Recent USA Sectoral Balances: Goldilocks, the Global Crash, and the Perfect Fiscal Storm

In the previous blog, we did some heavy lifting. Unless you are an economics or accounting nerd, you found it quite boring. This week we will take a little break from pure accounting, and apply what we’ve learned to a real world example. By now, long-time readers are quite familiar with the NEP’s approach to the GFC (global financial crisis). Let us revisit the Clintonian Goldilocks economy to find the seeds of the GFC, using our sectoral balance approach.

To be clear, what follows uses our sectoral balances identity plus some real world data to provide an interpretation of the causes of the crash. As always, interpretations are subject to disagreement. The identity as well as the data are not. (You can of course always begin analysis with other identities and other data.) Next week we return to a bit more accounting.

Back in 2002 I wrote a paper announcing that forces were aligned to produce the perfect fiscal storm. (I note that in recent days a few analysts—including Nouriel Roubini—have picked up that terminology.) What I was talking about was a budget crisis at the state and local government levels. I had recognized that the economy of the time was in a bubble, driven by what I perceived to be unsustainable deficit spending by the private sector—which had been spending more than its income since 1996. As we now know, I called it too soon—the private sector continued to spend more than its income until 2006. The economy then crashed—a casualty of the excesses. What I had not understood a decade ago was just how depraved Wall Street had become. It kept the debt bubble going through all sorts of lender fraud; we are now living with the aftermath.

Still, it is worthwhile to return to the so-called “Goldilocks” period (mid to late 1990s, said to be “just right”, with growth sufficiently strong to keep unemployment low, but not so swift that it caused inflation) to see why economists and policymakers still get it wrong. As I noted in that earlier paper,

It is ironic that on June 29, 1999 the Wall Street Journal ran two long articles, one boasting that government surpluses would wipe out the national debt and add to national saving—and the other scratching its head wondering why private saving had gone negative. The caption to a graph showing personal saving and government deficits/surpluses proclaimed “As the government saves, people spend”. (The Wall Street Journal front page is reproduced below.) Almost no one at the time (or since!) recognized the necessary relation between these two that is implied by aggregate balance sheets. Since the economic slowdown that began at the end of 2000, the government balance sheet has reversed toward a deficit that reached 3.5% of GDP last quarter, while the private sector’s financial balance improved to a deficit of 1% of GDP. So long as the balance of payments deficit remains in the four-to-five percent of GDP range, a private sector surplus cannot be achieved until the federal budget’s deficit rises beyond 5% of GDP (as we’ll see in a moment, state and local government will continue to run aggregate surpluses, increasing the size of the necessary federal deficit). [I]n recession the private sector normally runs a surplus of at least 3% of GDP; given our trade deficit, this implies the federal budget deficit will rise to 7% or more if a deep recession is in store. At that point, the Wall Street Journal will no doubt chastise: “As the people save, the government spends”, calling for a tighter fiscal stance to increase national saving!

Turning to the international sphere, it should be noted that US Goldilocks growth was not unique in its character. [P]ublic sector balances in most of the OECD nations tightened considerably in the past decade–at least in part due to attempts to tighten budgets in line with the Washington Consensus (and for Euroland, in line with the dictates of Maastricht criteria). (Japan, of course, stands out as the glaring exception—it ran large budget surpluses at the end of the 1980s before collapsing into a prolonged recession that wiped out government revenue and resulted in a government deficit of nearly 9% of GDP.) Tighter public balances implied deterioration of private sector balances. Except for the case of nations that could run trade surpluses, the tighter fiscal stances around the world necessarily implied more fragile private sector balances. Indeed, Canada, the UK and Australia all achieved private sector deficits at some point near the beginning of the new millennium. (Source: L. Randall Wray, “The Perfect Fiscal Storm” 2002, available at http://www.epicoalition.org/docs/perfect_fiscal_storm.htm)

Let us revisit “Goldilocks” and see what lessons we can learn from “her” that help us to understand the Global Financial Collapse that began in 2007. As we now know, my short-term projections predicting the demise of Goldilocks into a recession were not too bad, but the medium-term projections were off. The Bush deficit did grow to 5% of GDP, helping the economy to recover. But then the private sector moved right back to huge deficits as lender fraud fuelled a real estate boom as well as a consumption boom (financed by home equity loans). See the chart below (thanks to Scott Fullwiler). Note that we have divided each sectoral balance by GDP (since we are dividing each balance by the same number—GDP—this does not change the relationships; it only “scales” the balances). This is a convenient scaling that we will use often in the MMP. Since most macroeconomic data tends to grow over time, dividing by GDP makes it easier to plot (and rather than dealing with trillions of dollars—so many zeroes!—we express everything as a percent of total spending).

