In Blog #2 we introduced the basics of macro accounting, and in Blog #3 we took a break from accounting to take a look at the rise and fall of the Goldilocks economy in the US. Thus, we applied our sectoral balance identity to the case of the US. In today’s blog we will go a bit deeper into the accounting, looking at the relation between flows (deficits) and stocks (debts). To avoid making mistakes we need to make sure that we have “consistency” between our flows and our stocks. We want to make sure that all spending and saving comes from somewhere and goes somewhere. And we must make sure that one sector’s surplus is offset by a deficit in another sector. This is a lot like keeping track of the scores in a baseball game, and in fact most financial “scores” really are electronic entries in the modern world.
We will also try to say something about causation. It is not sufficient to say that at the aggregate level, the private balance plus the government balance plus the foreign balance equals zero. We would like to be able to understand why the private sector balance was negative during the Clinton Goldilocks years while the government balance was positive—how did we get to that point, and what sorts of processes did it induce. Obviously that is necessary before we can really analyse the situation and formulate policy. Unlike the macro accounting identity (which must be true), it is not possible to say with certainty what causes a particular sector’s balance. It is quite easy to say that if the government runs a surplus and if the foreign balance is positive (foreign sector spends less than its income) then the domestic private sector must by accounting identity be negative (running a deficit). It all must sum to zero.
Explaining why the private sector had a deficit during the Goldilocks years is harder; it is even harder to project if and for how long that deficit would continue. I already made clear in Blog 3 that I got the timing wrong—private sector deficits continued for about 4 years longer than I expected. Projections are darned hard to get right—if they were easy, MMTers would all make lots of money placing bets on outcomes. Another way of stating this is to say that a good understanding of MMT does not give one any monopoly on explanations of causation. We must not be overly confident. As the late and great Wynne Godley used to put it, he did not make forecasts, rather, he made contingent projections.
For example, carrying on with the work of Godley, the Levy Economics Institute (www.levy.org) makes such projections. Typically it begins with CBO (Congressional Budget Office) projections of the path of government deficits and of economic growth over the next few years. CBO projections are largely determined by current law (ie: laws determining government spending and taxing, as well as mandates over deficit reduction). However, the CBO’s projections are not stock-flow consistent and do not adopt the three sector balances approach (this used to drive Godley crazy). In other words, they are incoherent. But given projections over the government balance and GDP growth as well as empirical estimates of various economic parameters (propensity to consume and import, for example), one can produce a stock-flow consistent model that produces the implied sectoral balances as well as path of debt. The Levy Institute often finds that economic growth rates (for example) plus government deficit projections used in CBO forecasts imply highly implausible balances in the other two sectors (domestic private and foreign) as well as private debt ratios. To do that kind of analysis, you must go beyond the simple accounting identities.
Deficits -> savings and debts -> wealth. We have established in our previous blogs that the deficits of one sector must equal the surpluses of (at least) one of the other sectors. We have also established that the debts of one sector must equal the financial wealth of (at least) one of the other sectors. So far, this all follows from the principles of macro accounting. However, the economist wishes to say more than this, for like all scientists, economists are interested in causation. Economics is a social science, that is, the science of extraordinarily complex social systems in which causation is never simple because economic phenomena are subject to interdependence, hysteresis, cumulative causation, and so on. Still, we can say something about causal relationships among the flows and stocks that we have been discussing in the previous blogs. Some readers will note that the causal connections adopted here follow from Keynesian theory.
a) Individual spending is mostly determined by income. Our starting point will be the private sector decision to spend. For the individual, it seems plausible to argue that income largely determines spending because one with no income is certainly going to be severely constrained when deciding to purchase goods and services. However, on reflection it is apparent that even at the individual level, the link between income and spending is loose—one can spend less than one’s income, accumulating net financial assets, or one can spend more than one’s income by issuing financial liabilities and thereby becoming indebted. Still, at the level of the individual household or firm, the direction of causation largely runs from income to spending even if the correspondence between the two flows is not perfect. There is little reason to believe that one’s own spending significantly determines one’s own income.
b) Deficits create financial wealth. We can also say something about the direction of causation regarding accumulation of financial wealth at the level of the individual. If a household or firm decides to spend more than its income (running a budget deficit), it can issue liabilities to finance purchases. These liabilities will be accumulated as net financial wealth by another household, firm, or government that is saving (running a budget surplus). Of course, for this net financial wealth accumulation to take place, we must have one household or firm willing to deficit spend, and another household, firm, or government willing to accumulate wealth in the form of the liabilities of that deficit spender. We can say that “it takes two to tango”. However, it is the decision to deficit spend that is the initiating cause of the creation of net financial wealth. No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend.
