Tag Archives: sectoral balances

Claims Economists Make

Economists struggle with simple things. Two examples.

National Saving, Trade Deficits etc.

In a blog article Has Anyone Heard of the Trade Deficit?, Dean Baker uses the sectoral balances identity to make a claim which is presented like a no-go theorem.

Baker says:

Fans of arithmetic (a tiny minority among DC policy types) like to point out that a large trade deficit implies negative national savings. In other words, if we have a trade deficit then by definition the United States as a whole has a negative saving rate.

This means that we either must have budget deficits (negative public savings) or negative private savings, or both. There is no way around this fact.

Baker confuses saving with saving net of investment – just like the Neochartalists. (Confuses S with S minus I)

Without proof, the sum of saving of a whole economy is given by

S = I + BP

where (here) S is the sum of the savings of all resident sectors of the economy – the “national saving”, I is the total investment expenditure of the resident sectors of the economy (i.e., both private and public) and BP is the current account balance of international payments.

So it is possible for an economy to have a trade deficit and hence a negative BP (although it’s not always the case that the trade deficit translates into a current account deficit) and still have I + BP positive if investment is sufficiently high. So an economy can have positive national saving with a trade deficit.

Of course it must be said that the persons he is attacking are wrong. The claim (of the persons he is criticizing) is that the United States should save more (by a reduction in budget deficits brought about by a tightening of fiscal policy and/or higher propensity to save of the private sector achieved in some way). This is illegitimate as such a policy will induce a recession in the United States. Via the paradox of thrift, an increase in the private sector propensity to save can lead to lower saving of the private sector. Investment will fall because of lower sales expectations and the recession in the United States caused by the fiscal tightening will most likely lead to a recession in the rest of the world reducing its exports so that the only thing achieved is higher world unemployment.

Debt/GDP Ratio

In a series of posts aimed at showing something, Randall Wray claims the following:

… To simplify, if the interest rate is higher than the economy’s growth rate, then the debt ratio rises continuously…

Of course he also claims that if g>r, the debt ratio stabilizes.

Now, the debt sustainability conditions relating the interest rate and the growth rate of output are misleading. I showed this two posts back, where I showed that the claim that the condition that g>r ensures stabilization of the public debt/gdp ratio is incorrect. The above quote claims the opposite and is equally erroneous and misleading.

An economy can have the growth rate lower than the interest rate and still not have an exploding debt ratio.

A standard error in such analysis is to treat the budget deficit as exogenous. 

Consider an economy without a strong balance of payments constraint and with inflation less of a trouble. A fiscal expansion brings about an increase in output and this has the effect of stabilizing the debt ratio in two ways: the higher output itself and an increase in tax revenues of the government due to higher output. The budget balance may go into primary surplus automatically even though the government may not be targeting this.

In other words, if r>g, the sequence dgiven by the relation

dt – dt-1 = λdt-1 – pbt

(where λ is equal to (r-g)/(1+g) and  dt is the debt/gdp ratio at the end of time period t and pbt is the primary budget balance of the government in the period) would seem to explode because of the first time on the right hand side. But higher output will automatically lead to a dynamics for pbensuring sustainability.

How this works was shown by Wynne Godley in an article The Dynamics Of Public Sector Deficits And Debts written in 1994 written by his co-author Bob Rowthorn in J. Michie and J. Grieve Smith (eds), Unemployment in Europe (London: Academic Press), 1994 pp. 199-206 and which was originally a paper to the UK Treasury around ’92-’93.

For a demand constrained economy:

… Note that the primary budget balance adjusts automatically so as the stabilise the debt to GDP ratio. This spontaneous adjustment occurs through induced variations in GDP. The government cannot directly determine the primary balance. It can only control r, θ and G, and once the time path of these is fixed as above, the variable Y will evolve so as to stabilise the ratio B/Y. If this ratio is too large, Y will grow rapidly and generate sufficient tax revenue to bring this ratio down.

There is a standard proposition that the government cannot permanently maintain a primary deficit if the interest rate is greater than the growth rate (r>g) … even if true, the statement can be misleading. In a demand-constrained economy, the level of Y relative to G will automatically adjust so as to produce a primary balance (deficit or surplus) to stabilise the ratio B/Y …

[Emphasis mine]

(θ is the tax rate in the model in above paper). Also see this post Wynne Godley And The Dynamics Of Deficits And Debts

It is counterproductive to go around making statements about the conditions on interest rate and the growth rate without qualifications and care and considering a situation/history and future scenarios.