This chart shows the “mirror image”: a government deficit from 1980 through to the Goldilocks years is the mirror image of the domestic private sector’s surplus plus our current account deficit (shown as a positive number because it reflects a positive capital account balance—the rest of the world runs a positive financial balance against us). (Note: the chart confirms what we learned from Blog #2: the sum of deficits and surpluses across the three sectors must equal zero.) During the Clinton years as the government budget moved to surplus, it was the private sector’s deficit that was the mirror image to the budget surplus plus the current account deficit.

This mirror image is what the Wall Street Journal had failed to recognize—and what almost no one except those following the Modern Money approach as well as the Levy Economic Institute’s researchers who used Wynne Godley’s sectoral balance approach understand. After the financial collapse, the domestic private sector moved sharply to a large surplus (which is what it normally does in recession), the current account deficit fell (as consumers bought fewer imports), and the budget deficit grew mostly because tax revenue collapsed as domestic sales and employment fell.

Unfortunately, just as policymakers learned the wrong lessons from the Clinton administration budget surpluses—thinking that the federal budget surpluses were great while they actually were just the flip side to the private sector’s deficit spending—they are now learning the wrong lessons from the global crash after 2007. They’ve managed to convince themselves that it is all caused by government sector profligacy. This, in turn has led to calls for spending cuts (and, more rarely, tax increases) to reduce budget deficits in many countries around the world (notably, in the US and UK).

The reality is different: Wall Street’s excesses led to too much private sector debt that crashed the economy and reduced government tax revenues. This caused a tremendous increase of federal government deficits. {As a sovereign currency-issuer, the federal government faces no solvency constraints (readers will have to take that claim at face value for now—it is the topic for upcoming MMP blogs).} However, the downturn hurt state and local government revenue. Hence, they responded by cutting spending, laying-off workers, and searching for revenue.

The fiscal storm that killed state budgets is the same fiscal storm that created the federal budget deficits shown in the chart above. An economy cannot lose about 8% of GDP (due to spending cuts by households, firms and local and state governments) and over 8 million jobs without negatively impacting government budgets. Tax revenue has collapsed at an historic pace. Federal, state, and local government deficits will not fall until robust recovery returns—ending the perfect fiscal storm.

Robust recovery will reduce the overall government sector’s budget deficit as the private sector reduces its budget surplus. It is probable that our current account deficit will grow a bit when we recover. If you want to take a guess at what our “mirror image” in the graph above will look like after economic recovery, I would guess that we will return close to our long-run average: a private sector surplus of 2% of GDP, a current account deficit of 3% of GDP and a government deficit of 5% of GDP. In our simple equation it will look like this:

Private Balance (+2) + Government Balance (-5) + Foreign Balance (+3) = 0.

And so we are back to the concept of zero!

28 Responses to Recent USA Sectoral Balances: Goldilocks, the Global Crash, and the Perfect Fiscal Storm

  1. I asked this in another post, but I think the post was too old for the comment to be noticed: how does the Fed fit into this identity? Can't the Fed print dollars and inject them into the equation as a sort-of external force?

    • Basil,

      Throughout this MMP, the “government” or “public sector” consists of the Fed, Treasury, and all other government agencies. They are amalgamated as one entity, for simplicity in discussion.

      Yes, the Fed can print/create dollars. This act is classified as a “government deficit.” Unlike a private deficit, the government deficit is sustainable because, as you alluded, the Fed creates the $US. The Fed cannot–by definition of its existence as the monopolistic, sovereign $US issuer–run out of money. The only constraint on government deficit spending is inflation, which is thoroughly explained here: http://bilbo.economicoutlook.net/blog/?p=10554

