Highlights of part I – Macro Fundamentals

In the first part of this seminar we begin by defining what heterodox economics is and how it differs from the orthodox approach.
We then introduce a fundamental approach that allows to consistently explain macroeconomics fluctuations: the sectoral balances approach. We divide the economic system into 3 sectors (Private, Public and Foreign) and analyse how they work and interact with each other.


Orthodox and Heterodox

The first step of this seminar is to clarify what heterodox economics is and how it differs from the orthodox approach.

Orthodox macroeconomics identifies the most recent and dominant theories or school of thought, the predominant approach to economics followed by the mainstream. I will hereafter use the terms orthodox and mainstream as surrogate.

Today the orthodox macroeconomics approach is the Neoclassical Economics. You all have come across it; starting from schools, throughout universities and work places. It is likely to be the only macroeconomic approach you ever heard of.

Orthodox economics in one sentence:

The study of allocation of scarce resources among unlimited wants.

The foundations of orthodox economics:

  • Natural (individualistic) human behaviour.
  • Individuals are rational: maximise own utility under constraints, they only care about their own pleasure and disregard other individuals.
  • Equilibrium: set of prices that clear the markets; these prices
    constitute an invisible hand that leads individuals toward
    maximum utility.
  • Trade-off in resources allocation.
  • Government has secondary or no role: its only purpose is to provide what the free market cannot, like military defence.

Heterodox economics, although being the key for understanding modern economies, is all but mainstream and probably you never heard much about it.

Heterodox economics in one sentence:

The study of social creation and social distribution of society’s
resources.

The foundations of heterodox economics:

  • Social human behaviour: cooperation is key to survival
  • Equilibrium: prices reflect many non-rational and non-economic
    factors
  • Resources are socially created and distributed
  • The government has a central role

An overview of relative macroeconomics theories.

Orthodox economics

  • Neoclassical/Marginalist approach
    • New Classical (Lucas, Phillips, 40s)
    • Real Business cycle (Chicago school, 80s)
    • Supply side economics (M. Thatcher, R. Regan)
    • Austrian school (F. Hayek, L. von Mises)
  • Neoclassical Keynesian 
    • New Keynesian (P. Samuelson, R. Solow)
    • New Monetary Consensus (M. Friedman)

Heterodox economics

  • Institutionalist (T. Veblen, J. T. Commons, J. K. Galbraith)
  • Keynes and Post-Keynes (M. Kalecki, J. Robinson, P. Davidson, H. Minsky, J. Kregel)
  • Marx approach (K. Marx, V. Lenin, M. H. Dobb, P. Sweezy)

The macroeconomic sectors

You, as an individual or a firm are part of a macroeconomic system. Every economic decision (spending, saving, borrowing money, travel around the world, etc…) you take has a direct effect on this system and the other individuals co-existing in it. The same applies for all other physical persons or institutions existing, operating and interacting in this macroeconomic system, their economic decisions will affect you.

Let’s pick a country of residence (you have to live somewhere) and start defining this macroeconomic environment.

Let’s say you are in Ireland (you can pick any country, the same reasoning applies), your macroeconomic environment is built on 3 main sectors:

  1. domestic public sector
  2. domestic private sector
  3. foreign sector

The domestic public sector contains all the domestic government entities, hence the central government (the State), the local governments (regions, provinces and municipalities) and the public authorities (profit and non-profit organisations owned and run by the government).

The domestic private sector contains everything which is not public, and so we have households, firms and private non-profit organisations.

All public and private entities outside the domestic space belong to the foreign sector, or rest of the world.

The macroeconomic sectors:

  • Domestic public sector
    • Central government
    • Local government
    • Public authorities/agencies
  • Domestic private sector
    • Households
    • Firms
    • No-profit organisations
  • Foreign sector
    • Import/Export from/to foreign entities, private and public

The environment built upon these 3 sectors is nothing less than the Planet Earth. This system is therefore closed because, as far as I know, we don’t have ongoing economic relationship with any other planet in or outside the solar system.

In this closed system everything that moves from one sector has to go at least to one of the other two, if one sector is giving at least one of the other is receiving. If one is winning, by identity, at least one of the other two is losing. If none is winning then none is losing either.

One sector loss corresponds to a win for at least one of the other two.

sectors_base2

The figure above gives you a visual idea of the 3 sectors system. Every entity or transaction that exists or is produced on this planet, the Earth, must belong to at least one sector.

Think about the game Monopoly played by several opponents (I will use Monopoly few times to exemplify macroeconomic concepts).

