Recently CNBC asked Paul Krugman to argue against government spending which provoked Krugman to write a blog post Zombies On CNBC.
Krugman is asked – how high can government expenditure go – 100%?
Okay two theoretical questions which are purely theoretical – nothing much to do with the discussion above.
Can government expenditure be greater than 100% of gdp?
Economists use the phrase net investment to describe investment net of consumption of fixed capital (“depreciation”). This can go negative if the consumption of fixed capital is higher than gross investment. This happened in the United States in 2009 – for example because of the deflationary environment. The System of National Accounts uses the phrase “gross fixed capital formation” and in quarterly gdp news release you see this phrase being used than investment. Can this go negative for an economy as a whole?
The fact that I have asked the two questions means the answer is likely yes.
So how?
Comments welcome – although I do not publish them.
Some time back I had started with the first part of a series of posts on this topic: see Balance Of Payments: Part 1. From the same post, here’s from the Australian Bureau of Statistics’ manualBalance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998
(click to enlarge)
So we have the current account, the financial and the international investment position at the beginning and end of each accounting period. In addition we have, revaluations on assets and liabilities. These arise due to change in the value of assets (such as rise in stock markets) and due to movement of the exchange rate or both.
Also, textbooks use a slightly different language than official statistics and manuals. Textbooks simply use the phrase capital account when they mean the financial account.
I aim to go into each of this and the behaviour of institutions who are involved in the whole process and how it leads to changes in assets and liabilities of all sectors and the consequences. We will see how endemic current account deficits act as a hemorrhage in the circular flow of national income as Wynne Godley would put it and decides the fate of nations as Anthony Thirlwall may have it.
To really appreciate, one needs to have a strong methodology for studying this. One way is to use G&L’s transactions flow matrix but it can get complicated in case of two nations. Needless to say, from a modeling perspective, it is more useful than the usual way of studying balance of payments. However, for appreciating G&L methodology one needs to first understand the usual way of studying this.
Double Entry Versus Quadruple Entry Bookkeeping
In contrast to national accounts, Balance of Payments is based on double entry bookkeeping. Here’s from the IMF’s Balance of Payments And International Investment Position Manual (BPM6), pg 9:
The balance of payments is a statistical statement that summarizes transactions between residents and nonresidents during a period. It consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account. Under the double-entry accounting system that underlies the balance of payments, each transaction is recorded as consisting of two entries and the sum of the credit entries and the sum of the debit entries is the same.
In contrast, national accounts as per SNA2008 or G&L’s way of doing it uses quadruple entry bookkeeping who point out in their book Monetary Economics that:
… Copeland pointed out that, ‘because moneyflows transactions involve two transactors, the social accounting approach to moneyflows rests not on a double-entry system but on a quadruple-entry system’. Knowing that each of the columns and each of the rows must sum to zero at all times, it follows that any alteration in one cell of the matrix must imply a modification to at least three other cells. The transactions matrix used here provides us with an exhibit which allows to report each financial flow both as an inflow to a given sector and as an outflow to the other sector involved in the transaction.
The structure of an economic model that is relevant for a capitalist economy needs to include the interrelated balance sheets and income statements of the units of the economy. The principle of double entry book keeping, where financial assets are liabilities on another balance sheet and where every entry on balance sheet has a dual in another entry on the same balance sheet, means that every transaction in assets requires four entries.
The System of National Accounts 2008 (2008 SNA) says (page 21):
In principle, the recording of the consequences of an action as it affects all units and all sectors is based on a principle of quadruple entry accounting, because most transactions involve two institutional units. Each transaction of this type must be recorded twice by each of the two transactors involved. For example, a social benefit in cash paid by a government unit to a household is recorded in the accounts of government as a use under the relevant type of transfers and a negative acquisition of assets under currency and deposits; in the accounts of the household sector, it is recorded as a resource under transfers and an acquisition of assets under currency and deposits. The principle of quadruple entry accounting applies even when the detailed from-whom-to-whom relations between sectors are not shown in the accounts. Correctly recording the four transactions involved ensures full consistency in the accounts.
Simple example: your and my favourite: loans make deposits. The following is a transaction where a household has borrowed some funds from the banking sector:
Introduction To Current Transactions
I mentioned that in recording transactions between residents and nonresidents and presenting it as balance of payments, national accountants use double entry bookkeeping (as opposed to quadruple), so any transaction in the current account necessarily involves another entry in the financial account (ignoring barter and accidental cancellations). However, the opposite is not the case: a transaction on the financial account will lead to another entry in the financial account and not directly in the current account. A purchase of US equities by a UK resident cannot be said to cause or increase the US current account deficit.
