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Modern Monetary Theory and Practice: An Introductory Text

William Mitchell, L. Randall Wray and Martin Watts

79

Chapter 5: Sectoral Accounting and the Flow of Funds

Chapter Outline

5.1 Introduction

5.2 The Sectoral Balances View of the National Accounts

- How can we use the sectoral balances framework?

5.3 Revisiting Stocks and Flows

- Flows

- Stocks

- Inside wealth versus outside wealth

- Non-financial wealth (real assets)

5.4 Integrating NIPA, Stocks, Flows and the Flow of Funds Accounts

- Causal relationships

- Deficits create financial wealth

5.5 Balance Sheets

5.6 The Flow of Funds Matrix

- Flow of funds accounts and the national accounts

Appendix

- A graphical framework for understanding the sectoral balances

Learning Objectives

1. Understand the relationship between sectoral balances and changes to net financial assets.

2. Recognise the distinction between vertical and horizontal transactions in their impact on net

financial assets.

3. Interpret a balance sheet (stocks) and period to period changes of its items (flows).

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5.1 Introduction

In Chapter 4, we saw that the national accounts divided the national economy into different

expenditure categories – consumption by persons/households (note housing is investment);

investment by private business firms; spending by the government; exports to and imports from

the foreign sector.

The most basic macroeconomics rule is that one person’s spending is another person’s income.

Another way of stating this rule is that the use of income by one person (i.e. spending) will

become the source of income for another person or persons.

In this Chapter, we extend our understanding of the national accounts, which record these

different flows of expenditure and income. The sectoral balances perspective of the national

accounts brings the uses and sources of national income together. We show that when

appropriately defined, the sectoral balances must sum to zero. We expand our discussion of

stocks and flows and then introduce the flow of funds by reference to the sectoral balances.

The sectoral balances approach helps us to understand the relations among the spending and

income balances of the households, firms, government, and foreign sectors of the economy. For

example, they allow us to conclude that it is impossible for all sectors to run surpluses (that is, to

‘save overall’ – spend less than their income) simultaneously. For one sector to run a surplus, we

need at least another to run a deficit (spend more than their income). You will learn that for those

nations, which run external deficits against the rest of the world, then, in order for households

and firms together (that is, the private domestic sector) to run surpluses (spending less than

income in order to save overall) it is necessary for the government to run fiscal deficits (spend

more than taxes). There are many useful insights that can be gained from an understanding of a

nation’s sectoral balances.

5.2 The Sectoral Balances View of the National Accounts

The Australian Bureau of Statistics publication – Australian System of National Accounts:

Concepts, Sources and Methods, 2014 – provides an excellent source for understanding the

background concepts that are used to derive the sectoral balances framework. The discussion is

generally applicable to all countries.

From this framework, economists derived what is called the basic income-expenditure model in

macroeconomics to explain the theory of income determination that forms the core of the so-

called Keynesian approach (see Chapter 7).

The income-expenditure model is a combination of accounting identities drawn from the national

accounting framework and behavioural theories about how flows of expenditure by households,

firms, governments, and foreigners combine to generate sales, which in turn, motivate output and

income generation.

Remember, that an expenditure flow is measured as a certain quantity of dollars that is spent per

unit of time. So for example, in the June-quarter 2015, the Australian Bureau of Statistics

estimated that household consumption in Australia was $A220,913 million in real, seasonally-

adjusted terms.

Conversely, a stock is measured at a point in time and is the product of prior, relevant flows. For

example, the Australian Bureau of Statistics estimated that total employment in Australia in

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October 2015 was 11,838.2 thousand. The flows that generated this stock of employment were

all the movements of workers between the different labour force categories: employment,

unemployment, and not in the labour force. Of course, most workers remained in the same labour

force category as they were in September 2015.

The accounting aspects that underpin the income-expenditure model draw on different ways of

thinking about the national accounts.

We can view the national accounts in several ways. First, from the perspective of the sources of

national income, we can write out the sources of spending that flow into the economy over a

given period, using the following shorthand.

(5.1) GDP ≡ C + I + G + (X – M)

that is, total national income (GDP) is the sum of total final consumption expenditure (C), total

private investment (I), total government expenditure (G) and net exports (X – M). Note the use of

the mathematical symbol ≡, which denotes an Identity that is true by definition.

At this stage we simply take these flows of expenditure as given and understand them to be parts

of the national accounts of a nation.

When these components of spending are summed, they equal aggregate demand for goods and

services in a particular period. Aggregate demand, in turn, generates a response by producers

(private and public) in the form of production, which, in turn, generates flows of income to

suppliers of inputs into production (wages, profits). The sum of those flows equals national

income.

As we noted in Chapter 4, the trade account is only one aspect of the financial flows between the

domestic economy and the external sector. We must include net external income flows (FNI),

which arise from the dividend and income flows that accrue to investments that residents make

abroad minus the dividend and interest flows that residents have to pay foreign investors who

have interests within the nation.

Adding in the net external income flows (FNI) to Equation (5.1) for GDP we get the familiar

definition of gross national product or gross national income measure (GNP):

(5.2) GNP ≡ C + I + G + (X – M) + FNI

At this stage, we could make the analysis quite complicated by considering retained earnings in

corporations and the like, but here we assume that all income generated by firms and

corporations ultimately is received by households.

To obtain the sectoral balances form of the identity, we subtract total taxes net of transfers (T)

from both sides of Equation (5.2), using the rules that govern the manipulation of equations, as

outlined in the Methods, Tools and Techniques Appendix.

We thus obtain:

(5.3) GNP – T ≡ C + I + G + (X – M) + FNI – T

Now we can collect the terms by arranging them according to the three sectoral balances:

(5.4) (GNP – C – T) – I ≡ (G – T) + (X – M + FNI)

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The terms in Equation (5.4) are relatively easy to understand now. The term (GNP – C – T)

represents total income less the amount consumed by households less the amount paid by

households to government in taxes net of transfers. Thus, it represents household saving.

The left-hand side of Equation (5.4), (GNP – C – T) – I, thus is the overall saving of the private

domestic sector, which is distinct from total household saving denoted by the term (GNP – C –

T).

In other words, the left-hand side of Equation (5.4) is the private domestic financial balance. If

it is positive then the sector is spending less than its total income (so the sector is adding to its

stock of net financial assets) and if it is negative the sector is spending more than its total

income.

The term (G – T) is the government financial balance or primary fiscal balance and is in deficit

if government spending (G) is greater than government tax revenue (T), and in surplus if the

balance is negative.

Finally, the other right-hand side term (X – M + FNI) is the external financial balance,

commonly known as the Current Account Balance (CAB). It is in surplus if positive and deficit

if negative. It is the balance between the spending/income flows of foreigners in the nation and

the spending/income flows by residents that go to foreign nations.

