## Tuesday, May 10, 2011

### Financial Sector Balance II

In a previous blog I plucked an equation out of James Galbraith’s “The Predator State” and tried to put it to the test graphically. One of my friends, whose initials are Duane, objected to having the equation in terms of deficits so that a negative deficit was a surplus. Another friend was unconvinced. Apparently my first attempt was a pedagogical flop.
This is a very important top topic even if it is basically bookkeeping. Economists call it macroeconomics. We are concerned with the three sectors; foreign, which is just exports and imports; private, which comprises all domestic households and businesses; and public, which comprises federal, state, and local governments. All the people are in the private sector. This is where business and governments find their labor. Ultimately, households end up with all income, and households contribute the bulk of GDP.

 Figure 1. Sectors that contribute to GDP
What follows is a simple derivation of the sector balance equation. GDP is a measure of the market value of all goods and services in the country in a year and can be expressed in, at least, two ways. First we look at it in terms of sources of money in the domestic economy, which we express as follows:

(1)    GDP = C + I + G + (X - M),
where C is the sales side of household consumption, I is business investment, G is federal government spending. (X - M) represents the net value of exports.
Alternatively, we can look at uses of income, which gives us
(2)   GDP = C + S + T,
where C is spending side of household consumption, S is total household saving, and T is federal taxes.
Equating (1) and (2) and canceling the C’s we have

(3)    S + T  = I + G + (X - M).
After rearranging terms, we have our sector balance equation

(4)     (S - I) + (T - G) = (X - M).   Each term is positive in surplus and negative in deficit.
(S - I) in surplus indicates net saving in the private sector, and net borrowing in deficit. (T - G) indicates public surplus when positive and deficit when spending exceeds taxes. (X - M) is net exports and is in deficit when imports exceed exports.
Figure 2 shows a chart of the terms in equation (4) using data from the Bureau of Economic Analysis. For this chart, I was able to find more appropriate data series than in the earlier post. Clearly, the data validate equation (4) quantitatively.

 Figure 2. Sector data from BEA as per cent of GDP from 1960 QI to 2010 QIV
Perhaps the most striking feature of the chart is the consistency with which public deficit (T - G) is reflected in private saving (S - I). It is good for some saving to occur. We like to have a prospering and growing economy with increasing wealth. But, when facing hard times, we run into the Paradox of Thrift. If one household saves it is good for that household, but when every household saves the economy suffers. As households reduce consumption, firms lay off workers, tax revenues fall while unemployment insurance rises leading to increased deficits. We see these effects in the 1973 and 1979 oil crises and the subsequent recessions. And, we see it big time currently.
There is another interesting period in the late 90’s where the foreign deficit (X - M) is growing rapidly and is demanding a deficit on the domestic side of equation (4). Uncharacteristically, during this period the public sector is in surplus and the private sector takes on the role of running a deficit by continued borrowing.
In the run-up to the election in 2000, there was some argument about what to do with the surplus. Al Gore wanted to put it in a “lock box.” G W Bush bided his time and reduced taxes in 2001 and 2003 in addition to introducing Medicare drug benefits and launching a war. That got rid of the surplus but, perhaps, produced insufficient deficit to overcome the mounting borrowing in the private sector. Overweighted with debt, the private sector collapsed into the Great Recession. Then private saving zoomed to unprecedented levels as did public deficits.
With persistent trade deficits, the public sector, the private sector or both will be in deficit. In the period around 2006, both sectors shared the load. When the private sector is in deficit, wealth is flowing out to the other sectors. Likewise, when the public sector is in deficit, it is feeding the other two.
It is important to realize that sector balance observations do not prove causation, but they are valuable in understanding where money flows under various circumstances.
Understanding the nature of the sector flows, it is hard to understand why anyone would want to balance the public budget or especially, run it into surplus. Assets would move from the private sector tending to make people poorer.