Still, it is true that the household or firm will not be able to deficit spend unless it can sell accumulated assets or find someone willing to hold its liabilities. We can suppose there is a propensity (or desire) to accumulate net financial wealth. This does not mean that every individual firm or household will be able to issue debt so that it can deficit spend, but it does ensure that many firms and households will find willing holders of their debt. And in the case of a sovereign government, there is a special power—the ability to tax–that virtually guarantees that households and firms will want to accumulate the government’s debt. (That is a topic we pursue later.) We conclude that while causation is complex, and while “it takes two to tango”, causation tends to run from individual deficit spending to accumulation of financial wealth, and from debt to financial wealth. Since accumulation of a stock of financial wealth results from a budget surplus, that is, from a flow of saving, we can also conclude that causation tends to run from deficit spending to saving.
c) Aggregate spending creates aggregate income. At the aggregate level, taking the economy as a whole, causation is more clear-cut. A society cannot decide to have more income, but it can decide to spend more. Further, all spending must be received by someone, somewhere, as income. Finally, as discussed earlier, spending is not necessarily constrained by income because it is possible for households, firms, or government to spend more than income. Indeed, as we discussed, any of the three main sectors can run a deficit with at least one of the others running a surplus. However, it is not possible for spending at the aggregate level to be different from aggregate income since the sum of the sectoral balances must be zero. For all of these reasons, we must reverse causation between spending and income when we turn to the aggregate: while at the individual level, income causes spending, at the aggregate level, spending causes income.
d) Deficits in one sector create the surpluses of another. Earlier we showed that the deficits of one sector are by identity equal to the sum of the surplus balances of the other sector(s). If we divide the economy into three sectors (domestic private sector, domestic government sector, and foreign sector), then if one sector runs a deficit at least one other must run a surplus. Just as in the case of our analysis of individual balances, it “takes two to tango” in the sense that one sector cannot run a deficit if no other sector will run a surplus. Equivalently, we can say that one sector cannot issue debt if no other sector is willing to accumulate the debt instruments.
Of course, much of the debt issued within a sector will be held by others in the same sector. For example, if we look at the finances of the private domestic sector we will find that most business debt is held by domestic firms and households. In the terminology we introduced earlier, this is “inside debt” of those firms and households that run budget deficits, held as “inside wealth” by those households and firms that run budget surpluses. However, if the domestic private sector taken as a whole spends more than its income, it must issue “outside debt” held as “outside wealth” by at least one of the other two sectors (domestic government sector and foreign sector). Because the initiating cause of a budget deficit is a desire to spend more than income, the causation mostly goes from deficits to surpluses and from debt to net financial wealth. While we recognize that no sector can run a deficit unless another wants to run a surplus, this is not usually a problem because there is a propensity to net save financial assets. That is to say, there is a desire to accumulate financial wealth—which by definition is somebody’s liability.
Conclusion. Before moving on it is necessary to emphasize that everything in this blog (as well as Blog #2) applies to the macro accounting of any country. While examples used the dollar, all of the results apply no matter what currency is used. Our fundamental macro balance equation,
Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0
will strictly apply to the accounting of balances of any currency. Within a country there can also be flows (accumulating to stocks) in a foreign currency, and there will be a macro balance equation in that currency, too.
Note that nothing changes if we expand our model to include a number of different countries, each of which issues its own currency. There will be a macro balance equation for each of these countries and for each of the currencies. Individual firms or households (or, for that matter, governments) can accumulate net financial assets denominated in several different currencies; vice versa, individual firms or households (or governments) can issue net debt denominated in several different currencies. It can even become more complicated, with an individual running a deficit in one currency and a surplus in another (issuing debt in one currency and accumulating wealth in another). Still, for every country and for every currency there will be a macro balance equation.
OK that is enough for this week. Can I remind commentators and questioners that this is a Primer. We will collect questions and comments until Wednesday and then post a response. We appreciate comments and questions directly related to this blog. We really do not want comments from those who have already examined and rejected MMT.