We can say that:

The private domestic financial balance equals the sum of the government financial balance

plus the current account balance.

This is an accounting statement.

Note that by re-arranging Equation (5.4) we get another version of the sectoral balances

equation:

(5.5) (S – I) + (T – G) - CAB ≡ 0

which shows that, when suitably defined, the balances sum to zero.

For example, let us assume that the external or foreign balance equals zero. Let us further assume

that the private domestic sector’s income is $100 billion while its spending is equal to $90

billion, which delivers an overall surplus of $10 billion over the year. Then, from the identity,

Equation (5.5), the government sector’s fiscal deficit for the year is equal to $10 billion. We

know that the private domestic sector will accumulate $10 billion of net financial wealth during

the year, consisting of $10 billion of domestic government sector liabilities (given that the

external balance is zero).

As another example, assume that the foreign sector spends less in the nation in question relative

to the income it receives from that nation, which generates a current account surplus of $20

billion. At the same time, the government sector also spends less than its income, running a fiscal

surplus of $10 billion. From our accounting identity, we know that over the same period the

private domestic sector must have run an overall deficit equal to $30 billion ($20 billion plus $10

billion). At the same time, its net financial wealth will have fallen by $30 billion as it sold assets

and/or issued debt. Meanwhile, the government sector will have increased its net financial wealth

by $10 billion (reducing its outstanding debt or increasing its claims on the other sectors), and

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the foreign sector will have increased its net financial position by $20 billion (also reducing its

outstanding debt or increasing its claims on the other sectors).

It is apparent that if one sector is going to run a surplus, at least one other sector must run a

deficit. In terms of stock variables, in order for one sector to accumulate net financial wealth, at

least one other sector must be in deficit. It is impossible for all sectors to accumulate net

financial wealth by running surpluses.

How can we use the sectoral balances framework?

Figure 5.1 UK sectoral balances, 1960 to 2014

Source: OECD (2015) (see also Watts and Sharpe, 2016). Note: Imports (M) include net income flows in this graph.

The UK sectoral balances shown above (Figure 5.1) replicate Equation (5.5), except that the

balances which sum to zero, are expressed as percentage shares of GDP.

At this stage 3 observations are appropriate:

1. Despite the contemporary rhetoric, the UK has rarely run an annual fiscal surplus. Indeed seven surpluses have been achieved since 1960.

2. Like a number of other developed economies, including the USA and Australia, current account surpluses have also been relatively rare.

3. Private sector balances have typically been in surplus. The limited occurrence of private sector deficits have been often accompanied by fiscal surpluses. The three annual fiscal

surpluses between 1998 and 2000 were accompanied by current account deficits and

relatively large private sector deficits (7.3 percent of GDP in 2000). The 2001 economic

slowdown followed (Watts and Sharpe, 2016). Wray (1999) notes that fiscal surpluses

usually have been followed by recessions in the USA. A similar pattern is evident in most

advanced economies.

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Government balance (G-T) External balance (X-M) Private Domestic balance (S-I)

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In Chapter 7 we will develop an understanding of how expenditure drives income generation via

the principle of aggregate (effective) demand. The principle tells us that total income in the

economy per period will be exactly equal to total spending from all sources but also details the

behavioural processes involved that bring that equality into line.

We will outline theories of the components of expenditure. For example, there are various

theories of household consumption expenditure but all of them suggest that consumption is

determined positively by changes in disposable income. The response of consumption to a

change in income is called the Marginal Propensity to Consume (MPC). It is normally

hypothesised that the MPC will be less than one, so that the residual of disposable income not

consumed will be positive. That constitutes saving.

So the private domestic sector financial balance (S – I) will increase, other things equal, when

national income rises.

Similarly, taxation revenue (net of transfers) is considered to be a positive function of national

income. So, other things equal, the government financial balance (G – T) falls when national

income rises, and vice versa. Similarly, government spending automatically increases when

national income falls as a result of welfare payments rising. In this way, the government fiscal

deficit (surplus) is said to operate as an automatic stabiliser, with net expenditure being higher

when national income is lower and vice versa.

Imports are also considered to be a positive function of national income – so when national

income increases, we simultaneously buy more locally-produced goods and more imported

goods. So the external balance falls when national income rises, and vice versa, other things

equal.

In turn, changes in financial balances by sector are driven by joint impact of changes in

expenditure and national income flows, as outlined above.

The accounting structures that underpin the sectoral balances framework also allow us to check

logic. For example, if a politician says that the government and non-government sectors should

simultaneously reduce their net indebtedness (increase their net wealth) (assuming neo-liberal

public debt issuance strategies) then we know that is not possible. We don’t have to resort to

theory to make those sorts of conclusions.

But the accounting structures do not allow us to determine the validity of a political statement

that austerity measures will stimulate growth. At that point we need theory but we should still

use the sectoral balances framework to draw inferences about the overall macroeconomic

outcome when sectoral balances respond to the imposition of austerity.

5.3 Revisiting Stocks and Flows

Flows

In this section we re-examine the concepts of stock and flow variables, which were briefly

outlined in Chapter 1, and delineate their differences, as well as the relationship between the two.

This will enable us to clearly set out the necessary relationships between deficit spending and

saving, and between debts and financial deficits and debts. This Chapter will clarify these

fundamental accounting relationships.

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Flow variables are measured over time. The simplest example is personal income, which can be

stated as $10 per hour, or $400 per week, or $20,000 per year. The important point is that

without a clear statement of the time component, any statement of a flow is incomplete and

somewhat meaningless: if one says one’s income is $100, we need to know whether that is per

hour, per day, per week, or per year to make sense of it. It is also useful to work with growth of

flow variables, often calculated as annual growth rates. For example, your employer might offer

a labour contract that provides for annual cost of living increases equal to 4% per year. In the

first year you would receive $20,000, while in the second you would receive a wage income of

$20,800 ($20,000 plus 4% of $20,000, which is equal to $800).

What flows? When we speak of the flow of a river, it is obvious that it is water, which is

flowing, measured in terms of thousands of cubic metres per second. However, it is not so clear

what is flowing when we refer to flows of income and expenditure. For example, what flows to

provide a wage income equal to $20,000 per year? The simple answer is ‘dollars’. You work for

your employer 8 hours a day, 5 days a week, and after two weeks you receive a cheque drawn on

a bank or an electronic transfer for the sum of $800 (ignoring possible deductions for taxes and

benefits). Even on payday, it is difficult to conceive of the pay cheque as the ‘dollars’ that were

flowing while you were working. Actually, as we will see in Chapter 6, the cheque is really just

an IOU issued by your employer’s bank that is denominated in your nation’s money of account -

the dollar in our example.