One example: if you are are US citizen travelling to the UK and have pay for coffee at the London airport by paying in Federal Reserve notes, it will give rise to an entry in the current account (credit from the perspective of the UK balance of payments) and a debit (increase in assets of UK residents: change in currency notes). This is just transaction among thousands and the question is how is all this to be recorded and more importantly (later) what does it tell us.
Here’s how a standard balance of payments table looks like (note: this does not include international investment position)
(source: UK Pink Book 2011; click to enlarge)
We will go over details in the next post in this series. For now let us see how this looks for the example presented earlier: A US traveller pays $10 for coffee at the London Heathrow airport with Federal Reserve currency notes. Assuming the current exchange rate, the following (double) entries need to be included in the UK balance of payments:
£
Credits
Debits
Current Account
Goods and Services
6.328
Financial Account
Bank Deposits, Foreign Currency Assets
6.328
This is a simple example – hardly needing so much background and information but in the next post in this series, we will look at complicated examples where intuitions can easily go wrong. If the above were the only transaction between UK and US residents in the accounting period (quarter/year), this will also change the US indebtedness to the UK by £6.328 or $10 and this will be shown in the international investment positions of the UK and the US. If the exchange rate had moved from the start of the period, revaluations would need to be done to record the closing stocks of assets and liabilities.
In one of my recent posts, Saving Net Of Investment, I went into gross saving versus saving net of consumption of fixed capital. I showed how depreciation – or more appropriately, consumption of fixed capital – is treated in the flow of funds accounts.
Since the transactions flow matrix is a powerful tool for visualizing flow of funds, the question is where depreciation makes an appearance. The following table created by me using shows how for a simple economy.
FIGURE 1. Transactions Flow Matrix (click to enlarge)
Here “Firms” is a shorthand for all production firms as a sector and I took the consumption of fixed capital of firms only for illustration purposes. (Else I would have needed to break the households’ accounts into current and capital accounts – eating up space).
Investment here is gross investment and consumption of fixed capital makes its appearance in the line 3. It is a negative item in the current account and a positive item in the capital account. So it more of a book-keeping device but an important one because depreciation is not unimportant. The definition of profits is that of Wynne Godley and is slightly different from National Accounts. Also, while undistributed profits is a source of funds, CFC is also!
So undistributed profits (FU) and consumption of fixed capital (CFC) are both sources of funds. (Positive signs denote sources of funds and negative – uses of funds). This can be confusing because depreciation is a negative for net worth. The reason is that, as I have mentioned before, revaluations need to be done before end of period stocks are calculated. And it is where consumption of fixed capital will make a reappearance – subtracting from net worth due to a reduction in the value of nonfinancial assets.
It is important to keep in mind that equities are also sources of funds as the last line (above Σ) shows. So net saving (undistributed profits for firms) and consumption of fixed capital add to changes in net worth. (Note: Net is net of consumption of fixed capital here and not net of investment!).
This can be seen from the UK Blue Book 2011.
FIGURE 2. UK Blue Book 2011 Accumulation Accounts (click to enlarge)
A Digression
What is the origin of the confusing phrase “net saving” – saving net of investment? I believe it came from Nicholas Kaldor himself who originated the sectoral balances approach. Here’s from The Scourge Of Monetarism, 1982, pp 48-50:
The PSBR in any year can be defined as the public sector’s net de-cumulation of financial assets (net dissaving) which by accounting identity must be equal to the net acquisition of financial assets (net saving) of the private sector, home and overseas; which in turn can be broken down to the net acquisition of financial assets of the personal sector, of the company sector, and the overseas sector (the latter is the negative of the balance of payments on current account).
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:
click to view on Google Books
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 = If + 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:
SAVf = FU
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
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”:
Yesterday Wolfgang Münchau wrote an article in the Financial Times The Bundesbank has no right at all to be baffled in which he gave his opinion about Bundesbank President Jens Weidmann’s leaked letter to the European Central Bank President Mario Draghi expressing concerns on the Bundesbank’s TARGET2 assets.
According to the Bundesbank December 2011 Monthly Report, its claims on the rest of the Eurosystem was around €476bn (and that it reduced somewhat in December!)
