I have noted some misperceptions about the derivation, meaning and application of the so-called sectoral balances framework that is used in Modern Monetary Theory (MMT) to help explicate the relationship between the government and the non-government sectors. Some of this confusion appears to be the product of a deeper misunderstanding of the difference between stocks and flows and relationships between flows in economics. Those who conclude that this framework is really just an accounting structure are incorrect. Equally, those who conclude that the accounting relationships that are part of the sectoral balances framework are matters of interpretation are also incorrect. It should be clear that the sectoral balances framework combines accounting structures, which are derived from the national accounts framework used by statisticians to measure economic activity, and theoretical propositions, which seek to explain relationships between variables within the accounting structures. In other words, we need to understand both the accounting aspects that are true by definition as well as the underlying theoretical structures which drive the balances.
One reader suggested that a Jeremy Corbyn adviser had largely dismissed the sectoral balances framework as having any economic content as evidenced by this Tweet (October 29, 2015):
I was also referred to a recent blog written by the senior economist at the British TUC – Fiscal fallacies (2): accounting identities and the case for government loan-expenditures – which appears to entertain the view that the sectoral balances framework provides a “case for expansionary policy”.
Both these inputs are unhelpful.
Background to the flow-of-funds approach
The sectoral balances framework is intrinsically linked to the flow of funds analysis. An early exponent of the flow-of-funds approach, Lawrence Ritter wrote in 1963 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. That is the sum and substance of the matter.
[Full reference: Ritter, L.W. (1963) ‘An Exposition of the Structure of the Flow-of-Funds Accounts’, The Journal of Finance, 18(2), May, 219-230]
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. That is flows feed stocks and the flow-of-funds accounts ensure that all of the monetary transactions are correctly accounted for.
This approach underpinned the work of the so-called New Cambridge approach who were 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, who were from a Keynesian persuasion but departed from the usual Keynesian thinking when it came to balance of payments issues. I will leave that discussion for another day.
While the sectoral balances approach had been understood much earlier (for example, by Nicolas Kaldor and others), it became popularised by the New Cambridge macroeconomics analysis which introduced the concept of the net acquisition of financial assets of the private sector (NAFA) into the forefront of its Keynesian income-expenditure model.
Like Lawrence Ritter, the Cambridge economists considered it interesting to trace the flow of funds between the different sectors of the economy, which they divided into three sectors:
1. The government sector – which comprised all levels of government and their agencies.
2. The private domestic sector – which comprised households and firms ( including banks).
3. The external sector – which comprised all non-residents (private households, firms and governments).
From an Modern Monetary Theory (MMT) perspective (2) and (3) comprise the non-government sector.
After all the transactions have flowed in any given period, any one of these sectors could record a financial deficit or surplus. A financial deficit (surplus) is defined as a state where total income is less (more) than the sector’s spending.
So for the private domestic sector, it is in financial surplus (deficit) when its disposable income exceeds (is less than) its spending on consumption goods and/or investment goods.
The external sector is in surplus (deficit) when total export revenue is greater than (less than) the payments for imports. The external balance includes the so-called net primary and secondary income flows that accrue to residents as a consequence of interest and dividends received on overseas ownership (offset by similar payments to foreigners).
While the trade balance refers to the difference between export and import revenue on goods and services, the external sector balance overall is equivalent to the Current Account balance that includes the net income flows.
The government sector deficit (surplus) arises when total government expenditure is greater than (less than) total tax and other revenue.
The interpretation of these balances in the New Cambridge approach, is that when a particular sector has a financial surplus (that is, its income exceeds its expenditure) it is able to add to its net financial assets through additional purchases of new assets or reducing its existing debt obligations.
MMT adopts the same interpretation although when applied to the government sector to conclusion is somewhat meaningless other than in a purely accounting sense.
The New Cambridge expression for the private sector NAFA(p) is:
(1) NAFA(p) = Yd – (C + I)
where Yd is total disposable income of the private domestic sector, which is total national income (Y) minus total taxes net of transfers (T); C is total consumption expenditure and I is total capital expenditure including unintended inventory accumulation (investment) of the private domestic sector.
Expression (1) is defined in terms of dollar flows of income and spending.
From a stock prospective, NAFA(p) is also measured by the difference between the stock of net financial assets at time t and the stock at time t-1, where t-1 is some earlier period (t is just a time indicator, so t is now and t-1 might be last year).
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).
Note, if we aggregate the non-government sector then we get the standard MMT result that financial transactions within the non-government sector do not alter the net financial position of that sector. Only financial exchanges between the government and non-government sector can be a source of increased net financial assets in the non-government sector.
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 net acquisition of financial assets, that is, achieved 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 how the 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.
The Sectoral Balances approach
The Sectoral Balances perspective of the National Accounts also brings the uses and sources of national income together.
The most basic macroeconomics rule is that one person’s spending is another person’s income. At the sectoral level the same proposition holds. Another way of stating this rule is that the use of income by one person will become the source of income for another person or persons. Similarly, at the sectoral level.
The National Accounts divided the national economy into different expenditure categories – consumption by persons/households; investment by private business firms; spending by the government; exports to and imports from the foreign sector.
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.
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.
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, motivates 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 $220,913 millions 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 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.
A flow is like a stream of water measured as litres per second (for example) whereas a stock is like a reservoir level measured at some point in time.
So the way that MMT uses the sectoral balances approach has to be understood not only in terms of the accounting structure that underpins the flow of funds but also in terms of the theoretical conjectures that link the variables within the financial balances and provide some guidance about the way in which the balances adjust once disturbed by external factors.