In fact, we can conceive of your work for hourly wages as an implicit accumulation of the IOUs

of your employer. Over the course of the two weeks during which you worked, you earned a

flow of wages equal to $10 for each hour worked, received in the form of an implicit promise

from your employer to pay you in dollars at the end of the two week period. Indeed, in the event

of a dispute, the court system would recognize the legal obligation of your employer to pay

dollars to you for hours worked. In this sense, we can conceive of each hour worked leading to

your accumulation of IOUs of your employer denominated in dollars. On payday, your employer

extinguishes their IOUs by delivering to you a cheque or a transfer for the total obligations

accumulated over the two-week period. Two important conclusions follow from this example.

Flows are measured in terms of money. The money of account is the means by which we

measure flows of income or spending. The associated flow of currency can take a physical form

of notes and coins, but equally can be an electronic entry, say in a private bank account. Thus, in

contrast to a flow of water, the flows of spending or income do not always take a physical form.

As we will explore later, metal coins and paper currency are really nothing more than

government IOUs denominated in the money of account. While government currency is in some

respects different from the cheques issued by banks and from the implicit IOUs you accumulate

against your employer, all share a common characteristic because all are IOUs denominated in

dollars.

We also need to differentiate between flows of income and spending denominated in the money

of account from the associated flows of (labour) services and goods and services. In principle,

consumer goods and services are used up to satisfy the needs and desires of households,

however, consumption purchases made this week could include goods that will be used for many

months or even years. Economists typically record consumption at the time the purchase is made

and at the dollar value of the purchase even while recognising that goods and services purchased

might provide a stream of ‘satisfaction’ over a long period of time.

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Stocks

Flows accumulate as stocks. The flow of water in a stream can be accumulated in a reservoir

behind a dam, or in the cup we dip into the stream. The stock of water is then the number of

cubic metres in the reservoir, or the half litre in the cup. Unlike a flow, a stock can be measured

without reference to a time period as it exists at a point of time. We can measure the stock of

water in a lake at noon on the last day of the summer as 1.5 billion cubic metres, and at noon on

the last day of the following winter as 2.0 billion cubic metres. Because the stock has increased,

we can surmise that the inflow of water during the passing of six months has been greater than

the outflow of water over that period, by an amount equal to 0.5 billion cubic metres.

Let us continue to assume that you receive a biweekly pay cheque equal to $800, twenty-five

times a year for a total annual income of $20,000. On payday, you deposit your employer’s

cheque in your bank account, increasing your deposit by $800. Your bank deposit represents a

portion of your wealth, held in the form of a financial asset, which is a claim on your bank.

Because wealth is measured at a point in time, it is a stock variable. In addition to your bank

account, you might also hold other forms of financial wealth (stocks and bonds, currency in your

pocket, other types of bank deposits) as well as real wealth (a car, real estate, a business firm, art

and jewels). Again, all of these are stock variables whose value is measured in terms of the

money of account at a point in time.

Once you have deposited your $800 pay cheque, you begin to draw down your bank account to

finance your purchases. Let us continue to assume that your annual consumption will be $18,000

for the year, comprised of purchases of consumer goods (food, fuel for your automobile,

clothing) and consumer services (entertainment, medical care, legal services). Hence, between

pay cheques, you spend a total of $720 for consumption, drawing down your bank account by

that amount to finance these purchases.

Over the year, your flow of wage income has been equal to $20,000 and you have spent $18,000

of that on consumption. Then you have accumulated a stock equal to $2000 - which is equal to

the inflow of income less the outflow of spending. Recalling our definition from above, your

flow of saving over the year is also equal to $2000, because saving is defined as the residual

dollar value of income that has not been spent over the period.

This will accumulate as an addition to your stock of wealth. If you allow the funds to accumulate

in your cheque account - which we will initially assume does not earn interest - the annual

addition to your financial wealth will be $2000. Alternatively, you could instead purchase

interest-earning bonds, another form of financial wealth. In this case, however, you will also

have a flow of interest earnings, in addition to your labour income. The flow of interest income -

let us say it amounts to $200 over the course of the year - will also add to your stock of financial

wealth (so that the total addition to your stock of financial wealth is $2200).

However, there are many other possible uses of your saving flow. You might decide to buy

stocks or other kinds of financial assets. Or, you might purchase real assets - a collectable car,

real estate, or equipment for your family’s business firm. The saving decision can be analysed as

a two-step process: first as a decision to withhold a portion of one’s income flow from spending,

and second a decision as to the form in which wealth will be accumulated. An income flow is

first realised as an accumulation of IOUs - normally, claims on a bank in the form of a deposit -

that in the second step is used to purchase an asset.

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One’s financial asset is another’s financial liability. It is a fundamental principle of accounting

that for every financial asset there is an equal and offsetting financial liability. The cheque

deposit (also called a demand deposit or a sight deposit) is a household’s financial asset, offset

by the bank’s liability (or IOU). A government or corporate bond is a household asset, but

represents a liability of the issuer (either the government or the corporation). The household has

some liabilities, too, including student loans, a home mortgage, or a car loan. These are held as

assets by the creditor, which could be a bank or any of a number of types of financial institutions

including pension funds, hedge funds, or insurance companies. A household’s net financial

wealth is equal to the sum of all its financial assets (equal to its financial wealth) less the sum of

its financial liabilities (all of the money-denominated IOUs it issued). If that is positive, it has

positive net financial wealth.

Examples of stocks include: stock of capital; inventories; financial wealth; and net worth.

Inside wealth versus outside wealth

It is often useful to distinguish among types of sectors in the economy. The most basic

distinction is between the public sector (including all levels of government) and the domestic

private sector (including households and firms). Note here we are simplifying by excluding the

foreign sector as if the economy was completely closed to trade and capital flows.

If we were to take all of the privately-issued financial assets and liabilities, it is a matter of logic

that the sum of financial assets must equal the sum of financial liabilities. In other words, net

financial wealth would have to be zero if we consider only private sector IOUs. This is

sometimes called ‘inside wealth’ because it is ‘inside’ the private sector. In order for the private

sector as a whole to accumulate net financial wealth, it must be in the form of ‘outside wealth’,

that is, financial claims on another sector. Given our basic division between the public sector and

the domestic private sector, the outside financial wealth takes the form of government IOUs. The

private sector holds government currency (including coins and paper currency) as well as the full

range of government bonds (short term bills, longer maturity bonds) as net financial assets,

which is a portion of its positive net wealth.

Net private financial wealth equals public debt. Recall from our discussion above that

accumulation of stocks requires flows. The private sector accumulation of net financial assets

over the course of a year is made possible only because its spending is less than its income over

that same period. In other words, it has been saving, enabling it to accumulate a stock of wealth

in the form of financial assets. In our simple example with only a public sector and a domestic

private sector, these net financial assets are government liabilities—government currency and

government bonds. These government IOUs, in turn, can be accumulated only when the

government spends more than it receives in the form of tax revenue. This is called a ‘government

deficit’, which is the flow of government spending less the flow of government tax revenue

measured in the money of account over a given period (usually, a year). This deficit accumulates

to a stock of government debt—equal to the private sector’s accumulation of financial wealth

over the same period.