During the game, the players compete against each other and they all compete against the Bank.

In this case the players are the domestic private sector while the Bank is the domestic public sector.

When the game starts the players and the Bank have an initial stock of “wealth” and while the game progresses that wealth will be exchanged within players and between the players and the bank.

The players decisions will cause certain exchanges of wealth both within the players and/or between players and bank.

Every time players lend on each other lands or station they transfer a certain amount of wealth (money) to each other; the wealth is only transfer within players nothing goes to the bank and nothing comes from it.

Players will also exchange wealth with the bank, for instance when receiving $200 when passing “Go”, or having to pay a fine when getting out from jail.

The domestic private sector, hereby represented by the players cannot produce wealth, it can only move around the same amount of existing wealth. How can the players, hence the private sector increase the total amount of wealth? There is only solution, they need the bank, hereby representing the domestic public sector to lose some of its wealth.

The players cannot accumulate money if the bank doesn’t lose some of them.

This happens for instance every time the players receive their $200 as the pass “Go”; the bank loses 200 and the players gain 200.

Remember the system is closed every flow from one sector has to go to the other sector; one’s win corresponds to someone else’s loss.


Gross Domestic Product

We have introduced what the macroeconomic sectors are and the way they interact through wealth exchanges.

We now need to move from an abstract 3 sectors system to the real world by quantifying their respective wins and losses, and for doing that we need an indicator, a measure of the wealth and income of a country, the Gross Domestic Product.

The Gross Domestic Product (GDP) is the most common indicator used to measure the output, or the aggregate income, of a country.

There are 3 different approaches for calculating the GDP:

  • Expenditure approach: Sum of all expenditures by the different economic sectors
  • Production approach: Sum of the total value of all the economic outputs after deducting the cost of intermediate goods
  • Income approach: Sum of the income earned by all the factors of production

We will combine the expenditure and income approach in order to derive the balance of each of the 3 sectors, namely the sectoral balances.

Following the expenditure approach, GDP is obtained as a sum of 5 principal components:

  • Consumption
  • Investment
  • Government Expenditure
  • Export
  • Import

GDP expenditure ⇒ GDP = C + I + G + X – M 
= Consumption + Investment + Government Expenditure + Export – Import

This relation states that the total national income (GDP) is equal to the sum of final consumption expenditure (C), total private investment (I), total government expenditure (G) and net export (X-M).

From the income approach, we learn that GDP (national income) can be used for:

  • Consumption
  • Saving
  • Tax payment

GDP income ⇒ GDP = C + S + T = Consumption + Saving + Tax payment

By equating the two GDP definitions, GDP expenditure = GDP income, we get:

C + S + T = C + I + G + X – M

And after rearranging the terms (C is cancelled out):

T – G + S – I + M – X = 0

We now proceed to assign each portion of the GDP to each sector of the economy. Each sector has its own balance identity, with relative outflows and inflows, defined in GDP terms.

The 3 fundamental balance identities:

Domestic public balance
Public revenue – Public expenditure →T – G

Domestic private balance
Private Saving – Private Investment →S – I

Foreign Balance
Import – Export →M – X

We can rewrite these 3 balance identities as follows, they are equivalent:

Government Net Lending ⇒ (G – T)
When the public sector expenditure (G) is higher than its revenue (T) the public sector is lending to either the private or the foreign sector, or both.
In case T is higher than G than the public sector is borrowing instead.

When the domestic public sector is a net lender it is in deficit while it is in surplus when it is net borrower.

Private Sector Net Financial Wealth ⇒ (S – I)
When the aggregate saving is higher then the aggregate investment the private sector is having a surplus of financial wealth, net accumulation of financial wealth.

Foreign Net Lending ⇒ (X – M)
When the export of a country exceeds the import it means that the foreign sector is lending hence it is in deficit with our domestic country.

The figure below gives you an idea on how the different flows move between the 3 sectors.

sectors_flow
Flows between the 3 sectors

For the public sector, G is a wealth outflow (public spending) while T is an inflow (tax income, public revenue).

Import (M) and export (X) are respectively a financial inflow and outflow for the rest of the world.

Saving (S) and Investment (I) are endogenous to the private sector. This essentially means that the private domestic sector cannot accumulate financial wealth without the public and/or foreign outflows (we will deepen this concept in the coming paragraphs). What the private sector can do is to move wealth from one individual to another so that the internal distribution of wealth changes but the aggregate wealth remains the same, unless either the public or the rest of the world put more into it.

Let’s clarify this last paragraph by resuming our Monopoly game with a twist so that we can introduce the foreign sector.