There is one place where this condition is useful. Consider a balance of payments constrained economy. In studying the sustainability of the external debt of a country, one can conclude that if r>g (where r is the effective interest rate paid on foreign liabilities), then the debt dynamics will lead to an exploding debt even if the trade balance is held constant. Of course that doesn’t mean if r<g alone ensures sustainability.

Wynne Godley And The Dynamics Of Deficits And Debts

In a five-part series in his blog, Functional Finance and the Debt Ratio Scott Fullwiler claims that if the interest rate is held below the growth rate of output, sustainability of the public debt/gdp ratio is guaranteed in the sense that the ratio converges and does not keep increasing forever. This is erroneous and his conclusions are misleading.

Wolfgang Schäuble understands the connection between public finances and international competitiveness, although his solutions are all wrong. Heteredox economists should understand this connection as well!

Rather than write a detailed essay, I thought I should directly get to the point and pinpoint his errors. Of course, several Post Keynesians even before Fullwiler wrote his 2006 paper Interest Rates And Fiscal Sustainability (referred in his posts) have made this claim and this criticism applies to them as well.

While there are future scenarios, where growth improves the public debt/gdp ratio, it does not mean that all scenarios lead to a convergence. Fullwiler has examples in his posts where he shows how the convergence happens. But it doesn’t prove much.

Fullwiler’s error is a simple mathematical one. He sums the series for debt-sustainability equation and shows the the public debt/gdp ratio converges to

– pb/(g – r)

where pb is the primary balance/gdp ratio, g is the growth rate of output and r the interest rate. [notations are changed somewhat without any effect on conclusions]

This is a wrong result because it assumes that the primary balance is constant as a percentage of gdp. The series he sums need not converge if the primary balance in each period is different. One such scenario is when the deficit in each period is bigger than the deficit of the previous period. Fullwiler claims:

… in terms of convergence or unbounded growth of the debt ratio, as Jamie Galbraith put it, “it’s the interest rate, stupid!” since any level of primary deficit can converge if the interest rate is below the growth rate.

[italics and link in original]

This is repeated:

… More importantly, given an interest rate lower than GDP growth, any primary budget deficit will eventually converge …

Now this doesn’t make sense. The claim that “any” level of primary deficit can converge if the interest rate is below the growth rate is incorrect. For example, if we have primary balances pb0, pb1, pb2 and so on and each of them is growing sufficiently faster, the debt/gdp ratio is explosive even if interest rate is less than the growth rate of output. His result is valid if each of the balances pb0, pb1, pb2 … are equal to each other and not in general.

In other words, if g>r, the sequence dn given by the relation

dt – dt-1 = λdt-1 – pbt

where λ is equal to (r-g)/(1+g) need not converge for general values of pband only converges in special circumstances (if suppose the pbn are all equal or more realistic if there is a mechanism to bring the primary deficit into a surplus which may or may not be a discretionary attempt by the government.)

Example

Nothing of the above is purely academic. So in what situation can the public debt explode?

Let us assume an open economy. Let us assume that a country’s exports is X0 and not growing because of its inability to increase its market share or because of limited demand in world markets due to deflationary policies adopted by the rest of the world. Or both.

If one imagines a scenario in which there is growth in output and hence income, imports rise as well in a world of free trade.  This implies the current account deficit explodes. While growth may work to improve the debt/gdp ratio, the current account deficits work to worsen the debt ratio. The net effect is that “growth” instead of improving the debt/ratio worsens it.

This can be seen if one remembers that the sectoral balances identity connects the public sector deficit and the current balance of payments. We have

NAFA = PSBR + BP

where NAFA is the private sector net accumulation of financial assets, PSBR is the public sector borrowing requirement (the deficit) and BP is the current account balance of international payments.

Since the private sector typically wishes to have a positive NAFA (else there is another unsustainable process!), an exploding BP leads to an exploding PSBR if output grows much faster than exports. This implies the public debt/gdp grows forever and growth is not sustainable.

Now Fullwiler can potentially claim that the government can “simply credit bank accounts” and public debt/gdp and external debt/gdp rising forever is no cause for trouble but then why write a post claiming convergence of the ratios!