A complete explanation of the process of government spending and taxing will be provided in

Chapter 13. What is necessary to understand at this point is that the net financial assets held by

the private sector are exactly equal to the net financial liabilities issued by the government in our

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two-sector example. If the government spending always equals its tax revenue, the private

sector’s net financial wealth would be zero.

Rest of world debts are domestic financial assets. We can broaden our analysis by considering

the financial assets and liabilities of the rest of the world. So we now form three sectors in this

open economy: a domestic private sector, a domestic public sector, and a ‘rest of the world’

sector that consists of foreign governments, firms, and households. In this case, it is possible for

the domestic private sector to accumulate net financial claims on the rest of the world, even if the

domestic public sector runs a balanced budget, with its spending over the period exactly equal to

its tax revenue. The domestic sector’s accumulation of net financial assets is equal to the rest of

the world’s issue of net financial liabilities. Finally, and more realistically, the domestic private

sector can accumulate net financial wealth consisting of both domestic government liabilities as

well as rest of world liabilities. It is also possible for the domestic private sector to accumulate

government debt (adding to its net financial wealth) while also issuing debt to the rest of the

world (reducing its net financial wealth). In the next section we turn to a detailed discussion of

sectoral balances.

Non-financial wealth (real assets)

One’s financial asset is necessarily offset by another’s financial liability. However, real assets

represent one’s wealth that is not offset by another’s liability, hence, at the aggregate level net

wealth equals the value of real (non-financial) assets. To be clear, you might have purchased an

automobile by going into debt. Your financial liability (your car loan) is offset by the financial

asset held by the auto loan company. Since those net to zero, what remains is the value of the

real asset - the car. In most of the discussion that follows we will be concerned with financial

assets and liabilities, but will keep in the back of our minds that the value of real assets provides

net wealth at both the individual level and at the aggregate level. Once we subtract all financial

liabilities from total assets (real and financial) we are left with non-financial (real) assets, or

aggregate net worth.

5.4 Integrating NIPA, Stocks, Flows and the Flow of Funds Accounts

The sectoral balances framework, which is derived from the national accounts framework, was

explored in Section 5.2. It is intrinsically linked to the flow of funds analysis. They are different,

but related, ways of considering national economic activity.

An early exponent of the flow-of-funds approach, Lawrence Ritter (1963:220) wrote that:

The flow of funds is a system of social accounting in which (a) the economy is divided

into a number of sectors and (b) a ‘sources- and-uses-of-funds statement’ is constructed

for each sector. When all these sector sources-and-uses-of-funds statements are placed

side by side, we obtain (c) the flow-of-funds matrix for the economy as a whole.

Thus, the flow-of-funds accounts allow us to link a sector’s balance sheet (statements about

stocks of financial and real net wealth) to income statements (statements about flows) in a

consistent fashion. In a monetary economy, flows of expenditures measured in terms of dollars

spent over a period involve transactions between sectors in the economy, which also have logical

stock counterparts, that is flows feed stocks. The flow-of-funds accounts ensure that all of these

transactions are correctly accounted for.

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This approach underpinned the work of the so-called New Cambridge approach that was part of

the Cambridge Economic Policy Group at the University of Cambridge in the early 1970s. Key

members of this group were Martin Fetherston, Wynne Godley and Francis Cripps, all of who

were of a Keynesian persuasion.

While the sectoral balances approach had been understood much earlier (for example, by

Nicholas Kaldor and others), it was popularised by the New Cambridge macroeconomic analysis

which introduced the concept of the Net Acquisition of Financial Assets (NAFA) into the

forefront of its Keynesian income-expenditure model (see below).

Like Lawrence Ritter, the Cambridge economists were interested in tracing the flow of funds

between the different sectors of the economy, which they divided into the government sector; the

private domestic sector and the external sector, as outlined above. These transactions have

occurred in a given period, and these sectors could record a financial deficit or surplus.

We can re-write Equation (5.5) as follows:

(5.5) (S – I) = NAFA = (G – T) + CAB

(S – I) is the private domestic financial balance or NAFA of the private domestic sector. The

private domestic sector is in financial surplus (deficit) when its disposable income (GNP - T)

exceeds (is less than) its spending on consumption goods and investment goods.

From a stock perspective, NAFA can also be measured by the difference between the private

domestic sector’s stock of net financial assets at time t and the stock at time t-1, where t could be

2016, so that t-1 would be 2015.

Noting the stock/flow distinction, Equation (5.5) can be interpreted as meaning that if its right

hand side is positive, government sector deficits (G – T > 0) and current account surpluses (CAB

> 0) generate national income and additional net financial assets for the private domestic sector.

Then NAFA>0, which means that the private sector is running a surplus, and acquiring new

assets and/or reducing its existing debt obligations, whereas the government financial balance is

negative.

Conversely, fiscal surpluses (G – T < 0) and current account deficits (CAB < 0) reduce national

income and undermine the capacity of the private domestic sector to net save and add to its stock

of net financial assets. In this case NAFA<0, so that the private domestic sector is running down

its net financial position by borrowing from the other sectors and/or by liquidating some of its

stock of accumulated wealth.

If G – T < 0, then the government sector is spending less than it is taking out of the economy in

taxation and undermining the capacity of the other two sectors to accumulate net financial assets

by running surpluses and vice versa.

CAB is the external sector financial balance (the Current Account Balance) and comprises the

trade balance (that is, the difference between export and import revenue on goods and services)

and the net income flows that accrue to residents as a consequence of interest and dividends

received on overseas ownership (offset by similar payments to foreigners).

If the overall external sector balance is in deficit then the national economy is borrowing from

abroad or running down its net financial position in other ways and foreigners are accumulating

financial asset claims and vice versa.

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Equation (5.5) can also be written as:

(5.6) [(S – I) – CAB] = (G – T)

where the term on the left-hand side [(S – I) – CAB] is the non-government sector financial

balance and is of equal and opposite sign to the government financial balance, T - G.

This is the familiar Modern Monetary Theory (MMT) conclusion that a government sector

deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).

MMT adopts the same interpretation of these balances as the New Cambridge approach, but

when applied to the government sector, any conclusion is somewhat meaningless other than in a

purely accounting sense.

Importantly, transactions within the private domestic sector do not alter the net financial position

of the sector overall. For example, if a bank creates a loan for one of its customers then its assets

rise but on the other side, the liabilities of the customer increases by an equal amount – leaving

no change in the net position of the sector.

The only way the private domestic sector can increase its net financial assets is through

transactions with the government or external sector – for example, by acquiring a government

bond or buying a foreign government bond (or a foreign corporate bond). These two points are

key MMT insights.

