Monthly Archives: February 2012

William Dudley On U.S. Sectoral Balances

Discussions of the U.S. public debt and fiscal deficits curiously miss on the connection with the external sector. Even the Congressional Budget Office (CBO)’s The Budget And Economic Outlook report misses this connection when projecting the public debt over many scenarios.

Last week the President of the Federal Reserve Bank of New York, William Dudley gave a speech at a “Panel Discussion on Fiscal Challenges” and the two topic discussed by him were: the interest expense of the US government on its debt  and the U.S. sectoral balances.

According to him, “we are in an unusual period in which net interest expense is temporarily depressed”. You can read about it at the FRBNY web page of the speech.

Which brings me to his discussion on sectoral balances. This is not the first time he has talked on this and the public debate on the public debt and fiscal deficit of the United States almost always miss the important connection of this with the external sector imbalance. But Dudley knows the importance of this in policy making, even though he begins his talk by saying that discussion of fiscal policy “for central bankers [is] always dangerous waters to swim in”.

Here’s Dudley’s chart:

Let’s just say Dudley is less dogmatic about fiscal policy than his colleagues because he says:

Fiscal adjustments require offsetting changes in private-sector spending and saving behavior, and in the trade sector. Prudent economic policies and international coordination can help ensure that such adjustments take place in ways that support economic activity (and, by extension also support government revenue).


On one hand, the U.S. economy must be reoriented toward global demand and stronger net exports. On the other hand, there will have to be offsetting adjustments elsewhere in the world. After all, on a global basis, the current account balance—properly measured—must sum to zero. This means that countries with significant trade surpluses will need to reorient their economies over time toward increasing domestic demand and running smaller trade surpluses.

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 from his book Shaking The Invisible Hand:

click to view on Google Books


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.

click to view on Google Books

The Un-Godley Private Sector Deficit

Economists worry too much about the government’s deficit although they seem to not know about the private sector deficit.

Goldman Sachs’ chief economist Jan Hatzius came to know about the sectoral balances approach and called the difference between United States’ private expenditure and income in “The Un-Godley Private Sector Deficit”. He later included the sectoral balances approach in his forecasting models.

Here’s the sectoral balances for the United States using data from the Federal Reserve’s Z.1 Flow Of Funds Accounts Of The United States:

GDP appears in Table F.6 and sectoral balances in Table F.8 – as “Net Lending(+)/Net Borrowing(-)”. The above is using quarterly seasonally adjusted data. Easy work. Excel data is available at the Federal Reserve’s page here

It can be verified that

Private Sector Balance = Government Deficit + Current Balance of Payments

The red line is the private sector balance and is the difference between the private sector income and expenditure. When positive, the private sector is in surplus and when negative, it is in deficit.

For most of history having been positive (and back to being positive now), the private sector balance made a dramatic shift in the mid-1990s reaching as low as as -5.8% in Q1 2000 (and hence “private sector deficit”). This implied that before the recession, growth in the United States was driven by higher private expenditure relative to income. The flip side of this growth was that due  to the Un-Godley private sector deficits, the budget went into a surplus while private indebtedness continued to rise.

This was enough to cause a recession in the early 2000s and the US government had to provide a massive fiscal stimulus to prevent a severe recession. The Federal Reserve also provided stimulus by keeping interest rates low but the private sector went into a deficit again – rushing to participate in a boom. The result of all this was the increase in the current account deficit of the United States to about 6.43% of GDP at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale and cracks started to appear in the foundations of growth – as warned by a series of articles from the Levy Institute.

This appears a bit like Scenario 4 in a Levy Institute paper Debt And Lending – A Cri De Coeur by Wynne Godley and Gennaro Zezza from April 2006 – the “gloomiest variant” according to the authors – where a drastic fall in private expenditure relative to income induces a recession in the United States, reducing the current account balance dramatically and increasing the budget deficit (to eventually enough to become the central debate in US politics).

And it turned out that the private sector deficit quickly went into a surplus – faster than the scenario presented above because the private sector could not handle the rise in indebtedness. The fall in private expenditure relative to income also meant – as mentioned above – that the United States went into a deep recession – from which it is still recovering.

Reply To A Comment On Saving Net Of Investment

My previous post Saving Net Of Investment was written to disprove claims made by Neochartalists such as

Without a government deficit, there would be no private saving.