  2. Here’s the trouble with +2-5+3=0Assuming a differential of +1 between growth and “interest rate”, the standard debt sustainability equation shows that the public debt rises to 5%/1%=500% of GDP. (btw, r<g is hardly a sustainability condition. Just put the sequences where current account balance increases 1% every year for example. )If that is not troublesome, here’s more complication. The world represented by sequences of current account deficit of 3% implies increasing claims by foreigners on US sectors (both private and public). This means, more and more interest/dividends are being paid over time adding to +3% – UNLESS the US takes discretionary measures to improve exports. So at some point the factor income turns negative and the net international investment position is hurtling deep in negative territory. So +3 can hardly be said to remain at +3 unless the US attempts to improve exports or fine tunes this by fiscal restraint. Also, the assumption that +3 remains around that level says nothing about demand at home and abroad. Why hasn’t this happened so far? Two reasons. The first reason is that US direct investment abroad have been making a killing and direct investment by foreigners is earning next to nothing. So the “factor income from abroad” has stayed positive for a long time and in fact has been increasing recently! (Line 75 here http://www.bea.gov/newsreleases/international/transactions/2011/pdf/trans111.pdf )The second reason is that assets held abroad have made tremendous valuation gains, both due to increased valuation in the foreign currency as well as the depreciation of the dollar over time. There is a third complication which is indeed complicated. A depreciation of the dollar does not lead to capital losses on liabilities to foreign sectors but increases the value of the assets held abroad when converted back to the dollar. This leads to a higher consumption and hence more demand creation and though is good for employment has the flipside of increasing imports :). Don’t have much to say on that at this point. If the US wants to grow faster than the rest of the world via a simple fiscal relaxation, its current account would deteriorate. I have seen arguments in the blogosphere that growth stabilizes debt/gdp ratios where debt is for both public debt and the net international investment position which I believe is hardly right. For growth faster than what the rest of the world grows implies a deteriorating current account balance implying the debt/gdp growing over time. So +2-5+3=0 can hardly be long run if with or without full employment. One way out of this is via a smooth depreciation of the dollar by market forces. However, this Mundell-Fleming kind of “dream scenario” is just one of the possible future scenarios and it will be a miracle if market forces achieve this. One argument that can be made against this is that there are no grandchildren involved here. However, there is no need to talk of the grandchildren because current account deficits lead to losses in employment due to leakages in demand. So the present population is already affected. Another point I wish to make is that one can continue to argue that the public debt/gdp and the NIIP/gdp can continue growing till eternity but then in that case, one really shouldn’t be arguing for “automatic stabilizers”.

  3. "(btw, r<g is hardly a sustainability condition. Just put the sequences where current account balance increases 1% every year for example. )"Sorry should be: decreases 1% every year instead of increases.

  4. Randall, I can get to this post from the left-hand menu, but it is not showing up in the blogroll.

  5. "I had recognized that the economy of the time was in a bubble, driven by what I perceived to be unsustainable deficit spending by the private sector—which had been spending more than its income since 1996."Was the private sector using stock prices to dissave in the late 1990's?"What I had not understood a decade ago was just how depraved Wall Street had become. It kept the debt bubble going through all sorts of lender fraud; we are now living with the aftermath."What about the fed and greenspan? Did they need a debt bubble to fight price deflation from cheap labor and positive productivity growth so housing was used as collateral, sweeps accounts lowered the effective reserve requirement, and SIV's lowered the effective capital requirement?

  6. I believe you are again assuming the currency printing entity is not allowed to create more medium of exchange with no bond/loan attached (meaning it could dissave/run a deficit).

  7. "After the financial collapse, the domestic private sector moved sharply to a large surplus (which is what it normally does in recession), the current account deficit fell (as consumers bought fewer imports), and the budget deficit grew mostly because tax revenue collapsed as domestic sales and employment fell."IMO, the rich mostly continued saving and the lower and middle class mostly stopped dissaving (preferably with debt).

  8. "{As a sovereign currency-issuer, the federal government faces no solvency constraints (readers will have to take that claim at face value for now—it is the topic for upcoming MMP blogs).}"I believe you mean the currency printing entity would be expected to bailout the bondholders. If that happened, what would be the consequences?

    • There would be no consequences. Printing money (or more accurately, “typing the digits”) to pay for the bonds is an asset swap, such as quantitative easing. No inflationary effect.