According to Münchau,
The Bundesbank initially dismissed the Target 2 balance as a matter of statistics. Their argument was: yes, it is recorded in the Bundesbank’s accounts, but the counterparty risk is divided among all members according to their share in the system. But last week, Jens Weidmann, president of the Bundesbank, acknowledged the Target 2 imbalances are indeed important, and an unacceptable risk. The Bundesbank has now joined the united front of German academic opinion.
and that:
One would assume that the best policies would be those that attack the root of the problem – the imbalances themselves. One of the deep causes behind this problem is, of course, Germany’s persistent current account surplus. The problem can thus easily be solved through policies to encourage Germany to raise its imports relative to its exports. You need policies that provide eurozone-wide backstops to the banking sector, and also policies to insure against asymmetric shocks. And you need to harmonise many aspects of structural policy to ensure imbalances do not become entrenched.
But there is no appetite for any of this in Germany. Instead, the Bundesbank prefers to solve the problem by addressing the funding side. Mr Weidmann proposed last week that Germany’s Target 2 claims should be securitised. Just think about this for a second. He demands contingent access to Greek and Spanish property and other assets to a value of €500bn in case the eurozone should collapse. He might as well have suggested sending in the Luftwaffe to solve the eurozone crisis. The proposal is unbelievably extreme.
This is indeed extreme but there are ones who argue that the Bundesbank’s (approximately) €476bn TARGET2 assets do not matter much – because the Bundesbank being the issuer of settlement balances of banks cannot go broke. This is from the Irish Economy Blog:
First, every national central bank in the Eurosystem currently has assets that exceed their liabilities and total Target2 credits equal Target2 liabilities. Thus, the most likely resolution of Target imbalances in the case of a full Euro breakup would be a pooling of assets held by Target2 debtors to be handed over to Target2 creditors to settle the balance. This may leave the Bundesbank holding a set of peripheral- originated assets that may be worth less that face value but this scenario would result in losses to the Bundesbank that would be far short of the current value of its Target2 credit.
Second, as Gavyn Davies discusses in this interesting FT article, central bank balance sheets are simply not the same as normal private sector balance sheets. It is unwise for central banks to go around printing money to purchase worthless assets so it is generally appropriate to insist that a central bank’s assets at least equal the value of the money it has created.
That said, should the Bundesbank end of losing a bunch of money because its Target2 credit was worth less than stated, there would be no earthly reason why the German public would need to give up large amounts of money to ensure that the Bundesbank remained “solvent”.
In a post-euro world, the Bundesbank would be one of a select number of central banks that could be counted on to print a currency likely to retain its value. Weidmann could write himself a cheque, stick it in the vaults and declare the Bundesbank to be solvent without any need to call on the German taxpayer.
I had written on this sometime back in the post Who is Germany? so I refer the reader to the post. Briefly my argument is that the TARGET2 balance is an important item in Germany’s International Investment Position. If there is a breakup of the Euro Area, then Germany’s wealth reduces. Indeed Karl Whelan has somewhat changed his position – from arguing it doesn’t matter to arguing that there will be a demand for settlement!
Matters can get worse in case there is a dreadful scenario in which the financial firms do a panic selling of assets in the Euro Area but held outside Germany and make a “flight to quality” to Germany. This by itself does not change Germany’s net international position (only gross items in IIP) but if the breakup results in a default by the “periphery”, Germany’s wealth erodes (among other assets, TARGET2 claims vanish overnight) and it can become a net debtor of the rest of the world from being a net creditor!
National Balance Sheet
In one of my recent posts, I went into the concept of “National Saving”. The stock counterpart of this is the “Net Worth”. It is calculated by first taking the nonfinancial assets within a nation’s boundary (defined appropriately on what is counted and what is not). Then one adds financial assets and liabilities. The claims within sectors of an economy cancel out because every asset has a counterpart liability and one is left with assets and liabilities with the rest of the world.
This is the SNA concept of net worth. It is done for example for the case of Australia in the following manner by the Australian Bureau of Statistics. (Link to the full release Australian System of National Accounts 2010-11)
So if a nation’s external assets are impaired for whatever reason, its wealth reduces. It doesn’t matter if it is the central bank whose assets are impaired. This is counter-intuitive because no sector immediately may “feel the pinch” due to the central bank’s loss of assets held abroad.