I don’t publish comments and respond privately and I had two comments from someone whom I couldn’t track back. So here’s a reply.

Hi Ramanan,

Great work here.  Thanks.

Two questions.

1.  Can you explain what this means precisely?  Does it just mean the household sector was borrowing more when the surplus was run?  Where did their savings come from exactly?

2.  It’s perfectly possible for the private sector to save if the budget is balanced and the foreign sector runs a trade surplus, right?


Just to add one more question.  How can the private sector save without a government budget deficit?  Is this accurate?

1.  Household’s must be paid in the form of an asset, the firm’s liability?

2.  The country must run a current account surplus (balanced budget deficit)?

My whole point is that saving and “net saving” are drastically different. A sector or the whole private sector can have positive saving and a net borrowing (flow) simultaneously.

Can you explain what this means precisely?  Does it just mean the household sector was borrowing more when the surplus was run?  Where did their savings come from exactly?

Yes the household sector was in deficit in 1999 onward as can be seen from line 48 of the F.8 data I attach in my blog.

It’s perfectly possible for the private sector to save if the budget is balanced and the foreign sector runs a trade surplus, right?

Yes of course. It is also possible for the private sector to having positive saving if the budget is balanced and the foreign sector runs a surplus or deficit. Of course, we are talking of the possibility (not sustainability) but data shows this was true in reality as well.

How can the private sector save without a government budget deficit?  Is this accurate?

1.  Household’s must be paid in the form of an asset, the firm’s liability?
2.  The country must run a current account surplus (balanced budget deficit)?

Yes the private sector can save without a budget deficit – which is what the data I linked shows 🙂

It’s not even necessary to run a trade/current account surplus for this. And that’s what the F.8 data for 1998-2000 shows.

This is because saving takes the form of both accumulation of real assets and financial assets.

The whole point is that saving is just defined as disposable income minus consumption expenditure. Expenditure for house purchase is not subtracted, for example.

I have an example here at the end of the blog post Income And Expenditure Flows And Financing Flows in the section titled “Example”



Saving Net Of Investment

There is a tendency of some economic commentators going for the overkill to make inaccurate statements such as

Without a government deficit, there would be no private saving.

See here and here. (h/t Steve)

But this is mixing up saving for saving net of investment.

Now, “saving net of investment” is sometimes called “net private saving”, although the originators such as Wynne Godley always specified this.

I guess the the root of the confusion on the part of those who have inherited this terminology from the originators is to treat the “net” in net private saving as a result of netting due to aggregation alone, and take the sectoral balances identity – whereas the “net” is crucially net of investment.

In a recent post Income And Expenditure Flows And Financing Flows, I went into concepts such as saving, saving net of investment, net acquisition of financial assets, net incurrence of liabilities, and “net lending(+)/net borrowing(-)” and you may read the example there on the calculation of these flows. I also went into clarifying this by an example but let’s just check this for the case of the United States with actual data from the Federal Reserve Z.1 Statistical Release Flow Of Funds Accounts Of The United States from the historical data from 1995-2004 available here. In particular the table F.8.

In the above, the data highlighted in blue is the current account balance. With the whole nation’s expenditure higher than income, it’s net lending was negative – i.e., it was a net borrower (from the rest of the world).

Also, the government budget was in surplus in the years (line 49 highlighted in red).

Also, here’s the part which has the potential to create more confusions. The Net Saving defined by the flow of funds accountants is Saving net of Consumption of Fixed Capital (i.e., depreciation). So this can be checked from items highlighted in yellow.

So, the private sector had a positive saving even though the budget was in surplus and the current balance of payments in deficit!

Of course, this meant that the private sector financial balance is negative and this you can see in line 43 highlighted in Red.

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

Banco de España’s TARGET2 Liabilities

Spain as a nation owes the rest of the world around €995bn according to the Banco de España International Investment Position data which is very high when compared to the 2011 GDP of €1,073bn. (And according to today’s release, real GDP fell 0.3% q/q in Q4 2011.)