There is a diagram in the post which I modified below with a red line for a path for the sectoral balances. Is the claim that this line extrapolated leads to a stabilizing debt ratio?

[image updated]sf-p4-fig9-modified-corrected

Wynne Godley And Debt Dynamics

The above was pointed out by Wynne Godley in the 1970s. The following brings it out clearly. It is from an appendix to an article written by his co-author Bob Rowthorn in J. Michie and J. Grieve Smith (eds), Unemployment in Europe (London: Academic Press), 1994 pp. 199-206 and was originally a paper to the UK Treasury around ’92-’93

The main conclusions are as follows. Consider an economy in which neither inflation nor the balance of payments is a constraint on output, so that any permanent increase in demand leads to an equal and permanent rise in output. In such an economy, tax cuts or additional government expenditure are eventually self-financing. They lead to some increase in government debt, but not to an explosion, since this debt will ultimately stabilise. The factor stabilising the debt is the behaviour of output. Following a fiscal stimulus, output will rise and tax revenue will automatically increase. Moreover, the expansion will continue to the point where additional tax revenue is sufficient to halt government borrowing and stabilise the debt. In an inflation-constrained economy, the expansionary process will lead to an unsustainable inflation and the government will be compelled to half the expansion before tax revenue has increased sufficiently to stabilise the government debt. In a balance of payments constrained economy, the government debt will grow without limit because the output multiplier will be too small to generate the tax revenue required to stabilise government debt. The counterpart to expanding government debt will be an expanding national debt to foreigners.

Conclusion

Now this may sound as a pessimistic view for any individual nation or the world as a whole. The real problem is free trade – the most sacred tenet of the economics profession.

Random Tidbits On National Accounts And Keynesian Models Of Income And Expenditure

I came across this article (via a Tweet from Stephen Kinsella): Accounting As The Master Metaphor Of Economics by Arjo Klamer and Donald McCloskey which discusses how the framework of national accounts has been pushed to the background in economic analysis over the years.

It is a nice read – although boring in a few places. I found this reference to John Hicks’ 1942 book The Social Framework: An Introduction To Economics in the above article and managed to get a copy – although a used one but with almost no usage. As described in the Klamer-McCloskey’s article, Hicks’ textbook really goes into details of national accounts and he seems to have had a great intuition of how it all works.

John Hicks - The Social Framework

Hicks’s book gives a nice introduction to how important national accounts are in understanding and describing the production process and economic cycles.

Here is a scan of two pages on the balance of payments – the topic I like the most.

John Hicks Balance Of Payments

(click to enlarge)

Hicks understood how weak balance of payments can cause troubles. Of course, it took the genius of Nicholas Kaldor to realize the supreme importance of balance of payments in the determination of national income and expenditure. Leaving that aside, the text has nice ideas and discussions on how stocks and flows feed into one another.

John Hicks is famous for an entirely different reason – the IS/LM model. Later he accepted it was a huge mistake, but put it mildly: “… as time as gone on, I have myself become dissatisfied with it”. But economists still keep using it and keep erring.

Also, Hicks was to soon abandon/forget his own social accounting approach as per Klamer-McCloskey’s article. Perhaps, not really.

In an extremely important paper, Wynne Godley said:

To come down to it, the present paper claims to have made, so far as I know for the first time, a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition. My belief is that nothing the paper contains would have been surprising or new to, say, Kaldor, Hicks, Joan Robinson or Kahn.

John Hicks also had another nice book called A Market Theory Of Money written in 1989. Here is a great insight (also the view of Kaldor) from Page 11, Chapter 1 named “Supply And Demand?” on how to create a dynamic Keynesian theory of determination of national income and expenditure:

… The traditional view that market price is, at least in some way, determined by an equation of demand and supply had now to be given up. If demand and supply are interpreted, as had formerly seemed to be sufficient, as flow demands and supplies coming from outsiders, it is no longer true that there is any tendency over any particular period, for them to be equalized: a difference between them, if it were not too large, could be matched by a change in stocks. It is of course true that if no distinction is made between demand from stockholders and demand from outside the market, demand and supply in that inclusive sense  must be equal. But that equation is vacuous. It cannot be used to determine price, in Walras’ or Marshall’s manner. For what matters to the stockholder is the stock that he is holding: the increment in that stock, during a period is the difference between what is held at the end and what was held at the beginning, and the beginning stock is carried over from the past. So the demand-supply equation can only be used in a recursive manner, to determine a sequence (It is a difference or a differential equation); it cannot be used directly to determine price, as Walras and Marshall had used it.

I came across a reference in the book (The Social Framework) to a paper by James Meade and Richard Stone on concepts on national accounts: The Construction Of Tables Of National Income, Expenditure, Savings And Investment written in 1941. It has the following interesting table:

James Meade & Richard Stone - Sectoral Balances

which is the now famous sectoral balances identity! Incidentally, it also includes Kalecki’s profit equation. In the above “Foreign Investment” shouldn’t be confused with Foreign Direct Investment flows in the financial account of the balance of payments. The authors define it as:

… equal to income generated by receipts from abroad less current expenditure abroad.

So can we call the profit equation SMK equation? 🙂

James Meade and Richard Stone were pioneers of national accounts. Incidentally, James Meade wrote a famous textbook on balance of payments.

Of course the way this is presented doesn’t make the connection between the financial account and current accounts. The sectoral balances was usually written by Wynne Godley as:

NAFA = PSBR + BP

where NAFA is the net accumulation of financial assets of the private sector, PSBR is the net public sector borrowing requirement, and BP is the current account balance of international payments. More on this connection below.

How it is to be derived in a stock-flow consistent framwork of Godley/Lavoie? If you click on this search Transactions Flow Matrix, you will find some blog posts on the background. First, we construct a flow matrix like this:

Simplified National Income Matrix

The last line is essentially Kalecki’s profit equation.

The above construction however raises an important question. Godley and Lavoie’s textbook (Chapter 2) quotes a famous 1949 article of Morris Copeland on this:

When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?

Copeland’s work was highly successful and established the flow of funds accounts of the United States in 1952.

Here is a republished version of the article (via Google Books):

 

If you prefer Google Books directly, here is the link: Social Accounting For Moneyflows.

Incidentally, Copeland was motivated to prove the quantity theory of money wrong when he did this work! Also Godley/Lavoie point out that John Dawson (the editor of the above book) says:

the acceptance of…flow-of-funds accounting by academic economists has been an uphill battle because its implications run counter to a number of doctrines deeply embedded in the minds of economists.

in an article from the chapter The Conceptual Relation Of Flow-Of-Funds Accounts To The SNA of the same book.

Over time, the system of national accounts (with its first version in 1947) has used some of the concepts of flow of funds accounting and now the framework is much more wider than usual textbook guides of national accounts. The flow of funds still retains importance because it has information which the system of national accounts such as (2008 SNA) doesn’t handle.

Here’s the UN website for the historical versions of the system of national accounts.

How does one look at this in a stock-flow coherent framework? Simple, we need a full transactions flow matrix – which not only includes income/expenditure flows but also financial flows. The following is how it looks like for a simple model:

Transactions Flow Matrix 3

(Click to zoom)

Of course, identities themselves shouldn’t be looked at as models. One needs a fully coherent accounting model of the economy based on behavioural assumptions and “closures”. See this essay Keynesian theorising during hard times: stock-flow consistent models as an unexplored ‘frontier’ of Keynesian macroeconomics Camb. J. Econ. (July 2006) 30(4): 541-565 by Claudio Dos Santos and also Wynne Godley and Marc Lavoie’s book Monetary Economics. As Dos Santos quotes Lance Taylor in the article:

Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another.

We Are NOT All Keynesians Now!

The Jan Hatzius interview on sectoral balances mentioned in the previous post – although has given it some popularity – has led to great confusions among economic commentators.

Here is a confused Professor from the famous institute INSEAD – Antonio Fatás on his blog.

Fatás implicitly denies that propensities to consume/save and government expenditure and taxing decisions have any impact at all on demand and hence output.

I quote from his blog. The quote includes that of Hatzius’ interview (in italics):

[Hatzius] “That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector’s financial balances. If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending.”

[Fatás] This paragraph is misleading (I will ignore again the fact that in an open economy things are more complex). It states (at least this is the way I read it) that growth depends on the “desired changes in these sector’s financial balance”. This is not correct. I can imagine an economy where those financial balances are not changing at all where output is growing very fast (and I can also imagine another one where output is collapsing). There is no connection between growth and these financial imbalances. As long as demand (private or public) is feeding into production and income, the private or public sector might be spending more than last year but their income is also increasing which can make the financial balance remain at the same level as before.

Jan Hatzius is discussing a model of business cycles and growth in the medium term – such as a year or two. But for Fatás, “this is not correct” and “there is no connection between growth and these financial imbalances”! He claims that demand can be feeding into production and income but doesn’t realize that a change in financial balances caused by say a change in the propensity to save or consume itself leads to changes in the source of demand.

Fatás is thinking of a situation – a type of a long run situation where the parameters in the models are not changing and there is high growth. But that does not mean “there is no connection between growth and these financial balances”. A spontaneous change in one or few parameters (such as the propensity to consume) or an exogenous change in the government expenditure changes financial balances and affects the growth rate.

But these things do not matter for him:

If we believe that we are in a situation where the output gap is large, there are unused resources and, as a result, output is determined by demand, what matters for growth is whether demand increases relative to last year and not so much the change in the desired changes in the financial balances of either the private or public sector.

Again forgetting that desired changes in the financial balances affect the sources of demand.

Somehow basic notions of the Keynesian principle of effective demand are difficult for economists to understand.

Jan Hatzius On Sectoral Balances

Business Insider’s Joe Weisenthal interviewed Goldman Sachs’ Jan Hatzius recently with questions aimed at his usage of the sectoral balances approach:

BI: Back to the balance sheet, multi-sectoral framework of looking at the economy. How did you come to this view? On Wall Street this is still very rare. I don’t see many economist talk about the economy this way, recognizing this identity and making projections based on it. How did you come to see this as the framework by which we should be looking at the economy right now?

HATZIUS: I’ve long been fascinated with looking at private sector financial balances in particular. There was an economics professor at Cambridge University called Wynne Godley who passed away a couple of years ago, who basically used this type of framework to look at business cycles in the UK and also in the US for many many years, so we just started reading some of his material in the late 1990s, and I found it to be a pretty useful way of thinking about the world.

It’s usually not something that gives you the secret sauce at getting it all right, because there are a lot of uncertain inputs that go into this analytical framework, but I do think it’s a reasonable organizing framework for thinking about the short to medium term ups and downs of the business cycle.

Basically, in order to have above trend growth, a cyclically strong economy, you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time.

There are other factors at play in the business cycle – I’m certainly not claiming that ‘this is it!’ – but I have found it to be pretty useful.

The full interview: Goldman’s Top Economist Explains The World’s Most Important Chart, And His Big Call For The US Economy

More On Wynne Godley’s Methodology

Matias Vernengo has a post on Stock-Flow Consistent Macroeconomics: Stock-Flow With Consistent Accounting (SFCA) Models.

He has a nice way of giving a short description of pricing in the G&L models:

In my view, the stock-flow and the demand driven (and I should say, the fact that price dynamics is orthogonal to the income flow determination structure) is the essential characteristic of this approach.

Also, Simon Wren-Lewis (from Oxford) has a new blog post on the sectoral balances approach – Sector Financial Balances As A Diagnostic Check, where he mentions Martin Wolf’s recent post on Wynne Godley’s approach. He (Wren-Lewis) has been admitting recently that DSGE models are not useful.

In the comments section Simon Wren-Lewis has this to say:

Martin Wolf sent me the following comment, which I am sure others will also find interesting:

“I used sectoral financial balances before the crisis, following Wynne. I argued that what was going on in the US external and household sectors were evidently unsustainable. This allowed me to argue that when the latter’s deficits were eliminated, there would be a recession and a huge fiscal deficit. What I had not expected was that the turnaround in the household sector would trigger a meltdown of the financial system.

“This makes it clear that one has to link the flow sectoral balances to the balance sheets in the economy. In this case, my mistake was not looking closely enough at the balance sheet of the financial sector. Good macroeconomic analysis has to examine the flows and stock meticulously and seek to assess whether the behaviour we see is sustainable. The assumption that private agents cannot make huge mistakes about the sustainability of what they are doing is, in my view, the biggest mistake in macroeconomics.”

