross positions. Consider that at year-end 2011 the volume of US Treasury debt outstanding was $10.5tr while the value of financial assets summed across the private sectors was $130.4tr (yes there is some double-counting) and the value of household sector total assets was $72.3tr of which $49.1tr was financial assets. At year-end 2010 the market value of US private sector assets held abroad was $19.8tr. When taking into account that just under half of US T-bonds are held by foreign agents it is clear that the role of the Treasury supplied NFAs as a source of savings and vehicle for private agents to accumulate wealth is relatively modest.

When one connects the dots between production and the MR Law you can begin to understand why private sector production matters so enormously to the living standards of the society.  In this regard, I is the core of improved living standards, because it is through I that we create things that make us more productive and therefore give us more time. But we must maintain a balance here and never forget that government can be an important facilitator of the wealth accumulation process who wields powerful tools that can aid us in driving demand, stabilizing economic growth and helping to improve overall living standards.

Conclusion

In sum, most of what we have been taught in school is based on a now defunct monetary system (the gold standard). Monetary Realism seeks to describe the operational realities of a modern fiat currency system.  While its description of the modern monetary system is accurate, it is by no means a holy grail. And those who apply policy prescriptions are merely utilizing the realities of the system to apply what they believe are sound uses of the system. It does not mean the government can just credit accounts and create real wealth.

One of the key understandings here is that government can be used as a tool to help the private sector to achieve prosperity. I think it’s important to understand that government is not always bad or that government spending is always evil.  In fact, government serves a vital purpose within our society.  How involved that government is in the day to day lives of its citizens is to be decided by the citizens themselves.

I believe Monetary Realism provides a more accurate portrayal of the monetary system in which we reside in the USA and in many other autonomous countries throughout the world.  It is my hope that a greater understanding of our monetary system will result in a less dogmatic, more pragmatic and more rational perspective of our economy so as to help us all in achieving the prosperity we desire.

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.

More Posts - Website

Follow Me: