Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Many readers keep calling for my views on Austrian economics. Apparently when pushing what we might call the Modern Monetary Theory (MMT) view they get hit with a barrage of Austrian school criticism along the lines that statism is dread and that by privatising everything you will improve the human condition. My first thought when I get E-mails like this is to wonder where my readers hang out in their spare time! I wasn’t aware that the Austrian school was anything more than a cobbled together bunch about as large as the modern monetary school (laughing). Anyway, I am taking the request seriously and as a start I present some background – some modern monetary armaments. We are going to war.
The Austrians claim that they predicted the crisis etc is nothing more than recognition that their major hypothesis is that anytime the government is involved in the economy eventually things turn sour. So eventually, given that economic activity cycles, you are going to be correct. However, their understanding of the way the fiat monetary system operates is non-existent. More on the another time.
For now, this blog introduces what is called stock-flow consistent macroeconomic accounting structures. It is based on a paper I wrote last year with James Juniper called There is no financial crisis so deep that cannot be dealt with by public spending.
It is at the pointy end of my blogs and won’t appeal to all. But if you really want to start understanding the quality of modern monetary theory then stock-flow accounting is a good place to start.
What this framework allows you to understand is why the prevailing orthodoxy in macroeconomics has failed. The framework shows you that the mainstream belief that markets self-equilibrate at levels that are remotely socially acceptable is erroneous. Markets do not self-regulate in ways that avoid major financial upheavals and these crises have profound impacts on the real economy.
In particular, the body of literature that is built upon the belief that fiscal policy should only be a passive support to an inflation targeting monetary policy is shown to be highly damaging to the long-term growth prospects of modern monetary economies.
The current crisis confirms that the only way that the non-government sector can save is for the government sector to run continual budget deficits. The stock-flow framework allows you to understand why this fiscal conduct is non-inflationary and, if managed properly, exerts downwards pressure on nominal interest rates and underpins full employment.
To understand how the modern monetary economy operates we need to take a step back into national accounting. First, a modern monetary system has three essential features:
- A floating exchange rate, which frees monetary policy from the need to defend foreign exchange reserves).
- A sovereign government which has a monopoly over the provision its own, fiat currency.
- Under a fiat currency system, the monetary unit defined by the government has no intrinsic worth. It cannot be legally converted by government, for example, into gold as it was under the gold standard. The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.
Within a modern monetary economy, as a matter of national accounting, the sovereign government deficit (surplus) equals the non-government surplus (deficit). The failure to recognise this relationship is the major oversight of neo-liberal (and Austrian) analysis.
In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. The sovereign government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment.
Additionally, and contrary to neo-liberal (and Austrian) rhetoric, the systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings.
The decreasing levels of net private savings which are manifest in the public surpluses increasingly leverage the private sector. The deteriorating debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity. So you have to trace the private indebtedness back to the conduct of the government sector.
The analogy neo-liberals (and Austrians) draw between private household budgets and the government budget is false. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.
With that in mind, modern monetary theorists develop a theory of unemployment based on the conduct of fiscal policy (compare that the Austrians who emphasise excessive real wages). In a fiat monetary system, unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income. Involuntary unemployment is idle labour unable to find a buyer at the current money wage.
In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns.
Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save. This is a fundamental mistake that neo-liberals (and Austrians make).
For example, if you read the classic Austrians, such as Murray Rothbard, you will get this sort of claim in his Power and Market (pages 204-205):
Unemployment is caused by unions or government keeping wage rates above the free-market level.
And this gem from America’s Great Depression (pages 43-44):
Generally, wage rates can only be kept above full-employment rates through coercion by governments, unions, or both. Occasionally, however, the wage rates are maintained by voluntary choice (although the choice is usually ignorant of the consequences) or by coercion supplemented by voluntary choice. It may happen, for example, that either business firms or the workers themselves may become persuaded that maintaining wage rates artificially high is their bounden duty. Such persuasion has actually been at the root of much of the unemployment of our time, and this was particularly true in the 1929 depression.
In a fiat monetary system where the government has currency sovereignty this analysis couldn’t possibly be true. More on this will appear in another blog.
All of the modern monetary propositions can be understood within a flow of funds framework which renders the underlying accounting between flows and stocks consistent. Mainstream economic models do not have stock-flow consistency and therefore fail to understand how the spending relations tie in with the wealth and other stock relations.
To understand the difference between a stock and a flow think of a bath-tub. The water in the bath is a stock – it is measured at a point in time. The water that comes into the bath (via the taps) and/or out of the bath (via the sink) are flows and you measure them as a rate of water flow per unit of time. So many litres per minute.
If the inflows are stronger than the outflows the water level in the bath will rise and vice-versa. In other words, flows add to and subtract from stocks.