Back to DSGE models. I think they are totally useless. I like this quote by Francis Cripps from an article in The Guardian from 27 Feb 1979: Economists With A Mission:

Martin Wolf On Wynne Godley’s Sectoral Financial Balances Approach

Martin Wolf who usually writes good articles on macroeconomic developments wrote recently on the sectoral balances approach (which he uses frequently anyway).

In his recent post The Balance Sheet Recession In The US he writes:

… I look at this through the lens of “sectoral financial balances”, an analytical framework learned from the work of the late Wynne Godley. The essential idea is that since income has to equal expenditure for the economy, as a whole, (which is the same things as saying that saving equals investment) so the sums of the difference between income and expenditures of each of the sectors of the economy must also be zero. These differences can also be described as “financial balances”. Thus, if a sector is spending less than its income it must be accumulating (net) claims on other sectors.

The crucial point is that, since sectoral balances must sum to zero, a rise in the deficit of one sector must be matched by an offsetting change in the others. It follows that if the fiscal deficit is increasing, the sum of the surpluses of the other sectors of the economy must be increasing in a precisely offsetting manner.

These are tautologies. But the virtue of this framework is that it forces us to ask what drives what: are, for example, fiscal deficits in the US (or UK) driving the surpluses in other sectors or are the surpluses in the other sectors driving the fiscal deficit? We can obtain answers by examining what behaviour is changing…

and that:

… The idea that the huge fiscal deficits of recent years have been the result of decisions taken by the current administration is nonsense. No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust…

Nice read: The Balance Sheet Recession In The US.

The sectoral balances approach should always be handled with supreme care. There are causalities running in all directions and one needs to ask what brings them to equivalence, what the value of policy instruments are, how is output changing etc.

The following is from Wynne Godley himself:

From the Levy Institute article The U.S. Economy – Is There A Way Out Of The Woods, November 2007

Although the three balances must always sum to exactly zero, no single balance is more a residual than either of the other two. Each balance has a life of its own, and it is the level of real output that, with minor qualifications, brings about their equivalence. Underlying the main conclusions of our reports is an econometric model in which exports, imports, taxes, and private expenditure are determined as functions of such things as world trade, relative prices, tax rates, and flows of net lending to the private sector. However, neither the knowledge that this is the case nor the perusal of any list of econometric equations will, on its own, impart any intuition as to why output moved as it did over any set period.

[boldening: mine]

Here’s from the article The U.S. Economy – A Changing Strategic Predicament, March 2003

It is well known to students of the National Accounts that the surplus of private disposable income over expenditure is equal to the government balance (written as a deficit) plus the current balance of payments (written as a surplus). While these balances are related to one another by a system of accounting identities, each has, to some extent, a life of its own that is reconciled with the other two via the aggregate income flow. The way the balances evolve provides a useful armature around which to organise a narrative account of economic developments, because any one of them is necessarily implied by the other two. Furthermore, the balances may give an early warning that unsustainable processes are taking place, for any high or rising balance implies a change in public, private, or foreign debts, which cannot grow without limit relative to income.

Wynne Godley with his CEPG partner Francis Cripps
(from Cambridge Group Sings The Blues, The Guardian, 17 April 1980)

Seven Unsustainable Processes – Original

Of all the economists, Wynne Godley had the rarest of rare ability to model and imagine the economic dynamics of the whole world. “… a full macroeconomic model in his head, which, by some sort of subconscious process, he computed.” as his obituary from FT said.

In the recent INET conference paper, Dirk Bezemer discusses Wynne Godley’s approach (among others’) and also refers to his paper Seven Unsustainable Processes from 1999.

I obtained this original scanned copy of the paper Seven Unsustainable Processes – Medium Term Policies For The United States And The World by Wynne Godley from 1999 from the Levy Economics Institute and  thought that since this version is missing for some reason from the levyinstitute.org website, I’ll post it here (after asking them if I may post).

Click to see the pdf.

Seven Unsustainable Processes from 1999

Here’s the link to the updated version of the paper from the year 2000. The original had a typo. Two columns in Table 1 appeared with incorrect headings (should have been the reverse).

Wynne Godley at the Levy Institute

Godley warns of the private sector indebtedness:

… Moreover, if, per impossibile, the growth in net lending and the growth in money supply growth were to continue for another eight years, the implied indebtedness of the private sector would then be so extremely large that a sensational day of reckoning could then be at hand.

