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Kaldor’s Growth Plan

Dani Rodrik has a Project Syndicate article titled No More Growth Miracles and in my view rightly identifies problems of the world economy, although has less to say how to resolve the crisis.

These were most well understood by Nicholas Kaldor (who was touched by genius in Wynne Godley’s words). In the previous post How To Find Nicholas Kaldor’s Works, I recommended his Rafaelle Matiolli Lectures which appeared in a book form titled Causes Of Growth And Stagnation In The World Economy.

The lectures were given in May 1984.

In the fifth and final lecture Kaldor – who understood the shortcomings of Keynesian economics – after having lectured on the causes of growth and stagnation in the world economy, summarizes the situation (page 86):

The fact that OPEC (as a group) is now in deficit on its current balance, and that Britain’s current account surpluses have virtually disappeared while the United States is in a large deficit, makes it a great deal easier for other developed countries to expand their economies than at any time since 1973. But there is still need for coordinated action, at least among the members of the European Community. As the French example has shown, an expansionary budget which is out of line with the fiscal stance of the other main countries of the group, quickly gets a country into serious payments difficulties owing to the resulting imbalance in trade.

But – as is the case now – and even back then policy makers meet and don’t do much ….

The lack of agreement on the fundamental lines of a policy for economic recovery is acutely felt, and the need for it is shown by the increasing frequency of inter-Governmental meetings at various levels: the next world summit meeting in which the heads of the leading western powers all participate is due to take place in London in a few weeks’ time.

If, by some miracle, this summit meeting, unlike all its predecessors, resulted in a constructive programme of recovery, what should its main provisions contain? I should like to end this series of lectures by suggesting the outline of a world-wide agreement on the necessary policies for recovery. The programme could be summed up under four main heads:

In present times, there are very few – in my opinion – who recognizes what needs to be done. Kaldor continues:

1. The first is coordinated fiscal action including a set of consistent balance of payments targets and “full employment” budgets [footnote]. If this does not prove to be politically feasible, it is inevitable that the growth of unemployment will sooner or later force governments to take measures that would make it necessary for them to expand demand without being frustrated by the inevitable balance of payments consequence of expanding their economies relative to their trading partners. This means that there needs to be some form of restriction that would limit the increase in “competitive” imports to some target ratio in relation to exports. Trade liberalisation, which played such an important part in the rapid economic progress during the years of expansion, becomes a serious obstacle to economic recovery in the case of prolonged stagnation due to the inability of countries to achieve a coordinated set of policies. But, given a proper recognition of the problem, that under conditions of unrestricted free trade the actual volume of production and trade may in fact be considerably less than under some system of regulated trade – a system which relates the volume of imports in manufactures from a particular group of countries, such as the members of the EEC, to some mutually agreed ratio to the exports of individual members to the rest of the group – there is no reason why full employment should not be restored through policies of expansion, preferably directed by the expansion of State investment. This coordinated action by all countries, instead of isolated actions by each country, is the first and most important requirement of recovery.

Keynesians and others who have come to understand fiscal policy are however too late. A unilateral fiscal expansion by one country will soon lead to balance of payments problems for it with the result that fiscal policy has to give in and become endogenous sooner or later. (Such is the case with India now, for example). So fiscal expansions need to be coordinated with other countries.

Also there is a footnote suggesting how the endogeneity of the budget deficit is commonly misunderstood:

Footnote: At present all countries have fairly large deficits in the general government budget, but these are largely the consequence of the low level of activity. On a “full employment” basis they would show a highly restrictive picture – they would show surpluses and not deficits. Contrary to appearances, the requirement of stability is for expansionary budgets with lower taxes and higher expenditure, and not further fiscal restriction (as is advocated, for example, by M. de Larosiere of the International Monetary Fund).

Point 2 is about bringing interest rates to as low as possible and this we already have in the present crisis. Point 3 is about stabilization commodity prices and point 4 about the problem of inflation which was more troublesome in the past due to trade unions’ bargaining.

Point 1 is the most important and relevant to the current scenario. Over the years, credit-led growth led to a boom which finally went bust but leaving the world with more “global imbalances”. Economists and politicians wish to resolve the crisis without giving up the doctrine of free trade. At least there is a pressure from the developed world to maintain status quo in spite of resistance from the developing world. As a recent article Protectionism Alert from The Economist recognizes, there is a tendency to move toward more protectionism in practice however which the magazine wishes to alert to the world – so that it is noted and steps taken beforehand to prevent it and free trade is pushed even more.

It should be noted that Kaldor’s plan is more than “coordinated fiscal expansion”. It is also about managing trade instead of relying on market forces. As argued by his “New Cambridge” colleagues, and stated by Kaldor, this will not lead to a decrease in world trade but actually an increase because of higher national output and income!

The first head of the programme is indeed what the world needs at the moment.

One of the listeners of his lectures was Mario Monti! More interestingly, Monti has a question to ask on this plan of Kaldor.

Here’s the Google Books Preview:


Updated 12 Aug 2012 3:10am GMT: Typos Corrected. 

Recommended Readings

The crisis has a lot of connections with the way Macroeconomics was done in the 1970s and this interests me a lot. Of course the equally important reason was that Nicholas Kaldor and Wynne Godley were highly involved in the public discussions. Here are some books I collected which have special importance to the Cambridge Economic Policy Group (CEPG):

I could manage to only get used copies of the first two books.

The book has the paper New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, by Martin Fetherston and Wynne Godley and comments by others such as Alan Blinder – which I mentioned in the post Debt Monetization. The book is also available from Wiley but you have to pay $500+ for it!

This one got the title right – it wasn’t Keynesianism versus Monetarism. It was New Cambridge versus Keynesianism versus Monetarism.

The following book by Peter Kenway was first published in 1994 but was republished recently because the crisis has deep roots with debates in the 1970s!

It has nice discussions about the various types of income/expenditure models of the 1970s in the UK with a lot on the CEPG. It gives nice lists of all models – some of them here (via amazon.com preview):

Here’s a short autobiography by Wynne Godley (written around 1999) on how he dissented from the profession. Here’s a Google Books preview from the book A Biographical Dictionary of Dissenting Economists edited by Philip Arestis and Malcolm C. Sawyer

I like this:

 … I had extraordinary difficulty in understanding, not the sentences, but what real life state of affairs mainstream ‘neoclassical’ macroeconomics could possibly be held to be describing. I went through the standard textbooks on macroeconomics and then back to the underlying professional literature (the locus classicus being, as I now see it, Modigliani. 1944 and 1963). I taught myself how to draw the diagrams and solve the equation systems, but for years could not make any connection between these and the real world as I knew it…

One of the things which made Godley dissenting was the proposal to control imports as the paper title suggests:

(click for link to the journal)

This was met with huge hostility as a Times article (from the late 70s) shows. Economists confused it as “selective protectionism”:

(click to enlarge and click again)

Kaldor’s Reflux Mechanism

The recent debates of Post Keynesians with Neoclassical/New Keynesians has highlighted that the latter group continues to hold Monetarists’ intuitions. Somehow the exogeneity of money is difficult for them to get rid of, in spite of their statements and rhetoric that money is endogenous in their models.

So there is an excess of money in their models and this gets resolved by a series of buy and sell activities in the “market” (mixing up decisions of consumption and portfolio allocation) until a new “equilibrium” is reached where there is no excess money.

Two-Stage Decision

While the following may sound obvious, it is not to most economists. Keynes talked of a two-stage decision – how much households save out of their income and how they decide to allocate their wealth. In the incorrect “hot potato” model of Neoclassical economists and their New “Keynesian” cousins, these decisions get mixed up without any respect for the two-stage decision. It is as if there enters an excess money in the economy from somewhere and people may consume more (as if consumption is dependent on the amount of deposits and not on income) till prices rise to bring the demand for money equal to what has been “supplied” (presumably by the central bank).

In their book Monetary Economics, Wynne Godley and Marc Lavoie have this to say (p 103):

A key behavioural assumption made here, as well as in the chapters to follow, is that households make a twostage decision (Keynes 1936: 166). In the first step, households decide how much they will save out of their income. In the second step, households decide how they will allocate their wealth, including their newly acquired wealth. The two decisions are made within the same time frame in the model. However, the two decisions are distinct and of a hierarchical form. The consumption decision determines the size of the (expected) end-of-period stock of wealth; the portfolio decision determines the allocation of the (expected) stock of wealth. This behavioural hypothesis makes it easier to understand the sequential pattern of household decisions.

[Footnote]: In his simulation work, but not in his theoretical work, Tobin endorsed the sequential decision that has been proposed here: ‘In the current version of the model households have been depicted as first allocating income between consumption and savings and then making an independent allocation of the saving among the several assets’ (Backus et al. 1980: 273). Skott (1989: 57) is a concrete example where such a sequential process is not followed in a model that incorporates a Keynesian multiplier and portfolio choice.

Constant Money?

So even if one agrees that loans make deposits, there is still a question of deposits just being moved around and the (incorrect) intuition is that someone somewhere must be holding the deposit and hence similar to the hot potato effect. The error in this reasoning is the ignorance that repayment of loans extinguishes money (meant to be deposits in this context).

Nicholas Kaldor realized this Monetarist error early and had this to say

Given the fact that the demand for money represents a stable function of incomes (or expenditures), Friedman and his associates conclude that any increase in the supply of money, however brought about (for example, through open-market operations that lead to the substitution of cash for short-term government debt in the hands of discount houses or other financial institutions), will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will “find themselves” with more money than they wish to hold). This defect, in their view, will be remedied, and can only be remedied, by an increase in expenditures that will raise incomes sufficiently to eliminate the excess of supply over the demand for money.

As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of “credit money” brought about by the creation of public or private debt, this is a fallacious piece of reasoning. It is an illegitimate application of the original propositions of the quantity theory of money, which (by the theory’s originators at any rate) were applied to situations in which money consisted of commodities, such as gold or silver, where the total quantity in existence could be regarded as exogenously given at any one time as a heritage of the past; and where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities. Until that happened, someone was always holding more gold (or silver) than he desired, and since all the gold (and silver) that is anywhere must be somewhere, the total quantity of precious metals to be held by all money-users was independent of the demand for it. The only way supply could be brought into conformity, and kept in conformity, with demand was through changes in the value of the commodity used as money.

[boldening: mine]

from Nicholas Kaldor wrote a major article in 1985 titled How Monetarism Failed (Challenge, Vol. 28, No. 2, link).

In his essay Keynesian Economics After Fifty Years, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983), Kaldor wrote:

The excess supply would automatically be extinguished through the repayment of bank loans, or what comes to the same thing, through the purchase of income yielding financial assets from the banks.

Here’s the Google Books preview of the page:

In his article, Circuit And Coherent Stock-Flow Accounting, (in Money, Credit, and the Role of the State: Essays in Honour of Augusto Graziani, 2004. Google Books link) Marc Lavoie showed how this precisely works using Godley’s transactions flow matrix. (Paper available at UMKC’s course site). See Section 9.3.1

The fact that the supply of credit and demand for money appeared to be independent

 … has led some authors to claim that there could be a discrepancy between the amount or loans supplied by banks to firms and the amount or bank deposits demanded by households. This view of the money creation process is however erroneous. It omits the fact that while the credit supply process and the money-holding process are apparently independent, they actually are not, due to the constraints or coherent macroeconomic accounting. In other words, the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding on the production side.

So if households wish to hold more deposits, firms will have to borrow more from banks. If households wish to hold less deposits, they will purchase more equities (in the model) and hence firms will borrow lesser from banks and/or retire their debt toward banks.

Other References

  1. Lavoie, M. 1999. The Credit-Led Supply Of Deposits And The Demand For Money – Kaldor’s Reflux Mechanism As Previously Endorsed By Joan Robinson, Cambridge Journal Of Economics. (journal link)
  2. Kaldor N. and Trevithick J. 1981. A Keynesian Perspective On Money, Lloyd’s Bank Review.

Is Paul Krugman A Verticalist?

24 years back, Basil Moore wrote a book Horizontalists And Verticalists: The Macroeconomics Of Credit Money (Cambridge University Press, 1988) which begins like this:

The central message of this book is that members of the economics profession, all the way from professors to students, are currently operating with a basically incorrect paradigm of the way modern banking systems operate and of the causal connection between wages, prices, on the one hand, and monetary developments, on the other. Currently, the standard paradigm, especially among economists in the United States, treats the central bank as determining the money base and thence the money stock. The growth of the money supply is held to be the main force determining the rate of growth of money income, wages, and prices.

… This book argues that the above order of causation should be reversed. Changes in wages and employment largely determine the demand for bank loans, which in turn determine the rate of growth of the money stock. Central banks have no alternative but to accept this course of events, their only option being to vary the short-term rate of interest at which they supply liquidity to the banking system on demand. Commercial banks are now in a position to supply whatever volume of credit to the economy their borrowers demand.

The book built on his own work and that of Nicholas Kaldor and Marc Lavoie among others goes on to describe the banking system, horizontalism and endogenous money. Money is credit-led and demand-determined was his message. Economists believing in the “incorrect paradigm” are Verticalists in Moore’s terminology.

Paul Krugman whom Post Keynesian have more respect than other mainstream economists probably disappointed them when he was arguing with Steve Keen in a 3-post blog series. Arguing like a Verticalist, Krugman claims (among other Verticalist claims) in his post Banking Mysticism, Continued:

… And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

The Defensive Nature Of Open Market Operations

The reason there is widespread misunderstanding of what the central bank does is because it carries out open market operations where it buys or sells government securities or does repurchase agreements. The orthodox view is that the central bank is acting the way it is to increase or decrease the amount of banks’ settlement balances and this affects the money supply – allowing banks to expand lending or leading them to contract – and thence the whole economy. The view is that the central bank has a direct control these operations and are purely volitional.

This is an incorrect view because no central bank claims to be “controlling” the money stock.

If money is truly endogenous, the question is why the central bank does these operations often. The reason is that operations of the central bank are defensive. 

In his article Endogenous Money: Accomodationist, Marc Lavoie argues:

Some post-Keynesians have pointed out long ago that open market operations had little or nothing to do with monetary policy.

For instance, It is usually assumed that a change in the Fed’s holdings of government securities will lead to a change, with the same sign attached, in the reserves of the commercial banking system. It was the failure to observe this relationship empirically which led us, in constructing the monetary financial block of our model, to try to find some other way of representing the effect of the Fed’s open market operations on the banking system. (Eichner, 1986, p. 100)

That other way is that ‘the Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system’ (Eichner, 1987, p. 849).

So the central bank purchases government bonds and/or does repos to neutralize the effects of transactions which change the settlement balances. One example is the flow of funds into and out of the government’s account at the central bank. Another is the demand for currency notes by banks to satisfy their customers’ needs. The central bank has no choice but to provide these notes.

Here’s a preview via Google Books:

Also see this post Alfred Eichner And The Federal Reserve Operating Procedures.

Krugman is partly right when he says, “Banks are important, but they don’t take us into an alternative economic universe.” However he fails to see that money is endogenous and the way the banking system works show this endogeneity.

Of course, Steve Keen has issues with his models and accounting with which Krugman has troubles. Keen defines aggregate demand to be gdp plus “change in debt”. As much weird this definition is, it is double counting when investment expenditure is financed by borrowing rather than internal sources of funds. Also, if a person sells a home to another person who has financed this purchase by borrowing and the former does not make expenditure from this income, this does not increase aggregate demand – a point raised by Marc Lavoie here (h/t “Circuit” from Fictional Reserve Barking). But as per Keen’s definition it does. In his first post, Krugman seems to say the same thing as Lavoie – but in a roundabout way.

The resulting debate has however highlighted the Verticalist intuition of Krugman!

Exorbitant Privilege

My last post was on U.S. net income payments from abroad and how it continues to be in the favour of the United States. The late Wynne Godley had been analyzing this since 1994. In an article titled U.S. Trade Deficits: The Recovery’s Dark Side?, written with William Milberg, he had a section called “Foreign indebtedness and the foreign income paradox” where he said:

So far, the practical consequences of the United States having become “the world’s largest debtor” have not been all that significant… But it would be an error to suppose that, because the net return on net assets has been negligible in the recent past, the same thing will be true in the future…

… Why did the net foreign income flow remain positive for so long after 1988? In order to understand this apparent paradox, it is essential to disaggregate stocks of assets and liabilities and their associated flows, and to distinguish (in particular) between financial assets and direct investments… The reason that net foreign income remained positive for so long can now be understood (at least up to a point) by making a comparison of the flows shown in Figure 3 with the stocks shown in Figure 2. The net inflow that arises from direct investment has been roughly equal to the net outflow on financial assets in recent years, even though the stock of financial liabilities has been about five times as large as the market value of net foreign investments. In other words, the rate of return on net direct investments far exceeded the rate on net financial liabilities

Figure 2 referred to is below:

and Figure 3:

which is what I redrew with updated data in my previous post. But as we saw the net income payments from abroad continues to be positive (!!) even till date but the reason is similar. Foreign direct investment in the United States has risen to $2.8T at the end of 2011 as per Federal Reserve’s Z.1 Flow of Funds while U.S direct investment abroad rose to $4.8T – significantly higher (even as a percent of GDP) than in the mid-90s.

The net direct investment has seen huge returns (both via income and holding gains) and so this killing has brought in good fortunes for the United States. Of course with the whole current account of balance of payments in deficit, the external sector bleeds the circular flow of national income in the United States and contributes to weak demand there.

So a current account deficit is bad for the United States but financing this deficit has been easy for the United States given that the US Dollar is the reserve currency of the world. Why do nations require reserve assets? The late Joseph Gold of the IMF gave a nice description in his book Legal and Institutional Aspects of the International Monetary System: Selected Essays:

What makes the US dollar the reserve currency of the world is difficult to argue. However it cannot be taken for granted that the United States may enjoy this exorbitant privilege given that the Sterling was once the darling of the financial markets and central banks.

After writing the previous post, I came across this interesting paper From World Banker To World Venture Capitalist – U.S. External Adjustment And The Exorbitant Privilege by Pierre-Olivier Gourinchas and Hélène Rey written in 2005.

Their argument is similar – direct investments have made huge returns for the domestic private sector of the United States and gives a good account of the external sector. Here’s a graph of the United States’ net international investment position using data reported by the Federal Reserve’s Z.1 Flow of Funds Accounts as well as the BEA’s International Investment Position:

Why the difference is a topic for another post. I don’t know it yet. Gourinchas and Rey have some answers. The Federal Reserve’s data is till 2011 end and quarterly (and seasonally adjusted) while BEA data is yearly and available till 2010.

So, from the graph above, the United States became a net debtor of the world around 1986. The indebtedness has been rising mainly due to the huge current account deficits the nation manages to run and is partly offset by “holding gains”.

Here’s a graph of the current account deficit plotted with other “financial balances” (since they are related by an identity)

I also discuss this in my post The Un-Godley Private Sector Deficit.

By the way, the U.S. was a creditor of the world when the Bretton Woods system of fixed exchange rates collapsed. Some authors describe this collapse by saying that money has become fiat since 1971 – whatever that means!

Gourinchas and Rey point out – correctly in my opinion:

The previous discussion points to a possible instability, even in an international monetary system that lacks a formal anchor. The relevant reference here is Triffin’s prescient work on the fundamental instability of the Bretton Woods system (see Triffin 1960). Triffin saw that in a world where the fluctuations in gold supply were dictated by the vagaries of discoveries in South Africa or the destabilizing schemes of Soviet Russia, but in any case unable to grow with world demand for liquidity, the demand for the dollar was bound to eventually exceed the gold reserves of the Federal Reserve. This left the door open for a run on the dollar. Interestingly, the current situation can be seen in a similar light: in a world where the United States can supply the international currency at will and invests it in illiquid assets, it still faces a confidence risk. There could be a run on the dollar not because investors would fear an abandonment of the gold parity, as in the 1970s, but because they would fear a plunge in the dollar exchange rate. In other words, Triffin’s analysis does not have to rely on the gold-dollar parity to be relevant. Gold or not, the specter of the Triffin dilemma may still be haunting us!

Gourinchas and Rey’s arguments depend on estimating a tipping point – the point where the net income payments from abroad turn negative. This of course depends on various assumptions but let us look at it.

The gross assets of the United States held abroad and liabilities to foreigners keep changing as the nation is able to increase its liabilities and use it to make direct investments abroad. The reserve currency status has provided the nation with this privilege as central banks around the world are willing to hold dollar-denominated assets. The positive return (as well as revaluation gains from the depreciation of the dollar – when it depreciates) helps reduce the net indebtedness but the current account deficit contributes to increasing it.

The following is the graph of gross assets and liabilities – using the Federal Reserve’s Z.1 Flow of Funds Accounts data and also BEA’s data for the ratio:

So assuming assets held abroad make a return rand liabilities to foreigners lead to payments at an effective interest rate rincome payments from abroad will turn negative whenever

r· A − r· L < 0

So A and L are changing due to the current account deficits and revaluation gains on assets and liabilities. Meanwhile, the effective interest rates are themselves changing in time because of various things such as short term interest rates set by the central banks, market conditions, state of the economy etc. Also, if the private sector of the United States makes more direct investments abroad, this will contribute to increase rA (if successful) and the process can go on with net income payments from abroad staying positive for longer. The tipping point is defined by Gourinchas and Rey as the ratio L/A beyond which the the net income payments turn negative. According to their analysis (based purely on historical data), this is 1.30.

If the net income payments from abroad turns negative, international financial markets and central banks may start suspecting the future of the exorbitant privilege according to the authors. Of course, it may be the case that even if it turns negative, the United States’ creditors don’t mind – this has been the case of Australia. The following is from the page 18 of the Australian Bureau of Statistics release Balance of Payments and International Investment Position, Australia, Dec 2011 and in their terminology – which is the same as the IMF’s – it is called “net primary income”)

(Australia’s Q4 2011 GDP was around A$369bn for comparison) and the above graph is quarterly.

So, to conclude the process can continue as long as foreigners do not mind. It shouldn’t be forgotten however that Australian banks had funding issues during the financial crisis and the RBA used its line of credit at the Federal Reserve via fx swaps to prevent a run on Australian banks and it is difficult to design policy without keeping in mind the possibility of walking into uncharted territory.

Once net primary income turns negative, the process can quickly run into unsustainable territory due to the magic of compounding of interest unless the currency depreciates in the favour of the nation helping exports. Else demand has to be curtailed to prevent an explosion but this hurts employment. Other policy options include promotion of exports and asking trading partners to increase domestic demand by fiscal expansion.

Updated: 19 March 2012

Kalecki’s Profit Equation

In my post The Transactions Flow Matrix, I went into how a full transactions flow matrix can be constructed using a simplified national income matrix. Let us reanalyze the latter. The following is the same matrix with some modifications – firms retain earnings and there are interest payments.

FU is the undistributed profits of firms. From the last line we immediately see that

SAVh + FU – If – DEF = 0

or that

FU = If + DEF – SAVh

This is Kalecki’s profit equation which says among other things that firms’ retained earnings is related to the government deficit! The equation appears in pages 82-83 of the following book by Michal Kalecki but Google Books may not allow the preview of the pages!

In their book Monetary Economics, Wynne Godley and Marc Lavoie say this in a footnote:

Note that neo-classical economists don’t even get close to this equation, for otherwise, through equation (2.4), they would have been able to rediscover Kalecki’s (1971: 82–3) famous equation which says that profits are the sum of capitalist investment, capitalist consumption expenditures and government deficit, minus workers’ saving. Rewriting equation (2.3), we obtain:

FU = I+ DEF − SAVh

which says that the retained earnings of firms are equal to the investment of firms plus the government deficit minus household saving. Thus, in contrast to neo-liberal thinking, the above equation implies that the larger the government deficit, the larger the retained earnings of firms; also the larger the saving of households, the smaller the retained earnings of firms, provided the left-out terms are kept constant. Of course the given equation also features the well-known relationship between investment and profits, whereby actual investment expenditures determine the realized level of retained earnings.

The above can of course also be written as:

I = SAVh + SAVf + SAVg = SAV

if one realized that the retained earning of firms is also their saving:


Business accountants know the connection between retained earnings and shareholders’ equity and in our language – which is that of national accountants/2008 SNA – it adds to their net worth just like household saving adds to their net worth.

Assuming away capital gains, we know from many posts that:

Change in Net Worth = Saving

Another View: Where Do Profits Come From

(h/t Magpie) I found this paper Where Do Profits Come From: Answering The Critical Question That Few Ever Ask – published by The Jerome Levy Forecasting Center – which has the following diagram among others:

(click to expand)

Where do we find the undistributed profits in the Federal Reserve’s Flow of Funds Statistic Z.1?

In Table F.102, there’s an item called “Total Internal Funds”:

(click to expand)

National Saving

Some of the previous posts went into the economic concept of Private Saving and Private Saving Net of Investment. For a closed economy these are:

Private Saving = Private Investment + Budget Deficit

Private Saving Net of Investment = Budget Deficit

For an open economy, we add the current balance of payments to the right of both these equations.

So we have the sectoral balances identity:


for Net Private Saving or Saving Net of Investment. Confusingly, Net Saving is used to mean Saving Net of Consumption of Fixed Capital. Consumption of fixed capital is the national accounting equivalent of depreciation but since there is a different accounting treatment, the former phrase is used.

In addition to Investment by the private sector, there’s also public investment and we need a bookkeeping concept of National Saving. 

Just like we consolidated the domestic private sector into one, we could also consolidate the whole nation for specific purposes.

First take a closed economy. Since Income = Expenditure and Saving is defined so that consumption and investment expenditures are treated differently, we have

Gross Saving = Gross Domestic Investment

To get Net Saving, one has to subtract consumption of fixed capital from both sides.

Economies however are open. Hence we need to modify the above equation. Simultaneously taking depreciation into account, we have:

Net Saving = Gross Domestic Investment – Consumption of Fixed Capital + Current Balance of Payments

Remember this Net Saving is different from the other usage which is Saving Net of Investment.

Before verifying that this is indeed the case for the United States, it is worth mentioning that the difference between saving and surplus (or financial balance) applies to the government sector as well. The following is from the Table F.8 of the Z.1 Flow of Funds Accounts of the United States.

(click to expand and click again to expand)

So in green – for the year 2001 for the United States – you see both the gross saving and saving net of consumption of fixed capital of the government sector is positive whereas the government’s budget balance is in deficit. 

This shouldn’t be surprising given we saw the same for the private sector.

Back to national saving, we can verify the identity. The current balance of payments is a nation’s income minus expenditure (only in a closed economy, these two are equal). If this is positive, the nation as a whole has a positive net lending. Else, it is a net borrower.

The identity can be seen using the numbers circled in red (and including the statistical discepancy).

The Paradox Of Thrift

The analysis above can mislead one into believing that since “saving” is a positive word, the nation as a whole should save by whatever means – such as by inducing the household sector to increase its propensity to save or aiming for a balanced budget (or worse, aiming to retire the public debt).

Both ideas are vacuous. A spontaneous increase in the propensity to save works by reducing the output and a tight fiscal stance achieves the same i.e., reducing the national saving or private saving as a whichever is the case – as a result of lower demand and output.

The Loanable Funds Fallacy

The simple accounting relations are also used in economics textbooks to promote saving in general because due to the above identity, one can be fooled into believing that a higher saving leads to higher investment. Again such ideas are promoted in public debates to argue against higher government expenditure and to even promote making balanced budget constitutional! The story goes that higher saving allows more investment because supposedly there are more funds to lend for investment.

This is based on the incorrect notion of the exogeneity of money. While this cannot be discussed in a single post, it’s where ideas of endogenous money and Horizontalism are illuminating.

Basil Moore had an article titled Saving Is The Accounting Record Of Investment, where he discusses some of the points here – never mind his claim that “total saving on an economy cannot reflect the volitional behavior of savers”. Here’s a Google Books preview:


The Mercantilists observe the accounting identity about national saving and the fact that it is related to the balance of payments and conclude that foreign trade is highly important in the growth of nations and hence well being and quality of life. The connection is that saving achieved via running a trade surplus with the rest of the world increases a nation’s net worth. To promote less consumption, the same mantra of national saving is used. So it is related to the paradox of thrift.

These ideas are used in public discussions on the problem of the external sector imbalance whether one believes in Mercantilism or not (their idea of rejection of the invisible hand). An increase in the household propensity to save (achieved by whatever means) or an attempt to reduce the budget balance by a tighter fiscal stance improves the current account balance, only because it results in a lower domestic demand and output and hence higher unemployment – all undesirable. That of course does not mean that one can unilaterally relax fiscal policy but just points to a more international effort needed badly right now to solve the problem of global imbalances.

While there is some truth to Mercantilists’ view, it’s for slightly different reasons – it is advantageous so some in one sense and injures others and hence inures everyone in the end.

Here’s Basil Moore on Keynes (from his 2006 book Shaking The Invisible Hand, pp 400-402):

In the General Theory Keynes introduced open economy considerations in his discussion of Mercantilism. He argued that the Mercantilists had been correct in their belief that a favorable balance of trade was desirable for a country, since increases in foreign investment increase domestic AD exactly like increases in domestic investment:

When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment. … the well-being of a progressive state essentially depends … on the sufficiency of such inducements. They may be found either in home investment or foreign investment … which between them make up aggregate investment. … The opportunities for home investment will be governed in the long run by the domestic rate of interest; whilst the volume of foreign investment is necessarily determined by the size of the favourable balance of trade. …

Mercantilist thought never supposed that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level…

In a society where there is no question of direct investment under the aegis of public authority,… it is reasonable for the government to be preoccupied … [with] the domestic interest rate and the balance of foreign trade. … when nations permit free movement of funds across national boundaries the authorities have no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade [are] the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of precious metals was their only indirect means of reducing the domestic rate of interest, and so increasing the inducement to home investment.