Once we understand the interlinked nature of the three sectors then it is a simple step to realise

that if one sector has improved its position by the net acquisition of financial assets, following a

financial surplus, at least one other sector must have reduced its net financial assets or run a

financial deficit.

The flow-of-funds framework allows us to understand that the funds a particular sector receives

during a period from current receipts, borrowing, selling financial assets, and running down cash

balances have to be equal to the total of its current expenditures, capital expenditures, debt

repayments, lending, and accumulation of cash balances. The approach clearly allows us to trace

the uses and sources of funds for each sector.

It should be emphasised that the flow-of-funds approach is based on accounting principles rather

than being a behavioural (theoretical) framework for understanding the factors, which explain

why these flows occur. Relatedly, there are no insights into the adjustment processes that govern

the change in net financial assets in each sector.

That is not to be taken as a criticism of the approach – it is merely an observation. It also doesn’t

reduce the utility and insights that the approach provides. Often economists like to denigrate

analyses that manipulate accounting identities as if they are too low brow. But any approach is

valuable if it provides useful ways of thinking.

Causal relationships

From the discussion above, it is clear that a non-government surplus is the same thing as a saving

flow and leads to the net accumulation of financial assets. By the same token, a deficit reduces

net financial wealth. If the private domestic or external sector runs a deficit, it must either use its

financial assets that have been accumulated in previous years (when surpluses were run), or it

must issue new IOUs to offset its deficits. The sector ‘pays for’ its deficit spending by selling

assets and reducing its bank deposits (‘dis-saving’), or it borrows (issues debt) to obtain bank

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deposits. Once it runs out of accumulated assets, it has no choice but to increase its indebtedness

every year that it runs a deficit. On the other hand, if the external or private domestic sector runs

a surplus then it will be accumulating net financial assets. This will take the form of financial

claims on at least one of the other sectors.

As we will discuss later, it is misleading to apply terminology such as ‘dis-saving’ or

‘borrowing’ to the sovereign government, which issues the currency.

While we have identified an accounting relationship between the sectoral balances, we can say

something about causal relationships between the flows of income and expenditure and the

impact on stocks.

Individual spending is mostly determined by income. For the individual, it is plausible to argue

that income 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 runs from income to spending even if the

correspondence between the two flows is not perfect.

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

by running a deficit, it can issue liabilities to finance purchases. Another household or firm will

accumulate these liabilities as net financial wealth. Alternatively, they might allow the

government to run a fiscal 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.

So ‘it takes two to tango’. However, the decision to deficit spend 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, such as a bank through the creation of a loan.

In the case of a sovereign government, there is a special power - the ability to tax, that guarantees

that households and firms will want to accumulate the government’s debt. We conclude that

while causation is complex, it tends to run from individual deficit spending to accumulation of

financial wealth, and from debt to financial wealth. Since the accumulation of a stock of

financial wealth results from a surplus, that is, from a flow of saving, we can also conclude that

causation tends to run from deficit spending to saving. At the sectoral, rather than individual,

level the same principles apply. Thus, 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.

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 above, spending is not necessarily constrained by income because

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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.

In MMT, we differentiate between horizontal and vertical transactions within the economy.

Horizontal transactions occur between people and firms within the non-government sector (for

example, purchases of goods and services, borrowing from banks). Vertical transactions occur

between the government sector and the non-government sector (for example, government

spending and taxation).

Horizontal transactions do not add to the stock of net financial assets held by the non-

government sector. 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

above, 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. Likewise if households choose

to deficit spend, that is, spend more than their flow of annual income, then they may secure bank

loans. In this case the net asset position of the private sector is unchanged. These are horizontal

transactions.

However, if the domestic private sector taken as a whole spends more than its income, it must

issue ‘outside debt’ held as ‘outside wealth’, which would be held by the foreign sector, but the

stock of net financial assets held by the non-government sector (private domestic plus foreign) is

again unchanged, since these are horizontal transactions.

The initiating cause of the private sector deficit is assumed to be a desire to spend more than

income, so the causation mostly goes from deficits to surpluses and from debt to net financial

wealth. While we recognise 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.

Vertical transactions do add to the stock of net financial assets held by the non-government

sector. On the other hand, assume that a fiscal deficit occurs (perhaps as a result of increased

government spending), and for simplicity the CAB is zero, then the private sector achieves a net

increase in its stock of financial assets. This transaction between the government and private

sector is referred as a vertical transaction and, in this instance, leads to an increase in net

financial assets held by the non-government sector. On the other hand, if the government runs a

fiscal surplus (by taking net spending out of the economy), with the CAB zero, the non-

government sector (specifically the private sector) suffers a loss in its net holdings of financial

assets.

In this section, we demonstrate how a flow-of-funds approach to the analysis of monetary

transactions highlights both the importance of the distinction between and vertical and horizontal

transactions and the fundamental accounting nature of the so-called government ‘budget’

constraint (GBC) identity, which we will refer to as the government fiscal constraint.

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5.5 Balance Sheets

Following Ritter, we can present a very simple ‘generalised balance sheet’, which would apply to

any sector, as being depicted in the following T-account, Figure 5.2

Several points are worth noting. Real assets are treated differently to financial assets because

they only appear on the balance sheet of the owner. Financial liabilities are different because

their existence as debt (to some other sector) means they will be matched by a financial asset on

at least one other sector’s balance sheet.

Financial assets denote monetary amounts owned by that sector, which by the same logic as

before means that there will be a matching liability on at least one other balance sheet within the

system.

When we consider the monetary system as a whole, we conclude that financial assets and

financial liabilities net to zero – that is, the total value of the financial assets equals the total

value of outstanding liabilities.

The accounting also tells us that for the overall economy, net worth equals to monetary value of

the real assets in the economy

Figure 5.2 A stylised sectoral balance sheet

Assets Liabilities and Net Worth

Financial assets:

1. Money

2. Other

Liabilities

Real assets Net worth

∑ ∑

The balance sheet depicts stocks but we can easily see how they might provide us with

information about flows, in the way the national accounts does. A stock is measured at point in

time (say, the end of the year) whereas flows measure monetary transactions over a period (say, a

year).

If we examine the difference between a balance sheet compiled at say December 31, 2015, and a

balance sheet compiled at December 31, 2016, we will be able to represent the information in the

balance sheet about assets, liabilities and net worth as flow data.

Consider Figure 5.3 (where the Δ symbol refers to changes over the period concerned). Now the

entries in the T-account denote uses and sources of funds (that is, flows) over the period of

interest. There are two components, one relates to financial assets and the other real assets and

net worth.

A given sector (for example, household, firm, government) can obtain funds by increasing their

liabilities by borrowing and incurring debt (ΔL). They can apply those funds to accumulating

more financial assets (ΔFA) or building cash balances (ΔM).

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Figure 5.3 A uses-and-sources-of-funds statement

Uses Sources

Δ Financial assets (lending) Δ Liabilities (borrowing)

Δ Money (cash balances)

Δ Real assets (investment) Δ Net worth (saving)

∑ ∑

If we wanted to complicate matters we could decompose ΔFA, ΔM and ΔL further, by

recognising that a given sector can also sell existing financial assets or run down cash balances to

obtain new funds. Similarly, it might use funds to reduce liabilities (pay down debts). So the

entries in Figure 5.3 are to be considered net transactions.

The second source and use of funds for a sector relates to changes in Real assets (ΔRA) and the

change in net worth (ΔNW) over a given period.

In the national accounts framework (see Chapter 4), we considered the division between the

capital account and the current account, where the former related to investment in productive

capacity and the latter referred to recurrent spending and income. The capital account measured

transactions, which change the real assets held and the net worth of the economy.

What do we mean by a change in real assets? In the national accounts, we considered gross

capital formation or investment, which is defined as expenditure on productive capital goods (for

example, plant and equipment, factories). This is a use of funds by firms in the current period.

Depreciation represents the difference between gross and net investment. For now though we

abstract from that real world complexity.

Finally, we consider the change in net worth for a sector in a given period is the residual after all

the uses and sources of funds have been accounted for. From an accounting perspective, net

worth is equal to the difference between total assets and total liabilities.

It follows that a change in net worth over the period of interest is equal to the difference between

the change in total assets and the change in total liabilities. If total assets increase by more

(decrease by less) than total liabilities increase (decrease) then the net worth of the sector has

risen.

Another way of thinking about the change in net worth, which is a flow of funds, is to link it to

the national accounts concept of saving.

In the national accounts framework, we consider household saving, for example, to be the

difference between consumption (a use) and disposable income (a source). This concept

generalises (with caution) to the statement that the surplus of a sector is the difference between

its current revenue and its current expenditure.

What happens to the flow of surplus funds? If the current flow of income is greater than the

current expenditure, then at the end of the period, the sector would have accumulated an

increased stock of total net assets – either by increasing the actual assets held and/or reducing

liabilities owed.

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The surplus between current income and current expenditure has to be matched $-for-$ by an

increase in the stock of total net assets. We have already discussed total net assets above but in

different terms.

We defined the change in net worth over a period as the difference between the change in total

assets and the change in total liabilities. That difference is exactly equal to the surplus of current

income over current expenditure.

Thus, from an accounting perspective, we can consider saving to be the change in net worth over

a period.

Figure 5.3, however, only implicitly includes the current account transactions – the flow of

current income and expenditure – inasmuch as we have defined the change in net worth (ΔNW)

to be the difference between the two current flows.

The simplicity of Figure 5.3, however, makes clear an essential insight – if a sector is running a

deficit (that is, it is spending more than it is earning or in the parlance used above, it is investing

more than it is saving) then it must obtain the deficit funds from its available sources:

 Increased borrowing

 Running down cash balances

 Selling existing financial assets

Conversely, a sector that it running a surplus (that is, it is spending less than it is earning or in the

parlance used above, it is investing less than it is saving) must be using the surplus funds to:

 Repay debt

 Build up cash balances

 Increase its financial assets (increasing lending)

We also have to be cautious in our terminology when considering the different sectors. If we are

considering the household sector, then it is clear that if they spend less than their income and

thus save, they are deferring current consumption in the hope that they will be able to command

greater consumption in a future period. The increase in their net worth provides for increased

future consumption for the household.

Similarly, for a business firm, if they are spending less than they are earning, we consider them

to be retaining earnings, which is a source of funds to the firm in the future.

We consider the private domestic sector as a whole (the sum of the households and firms) to be

saving overall, if total investment by firms is less than total saving by households. From the

national accounts, we consider that households save and firms invest.

However, in the case of the government sector such terminology would be misleading. If the

government spends less than they take out of the non-government sector in the form of taxation

we say they are running a fiscal surplus. A fiscal deficit occurs when their spending is greater

than their taxation revenue.

But a fiscal surplus does not increase the capacity of the sovereign government to spend in the

future, in the same way that a surplus (saving) increases the capacity of a household to spend in

the future.

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As we saw in Chapter 1, a sovereign, currency-issuing government faces no intrinsic financial

constraints, and can, at any time, purchase whatever is for sale in the currency that it issues. Its

capacity to do so is not influenced by its past spending and revenue patterns.

Figure 5.4 provides the most comprehensive framework for analysing the flow-of-funds because

it brings together the current transactions (income and expenditure), the financial transactions,

and the capital transactions that we have dealt with earlier. The capital and financial transactions

are captured in changes to the balance sheet (Figure 5.2).

Note when we talk about the sovereign government we are excluding the levels of government

that do not issue the currency. State and local governments are more like households or firms in

that respect, although they do have the capacity to tax and issue fines.

Figure 5.4 A complete sector uses-and-sources-of-funds statement

Uses Sources

Current expenditure

Δ Net worth (saving)

Current receipts

Δ Financial assets (lending) Δ Liabilities (borrowing)

Δ Money (cash balances)

Δ Real assets (investment) Δ Net worth (saving)

∑ ∑

The transactions above the dotted line comprise the income statement and record current

expenditure (uses). The balancing item above the dotted line constitutes the change in net worth

(ΔNW) or ‘saving’.

The changes in the balance sheet are shown below the dotted line and the balancing item is once

again, the change in net worth (ΔNW).

You can see that we could cancel out the change in net worth (ΔNW), which is the balancing

item in both the income statement and the change in the balance sheet. This would leave us with

the accounting statement that that sources of funds to a sector through current income and

borrowing must, as a matter of accounting, be used – for current expenditures, investment,

lending, and/or building up cash balances.

5.6 The Flow of Funds Matrix

The T-accounts tracing the sectoral sources and uses of funds can be summarised for all sectors

in the economy by the Flow-of-Funds Transactions Matrix, a stylised version of which is shown

in Figure 5.5.

The overriding accounting rule that governs the presentation of the flow-of-funds accounts is that

for the economy as a whole and for each sector in the economy the total sources of funds must be

equal to the total uses of funds. Remember that sources of funds provided by the various sectors

in the economy are used by those sectors.

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Figure 5.5 (taken from Ritter, 1963) shows three sectors and the total economy. At the most

aggregate level, the three sectors could be the private domestic sector, the government sector and

the external sector.

Figure 5.5 A stylised three sector flow-of-funds matrix

Sector A Sector B Sector C Total Economy

Flow U S U S U S U S

Saving (ΔNW)

Investment (ΔRA)

Lending (ΔFA)

Cash balances (ΔM)

Borrowing (ΔL)

For each period being accounted for, the statistician would record the flows of funds that related

to each of the row categories in the matrix. Most importantly, we have learned that for every

deficit sector, which saves less than it invests, there has to be offsetting surpluses in at least one

other sector.