Wynne Godley never liked the chimerical and primitive view of economists where anything and everything is traded in the markets via supply and demand. So,

The difference between the consensus view and that put forward here could not exist without a profound difference in the view of how the economy works. So far as the author can observe, the underlying theoretical perspective of the optimists, whether they realize it or not, sees all agents, including the government, as participants in a gigantic market process in which commodities, labor, and financial assets are supplied and demanded. If this market works properly, prices (e.g., for labor and commodities) get established that clear all markets, including the labor market, so that there can be no long-term unemployment and no depression. The only way in which unemployment can be reduced permanently, according to this view, is by making markets work better, say, by removing “rigidities” or improving flows of information. The government is a market participant like any other, its main distinguishing feature being that it can print money. Because the government cannot alter the market-clearing price of labor, there is no way in which fiscal or monetary policy can change aggregate employment and output, except temporarily (by creating false expectations) and perversely (because any interference will cause inflation).

No parody is intended. No other story would make sense of the assumption now commonly made that the balance between tax receipts and public spending has no permanent effect on the evolution of the aggregate demand. And nothing else would make sense of the debate now in full swing about how to “spend” the federal surplus as though this were a nest egg that can be preserved, spent, or squandered without any need to consider the macroeconomic consequences.

The seven unsustainable processes were:

(1) the fall in private saving into ever deeper negative territory, (2) the rise in the flow of net lending to the private sector, (3) the rise in the growth rate of the real money stock, (4) the rise in asset prices at a rate that far exceeds the growth of profits (or of GDP), (5) the rise in the budget surplus, (6) the rise in the current account deficit, (7) the increase in the United States’s net foreign indebtedness relative to GDP.

As it happened, the United States went into a recession but recovered quickly because of further deregulations and low interest rates which led to more borrowing, and a fiscal stimulus which put a floor on the downfall. However, the private sector went back into deficits and its indebtedness kept rising relative to income. The current balance of payments also went deeply in deficit rising to about 6.43% at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale. See the related post here: The Un-Godley Private Sector Deficit.

Not only did Godley see the crisis coming, he also figured out that the United States will soon run into policy issues and will have less room to come out of a crisis. In this 2005 strategic analysis paper The United States And Her Creditors – Can The Symbiosis Last? he and his collaborators (Dimitri Papadimitriou, Claudio Dos Santos and Gennaro Zezza) pointed out that:

The range of strategic policy options for the United States is beginning to narrow … As the normal equilibrating forces (changes in exchange rates) are being subverted, it is very far from obvious what the United States can do on her own …

In his last ever article, Prospects For The United States And The World – A Crisis That Conventional Remedies Cannot Resolve (from which I got the subtitle of my blog!), Godley and collaborators (Dimitri Papadimitriou and Gennaro Zezza) said:

The prospects for the U.S. economy have become uniquely dreadful, if not frightening. In this paper we argue, as starkly as we can, that the United States and the rest of the world’s economies will not be able to achieve balanced growth and full employment unless they are able to agree upon and implement an entirely new way of running the global economy.

Stressing the need for concerted action (from which I got the title of my blog!), the authors said:

… Fiscal policy alone cannot, therefore, resolve the current crisis. A large enough stimulus will help counter the drop in private expenditure, reducing unemployment, but it will bring back a large and growing external imbalance, which will keep world growth on an unsustainable path …

… What must come to pass, perhaps obviously, is a worldwide recovery of output, combined with sustainable balances in international trade. Since this series of reports began in 1999, we have emphasized that, in the United States, sustained growth with full employment would eventually require both fiscal expansion and a rapid acceleration in net export demand. Part of the needed fiscal stimulus has already occurred, and much more (it seems) is immediately in prospect. But the U.S. balance of payments languishes, and a substantial and spontaneous recovery is now highly unlikely in view of the developing severe downturn in world trade and output … By our reckoning (which is put forward with great diffidence), if the United States were to attempt to restore full employment by fiscal and monetary means alone, the balance of payments deficit would rise over the next, say, three to four years, to 6 percent of GDP or more—that is, to a level that could not possibly be sustained for a long period, let alone indefinitely …

… It is inconceivable that such a large rebalancing could occur without a drastic change in the institutions responsible for running the world economy—a change that would involve placing far less than total reliance on market forces.

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).

and

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.

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.