Keynes emphasized that any domestic employment advantage gained by export-led growth was a zero-sum game and “was liable to involve an equal disadvantage to some other country.” He argued that export-led growth aggravates the unemployment problem for the surplus nation’s trading partners, who are forced to engage in “an immoderate policy that (may) lead to a senseless international competition for a favourable balance, which injures all alike.” The traditional approach to improve the trade balance has been to attempt to make the domestic export and import-competing industries more competitive, either by forcing down nominal wages to reduce domestic production costs, or by devaluing the exchange rate. Keynes argued that gaining competitive gains by reducing nominal price variables would tend indirectly to foster a state of global recession. One’s trading partners would be forced to attempt to regain their competitive edge by instituting their own restrictive policies. When nations fail jointly to undertake expansionary policies to raise domestic investment and generate domestic full employment, free international monetary flows create a global environment where each nation has national advantages in a policy of export-led growth. The pursuit of these policies will lead to a race to the bottom, that “injures all alike.

the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire foundations upon which I was brought up and which for many years I taught—against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time.

These apposite warnings of Keynes have gone virtually unnoticed as mainstream economists have waxed enthusiastic about the benefits of liberalized financial markets and the export-led economic miracles of the Asian “Tigers,” and now the miracle of China. Modern economies have become more open than when Keynes was writing, so it is imperative that Keynes’ open economy analysis becomes better known.

Saving And Borrowing

I recently heard from an online commentator that saving is the opposite of borrowing. While there is some “intuition” to this, the following exercise is show it is possible to have a positive saving and incur huge liabilities at the same time.

To complicate the matter the word “Savings” is used. Now, in national accounts, this word is used as a plural of saving and it ought to be given up as a substitute for wealth because it creates more confusions in discussions.

I had recently gone into an example of concepts such Saving, Net Acquisition Of Financial Assets, Net Investment in Nonfinancial Assets, Net Incurrence Of Liabilities and “Net Lending(+)/Net Borrowing(-)”.

The example I wrote in that post was buried in something abstract, so let me extract the most essential paragraphs here and add a few things.

Let us suppose:

A household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75.

He 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 lend – assuming the bank does the creditworthiness checks and decides to lend – 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 Net Investment in Nonfinancial Assets 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). i.e., his Net Borrowing is +$495.

This means even though the person has a Saving of $5, he has incurred 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).

That can be confusing since Net Borrowing is $495 even though the person actually borrowed $450 from the bank.

As I have mentioned before, an alternative terminology exists where Net Acquisition of Financial Assets is used instead of Net Lending and Net Lending (to a sector) is used instead of Net Incurrence of Liabilities.

Table F.10

The Table F.10 of the Federal Reserve’s Statistical Release Z.1: Flow Of Funds Accounts Of The United States is below:

(click to expand and click again to expand)

The Flow of Funds Table F.10 may lead one to suppose that “Net Investment in Nonfinancial Assets” is Saving. Or to put it more simply one may suppose that “purchasing a house is saving”. Or worse “purchasing a house is dissaving”.

This is “Monetarist Intuition”. Here the house was purchased by incurring liabilities and sale of assets.

As we saw above – for the personal sector,

Saving = Disposable Income – Consumption.

NIPA accountants calculate it this way. But we also saw that

Saving = Net Acquisition of Financial Assets + Net Investment in Nonfinancial Assets – Net Incurrence of Liabilities

which can be verified from the table. This method is used by the Flow of Funds accountants.

As an aside, apart from definitional issues between Flow of Funds and NIPA, there can discrepancies and the following link discusses this without giving any conclusion.

Martin Wolf Pays A Generous Tribute To Anthony Thirlwall

Readers of this blog will notice how I attach special importance to the balance of payments in telling the story of how economies work.

In a recent blog post Can one have balance of payments crises in a currency union? at FT, Martin Wolf refers to the work of Anthony Thirlwall – who has made great contributions to the Kaldorian story of growth of nations.

(photo courtesy Wikipedia)

The following article on the Euro appeared in the Financial Times on 9 October 1991 and the FT link of the article is here.

The whole blog post is written nicely by Martin Wolf and although lacking the Kaldorian punch, definitely worth reading.

Let us start at the most basic level: that of the individual. Can individuals have a balance of payments crisis? Certainly.

: -)

Thirwall and his colleague John McCombie wrote this supremely insightful book in 1994 titled Economic Growth and the Balance of Payments Constraint

Updated 18 Mar 2014 (Broken link removed).