  9. Basil;The interaction of the Treasury and the Fed contains some complicated elements, but for the purposes here noted, the Fed is part of the consolidated government sector – its balance sheet is already included in the data being graphed, i.e. the Government Balance shown in pink. For a complete explanation of this and much else, try browsing the Billy Blog at:http://bilbo.economicoutlook.net/blog/Cheers

  10. Basil;Regarding: "Can't the Fed print dollars and inject them into the equation as a sort-of external force?"The short answer is 'no'. It's the Treasury that spends dollars into the economy to pay for the real goods and services that are thereby transferred to some agency of the federal government. The Fed's role is to set and support the Fed Funds interest rate, usually through buying and selling Treasury securities. Since the onset of the crisis, the Fed has performed many very unusual operations for a variety of purposes and purported purposes, but none of them amounts to "money printing" in the conventional sense. The impression people have that QE2 et al. have the effect of "flooding the economy with dollars" is mistaken. Warren Mosler's take on this situation is that everyone thinks there's a bumper crop of dollars out there but the reality is a crop failure. In part, this is because the U.S. Treasury securities the Fed is buying act to *remove* interest income from the private sector. More at:http://moslereconomics.com/2011/06/16/thoughts-on-the-euro/Cheers

  11. I am not seeing what this sort of sectoral financial flow has to offer for unemployment policy. Given that money flows to the private sector from a deficit in the government sector what does it mean? If you have say, more Bush tax cuts for the wealthy does that equate to more jobs? Evidence suggests not much. Why does the governement have to run a deficit to produce jobs? Can't the private investor simply borrow money for his business and thereby create jobs notwithstanding what the government deficit is doing?Or on the other side, if US corporations repatriate the cash back to the US that is an increase in private sector assets but there is no guarantee it will result in jobs either. In fact the last time they did this it had no effect I think? ( I assume here that corporate cash offshore is a foreign financial asset.)On your accounting why do you include state and local gov with the fed government? The feds are the only ones who can make money in your equation.In that regard, as noted, do not banks and investors also create credit that functions as money? As to government money, I get they cannot go broke but they do need to worry about their creditworhtyness? If investors come to believe the money is cheapened, they will go elsewhere with consequences on interest and exchange rates. That leads to my last question. If the govenrment leaves money on every street corner say, it is for non productive use. Such a use of money will also cheapen it with the same consequences.

  12. Anonymous: "Why does the governement have to run a deficit to produce jobs? Can't the private investor simply borrow money for his business and thereby create jobs notwithstanding what the government deficit is doing?"It theoretically could- but what's the business rationale for it in an environment like today, where aggregate demand is collapsed and consumers are paying down debt instead of spending? The company will hire when it is swamped with demand, but it doesn't see it. Consumers today are trying to deleverage. Deficit spending by definition delevers the private sector and adds income that could then be spent. You're right tax cuts to the wealthy might not do much, but tax cuts to the lower and middle classes have much more potential to raise aggregate demand.

  13. Basil said: "Can't the Fed print dollars and inject them into the equation as a sort-of external force?"Dale said: "It's the Treasury that spends dollars into the economy to pay for the real goods and services that are thereby transferred to some agency of the federal government."And, "The impression people have that QE2 et al. have the effect of "flooding the economy with dollars" is mistaken."Define dollars.

  14. Anonymous @4:21, define money.And, "Or on the other side, if US corporations repatriate the cash back to the US that is an increase in private sector assets but there is no guarantee it will result in jobs either. In fact the last time they did this it had no effect I think? ( I assume here that corporate cash offshore is a foreign financial asset.)"See the NY Times link at this link:http://www.cepr.net/index.php/blogs/beat-the-press/why-is-third-way-an-unlikely-ally-for-a-corporate-tax-break"But that’s not how it worked last time. Congress and the Bush administration offered companies a similar tax incentive, in 2005, in hopes of spurring domestic hiring and investment, and 800 took advantage. Though the tax break lured them into bringing $312 billion back to the United States, 92 percent of that money was returned to shareholders in the form of dividends and stock buybacks, according to a study by the nonpartisan National Bureau of Economic Research. This money comes from overseas operations and in some cases accounting maneuvers that shift domestic profits to low-tax countries. The study concluded that the program “did not increase domestic investment, employment or research and development.” Indeed, 60 percent of the benefits went to just 15 of the largest United States multinational companies — many of which laid off domestic workers, closed plants and shifted even more of their profits and resources abroad in hopes of cashing in on the next repatriation holiday."

  15. wh10 said: "Deficit spending by definition delevers the private sector and adds income that could then be spent. You're right tax cuts to the wealthy might not do much, but tax cuts to the lower and middle classes have much more potential to raise aggregate demand."I'd rather look at it this way:savings of the rich = dissavings of the gov't (preferably with debt) plus dissavings of the lower and middle class (preferably with debt)IMO, all that does is maintain and grow the savings of the rich.