Lawrence S. Ritter (1963:228-229) called the economy-wide flow-of-funds matrix:

… an interlocking self-contained system … [which] … shows, for a specified time period, the balanced sources-and-uses-of-funds statements for each sector, the

interrelations among the sectors, and the aggregate totals of saving, investment, lending,

hoarding, and borrowing for the economy as a whole. Any one sector may invest more or

less than it saves, or borrow more or less than it lends. However, for the economy as a

whole, saving must necessarily equal investment, and borrowing must equal lending plus

hoarding.

Thus a deficit sector, which saves less than it invests, must be offset by at least one other surplus

sector to net the flows to zero.

What are the practical uses of presenting economic data in this way?

Various uses can be made of the information provided in the flow-of-funds accounts.

The flow-of-funds accounts provide information of all financial flows within the economy on a

sector-by-sector basis. They allow researchers and policy makers to understand how funds flow

from one sector (say the household sector) through the banking system and onto final users by,

for example, firms engaged in productive investment.

They also allow researchers and policy makers to monitor major economic trends such as the

changing indebtedness of the sectors included and the sources of funding for the respective

sectors. For example, an understanding of the flow-of-funds accounts would have provided

insights into the growing indebtedness of the private sector prior the Global Financial Crisis in

2008 and perhaps, alerted policy makers to the likely financial instability arising from these

trends.

Economic researchers also use the flow-of-funds accounts to study saving patterns in the

economy. The accounts can tell us where the savings of a sector are being deployed. The

accounts can tell us which sector(s) are accumulating surpluses or deficits and the division

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between financial and real assets. They also allow us to understand patterns of gross capital

formation.

Economic researchers also use the flow-of-funds accounts to examine the dynamics of such

concepts as household wealth. We can learn how household balances sheets change over time

and how that wealth is composed. For example, one of the hallmarks of the period leading up to

the Global Financial Crisis in many countries was the shift in household wealth to riskier

categories, such as share holding sourced from margin loans. The shift in importance in overall

wealth from the more secure home mortgages to more risky sources of wealth was significant

because it exposed the economies to an increased risk of financial instability.

Finally, central banks use the flow-of-funds accounts to help them estimate the sensitivity of the

economy to changes in the availability of credit.

Flow of funds accounts and the national accounts

The flow-of-funds accounts complement the national accounts and the balance of payments

accounts, which are produced by national statistical agencies on a regular basis, as a way of

measuring economic activity in total and across the broad economic sectors.

We will consider the balance of payments accounts in Chapter 16.

There are important differences between the flow-of-funds accounts and the national accounts,

which can be summarised as:

 The national accounts contain no data pertaining to financial transactions – borrowing, lending or changes in cash balances. Only non-financial transactions are measured. The

flow-of-funds accounts fill that void.

 The national accounts focus on the current flows of final expenditure, output and income. As we saw in Chapter 4, transactions that involve so-called double counting or

intermediate transactions are excluded from the calculations of final expenditures. The

flow-of-funds accounts allow us to trace transactions involving assets that have been

created in past periods.

 The structure of the national accounts is such that consumer durable expenditure is included under current expenditure when conceptually it should be considered investment

activity. In the flow-of-funds accounts all sectors can invest and save.

Appendix

A graphical framework for understanding the sectoral balances

From Equation (5.4) we learned that the sum of the sectoral balances is zero as a matter of

accounting – so (I – S) + (G – T) + (X – M) = 0. We can construct an axis defining four

quadrants. Figure 5.6 depicts the government fiscal balance on the vertical axis and the external

balance on the horizontal axis.

So all points above zero on the vertical axis represent a government fiscal surplus (G < T) and all

points below zero on the vertical axis denote government fiscal deficits (G > T).

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Similarly, all points to the right of the zero line on the horizontal axis denote external surpluses

(X > M) and all points to the left of zero on the horizontal axis represent external deficits (X <

M).

Clearly, the origin of the axis denotes a position where all balances are equal to zero. From the

insight gained from Equation (5.4), we also know that when the private domestic balance is zero

(S = I), then the government fiscal deficit (surplus) has to equal the external deficit (surplus).

From Figure 5.6, the diagonal 45-degree line thus shows all combinations of government fiscal

balances and external balances where the private domestic balance is zero (S = I). We will refer

to this as the SI line.

We can use that knowledge to determine the segments of the diagram where the private domestic

balance is in surplus (S > I) and in deficit (S < I). To make it easier, we can express the sectoral

balances equation (5.4) in a different way:

(5.7) (S - I) = (G - T) + (X - M)

Equation (5.7) is just another way of expressing the accounting rule but in this case isolates the

private domestic balance on the left-hand side.

5.6 A graphical sectoral balances framework

Source: Parentau ?

Consider the orange dotted line A0B0 in Figure 5.6a, which cuts the horizontal axis where the

external deficit is 2 per cent of GDP. All points on that line segment correspond to a government

Fiscal Surplus

(G - T) < 0

Fiscal Deficit

(G - T) > 0

External Surplus

(X - M) > 0

External

Deficit

(X - M) < 0

Private

Domestic

Balance

(S = I)

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fiscal deficit of less than 2 per cent of GDP or a government fiscal surplus depending on which

side of the horizontal axis we are considering.

The private sector is in balance only at Point B0 where the budget deficit equals the external

deficit. So all points along A0B0 correspond to private domestic deficits (S < I).

Now consider the green dotted line A1B1, which cuts the horizontal axis where the external

surplus is 2 per cent of GDP. All points on that line segment correspond to a government fiscal

surplus of less than 2 per cent of GDP or a government fiscal deficit depending on which side of

the horizontal axis we are considering.

The private sector is in balance only at Point A1 where the budget surplus equals the external

surplus. So all points along A1B1 correspond to private domestic surpluses (S > I).

Now consider the blue dotted line A1A2. At Point A1, the private sector is in balance because the

budget surplus equals the external surplus.

Moving along A1A2 we encounter points where the external balance is less than the budget

surplus and thus have to correspond to a private domestic deficit (S < I).

Similarly, along B0B2, we move from a private sector balance at B0, to points where the external

deficit is less than the budget deficit, which means the private domestic balance will be in

surplus (S > I).

Figure 5.6a Deriving the private domestic sector balances

B1

A0 A

2 A1

B0 B2

-2 +2

Fiscal Surplus

(G - T) < 0

Fiscal Deficit

(G - T) > 0

External Surplus

(X - M) > 0

External Deficit

(X - M) < 0

Private

Domestic

Balance

(S = I)

-2

+2

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We can thus generalise this knowledge and conclude that all points above the 45-degree line on

either side of the vertical axis correspond to private domestic sector deficits and all points below

the 45-degree line on either side of the vertical axis correspond to private domestic sector

surpluses. Figure 5.6b renders this conclusion graphically.