Randall,Is there any material difference between the sectoral balances in a currency and the sectoral balances issued in the national accounts for GDP purposes.Clearly in the first the transactions recorded are just those transacted in the local currency, but in the second some of the transactions will have been in a different currency and simply valued in the local currency.In other words is there any significant revaluation effect at the aggregate level that we should be looking out for?
"No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend. "So do you consider inventory run up to be in the category of 'willing'.I'm thinking optimist makes perishable goods that in the end nobody wants to buy having somehow managed to persuade a bank to create the necessary money (possibly by having large valuable real thing to offer as collateral).Or is it the bank here that is 'willing' having been blinded to good sense by the security of the 'large valuable real thing'.
"No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend. "I also find it very confusing. A desire to accumulate wealth is very easy to realize – do not spend your income. Whenever anybody gets a paycheck technically the whole amount is saved. So saving or accumulation is realized by definition while spending requires action.
NeilWhy does investing in stock need to relate to deficit spending by the private sector?The investor may have borrowed to enable him to invest but surely to have been able to do this both parties (lender and borrower) must have been 'willing'
Игры рынкаYes, but the logic still holds. It is impossible for every individual in the private domestic sector to net save at the same time if that sector's aggregate balance is zero. If the private domestic sector has a balance of zero and some individuals are net saving, then at least one or more individuals must be doing the opposite. In the aggregate, if there is a private domestic sector surplus, then there must be a negative foreign balance and/or government deficit.
"Why does investing in stock need to relate to deficit spending by the private sector?"I didn't say it did. More that I'm trying to show that the private sector could do it all by itself."The investor may have borrowed to enable him to invest but surely to have been able to do this both parties (lender and borrower) must have been 'willing'"That's what I'm trying to get at. It looks like the initial deficit spend has to come from a lend/borrow decision somewhere. A spring of liquidity if you like.
Professor Wray:A profound thanks to you and other MMTers for the scrupulous distinction between flows and stocks. I've often found myself confused by economists who are seemingly not so scrupulous. I generally attribute this to my own amateurish ignorance and misunderstanding, but after some years deep in the NIPAs and FOFAs, and widespread reading on same, in many cases I feel quite certain that the confusion is not mine.On that, I wonder about "a) Individual spending is mostly determined by income." Is this important/necessary/useful for you exposition?This is certainly true for those of lower income/wealth, but less so in more affluent groups, where wealth is arguably a stronger correlate. It's difficult to tease out which drives/empowers spending, of course, because wealth creates income. This related to a common and rather perniciously confusing locution, "spending out of income." When somebody hands you a five dollar bill, you can't spend (create an outflow) out of that instantaneous inflow. You can only spend out of your stock — whether it's a Swiss bank account or the buck and a quarter you have in your pocket. Flows are strings of instantaneous events; stocks have existence and duration.You can only spend out of wealth, not out of income. Obvious, but a point of confusion out there in the world.Related: the common financial planner's nostrum that one should "only spend income, never touch principal," when of course any income *is* principal as soon as you get it.I'm sure you're headed this direction, but all this is directly related to the failure of national accounts to include capital gains in measures of income. While the reasoning behind that practice is understandable given the conceptual constructs used to consider "capital" when Kuznets created the accounts, I (and I'm sure others) feel that there's something fundamentally wrong in that accounting, even that there's a fundamental polticial wrongness lurking there.My intuition is that the failure is rooted in the classical confution/confusion of financial vs. real "capital."Any help in clearing up these confusions much appreciated. Any of the Levy projections that help that sort it out? Links?Thanks,Steve
"If a household or firm decides to spend more than its income… it can issue liabilities to finance purchases. These liabilities will be accumulated as net financial wealth by another household, firm, or government that is saving"I think you're talking about "net" from the perspective of individual private-sector entities here, rather than "net" across the whole private sector. However, the language is confusing. I would be at pains to disambiguate e.g. using "net individual financial wealth" and "net sectoral financial wealth".
Regarding:"If a household or firm decides to spend more than its income (running a budget deficit), it can issue liabilities to finance purchases. These liabilities will be accumulated as net financial wealth by another household, firm, or government that is saving (running a budget surplus). Of course, for this net financial wealth accumulation to take place, we must have one household or firm willing to deficit spend, and another household, firm, *or government* willing to accumulate wealth in the form of the liabilities of that deficit spender."(Emphasis added.)Given a currency-sovereign nation, doesn't the inclusion of "government" here exclusively mean some foreign government or its central bank? My understanding of domestic government budget surpluses is that they merely destroy the dollars that earlier spending created. Isn't it meaningless to suggest that a sovereign government "saves" its own fiat currency? If a household or firm spends while owing the government money – i.e. while having a tax liability – I suppose that can be thought of as government having "accumulate[d] wealth in the form of the liabilities of that deficit spender." But is this what was meant, or are we really talking about the propensity of the Chinese, Japanese or others to accumulate financial wealth in the form of T-bonds?Thanks!