That’s a bit of Mercantilism. It is true that Mercantilist policies “injures everyone alike” as argued by Keynes himself and later by many Post Keynesians (such as Basil Moore whom I quoted in this post). However, it cannot be argued that a potential asset impairment of the Bundesbank’s TARGET2 balance does not cost the German taxpayer. So the Bundesbank would indeed go behind debtor nations and ask them to settle claims!
Needless to say, this is no defense of Weidmann’s position!
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
$
Assets
900
Nonfinancial Assets Financial Assets
600 300
Liabilities and Net Worth
900
Securities Other Than Shares Loans Shares and Other Equity Net Worth
150 250 450 50
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
$
Assets
1,230
Nonfinancial Assets Financial Assets
1000 230
Liabilities and Net Worth
1,230
Securities Other Than Shares Loans Shares and Other Equity Net Worth
200 400 490 140
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
$
Assets
900
Nonfinancial Assets Financial Assets
600 300
Liabilities and Net Worth
900
Securities Other Than Shares Loans Net Worth Memo: Shares and Other Equity
150 250 500 450
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
$
Assets
1,230
Nonfinancial Assets Financial Assets
1000 230
Liabilities and Net Worth
1,230
Securities Other Than Shares Loans Net Worth Memo: Shares and Other Equity
200 400 630 490
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.
In the previous two posts, I went into a description of the transactions flow matrix and the balance sheet matrix as tools for an analytic study of a dynamical study of an economy.
During an accounting period, sectors in an economy are making all kinds of transactions. These can be divided into two kinds:
Income and Expenditure Flows
Financing Flows
Let’s have the transactions flow matrix as ready reference for the discussion below.
(Click for a nicer view in a new tab)
The matrix can easily be split into two – on top we have rows such as consumption, government expenditure and so on and in the bottom, we have items which have a “Δ” such as “Δ Loans” or “change in loans”. We shall call the former income and expenditure flows and the latter financing flows.
To get a better grip on the concept, let us describe household behaviour in an economy. Households receive wages (+WB) and dividends from production firms (called “firms” in the table) and banks (+FD_{f} and +FD_{b}) respectively) on their holdings of stock market equities. They also receive interest income from their bank deposits and government bills. These are sources of households’ income. While receiving income, they are paying taxes and consuming a part of their income (and wealth). They may also make other expenditure such as buying a house or a car. We call these income and expenditure flows.
Due to these decisions, they are either left with a surplus of funds or a deficit. Since we have clubbed all households into one sector, it is possible that some households are left with a surplus of funds and others are in deficit. Those who are in surplus, will allocate their funds into deposits, government bills and equities of production firms and banks. Those who are in deficit, will need funds and finance this by borrowing from the banking system. In addition, they may finance it by selling their existing holding of deposits, bills and equities. The rows with a “Δ” in the bottom part of transactions flow matrix capture these transactions. These flows will be called financing flows.
How do banks provide credit to households? Remember “loans make deposits”. See this thread Horizontalism for more on this.
This can be seen easily with the help of the transactions flow matrix!
The two tables are some modified version of tables from the book Monetary Economics by Wynne Godley and Marc Lavoie.
It is useful to define the flows NAFA, NIL and NL – Net Accumulation of Financial Assets, Net Incurrence of Liabilities and Net Lending, respectively.
If households’ income is higher than expenditure, they are net lenders to the rest of the world. The difference between income and expenditure is called Net Lending. If it is the other way around, they are net borrowers. We can use net borrowing or simply say that net lending is negative. Now, it’s possible and typically the case that if households are acquiring financial assets and incurring liabilities. So if their net lending is $10, it is possible they acquire financial assets worth $15 and borrow $5.
So the the identity relating the three flows is:
NL = NAFA – NIL
I have an example on this toward the end of this post.
I have kept the phrase “net” loosely defined, because it can be used in two senses. Also, some authors use NAFA when they actually mean NL – because previous system of accounts used this terminology as clarified by Claudio Dos Santos. I prefer old NAFA over NL, because it is suggestive of a dynamic, though the example at the end uses the 2008 SNA terminology.
While households acquire financial assets and incur liabilities, their balance sheets are changing. At the same time, they also see holding gains or losses in their portfolio of assets. What was still missing was a full integration matrix but that will be a topic for a post later. Since, it is important however, let me write a brief mnemonic:
where revaluations denotes holding gains or losses.
This is needed for all assets and liabilities and for all sectors and hence we need a full matrix.
We will discuss more on the behaviour of banks (and the financial system) and production firms some other time but let us briefly look at the government’s finances.
As we saw in the post Sources And Uses Of Funds, government’s expenditure is use of funds and the sources for funds is taxes, the central bank’s profits, and issue of bills (and bonds). Unlike households, however, the government is in a supreme position in the process of “money creation”. Except with notable exceptions such as in the Euro Area, the government has the power to make a draft at the central bank under extreme emergency, though ordinarily it is restricted. Wynne Godley and Francis Cripps described it as follows in their 1983 book Macroeconomics:
Our closed economy has a ‘central bank’ with two principle functions – to manage the government’s debt and to administer monetary policy. [Footnote: The central bank has to fund the government’s operations but this in itself presents no problems. Government cheques are universally accepted. When deposited with commercial banks the cheque become ‘reserve assets’ in the first instance; banks may immediately get rid of excess reserve assets by buying bonds.]. The only instrument of monetary policy available to the central bank in our simple system is the buying and selling of government bonds in the bond market. These operations are called open market operations. We assume that the central bank does not have the right to directly intervene directly in the affairs of commercial banks (e.g., to prescribe interest rates or quantitative lending limits) or to change the 10% minimum reserve requirement. But the central bank is in a very strong position in the bond market since it can sell or buy back bonds virtually without limit. This gives it the power, if it chooses, to fix bond prices and yields unilaterally at any level [Footnote: But speculation based on expectations of future yields may oblige the central bank to deal on a very large scale to achieve this objective.] and thereby (as we shall soon see) determine the general level of interest rates in the commercial banking system.
Given such powers, we can assume in many descriptions that the government’s expenditure and the tax rate is exogenous. However, many times, there are many constraints such as price and wage rises, high capacity utilization and low production capacity and also constraints brought about from the external sector due to which fiscal policy has to give in and become endogenous.
While I haven’t introduced open economy macroeconomics in this blog in a stock-flow coherent framework, we can make some general observations:
For a closed economy as a whole, income = expenditure. While it is true for the whole economy (worth stressing again: closed), it is not true for individual sectors. The household sector, for example, typically has its income higher than expenditure. In the last 15-20 years, even this has not been the case. If one sector has it’s income higher than expenditure, some sectors in the rest of the world will have its income lower than its expenditure. Many times, the government has its income lower than expenditure and we see misleading public debates on why the government should aim to achieve a balanced budget. When a sector has its income lesser than expenditure, it’s net lending is negative and hence is a net borrower from the rest of the world. It can finance this by borrowing or sale of assets. A region or a whole nation can have its expenditure higher than income and this is financed by borrowing from the rest of the world. A negative flow of net lending implies a net incurrence of liabilities – thus adding to the stock of net indebtedness which can run into an unsustainable territory. Stock-flow coherent Keynesian models have the power to go beyond short-run Keynesian analysis and study sustainable and unsustainable processes.
… it is important to have in mind that it is possible to get three kinds of trajectories with SFC models:
trajectories toward a sustainable steady state;
trajectories toward a steady state over certain limits;
explosive trajectories.
The analysis of SFC models’ dynamic trajectories and steady states is useful, first because it makes clear to the analyst whether the regime described in the model is sustainable or whether it leads to some kind of rupture—either because the trajectory is explosive or because it leads to politically unacceptable configurations. In these cases, as Keynes would say in the Tract, the analyst can conclude that something will have to change and even get clues about (i) what will probably change (since the sensitivity of the system dynamics to changes in different behavioural parameters is not the same); and (ii) when this change will occur (since the system may converge or diverge more or less rapidly).
Example
Note that Net Lending is different from “saving”. Say, a household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75 and takes a loan of to finance a house purchase near the end of the year whose price is $500. Assume that the Loan-To-Value (LTV) of the loan is 90% – which means he gets a loan of $450 and has to pay the remaining $50 from his pocket to buy the house. (i.e., he is financing the house mainly by borrowing and partly by sale of assets). How does the bank lending – simply by expanding it’s balance sheet (“loans make deposits”). Ignoring, interest and principal payments (which we assume to fall in the next accounting period),
His saving is +$100 – $20 – $75 = +$5.
His Investment is +$500.
His Net Incurrence of Liabilities is +$450.
His Net Accumulation of Financial Assets is +$5 – $50 = – $45.