In economics, this distinction is very important and most students fail to really understand it. I think that is because mainstream macroeconomics then doesn’t go onto to use the distinction properly, especially in the area of fiscal relations.
So the level of bank reserves is a stock – measured at some point each day. Government spending and taxation, consumer spending, saving, investment, exports, imports, etc are all flows of dollars per unit of time. Government spending adds to bank reserves and taxation reduces (drains) the stock of reserves.
Clearly, a theory of the economy that doesn’t recognise the intrinsic relations between the flows and stocks is missing the boat. Given that modern monetary theory is ground out of the operational accounting of the monetary system, its stock-flow consistency is impeccable and unique (a major strength).
A Flow of funds view of modern monetary macroeconomics
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 budget constraint identity.
It shows categorically that the Government Budget Constraint (GBC) is an ex post accounting identity rather than an ex ante financial constraint. You will recall that mainstream macroeconomics (and the Austrians) all believe the GBC somehow represents a financial constraint on government prior to it spending.
It doesn’t and cannot in a fiat monetary system unless the government adopts, voluntarily, a framework that replicates the operations of the ex ante GBC. In doing so it reduces its fiscal authority and bows to the pressure of those who oppose government intervention at a sufficient level to generate full employment.
A Flow-of-funds approach also shows that if the sovereign government runs cumulative surpluses which destroy net financial assets then the non-government must accumulate deficits in the form of increasing indebtedness which are unsustainable.
The distinction between vertical and horizontal transactions can be clearly demonstrated by examining the current transactions matrix for a simplified economy.
The last row of the current transactions matrix affords a crucial insight into the nature of (vertical) transactions between the government and non-government sectors.
These transactions must be clearly distinguished from their (horizontal) counterparts: those between banks, households, and firms. The basis for this distinction is that only vertical transactions give rise to net financial assets or increases in real wealth, whereas horizontal transactions net out to zero.
While transaction accounts (or T-accounts) are helpful for distinguishing between such things as high powered money and other forms of money, and for explaining why it makes theoretical sense to consolidate the central banking and treasury functions of government, they are not very helpful when it comes to establishing the difference between vertical and horizontal transactions.
However, this difference can easily be justified by examining a current transactions matrix for the economy, which depicts flows of goods and services and flows of monetary payments between institutions (households, banks, firms, and the government sector).
The following figure is what we call a current transactions matrix and is a highly simplified stock-flow consistent macroeconomic model. I recommend you print the figure by clicking on it and then using the print out it to follow the discussion. Note the -1 or t-1 just means last period’s value.
Here, consumption spending by households, C, comprises wages after tax, W-Tw, plus a fixed share a, of (lagged) household wealth, Vh.
Household wealth increases both through savings out of income, the latter including (lagged) interest receipts on deposits, ib, and dividends received from banks, Fb, and firms, Fd, inclusive of the capital gain on equities (a component subject to minor degree of simplification).
Firm investment is pDK (the D is the greek delta meaning change in), il is the loan rate of interest, and Tl is the tax rate on firm income. It is further assumed that the government chooses the bill rate of interest, ib, tax parameters and government spending as proportion of total capital.
Likewise, it is assumed that firms distribute a fixed share of after tax profits Fd as dividends, while banks distribute their total profits Fb to households. For simplicity, households are assumed to lend all their savings to firms without borrowing themselves.
The sources and uses of funds can be determined by reading the entries in each of the cells in any given column of the matrix.
For the household sector, the sources of funds include wages, interest on deposits, and distributed dividends from banks and firms. Uses of funds include consumption and payment of taxes on household income.
For firms, sources of funds include revenue from the sale of goods and services to households and government, as well as that component derived from the sale capital goods to other firms. These funds are used for investment, the payment of corporate taxes, the payment of interest on borrowings, and the distribution of dividends.
Banks receive interest on loans and issued bank bills, and use their funds for payment of interest on deposits and the distribution of profits.
By summing across the rows for the flow-of-funds accounts of banks, households and firms, it is apparent that all transactions cancel out with the exception of the interest paid on bank bills by government, the payment of taxes by firms and households, and the receipt of revenue by firms for the sale of goods and services to the government.
However, and very significantly, these components are all vertical transactions between the government and non-government sectors. That is they do not net to zero but create/destroy net financial assets in the non-government sector.
Government surpluses must equal non-government deficits
The bottom row of the Current Transactions Matrix indicates that government savings (surplus) or tax revenue net of government spending and payment of interest on bonds ((T – G – ibt-1Bt-1 – 1) are equal to the non-government sector’s dis-savings (deficit = pDK – Fu – Sh).