Figure 5.6b Private domestic surpluses and deficits

This graphical framework thus allows us to examine the implications of different policy options.

For a sovereign, currency-issuing government any point in the four-quadrants is permissible.

With private sector spending and saving decisions combining with the flows of income arising

from trade with the external sector driving national income, the government sector can allow its

balance to adjust to whatever magnitude is required to maintain full employment and price

stability.

For example, if the external account was in deficit and the private sector was saving overall, then

the drain on aggregate demand would require the government to run a deficit of sufficient size to

ensure total spending was sufficient to absorb the real productive capacity available in the

economy.

Alternatively, the external account might be in surplus which would add to aggregate demand

while the private sector might be spending more than it is earning, that is, in deficit overall. In

these situations the government would have to ensure it ran a surplus of sufficient size to ensure

the economy did not overheat and exhaust its productive capacity.

The strong economy would be associated with robust tax revenue growth, which would help the

government achieve its surplus. Discretionary adjustments in spending and taxation rates might

also be required.

Fiscal Surplus

(G - T) < 0

Fiscal Deficit

(G - T) > 0

External

Surplus

(X - M) > 0

External

Deficit

(X - M) < 0

Private Domestic

Balance

(S = I)

Private Domestic

Surplus

(S – I) > 0

Private Domestic

Deficit

(S – I) < 0

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But while any point would be permissible, we know that the private sector cannot sustain deficits

permanently. This is because the flows of spending which deliver deficits have to be funded. As

we learned in the earlier section of this Chapter when we considered the flow of funds, private

deficits ultimately manifest in an increasing stock of debt being held on the private sector’s

balance sheet.

This process of debt accumulation is limited because at some point the susceptibility of the

balance sheet to cyclical movements (for example, rising unemployment) increases and the risk

of default rises. In some historical instances, this process has collapsed after serious debt defaults

occurred (for example, in the early months of the Global Financial Crisis in 2007-08). In other

times, the private sector starts to reduce the precariousness of its balance sheet by reducing

spending and increasing saving in order to bring the debt levels it is carrying down to more

sustainable levels.

In the long-term, the only sustainable position is for the private domestic sector to be in surplus.

An economy can absorb deviations around that position but only for short-periods.

Figure 5.7 shows what we might define as the sustainable space available to governments that

issue their own currency. Note this excludes permanent private sector deficits, which are

unsustainable.

Figure 5.7 Sustainable space for sovereign governments

Fiscal Surplus

(G - T) < 0

Fiscal Deficit

(G - T) > 0

External Surplus

(X - M) > 0

External Deficit

(X - M) < 0

Private

Domestic

Balance

(S = I)

Modern Monetary Theory and Practice: An Introductory Text

William Mitchell, L. Randall Wray and Martin Watts

103

Now imagine that the government is forced to operate under a fiscal rule that bans fiscal deficits

greater than 3 per cent of GDP as shown by the red line in Figure 5.8. The formation of the

European Monetary Union introduced just such a fiscal rule under its’ Stability and Growth Pact.

The aim was to restrict the capacity of each member state to run government budget deficits.

We now must consider what the fiscal rule means for both permissible and sustainable spaces

available to a macroeconomic policy maker.

Clearly any point above the 3 per cent of GDP fiscal deficit line in Figure 5.8 is permissible.

However, using the same logic as before, the sustainable space requires that the private domestic

sector be in surplus overall, even though short-term deviations from this status can occur from

time to time.

Figure 5.8 shows the sustainable space for such an economy (the combination of red and blue

areas). The blue-shaded area shows the sustainable space available to policy makers in nations

that run external surpluses. The red-shaded area shows the sustainable space available to policy

makers in nations that run external deficits.

Thus the policy space that governments have to operate within when fiscal rules are imposed is

very limited relative to the options available to a sovereign, currency-issuing government, which

operates without any direct quantitative restrictions on the deficits they can run.

Figure 5.8 Sustainable space for governments constrained by fiscal rules

Fiscal Surplus

(G - T) < 0

Fiscal Deficit

(G - T) > 0

External Surplus

(X - M) > 0

External Deficit

(X - M) < 0

Private

Domestic

Balance

(S = I)

-3% Fiscal Rule:

Fiscal deficit LESS

THAN 3 per cent of GDP

Modern Monetary Theory and Practice: An Introductory Text

William Mitchell, L. Randall Wray and Martin Watts

104

Why is this important? A rule-free government can always utilise the available space to ensure

aggregate demand is sufficient to maintain full employment and price stability.

By definition, not every nation can run an external surplus because a surplus has to be matched

by a deficit or deficits in other nations. While the external surplus nations have more policy

flexibility when operating under a fiscal rule of the type shown in Figure 5.8, it still remains that

the allowable fiscal deficits may be insufficient to maintain the aggregate demand necessary to

sustain full employment.

The policy inflexibility facing nations which run external deficits and simultaneously have to

operate under fiscal rules as shown in Figure 5.8 become even more restrictive, as shown by the

small red triangle. When such an economy experiences a negative economic shock which leads

the private sector to seek to reduce its spending and target a sectoral surplus, the extent to which

the fiscal deficit can move to absorb the loss of overall aggregate demand is very limited.

It is highly likely that such an economy will experience enduring recessions as a result of the

artificial fiscal rules (restrictions) that are placed on the government. Note that such a situation is

representative of Greece and some other Mediterranean European nations.

The sustainable goal for a government should be to maintain full employment and price stability

and allow its fiscal balance to adjust accordingly to ensure aggregate demand is consistent with

those goals. A sovereign, currency-issuing government can always meet those goals if it chooses.

However, the imposition of fiscal rules restricts the government from achieving these goals and

makes the fiscal outcome the goal rather than the more significant macroeconomic goals of full

employment and price stability.

The lesson is that the government should never specifically target any particular fiscal outcome,

but rather, should target employment growth and price level stability.

References

Australian Bureau of Statistics (ABS) (2014) Australian System of National Accounts:

Concepts, Sources and Methods, ABS: Canberra.

OECD (2015) Organisation for Economic Co-operation and Development, Economic outlook

annex tables. Available at: http://www.oecd.org/eco/outlook/economicoutlookannextables.htm

(accessed 1 October 2015).

Parentau (year) ??? see Appendix figure 5.6 p22

Ritter, L.W. (1963) “An Exposition of the Structure of the Flow-of-Funds Accounts”, The

Journal of Finance, 18(2), May, 219-230.

Watts, M.J. and Sharpe, T.P. (2016) Sustaining Surpluses: Prospects and Implications, mimeo,

The University of Newcastle, NSW, January.

Wray, L.R. (1999) Surplus mania: A reality check, Levy Economics Institute, Policy Note 3,

available: http://www.levyinstitute.org/pubs/pn99_3.pdf.