  16. Hi – Layperson here. Some accounting terms and concepts are completely unfamiliar to people like myself. I think an expanded discussion of 'current account balance' in relation to 'capital account balance' and overall 'US balance of Payments' would be useful especially as it all nets to zero.

  17. I haven't had time to think through and formulate my questions well, but I have three questions/observations:1. What was the stronger driving factor in forcing the private sector into a deficit: the Govt Balance or the CA? It seems in magnitude the CA is forcing it more, but what is the causality across the sectors?2. The chart speaks to annual flows of income vs spending, but what about stocks? In other words, with all those years of govt deficits, net financial assets should have been growing significantly. As the govt deficit shrank in the Clinton years, the growth of NFA should slow, but not actually "grow negatively" until there was a surplus, and a minor one at that. So what happens to all the NFA- why isn't there enough "stocked-up wealth" to support a healthy economy and buffer against too much leverage? Hope that makes sense, but I am likely not conceptualizing correctly.3. You don't actually explicitly blame the debt bubble on the surplus. You blame it on the buildup of debt (duh), though implicitly suggesting larger deficits would have helped prevent over-leveraging. BUT, at the end of the day, I think the lesson, in this scenario, is not necessarily that the govt should have spent more, but better regulation should have been in place to prevent Wall Street excesses, certain lending practices, consumer protection/education, etc etc.

  18. "Why does the governement have to run a deficit to produce jobs? Can't the private investor simply borrow money for his business and thereby create jobs notwithstanding what the government deficit is doing?"In addition to what I stated above, the interest rate at which businesses can borrow is going to be affected by the perceived risk of that loan. And if a bank sees a down economy, and if it sees the past performance of the business is not that great (due to the down economy), that's going to increase the risk of the loan and thus the interest rate at which the business can borrow. So that's two major factors going against this idea.

  19. Cro-Magnon man here. It seems like to get to a recovery, the blue needs to come down (people need to spend more, save less, or at least rich people and corporations need to spend more and save less) and the red will get closer to zero when that money is spent and the resultant taxes are paid. But, we can't count on the rich and corporations to be patriotic, so the government could double down on their debt, print money for the sole purpose of hiring people to go to work doing a thousand jobs worth doing and that would raise the level of economic activity to increase tax payments to the government. But what do we do about the green bars? Is it a good thing or necessary to let the government deficits remain large to lower the capital accounts. I don't like owing them ferriners.

  20. You folks with the comments are making this too hard. I studied economics, both in college and for the CFA exam, and the conclusion I drew is the science of economics taught to today's professionals is "bat shit" crazy. I think to truly get MMT, you have to unlearn all the garbage stuffed in your heads. Prime example, devolving into the definition of dollars is a pointless pursuit to understand the MMT equation and its implications on economic policy.

  21. From what I understand from this chart, the larger the deviation from zero, bigger the imbalance between sectors. Does it mean for things to be *going well* sectorial imbalances must be within limits.

  22. “Wall Street’s excesses led to too much private sector debt that crashed the economy and reduced government tax revenues.” But in a zero-sum game, the money went somewhere, and it didn’t go to government, so how was net private sector debt excessive?

    • Lewis,

      To answer your question, you should go here, http://www.positivemoney.org/how-banks-create-money/proof-that-banks-create-money/ and read about how money is created by private banks. This website is in the UK, but the money creation method holds true in the US. All the money from this debt stays within the private sector.

      The problem of excessive debt is that the debtor must spend a high amount of income on repayment of that debt. Therefore, there is less to spend on other goods and services. This leads us to a necessary understanding of “net financial assets,” and how that affects these sectoral balances. This topic will be thoroughly discussed later in the MMP.

  23. Pingback: More Austerity Advice From the Very Rich: Buffett On Deficits! - New Economic Perspectives

  24. That one picture, the three sectoral balances, should be mailed to every politician and pundit. Seeing it changed my entire view of economics. Like many, since I didn’t know better and trusted the opinion of the smart, economically trained people, I used to believe in balancing the budget overall, austerity, government deficits are bad and can only be tolerated in recessions, intl trade was “bad” and we should try to export etc etc
    That picture kind of shattered my world view, and it caused me to read this blog, look into economics more, think about what the mainstream says and I ended up endorsing “mmt”. And it makes sense when one is not ideological. Seriously everyone should see this picture, and learn the basics behind it. I get many not wanting to care about what is money, bank operations and etc but I wish all could see this simple proof of how deficits really operate.