The accounting aspects that underpin the income-expenditure model draw on different ways of thinking about the national accounts.
First, we can measure the sources of spending that flow into the economy over a given period. Economists use the shorthand expression:
(2) GDP ≡ C + I + G + (X – M)
which says that total national income (GDP) is the sum of total final household consumption spending (C), total private investment including inventory accumulation (I), total government spending (G) and net exports (X – M).
Note the use of the mathematical symbol ≡ which denotes an Identity which is true by definition and the “equivalence … does not depend on the particular values of the variables”.
We often replace it with an equals sign (=) but we always know that this National Accounts Identity is an accounting statement which must always be true.
As it stands, the National Accounting Identity is not a theory. We will come back to that point presently.
Introducing theoretical conjecture allows us to introduce causality and develop an explanation of how expenditure drives income generation. The central role played by the principal of effective demand provides the causal link between expenditure and income.
It tells us that total income in the economy per period will be exactly equal to total spending from all sources but also the process involved that bring that equality into line.
We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (2)).
Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).
Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):
(3) GNP = C + I + G + (X – M) + FNI
At this stage, we could get quite complicated and consider things like retained earnings in corporations and the like, but here we assume that all income generated ultimately comes back to households (after all the distributions are made).
To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:
(4) 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) (GNP – C – T) – I = (G – T) + (X – M + FNI)
The the terms in Expression (5) are relatively easy to understand now. The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way).
In other words, it represents private domestic saving.
The left-hand side of Equation (3), (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 (3) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.
The term (G – T) is The government financial 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 (CAD). It is in surplus if positive and deficit if negative.
In English we could say that:
The private financial balance equals the sum of the government financial balance plus the current account balance.
Note that by re-arranging Expression (5) we get the familiar sectoral balances equation:
(6) (S – I) – (G – T) – CAD = 0
Following our earlier discussion of the flow-of-fund approach made popular by the New Cambridge economists, we can re-write Expression (6) in this way:
(7) (S – I) = (G – T) + CAD
which the New Cambridge economists interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAD > 0) generate national income and net financial assets for the private domestic sector.
Conversely, government surpluses (G – T < 0) and current account deficits (CAD < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.
Expression (7) can also be written as:
(8) [(S – I) – CAD] = (G – T)
where the term on the left-hand side [(S – I) – CAD] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.
This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).
In summary, our interpretation of the sectoral financial balances is as follows:
1. (S – I) is the private domestic financial balance or the NAFA of the private domestic sector. If it is in surplus, then that sector is lending funds to the other sectors. If it is in deficit, then the private domestic sector is borrowing from the other sectors or running down its net financial position in other ways (such as liquidating past wealth accumulation).
2. (G – T) is the government sector financial balance. If it is in surplus then the government sector is spending less than it is taking out of the economy in taxation and undermining the capacity of the two other sectors to accumulate net financial assets and vice versa.
3. CAD is the external sector financial balance. If it 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.
These are accounting statements. So in one sense, the claim that the sectoral balances is about accounting is factual. But of course it also is a highly limited conclusion.
At this stage, we know nothing about the state of the economy that would be associated with bringing these balances into line, nor do we know anything about where the economy has been and where it might be heading.
Further, we don’t know what motivates each of the financial balances accounted for.
At this point, to give traction to analysis we need to add theory. As noted above, once theoretical conjectures are included in the framework then we can start to explore causality, adjustment, and understand the state of the economy more fully, including the policy options that might drive the economy to where we want it to go.
The theoretical dimension of the sectoral balances framework takes this well beyond the accounting.
So the income-expenditure model is a theoretical structure that conjectures that changes in these financial balances are driven by national income flows, which in turn, are driven by changing expenditure flows.
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 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.
Imports are also considered to be a positive function of national income – so when national income rises we buy more locally- produced goods and more imported goods. So the external balance falls when national income rises, and vice versa, other things equal.
We could add more complex theoretical propositions to explain private domestic investment, exports, government spending, and net foreign income transfers. And indeed, larger macroeconomic models do just that.
But the point is that these theoretical conjectures allow us to hypothesise what will happen to the financial balances if there is an external event that leads to income changes.
For example, we might assume the government decides that the level of income is too low because spending is too low relative to full capacity spending and as a result unemployment is too high.
It introduces a discretionary increase in the deficit such that G – T rises. This stimulates national income via the expenditure multiplier process which increases disposable income, consumption expenditure, and household saving. It also stimulates increased import expenditure.
If nothing else changes, Private domestic net financial asset acquisition will increase and the external deficit will increase somewhat. The relationship between the sectoral balances will be maintained but national income will be higher and the net financial assets in the non-government sector will have changed.
More complex theoretical reasoning is obviously possible.
The accounting structures that underpin the sectoral balances framework allows to check logic. For example, if a politician says that the government and non-government 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 sort of conclusions.
But the accounting structures do not allow us to determine the validity of a political statement that says that austerity will stimulate growth. At that point we need theory and we can use the sectoral balances framework to draw inferences about which sectors will respond in which way when austerity is imposed.
The sectoral balances framework and the closely related flow-of-funds approach is an extremely useful analytical tool, which is very much underused by economists.
In one sense it is pure accounting. That provides useful insights in its own right. But to really use it as an engine for understanding and analysis we need to marry in theoretical conjectures that allow us comprehend how the balances respond to income shifts and how they correspond to different states of the economy.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.