Although, credit conditions in domestic and international money markets and capital markets in the Euro Area seemed to have eased in January, it seems Spanish banks are still not in the best shape. According to a Banco de España release, TARGET2 liabilities increased to around €176bn in January from around €151bn in December. Also, as a result banks in Spain have made heavy use of the LTRO facility as per the screenshot below:

(click to enlarge)

So capital flight out of Spain continues. Of course, this process can go on for longer than one could ever imagine earlier (because of the accommodative policy of the ECB and the laws governing the operations of the Eurosystem) but it is a good indicator of stress in balance-of-payments financing for Spain and the lack of fiscal space.

Net Worth: Part 2

A commenter on my post on Net Worth asked me if I could do an example.

Here it goes.

First I do it as done by national accountants as per 2008 SNA – the System of National Accounts and then by the method used by the Federal Reserve’s Z.1 Flow of Funds Accounts.

The example is from a Levy Institute working paper by Antonio C. Macedo e Silva and Claudio Dos Santos with tables created more neatly here.

Let us assume that a single firm starts with the following balance sheet.

Opening Stocks: 2011




Nonfinancial Assets
Financial Assets


Liabilities and Net Worth


Securities Other Than Shares
Shares and Other Equity
Net Worth



In the above Net Worth is defined as we did earlier by treating equities as liabilities of a corporation. As we saw in the table Transactions Flow Matrix in the post Sources And Uses Of Funds, firms finance investment by retained earnings, and incurring liabilities. It was a simplified matrix of course and firms may also by sale of assets they hold.

An important point in the analysis is that this is for a single firm not the consolidated corporate sector as I am going to assume it will purchase physical capital from another firm for which it is a part of current receipts and hence a source of funds for the latter. That is, in the Transactions Flow Matrix, “I” appears both in the current and capital account of the consolidated production firms sector but here we are interested in a single firm.

Let us assume in an accounting period the firm retains $90 of earnings and finances a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans,  issuing $40 of equities in the markets and selling existing financial assets worth $70.

The closing balance sheet will be as follows:

Closing Stocks: 2011




Nonfinancial Assets
Financial Assets


Liabilities and Net Worth


Securities Other Than Shares
Shares and Other Equity
Net Worth



We assume away capital gains i.e., asset prices haven’t changed for the sake of clarity. As you see, net worth has increased from $50 to $140 and this is due to the firm’s saving – undistributed profits of $90. In general, asset prices change all the time and there will be holding gains and/or losses in both assets and liabilities.

What about flows such as the financial balance?

Here Saving = +$90

Net Incurrence of Liabilities = (+$50) + (+$150) + (+$40) = +$240

Net Acquisition (or Accumulation) of Financial Assets = (-$70)

because of the sale of assets and hence

Net Lending by the firm = (-$70) – (+$240) = (-$310)

(This is also called NAFA in old terminology, instead of splitting Net Lending into Net Accumulation of Financial Assets and Net Incurrence of Liabilities.)

To check: this is equal to Saving Minus Investment which is +$90 – $400 which is equal to -$310 – the “financial balance” of the firm.

So even though we have a negative financial balance, the firm’s net worth has increased. However note that by doing so, the firm’s financial assets/liabilities ratio has reduced – increasing its fragility somewhat.

As mentioned earlier, the purchase of physical capital was from another firm and we have not consolidated the corporate sector and hence the above balance sheets are for a single firm only.

Alternative Approach

The Federal Reserve will do this differently because equities issued by corporations are treated as if they are not liabilities in its Z.1 Flow of Funds Accounts of the United States and accordingly the example will need to be modified to look like this:

Opening Stocks: 2011




Nonfinancial Assets
Financial Assets


Liabilities and Net Worth


Securities Other Than Shares
Net Worth
Memo: Shares and Other Equity



I have added Equities in “Memo” as per the Federal Reserve’s practice and the Net Worth at the beginning of the period is $500. With the same set of transactions – a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans,  issuing $40 of equities in the markets and selling existing financial assets worth $70, while retaining earnings of $90 in the period, the closing stocks will be as below:

Closing Stocks: 2011




Nonfinancial Assets
Financial Assets


Liabilities and Net Worth


Securities Other Than Shares
Net Worth
Memo: Shares and Other Equity



Here Net Worth increased by $130 from $500 to $630 because of retained earnings of $90 and issuance of equities of $40 in the period.

The second approach is more like an “own funds” approach.

Imbalances Looking For A Policy

… 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


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:

(click to expand in a new tab)

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.