I also agree with Steve Roth (if I catch his gist directly) that when it comes to behavioural assumptions that are partially conjectural (even if reasonable) I would keep these to the bare minimum possible at this early stage. Otherwise you give those who are not persuaded more reasons to become skeptical.And where a statement is simply going to add mystery at this stage (e.g. "in the case of a sovereign government, there is a special power—the ability to tax–that virtually guarantees that households and firms will want to accumulate the government’s debt. (That is a topic we pursue later.)") I would simply not even mention it until later. Mentioning it without explanation makes an otherwise persuasive narrative suddenly harder to imbibe!
Ian: "It is impossible for every individual in the private domestic sector to net save at the same time if that sector's aggregate balance is zero"Sure, but the logic is not the one you and this post claim. It is savers who force deficit spending and not the other way. This is the reason why "No matter how much others might want to accumulate financial wealth, they will not be able to do so unless someone is willing to deficit spend"seems wrong.
Dale: "Isn't it meaningless to suggest that a sovereign government "saves" its own fiat currency?"Thanks for asking, Dale. I have the very same question. Isn't that a locution we should avoid? Confusing within the conceptual constructs of MMT.
Dear Prof. Wray,In the macro economic equation we have 3 balances. Are those balances flows? The word balance suggests that something is balanced, means: the two sides of the balance are equal in magnitude?Flows have a magnitude as well as a direction, stocks a magnitude only. If the individual balances are not balanced, as I suppose, than one could take the balances as flows (magnitude non zero) into the flow called GDP. In dividing the individual balances in parts, (I-S), (G-T) and (X-M), one should be aware of the directions of the separated flows. Is this correct?I would like to thank You very much for taking time and energy to write this Primer and I welcome every monday for the next part.P:S: Living in Germany I know, that this country is a MMT dessert and I would apreciate every contact about MMT and this MMP from here.
Dear Prof. Wray,Thanks for writing this. I think it's a great idea to have a clear and accessible exposition of these ideas on-line, given that it's likely to require significant public pressure to get them accepted by policy-makers (or even into the mainstream discourse). I started reading about MMT a couple of months ago, after being directed to Bill Mitchell's blog, and I think I understand most of the essential concepts, but it tends to go little over my head sometimes. Particularly since I'm not very familiar with the terminology of finance and economics. In light of that, it's good to be able to revise some of the ideas here, where they're stated a bit more simply.Anyway, apologies for going off-topic here, but the reason I'm commenting is because I recently decided to wade into the comment section of one of the blogs at the Telegraph, after reading this: http://tgr.ph/l3INPf. The author is trying to justify the attacks on teachers' pensions currently being carried out as part of the UK government's austerity drive. I was hoping someone with an expert understanding of MMT might be able to vet my comment and tell me whether my imperfect understanding of the theory has led me to make a bit of wally of myself in public. Here's what I wrote:"What a predictable pile of crap. The message here is "private sector workers are paid appallingly, with awful pensions, so public sector workers should be paid appallingly too – and should also be given awful pensions". In the meantime (presumably), the vast majority of the economic surplus should continue to creamed off by the already fabulously wealthy top 10% of earners – mostly the rentier classes in finance, insurance and real estate.Tiresome red-baiting aside, there are some blatant falsehoods here as well. Chief among these is this one:"The Teachers Pension Scheme – like most public sector schemes – is“unfunded”. That means the cash comes from current governmentexpenditure. More plainly, it comes from tax being paid by you or I right now."Nonsense. In a modern (fiat) monetary economy, taxes *do not* fund government spending. Taxation is a functionally separate process from spending, and serves to drain private sector net financial assets and provide non-inflationary space in which the government can spend. The spending capacity of a sovereign government, which issues its own currency, is in no way revenue-constrained. Spending is carried out by altering the balances of privately held accounts at the central bank. Keystrokes on a computer. There is no operational constraint on the government's ability to do this. There may be a limit on the quantity of *real resources* available for the government to purchase – hence the need for taxation (to deprive the private sector of financial assets and force it to sell goods and service to the government in order to obtain the currency needed to extinguish tax liabilities) – but that is a separate issue.Besides, even if you think that taxes are required to "fund" spending on public sector pensions, there's an obvious alternative to cutting those pensions: Pay for them by taxing away the unearned income that gets raked of the economic surplus in form of interest and land rent. As well as providing an alternative to further decimating the middle class, this would bring down the cost of doing business in general and make our economy more efficient."Is that roughly accurate, or am I doing it wrong?
