Tuesday, 16 June 2015

Beware of using sectoral balances to reveal the flaw in Osborne’s budget surplus idea.

A number of people, e.g. Richard Murphy, Bill Mitchell and John Eatwell argue that sectoral balance analysis is helpful in revealing the flaw in the budget surplus idea recently advocated by the UK’s finance minister, George Osborne. This approach is dodgy.

Of course there is no denying the obvious point that a public sector surplus must be matched by a private sector deficit (assuming for the sake of simplicity we ignore the foreign sector). But that point apart, sectoral balance analysis has nothing to offer here. To see why, let’s consider Richard Murphy’s ideas, and we’ll start with a quote from his article, as follows.

“The principle is simple and is that there are just four sectors in the economy. They are:

1.Consumers = C
2. Government = G
3. Business, whose investment = I (their current trading is of course part of the flip side of C, and we must not double count).
4. The rest of the world, represented by the balance of trade = E”

Murphy continues (to quote):

“Now as a matter of fact the surpluses and deficits run by these groups must arithmetically balance in monetary terms, because double entry does work: every debit does indeed have a credit.

So if we use the same letters C, G, I and E to represent the net savings or borrowings of these groups in a period then:

C + G + I + E = 0

So, if consumers borrow someone else must lend.”

Well there’s something wrong there and as follows. If consumers borrowed ONLY FROM entities in one or more of the other sectors, then Murphy’s point would be true. But of course that’s nonsense.

The reality is that much of consumer borrowing is from OTHER CONSUMERS. That is, typically, what happens when a consumer gets a loan is as follows.  1, Consumer gets a loan from a bank, 2 the borrower spends the money, 3, the money is deposited on sundry other consumers’ bank accounts.

Now assuming the latter don’t spend the money (i.e. assuming they put it in a deposit or term account), then effectively the latter consumers have loaned money to the borrower mentioned at the outset above. The loan of course goes via a bank or banks.

It is thus quite untrue to say that if consumers borrow more, sundry entities in other sectors must LEND MORE.

In fact the latter point can be put in more general terms and for the following reasons.

Merging the consumer and business sectors.

Murphy’s sectors are unusual in that he splits the private sector into consumers and business. It’s more normal to split the domestic economy just into the private and public sectors. I.e. consumers and businesses are merged into one sector: the “private sector”.

But nothing useful is added to the analysis by splitting the private sector into consumers and businesses as Murphy does.

So returning to the point about borrowing, we can say that given an increase in borrowing by the private sector (consumers plus businesses) some of that borrowing will come from entities IN THE PRIVATE SECTOR.

In short, Murphy is completely wrong to say later on that:

“The government surplus or deficit is, in other words, the opposite of what is happening with consumer debt…”

Murphy needs to go back to the drawing board.

John Eatwell.

In his letter to the Financial Times, John Eatwell (Cambridge economist) says amongst other things that where there is a persistent surplus  “the accumulation of debt by the private sector will be a recipe for serious economic instability — an indebted private sector is very vulnerable to economic shocks.”

Well not necessarily. The reaction of the private sector to a withdrawal of central bank money (base money) may to some extent be to replace it with private bank created money, i.e. the private sector non-bank entities may borrow more from private banks. And that extra borrowing COULD BE on a totally responsible basis. Though to be realistic there is bound to be SOME IRRESPONSIBLE borrowing mixed in there. So Eatwell has a point.

Certainly the latter phenomenon, namely borrowing so as to maintain living standards seems to have been going on just prior to the 2007 crunch. On the other hand, as a general rule, private bank lending is PRO-CYCLICAL rather than anti-cyclical. It is thus debatable whether private banks, as a general rule, expand lending when there is a withdrawal of base money from the private sector.

To the extent that private banks DON’T react in the latter counter-cyclical way then effect the reaction of the private sector as a whole to a budget surplus is to accept the cut in demand, produce less, and consign a portion of the workforce to the dole queue.

In the event, the actual response of the private sector will doubtless lie somewhere between the above two extremes (1, replacing ALL the central bank money lost with privately created money with no consequent drop in demand, and 2, complete failure by the private sector to borrow more.)

Bill Mitchell.

