Thursday, April 26, 2012

The Most Important Macroeconomic Relationship

In 1999, the late Wynn Godley (1926-2010) predicted the great financial crisis. His insight into the economy was through the lens of the three-sector financial flow accounting discussed in the last blog
We can state the relationship in words as
Public Net Income + Private Net Savings + Net Foreign Imports = 0.
Godley noticed that with a perennially positive import balance and the then current government surpluses, which politicians and pundits applauded, the private sector savings would have to be negative. That is, the private sector was borrowing to finance imports and the public surpluses. Only a few economists noticed this conundrum, and Godley, a proponent of the Financial Sector Balance (FSB) accounting relationship, was among the first. 
At the Bureau of Economic Analysis (BEA) our nation’s bookkeepers compile piles and piles of data in their National Income and Production Account (NIPA) Tables. From these tables we can find the data series that illustrate the FSB relationship including what Godley saw and foretold. An FSB history is shown in Figure 1, where there are several characteristics to note. 
Figure 1. Financial sector balance flows add to zero at each point in time in accordance with the three- sector relationship.

  • When private saving increases (blue line) public deficit increases (red line). 
  • The oil crises that caused high oil prices in the 1970s resulted in a recession characterized by unusually high private saving and increased public deficits. Such is the signature of recessions.
  • During the 1980s, the Reagan tax cuts in 1981 increased public deficits contrary to “supply side theory.” In any event, the recession of 1982, possibly triggered by tight money policies, dominated the economy. The stock market crash in 1987 was laid at the feet of high deficits though high imports contributed to the deficit.
  • H W Bush promised in 1988 to hold the line on taxes, just read his lips. But, deficit hysteria put pressure on him to do something. In 1990, he reached a compromise that resulted in some tax increase. Then the recession of 1992 took over, private savings and deficits increased in unison and Bush lost reelection.
  • During the Clinton years, 1992-2000, a combination of tax increases and spending restraint produced both a public surplus and competition between Democrats and Republicans to take credit for what was interpreted to be a successful budget outcome.
We want to focus on what Godley noticed. As the public deficit was declining and becoming a surplus private saving was diminishing and becoming borrowing instead. Clearly, obsession with the deficit distracted our leaders from what was going on in the private sector.
It might have been worse but for the Bush tax cuts that allowed the deficit to increase again and gave the private sector some relief. But, it was too late. The housing crisis of 2007 took over the whole show. In a resounding example of Keynes’ “Paradox of Thrift” the private sector stopped spending, unemployment increased, automatic stabilizers (food stamps, unemployment insurance) kicked in and the deficit exploded.

Figure 1 gives us flows into and out of the sectors not the stock of debt or saving. It would be appropriate to ask how high did the private debt go and how does it compare to the public debt that everyone seems to be worried about? 
To answer those questions, we call upon Prof. Steve Keen of the University of Western Sydney, Australia, where he is noted for his mathematical modeling of financial instabilities. Figure 2 is taken from Keen’s presentation at the Berlin 2012 INET (Institute for New Economic Thinking) Conference.
Private debt, which is a burden, far exceeds public debt, which is a private asset.

Once again the data are clear. Concentration on public deficits and public debt distracted us from noticing the accumulation and huge build up of private debt. After the Great Depression in the 1930s, regulations were put in place to prevent financial instabilities. But, over the last four decades, Presidents, both Republican and Democrat, have presided over deregulation of the financial markets with the results we experience today. And, still we hear cries for more deregulation, and another Democrat President seems ready to oblige.
It wasn’t the public sector that got into debt trouble and couldn't pay its bills, it was the private sector. So, we might conclude; it’s the private sector debt, stupid!!

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