We have seen that the private sector represented by the players cannot increase its wealth without the external injection from the public sector (namely the bank).

As the game goes on, the players will keep exchanging wealth between them, some will increase the amount of money he has got (hence increasing saving, S) and some will decrease his saving every time he has to pay.

If someone picks an unlucky card from the community chest or ends up in jail he will have to transfer a certain amount of money to the bank, he will be actually paying a tax (T); but when he, for instance, passes “Go” he will instead receive money from the public sector (G).

In order to introduce the foreign sector we need a twist in the Monopoly rules.

Imagine if the players mentioned above are playing in the same room with other 250 groups of players, each group with its own game board.

If we allow the different groups to interact with each other, then we have included the foreign sector in our game (we have opened our economy…). We can for instance allow players to buy lands, to receive $200 or to pay jail fines from/to other boards. 

With this new rules the players may end up buying a land from another group of players allowing them to receive money every time someone from the other group lend on an occupied land. This twist opens up the possibility to increase the aggregate players’ wealth not only by injection of their domestic public sector (the bank of their board) but also by inflows coming from the domestic or public sectors of other game boards (namely the foreign sector). You can see this a sort of export (X).


Sectoral Balances and Stock-Flow consistency

The relations between the balances of the 3 sectors are the key to consistently understand the fluctuations occurring in the economic system.

godley
Wynne Godley

A Sectoral Balance model formalises the relations between the 3 balances and their impacts on the whole macroeconomics system. The pioneer works on this approach were undertaken by Wynne Godley. Today this approach is widely recognised (from left to right) and exploited by major financial actors, Goldman Sachs is one of them.

As we saw in the previous paragraph, domestic public, domestic private and foreign sector, form the whole macroeconomic system. This system as whole, is closed and every outflow of one sector corresponds to the inflow of (at least) one of the other two.

It follows that the sum of the 3 sector balances is equal to 0; due to the system being closed, at a global level all outflows and inflows must sum to 0.

Hence,

Domestic Private Balance + Domestic Public Balance + Foreign Balance = 0 ,

which is equivalent to:

Government Net Lending + Private Sector Net Financial Wealth + Foreign Net Lending = 0 ,

or:

Domestic Public Deficit + Domestic Private Surplus + Foreign Deficit = 0 ,

and in GDP terms:

(G – T) + (S – I) + (X – M) = 0.

From this simple relation we get 3 fundamental conclusions:

  1. The public deficit is equal to the private sector surplus plus/minus the foreign balance.
  2. If the government deficit increases the private net financial wealth also increases.
  3. A government running a deficit allows the private sector to accumulate financial wealth.

For the sake of simplicity, let’s consider a foreign sector in balance (X-M = 0) and focus on the relation government deficit – private surplus: (G – T) = (S – I).

The public deficit (G – T) is equals to the private sector surplus (S – I). If the government deficit increases the private net financial wealth also increases.
A government running a deficit allows the private sector to accumulate net financial wealth.

The private sector cannot create financial wealth without an exogenous injection that can come either from the government sector or the foreign sector (or the government sector only in case of a closed economy). You may object that this is not true since an individual can sell a good and receive money or borrow money, in both cases he is increasing his financial wealth. But this wealth increase is only limited to that individual, at aggregate level the amount of wealth remains untouched. If he sold a good, someone else must have bought it, likewise if he borrowed money some one must have lent it to him.

For every credit there has to be a debit as well as for every revenue there is an expense, so the private sector itself can just change the distribution of the same amount of financial wealth but not create new one. Credits and debits offset at aggregate level!


This is the financial side, the real side is a different story, you can always exchange goods-for-goods (barter) or (if you have the skills) you can do some enhancement to your house that can eventually increases its market value. In fact, after offsetting all the credits with all the debits what is left is the real value of all the assets of the private sector.

At aggregate level, as long as there is enough liquidity/financial wealth in the private sector an increase in the investment expenditure generates an increase in profits hence income, hence saving. In a situation where aggregate investment exceeds aggregate saving the private sector is short of financial wealth and only an expansive fiscal policy from the government can restore the equilibrium.


Private and public exogenous expenditures have different impacts on the sectoral balances. The same rate of growth in income has varying implications for the domestic private sector’s financial balance (saving minus investment or, equivalently, disposable income minus private spending) depending on the composition of the demand driving that growth. An increase in private investment pushes the private sector toward deficit. Even though the investment boosts income, saving will not rise as much as investment because of leakage to taxes and imports. In contrast, government spending adds income and saving for a given level of investment. An implication is that growth driven by private expenditure that occurs without compensating growth in government spending pushes the private sector into deficit except to the extent that net exports counter the effect.