As to Bill Mitchell’s analysis, I couldn’t see much wrong. However he goes into too much detail about sectoral balances. That is (to repeat) the only insight that sectoral balances have to offer when it comes to identifying the flaw in Osborne’s budget surplus idea is that a public sector surplus must be matched by a private sector deficit.

As to the size of the deflationary effect or “unemployment increasing effect” of that surplus, sectoral balance analysis has nothing to offer.


  1. If we are going to use the equation

    "C + G + I + E = 0",

    then we are mixing debt and money. This must be the case because G is composed of taxes plus a change in debt.

    Now if government runs a surplus, the question arises whether "base money" is withdrawn or if "debt" is withdrawn. I would argue that "debt" will be withdrawn unless the central bank decides that the amount of unrestricted money (usually called 'reserves') should be reduced. Running a surplus nothing more than the simple reverse of the original creation of 'debt'.

    IF any surplus collected by government was the result of a sudden increase in taxes. then the surplus collected could certainly have an inverse effect on employment, as you suggest.

    On the other hand, if economic activity increased because people cashed their bonds and spent the proceeds, then the increased taxes collected could be the source of a government surplus WITHOUT ANY INCREASE IN UNEMPLOYMENT.

    Turning our attention to the debt decision-making process, government can (and usually does) decide when to go into debt. The private sector has no choice but to accept government debt. Yes, private debt holdings would increase as the result of an increase in government debt BUT the real physical wealth of the private sector would depend upon the long term usefulness of any government debt spending.

    1. I’m not entirely sure what you’re saying, but I’ll have a stab at answering.

      “This must be the case because G is composed of taxes plus a change in debt.” Why any change in debt? Government basically only accepts one thing in payment of taxes, base money. Of course government OCCASIONALLY accepts other stuff: land, property, jewellery, and yes, debt in the form of Gilts (in the UK). But it only accepts the latter “weird” stuff if that stuff is easily converted to base money.

      It would be possible for government or government departments to open accounts at commercial banks and deposit money paid by taxpayers at those banks. And I’m not sure the tax authorities that. But if they do, they’d be free (as is everyone else) to convert money in such commercial bank accounts into base money at any time. So that money is as good as base money.

  2. We need to think-through government spending.

    All will agree that government can spend money that it takes in the form of taxes. Government can spend collected tax money as it wishes.

    What about government spending MORE than it collected in taxes? The money has been spent which is why the term G is used. THIS IS THE SUM OF ALL THE MICRO-ECONOMIC SPENDING DONE BY GOVERNMENT.

    Now look at the same spending from the MACRO-ECONOMIC perspective. Government has probably increased the money supply only a little (if any) but if there is a government deficit, there would have been an increase in debt level held by the private economy. Therefore, on the MACRO-ECONOMIC SCALE, the economy has worked not only for money during a one year period; the economy has worked for both money and additional debt. On the MACRO-ECONOMIC SCALE, the economy has traded labor and resources for money and debt.

  3. This misses the obvious ( and crucial) point that these sector balances are all net.
    it is probably clearer to refer to the Household sector rather than the consumer sector and it is perhaps clearer if this term is used.
    There is nothing at all unusual in using 4 sectors not 3. This was the approach used by Wynne Godley n his pioneering work on this topic.
    So Richard Murphy is right and you are wrong on this point. Where Murphy's position is more debatable is in the role of the external sector. Godley himself believed that fiscal policy had little effect because all the demand would leak into imports. That is a case for saying that at least some of the impact of government austerity is mitigated by an improvement in the balance of payments. But that is a very different point.

    1. I didn’t say that using 3 rather than 4 sectors was CRUCIAL to the argument. I realise the economy can be split into any number of sectors: e.g. it would be possible split the household sector into households headed by people with different hair colours. However, the 3 sector split is more common than the 4 in my experience. If Wynne Godley went for 4, I have no big objections.

      Re Godley I realize he had very pessimistic views on the balance of payments. He once claimed that devaluation might not work for the UK, and that in consequence there might be a dramatic reduction in living standards which would mean mass emigration from the UK: not one of his better predictions, clearly.

      As for the proportion of any increase in demand that leaks to imports, strikes me that that proportion will in the long run be about the same as total imports relative to GDP, (by long run I mean after resulting devaluations of Sterling and after those devaluations have done their work). In contrast, and BEFORE such devaluation, the first ratio will be somewhat higher than the second.


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