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.
The macroeconomics sectors
The macroeconomics environment can be divided in 3 sectors:
- domestic public sector
- domestic private sector
- 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 (all 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, companies 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 macroeconomics sectors:
- Domestic public sector
- Central government
- Local government
- Public authorities/agencies
- Domestic private sector
- No-profit organisations
- Foreign sector
- Import/Export by foreign entities, private and public
The environment built upon these 3 sectors is nothing less than the Planet Earth. This system is therefore close because, as far as I know, we are not currently trading with any other planet of the solar system.
In this close system everything that moves from one sector has to go at least to one of the other two and if one sector is winning, by identity, at least one of the other two is losing.
One sector loss corresponds to a win for at least one of the other two.
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.
Gross Domestic Product
Now we move from an abstract 3 sectors system to the real world, and for doing that we need an indicator, a measure of the wealth and growth 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 to calculate 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 use the Expenditure approach.
GDP is obtained as a sum of 5 principal components:
- Government Expenditure
GDP = C + I + G + X – M
= Consumption + Investment + Government Expenditure + Export – Import
We now proceed to assign each portion of the GDP to each sector of the economy but before doing this we need to extract two terms from the simple formula above, Saving and Taxation.
G – T = S – I + M – X
Each sector has its own balance identity, with relative outflows and inflows, defined in GDP terms.
The 3 balance identities:
Domestic public balance
Public revenue – Public expenditure →T – G
Domestic private balance
Private Saving – Private Investment →S – I
Import – Export →M – X
We can rewrite these 3 balance identities as follows, they are equivalent:
Government Net Lending ⇒ (G – T)
Since the government expenditure (G) is higher than government 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 government is borrowing instead.
When the domestic public sector is a net lender it is in deficit while it is in surplus when it is borrowing.
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.
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.
The figure below gives you an idea on how the different flows move between the 3 sectors.
For the public sector, G is an outflow (spending) while T is an inflow (collecting).
Import (M) and export (X) are respectively a financial inflow and outflow for the foreign sector.
Saving (S) and Investment (I) are endogenous to the private sector. This essentially means that the non-public domestic sector cannot accumulate financial wealth without the public and/or foreign outflows (we will deepen this concept in the coming paragraphs).
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.
A Sectoral Balance model formalises the relations between the 3 balances and their impacts on the whole macroeconomics system. The pioneer work on this approach was conducted by Wynne Godley and today it is widely recognised and exploited by major financial actors, Goldman Sachs is one of them.
As we saw in the previous paragraph, the 3 sectors, domestic public, domestic private and foreign, compose the whole macroeconomics system. This system as whole, is close and every outflow of one sector corresponds to the inflow of (at least) one of the other two.
It follows than the sum of the 3 sector balances is equal to 0; at a global level all outflows and inflows sum to 0.
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 ,
Domestic Public Deficit + Domestic Private Surplus + Foreign Deficit = 0 ,
and in GDP terms:
(G – T) + (S – I) +(X – M) = 0 .
The public deficit is equal to the private sector surplus plus/minus the foreign balance.
If the government deficit increases the private net financial wealth also increases.
A government running a deficit allows the private sector to accumulate financial wealth.
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 recognize 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:
If you notice 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:
the government deficit equals exactly the private sector surplus + the foreign surplus.
At each time point the sum of the 3 balances is exactly 0, that’s why the graph resembles a mirror.
From the Sectoral Balance model just introduced we can derive 5 fundamental macro-accounting principals:
- 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.
- 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).
- 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.
- 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.
- Foreign Liabilities are Domestic Financial Assets:
- Together with the public sector, the foreign sector is also a source of Outside wealth.
Stocks and Flows
From the sectoral balances we know that the 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.
A household has an income of 100$ per month and a spending of 90$.
Every month it has a balance surplus (income > spending) of 10$, 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?
A domestic private actor, household or firm has 2 options for running a deficit:
- Run down accumulated financial assets →Dissaving
- Acquire new IOUs → Borrowing
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:
→ draw from previously saved financial wealth and/or
→ borrow money
The figure below shows the possible equilibrium 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), although it is never possible to have both sectors in surplus or deficit (bottom).