This is a crucial accounting identity because it implies that, in periods when governments run continual budget surpluses, although economic growth could well be sustained over the short run, this will only happen if the non-government sector runs an on-going deficit, thus accumulating ever-increasing levels of debt.
Moreover, as surpluses destroy net financial assets, this increase in private sector debt will be matched by a continuous decline in net financial assets or wealth.
To show this, we must interpret the flow-of-funds accounts more closely for each of the sectors in terms of how they interact together. However, before this is attempted it is desirable to incorporating transactions with the rest-of-the-world.
Extending the framework to the Rest of the world accounts
The next table is a simplified transactions table which while simplifying the components of GDP, now includes a column for the rest-of-the-world (ROW) account.
Here, Gross Domestic Product, Y, is equal to Private expenditure, PX, plus government expenditure, G, plus exports, X, minus imports, M. The ROW account reveals that imports minus exports and transfers paid by the external sector, TF, equals the balance of payments deficit.
Every item in the Production (GDP) account is matched by a corresponding negative entry in some other column. Taxes net of transfers are received by the government.
Net property income, taxes and transfers, TF and TP, are paid by the external and private sectors, respectively.
The final row totals reveal that public sector net borrowing, PSNB, equals the private net acquisition of financial assets, NAFA (private savings less investment) minus the balance of payments surplus (or plus the deficit), BP.
From the perspective of a stock-flow consistent approach to macroeconomic modelling outlined above, the fundamental accounting identity states that government savings (surplus) or tax revenue net of government spending and payment of interest on bonds is equal to the non-government sector;s dis-saving.
That is, public sector net borrowing equals the private net acquisition of financial assets (private savings less investment) minus the balance of payments surplus (or plus the deficit). As governments have moved away from deficit spending at levels typical of the post-war period of full-employment, private sector debt levels have escalated.
The reason why this has happened is that causality flows from fiscal policy to the private sector simply because economic influences over the rest-of-the-world account change quite slowly, with income effects dominating over the price effects that are championed by neoclassical theorists.
In contrast, fiscal policy responds immediately to government decisions about spending and taxing. The transmission mechanism behind these changes is complex, as it operates within a portfolio setting, by changing relative rates-of-return between real investment, the equity-premium, and the term structure of bonds.
So the framework translates straightforwardly into the familiar sectoral balances accounting relations. They allow us to understand the influence of fiscal policy over private sector indebtedness.
You have seen this accounting identity for the three sectoral balances before:
(S – I) = (G – T) + (X – M)
So total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents. That has to hold as a matter of accounting. It is not my opinion.
Thus, when an external deficit (X – M < 0) and public surplus (G - T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. For Australia, while the current account deficit has fluctuated with the commodity price cycle, it has continued to deteriorate slightly over the longer term. Accordingly, the dramatic shift from budget deficits to surpluses from the mid-1990s onwards was mirrored by a corresponding deterioration in private sector indebtedness. The only way the Australian economy could keep growing in the period after 1996 was for the private sector to finance increased spending via increased leverage. This is an unsustainable growth strategy. Ultimately the private deficits will become so unstable that bankruptcies and defaults will force a major downturn in aggregate demand. Then the fiscal drag compounds the problem. The solution is simple. The government balance has to be in deficit for the private balance to be in surplus for a stable external balance. In terms of the slightly worsening current account deficit, we can interpret that as signifying an increased desire by foreigners to place their savings in financial assets denominated in Australian dollars. This desire means that that the foreign sector will allow us to enjoy more real goods and services from them relative to the real goods and services we have to export. We note that exports are always a "cost" while imports are "benefits". As long as there is a foreign desire for our financial assets, the real terms of trade will provide net benefits to Australian residents which manifests as the current account deficit. An external deficit presents no intrinsic problem despite views by the orthodoxy to the contrary. In Japan, by way of contrast, the sectoral balances reveals that the private sector surplus increased on a par with the long-term increase in budget deficits. In other words, the persistent and substantial fiscal deficits financed the saving desires of the private sector and helped to maintain positive levels of real activity in the economy. Conclusion
This stock-flow accounting structure conditions the way modern monetary theorists think. It is ground in the operational reality of the flow of funds within the economy.
So you cannot possibly say, for example, that the government can run indefinite surpluses while the current account is in deficit, and expect the domestic private sector to be able to save. It has to be that the only way the economy can grow in these circumstances is for the private domestic sector to be increasingly going into debt.
You may think that is fine and we can argue about that as a growth strategy and a reasonable way to manage the need for public goods. That is the debate part. But you cannot deny the former.
The problem is that the Austrians and mainstream economists do deny the accounting statements and demean the rest of their arguments as a consequence. Most of their solutions cannot “add up” in terms of the stock-flow relations.
Enough for now.