An example on how the sectoral balances approach is recognise in the real world.

Here follows a statement from the Chief economist of global investment research at Goldman Sachs, you will notice that he is basically saying the same things that we went through so far.

Extract from Business Insider – Goldman’s Top Economist Explains The World’s Most Important Chart, And His Big Call For The US Economy
“…every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero. That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic
relationship is once you recognise that cyclical impulses to the economy depend on desired changes in these sector’s financial balances.”
Jan Hatzius – Chief economist of global investment research at Goldman Sachs

Full interview at Business Insider:
http://www.businessinsider.com/goldmans-jan-hatzius-on-sectoral-balar=US&IR=T&IR=T


If you notice in the title of the article, there is a mention to the “World’s Most Important Chart”, this chart is displayed below.
The graph is an empirical representation of the 3 balances identity (an represents an empirical proof of what we have learned so far):
the government deficit equals exactly the private sector surplus + the foreign surplus.

At each point in time the sum of the 3 balances is exactly 0, that’s why the graph resembles a mirror.

goldman_bal

From the Sectoral Balance model just introduced we can derive 5 fundamental macro-accounting principals:

  1. One’s Financial Asset is someone else Financial Liability:
    • For every financial asset there must be an offsetting financial liability. If someone has a debit there must be someone else who has a credit.
  2. Net financial wealth of the private sector (Inside Wealth) is zero:
    • Since every credit has an offsetting debit (and vice versa), the sum of all private sectors financial assets and liabilities has to be 0. This means that the private sector can not accumulate financial wealth without financial inflows from the public sector or the foreign sector (Outside Wealth).
  3. Private Net Wealth = Private Real Asset Value:
    • In the previous point we state the private sector inside financial wealth is 0, this does not mean that the private economy has no wealth at all. After offsetting financial assets and liabilities what is left it the Real economy.
  4. Net Private Financial Wealth = Public Debt:
    • The outside wealth provided by the Public sector allows the accumulation of (Private) financial wealth hence, contrary to what mainstream economics believes, the Public debt of the government is the private sector wealth.
  5. Foreign Liabilities are Domestic Financial Assets:
    • Together with the public sector, the foreign sector is also a source of Outside wealth.
sectors_wealth
Inside and outside wealth

Stocks and Flows

From the sectoral balances we know that an increase in the public sector deficit leads to an equal increase in the private sector surplus. The surplus allows the private sector to accumulate financial wealth.

Let’s put this in terms of stock and flows and explain it with an example.

flow_stock


Example:

A household has an income of 100$ per month and a spending of 90$.

Every month it has a balance surplus (income greater than spending) of 10$, if we hypothesise that income and spending are constant over the course of the year, the household has 10$ of saving flow each month.

At the end of the year the sum of all the monthly flows accumulates to a stock corresponding to the accumulated households’ financial wealth (1200$).

If the same household had a spending of 110$ instead, there would be the opposite effect: a monthly budget deficit would generate and indebtedness flow of 10$ that at the end of the year would reduce the financial wealth by the 1200$.


How can a sector run a deficit?

When domestic private individuals (households or firms) require funding for spending or investing and are short of money, they need to run a deficit.

They have got 2 options for running a deficit:

  • Run down accumulated financial assets →Dissaving
  • Acquire new IOUs*→ Borrowing

Both options will cause the private financial wealth to diminish. Either you borrow money from a bank or draw from your saving account your financial wealth decreases.

* An IOU, I-owe-you, is a financial liability, a debit.

Example:
Consider a situation where the public sector goes in surplus and the foreign sector remains in balance. By identity the private sector goes into deficit and it is forced to either:
→ draw from previously saved financial wealth and/or
→ borrow money


The figure below shows the possible equilibria in the economic system when the foreign sector is in balance. Since the sum of the 3 balances must always be 0, we can either have a situation when the public sector is in surplus and the private is in deficit (top-left) or vice-versa (top-right), it is clearly never possible to have both sectors in surplus or deficit (bottom).

sector_profit

There is actually a third plausible scenario that I didn’t specifically included here but still theoretically possible, the one where all the 3 sectors are in balance.


Continue to Part II – Money and Money Things:
In the next part, Money and Money Things, we start with the evolution of Money from primitive society to contemporary era (traditional and modern money view). This leads to a review of the main differences between Orthodox and Heterodox macroeconomics.
The last section focuses on the difference between Money and Money Things along side the different currency regimes.