His Net Lending is = -$45 – (+$450) = -$495 which is Saving net of Investment ($5 minus $500).
This means even though the person has “saved” $5, he has incurred an additional liability of $450 and due to sale of assets worth $45, he is a net borrower of $495 from other sectors (i.e., his net lending is -$495).
Assume he started with a net worth of $200.
Opening Stocks: 2010
$
Assets
200
Nonfinancial Assets Deposits Equities
0 30 170
Liabilities and Net Worth
200
Loans Net Worth
0 200
Now as per our description above, the person has a saving of $5 and he purchases a house worth $500 by taking a loan of $450 and selling assets worth $50. We saw that the person’s Net Accumulation of financial assets is minus $45. How does he allocate this? (Or unallocate $45)? We assume a withdrawal of $10 of deposits and equities worth $35. At the same time, during the period, assume he had a holding gain of $20 in his equities due to a rise in stock markets.
Hence his deposits reduce by $10 from $30 to $20. His holding of equities decreases by $15 (-$35 + $20 = -$15)
How does his end of period balance sheet look like? (We assume as mentioned before that the purchase of the house occurred near the end of the accounting period, so that principal and interest payments complications appear in the next quarter.)
Closing Stocks: 2010
$
Assets
675
Nonfinancial Assets Deposits Equities
500 20 155
Liabilities and Net Worth
675
Loans Net Worth
450 225
Just to check: Saving and capital gains added $5 and $20 to his net worth and hence his net worth increased to $225 from $200.
Of course, from the analysis which was mainly to establish the connections between stocks and flows seems insufficient to address what can go wrong if anything can go wrong. In the above example, the household’s net worth gained even though he was incurring a huge liability. What role does fiscal policy have? The above is not sufficient to answer this. Hence a more behavioural analysis for the whole economy is needed which is what stock-flow consistent modeling is about.
One immediate answer that may satisfy the reader now is that the households’ financial assets versus liabilities has somewhat deteriorated and hence increased his financial fragility. By running a deficit of $495 i.e., 495% of his income, the person and his lender has contributed to risk. Of course, this is just one time for the person – he may be highly creditworthy and his deficit spending is an injection of demand which is good for the whole economy. After all, economies run on credit. While this person is a huge deficit spender, there are other households who are in surplus and this can cancel out. In the last 15 years or so, however (before the financial crisis hit), households (as a sector) in many advanced economies ran deficits of the order of a few percentage of GDP. If the whole household sector continues to be a net borrower for many periods, then this process can turn unsustainable as the financial crisis in the US proved.
Now to the title of the post. Flows such as consumption, taxes, investment are income/expenditure flows. Flows such as “Δ Loans”, “Δ Deposits”, “Δ Equities” are financing flows. Income/expenditure flows affect financing flows which then affect balance sheets, as we see in the example.
In my previous post Sources And Uses Of Funds, I used the term “net worth”, and the reader would have noted the the strange dissimilarity with business accounting.
It’s best first to verify that national accountants (with the exception of the Federal Reserve’s Z.1 flow of funds accounts of the United States) do it the way described in the previous post.
The UK Blue Book 2011 has the following description of Non-financial corporations’ balance sheet at the end of 2010:
Assets
Nonfinancial Assets Currency and Deposits Securities Other Than Shares Loans Shares and Other Equity Other Accounts Receivable
Liabilities and Net Worth
Currency and Deposits Securities Other Than Shares Loans Shares and Other Equity Other Accounts Payable Net Worth
£, billion
4,029.2
1,781.8 687.8 85.3 448.5 876.8 135.9
4,029.2
– 390.9 1,245.1 2,201.4 163.9 28.0
The relevant tables are below:
So “Shares and Other Equity” is treated as a liability of the corporation even though dividends are not compulsory. In a sense, equities are treated as being equivalent to debt securities. How does one calculate this? Assuming the relevant information is available, one simply needs to calculate the market value of equities issued by corporations.
The tendency to treat equities issued by corporations as not liabilities is misleading. This is all the more important if foreigners hold a large amount of equities and this may underestimate the indebtedness to foreigners. Indeed statistical agencies of many nations release data for the loosely defined term “external debt” and do not count equities held by foreigners in this. This “intuition” can easily be dismissed – foreigners can liquidate equities.
For comparison, below is the similar Z.1 statistic of Nonfarm Nonfinancial Corporate Businesses of the United States
The Federal Reserve by excluding the market value of equities issued in liabilities, exaggerates the net worth of corporations.
Business accounts commonly (but not invariably) record costs on an historic basis, partly to ensure that they are completely objective. Historic cost accounting requires goods or assets used in production to be valued by the expenditures actually incurred to acquire those goods or assets, however far back in the past those expenditures took place. In the SNA, however, the concept of opportunity cost as defined in economics is employed. In other words, the cost of using, or using up, some existing asset or good in one particular process of production is measured by the amount of the benefits that could have been secured by using the asset or good in alternative ways. Opportunity cost is calculated with reference to the opportunities foregone at the time the asset or resource is used, as distinct from the costs incurred at some time in the past to acquire the asset. The best practical approximation to opportunity cost accounting is current cost accounting, whereby assets and goods used in production are valued at their actual or estimated current market prices at the time the production takes place. Current cost accounting is sometimes described as replacement cost accounting, although there may be no intention of actually replacing the asset in question after it has been used.
So current cost accounting or replacement cost accounting is used. We saw in the last post that financial assets and liabilities are to be valued at their market values. In addition, real estate will be evaluated at the market price. Capital goods are to be valued at their replacement cost. Inventories should be valued at the current cost of production, not at the price the producers expect to it to sell.
Moreover, according to the SNA:
Current cost accounting has ramifications that permeate the entire SNA. It affects all the accounts and balance sheets and their balancing items. A fundamental principle underlying the measurement of gross value added, and hence GDP, is that output and intermediate consumption must be valued at the prices current at the time the production takes place. This implies that goods withdrawn from inventories must be valued at the prices prevailing at the times the goods are withdrawn and not at the prices at which they entered inventories. This method of recording changes in inventories is not commonly used in business accounting, however, and may sometimes give very different results, especially when inventory levels fluctuate while prices are rising. Similarly, consumption of fixed capital in the SNA is calculated on the basis of the estimated opportunity costs of using the assets at the time they are used, as distinct from the prices at which the assets were acquired. Even when the fixed assets used up are not actually replaced, the amount of consumption of fixed capital charged as a cost of production should be sufficient to enable the assets to be replaced, if desired. When there is persistent inflation, the value of consumption of fixed capital is liable to be much greater than depreciation at historic costs, even if the same assumptions are made in the SNA and in business accounts about the service lives of the assets and their rates of wear and tear and obsolescence. To avoid confusion, the term “consumption of fixed capital” is used in the SNA to distinguish it from “depreciation” as typically measured in business accounts.
Back to Net Worth
The SNA has this description of net worth:
Net worth is the difference between the value of all financial and non-financial assets and all liabilities at a particular point in time. For this calculation, each asset and each liability is to be identified and valued separately. As the balancing item, net worth is calculated for institutional units and sectors and for the total economy.
For government, households and NPISHs [Non-profit institutions serving households], the value of net worth is clearly the worth of the unit to its owners. In the case of quasi-corporations, net worth is zero, because the value of the owners’ equity is assumed to be equal to its assets less its liabilities. For other corporations, the situation is less clear-cut.
In the SNA, net worth of corporations is calculated in exactly the same way as for other sectors, as the sum of all assets less the sum of all liabilities. In doing so, the value of shares and other equity, which are liabilities of corporations, are included in the value of liabilities. Shares are included at their market price on the balance sheet date. Thus, even though a corporation is wholly owned by its shareholders collectively, it is seen to have a net worth (which could be positive or negative) in addition to the value of the shareholders’ equity.
Update: Corrected the values in the table at the beginning of the post.
In a recent post, I went into what is called the Transactions Flow Matrix. This is used heavily in Stock-Flow Consistent Modeling of the whole economy. The underlying theme is “everything comes from somewhere and goes somewhere, and there are no black holes”.
I also mentioned about a Balance Sheet Matrix. What is it?
Sectors in an economy have assets and liabilities. Assets can be both financial as well as nonfinancial. Since nonfinancial assets are nobody’s liability, liabilities are financial. Very quickly, a balance sheet matrix is created by assigning a + sign to assets and a (-) sign to liabilities.
As per the System of National Accounts, all assets and liabilities are to be evaluated at market prices. According to 2008 SNA,
So a corporation or the government may have issued bonds at $100 but since the value fluctuates everyday and even during the day, it is possible that the bond price may reach $103. If it is the last day of the period for which the balance sheet is compiled, then the liability should be entered as $103, not $100.
We will have more to see in another post but let us just have a cursory look at an item called net worth. Since balance sheets should balance, we include this item in liabilities or rather call the right hand side of a balance sheet “Liabilities and Net Worth”. The term Net Worth has an intuitive appeal. If I have assets worth $100 and owe someone (say a bank) $10 and nothing more or less, my net worth is $90.
So let us quickly jump into the balance sheet matrix of a model economy.
In the previous post on the Transactions Flow Matrix, I had amalgamated the sectors Government and Central Bank into one, but now I have separated them so that there is higher clarity.
The reason I am writing this post is to stress the importance of signs. So in the above you will notice that households have a liability of L_{h} and hence appears with a negative sign. We shall see below however, that since loans are a source of funds, it will appear as a positive sign in the transactions flow matrix!
So households hold currency notes, deposits, bills and equities and these have counterpart in some other sector. And this should be the case because every financial asset is someone else’s liability. Also, from the matrix, the sum of net worths of all sectors (for a closed economy, at any rate) is equal to the value of the nonfinancial assets. This result isn’t surprising since financial assets cancel out with their counterpart liabilities.
We now jump to the transactions flow matrix – which I remade and added a lot of complications as compared to the previously related post The Transactions Flow Matrix
(Click to enlarge in a new tab)
These matrices are almost exactly similar to what appears in Wynne Godley and Marc Lavoie’s book Monetary Economics.
The difference between the two matrices is that the balance sheet matrix records assets and liabilities at the beginning or the end of a period, whereas the transactions flow matrix records transactions during an accounting period.
In the previous post I had briefly stressed the importance of signs but now we have the balance sheet matrix as well ready, let me stress this again using a few lines from G&L’s book on the transaction flow matrix (page 40):
The best way to take it in is by first running down each column to ascertain that it is a comprehensive account of the sources and uses of all flows to and from the sector and then reading across each row to find the counterpart of each transaction by one sector in that of another. Note that all sources of funds in a sectoral account take a plus sign, while the uses of these funds take a minus sign. Any transaction involving an incoming flow, the proceeds of a sale or the receipts of some monetary flow, thus takes a positive sign; a transaction involving an outgoing flow must take a negative sign. Uses of funds, outlays, can be either the purchase of consumption goods or the purchase (or acquisition) of a financial asset. The signs attached to the ‘flow of funds’ entries which appear below the horizontal bold line are strongly counter-intuitive since the acquisition of a financial asset that would add to the existing stock of asset, say, money, by the household sector, is described with a negative sign. But all is made clear so soon as one recalls that this acquisition of money balances constitutes an outgoing transaction flow, that is, a use of funds.
So the government expenditure G has a minus sign because it is a use of funds and its sources are taxes, net issuance of bills and central bank profits.
The sources of funds for the production sector (abbreviated “firms”) is retained earnings (or undistributed profits, called FU), loans from banks and the issuance of equities and also sales (the consumption by households), government purchase of goods and investment itself because producers create tangible capital for themselves as a whole.
Now compare signs in the two matrices – equities are a source of funds for firms and hence has a positive sign in the transactions flow matrix but equities are also liabilities and hence the stock of equities appears with a negative sign in the balance sheet matrix.
Similarly, borrowing via loans are a source of funds for households and hence the positive sign in Table 2 while in Table 1 it appears with a minus sign.
For banks, making loans is a use of funds and taking deposits a source of funds. Hence minus and plus respectively in Table 2.
Also, the equities and loans in Table 2 are flows whereas in Table 1 they are stocks. Hence in Table 2, we have “Δ Loans” or change in loans, whereas in Table 1 its simply “Loans”.
Once we have a beginning of period balance sheet matrix and the transactions flow matrix, how do we construct the end of the period balance sheet matrix? I will leave this question for another post because I will have to introduce capital/holding gains and something called a full integration matrix. Before that I will have another post on real numbers taken from statistical releases to get more a intuitive feel for the balance sheet matrix.
The three matrices (the transactions flow matrix, the balance sheet matrix and the full integration matrix) go into the heart of “how money is created”. For this to be seen in detail, I will have to go into “monetary circuits” using transaction flows and that is the topic of yet another post. If you really understand how loans make deposits, the two tables should set you into a dynamical view of the whole process – a description completely different than the chimerical money multiplier model.