Professor Wray,As long as we're all here demanding answers and making requests, could you provide an algebraic description of MMT and its prescriptions as part of the MMP?
Dale: "Isn't it meaningless to suggest that a sovereign government "saves" its own fiat currency?"Is it? If a government runs a surplus — i.e. taxes are greater than spending — then it is 'saving', surely.It might be a dumb thing to do. But defining a stupid action is not to undertake a stupid action.
Dr. Wray,A couple questions-1. Can you please provide a concrete example or paper from Levy demonstrating the CBO’s stock-flow inconsistencies? How do they calculate things and exactly what do they do wrong? Is it along the lines of what you suggested a post ago- that they just grow the numbers to infinity as you said without accounting for other changes? How do they get away with these inconsistencies? I realize MMT places considerable emphasis on the sectoral balances, but mainstream is aware of it too- how do they let the CBO get away with errors?2. Regarding the deficits create financial wealth idea- do you mean in the very short-run? In other words, what happens if the debt is eventually written down – perhaps no financial wealth is created or even lost eventually. Or in that scenario does it mean the borrower gained financial wealth in that situation rather than the lender? I understand the general point, but (excuse me for jumping the gun), it’s the same issue as saying the gov’t creates financial wealth by deficit spending. Yes, new $1 bills ( or electronic credits) enter the economy, but the “value” of that $1 bill can fluctuate (deflation, cost-push or demand-pull inflation). Financial wealth to me isn’t just the accounting statement- it’s the net present value of cash flows. Also, you say individual deficits create individual financial wealth, but if the govt deficit spends, doesn’t that create net financial wealth for the individual (going along with the general premise)?3. Can you please further clarify this “propensity to save issue?” “ While we recognize that no sector can run a deficit unless another wants to run a surplus, this is not usually a problem because there is a propensity to net save financial assets.” Do you mean that usually someone is looking to save, which means they might invest in something, which means someone can get a loan?
“It is here necessary to explain the primitive and the only true commercial or economic meaning of the word ‘spending.’ It is simply the correlative of income. What A pays to B is A’s spending and B’s income from A. A is B’s debtor and B is A’s creditor. The words ‘spending and ‘income’ express a transaction between two parties, and they express the same transaction seen from two opposite sides. A will speak of this transaction as a spending, while B will speak of it as income. As I shall have frequent occasion to use these two words, it is necessary that the reader should familiarise himself with this conception which, though simple enough to the banker or financial expert, is apt to be confusing to the ordinary reader, owing to the many derivative meanings which are associated with the word ‘spending.’ Whether, therefore, in my comments, the word spending or income is used, the thing spoken of is precisely the same in both cases, the one or the other word being used according as the situation is being looked at from the point of view of the spender or of the recipient.”The question should not be “Does spending cause income?” or “Does income cause spending?” Instead, the question should be “Does spending cause more spending?” and the answer, of course, depends on who spends, and on what he spends.Pepe
Per your reference to Blog#3 and the third paragraph above:
Explaining why the private sector had a deficit during the Goldilocks years is harder; it is even harder to project if and for how long that deficit would continue.
I think a core part of the explanation could be system lag time. If a thermostat has a lag time in changing the inside temperature of a building, what’s the lag time in a system as complex (complicated) as a national economy? Realistically, it’s impossible to measure lag time within the national economy, but maybe the numbers shown are a partial shadow?
I’ve enjoyed two of your books. It was tough slogging, but I got through your latest book on macoeconomic basics.
Anyway, about sector balances. Is there a balance between private loans and redeemed debt. I was first alerted to this by someone remarking that people with huge credit card debt and/or college loan debt were not consuming other than basics to live day to day while trying to pay down their debts (redemption). But those same people were on a consuming binge when the ran up their credit card and college loan debts. So, I thought perhaps we should
modify the sector balance formula
(G – T) + (S – I) + (X – M) + (L – R) = 0.
What do you think?