Rob Parenteau gets sectoral balances right
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First and foremost, I owe Rob Parenteau a big apology. Parenteau is the originator and first user of the clever term “Austerian”, which I erroneously attributed to Mark Thoma. Thoma never claimed parentage. I first encountered the term on his blog and a quick Google search turned up no antecedents, so I went with that. But Google does not index everything. I apologize for the error, and thank Marshall Auerbach who first pointed it out to me.
Parenteau’s contributions go far beyond a catchy neologism, however. I recommend his most recent post at Naked Capitalism, which is the best use of the “sectoral balances approach” to economic analysis that I have seen in the blogosphere.
The “sectoral balances approach” (frequently attributed to Wynne Godley) decomposes financial stocks and flows by virtue of a tautology. Every financial asset is also some entity’s liability. The sum of all financial positions is by definition zero. So we can write:
Suppose that, quite arbitrarily, we divide the world into a “foreign” and a “domestic” sector. Then we have:
NET_FOREIGN_FINANCIAL_POSITION + NET_DOMESTIC_FINANCIAL_POSITION = 0 
Suppose that, again arbitrarily, we decompose the domestic economy into a public and private sector:
Substituting into our previous expression, we get
We can also write this in terms of changes or flows. Since the sum above must always be zero, it must be true that any changes in one sector are balanced by changes in another:
Two of the flows in the equation above have conventional names, so we can rewrite:
ΔNET_PRIVATE_DOMESTIC_FINANCIAL_POSITION = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT 
This decomposition has been quite prominent in the blogosphere. I first encountered it in conversation with the always excellent Winterspeak, and associate it with the “Modern Monetary Theorists” or “chartalists”. But it’s been used widely, very recently for example by Martin Wolf.
The usual argument goes something like this: In the aftermath of a terrible credit bubble, in most countries, the private sector is desperate to “delever”, or reduce its indebtedness, which is equivalent to increasing its net financial position. As a matter of pure arithmetic, equation 8 must always be in balance. If the private sector of a country is to force the left-hand term positive, the country must either run a current account surplus (e.g. by exporting more than it imports) or else its government must run a deficit. Some countries may “export their way” to financial health, but not all can, since every current account surplus must be matched by a deficit elsewhere. If we put “beggar thy neighbor” strategies aside and set the current account to zero, any improvement in the financial position of the private sector must be offset by a deficit of the public sector.
This is true by definition. Once the terms have been defined, there is nothing to argue about. If we want the financial position of the private sector to improve (defined as increasing total financial assets less liabilities), and we consider a country whose external account is in balance or deficit, then the public sector must run a deficit.
However, a thing can be true but still misleading. The catch is an assumption, that an increase in the net financial position of the private sector is a good thing, something that we should encourage or at least accommodate. This is where Parenteau is great. He decomposes the domestic private sector into a household and business sector:
ΔNET_HOUSEHOLD_FINANCIAL_POSITION + ΔNET_BUSINESS_FINANCIAL_POSITION = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT 
(Note that “business” here means any non-household private entity that could have a financial position. It would include, for example, non-profit organizations.)
Let’s try to come up with better names for ΔNET_HOUSEHOLD_FINANCIAL_POSITION and ΔNET_BUSINESS_FINANCIAL_POSITION.
ΔNET_HOUSEHOLD_FINANCIAL_POSITION is just net household financial income.
NET_BUSINESS_FINANCIAL_POSITION is, by definition, all business financial assets minus all business liabilities (including shareholder equity). On a business’ balance sheet, “all business liabilities (including shareholder equity)” is necessarily the same as “total business assets”. So we can write:
NET_BUSINESS_FINANCIAL_POSITION = BUSINESS_FINANCIAL_ASSETS – TOTAL_BUSINESS_ASSETS 
NET_BUSINESS_FINANCIAL_POSITION = -(TOTAL_BUSINESS_ASSETS – BUSINESS_FINANCIAL_ASSETS) 
NET_BUSINESS_FINANCIAL_POSITION = -BUSINESS_NONFINANCIAL_ASSETS 
Now use our new definitions to rewrite equation :
NET_HOUSEHOLD_FINANCIAL_INCOME – ΔBUSINESS_NONFINANCIAL_ASSETS = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT 
NET_HOUSEHOLD_FINANCIAL_INCOME = CURRENT_ACCOUNT_SURPLUS + CONSOLIDATED_GOVERNMENT_DEFICIT + ΔBUSINESS_NONFINANCIAL_ASSETS
Now we can tell what I think is a much more informative story. It is not the “private sector” whose financial position needs to improve. Businesses exist to increase the value of their liabilities to shareholders and creditors. They do not “delever” by reducing the sum of those liabilities. “Leverage” properly refers to the ratio between different sorts of liabilities, debt versus equity, not the total quantity of claims. In a good economy, the financial indebtedness of business entities will be increasing, as the value their real assets grows! Growth in the “net private sector financial position” could come from an increase in household income (yay!) or a decrease in the value of real business assets (yuk!). We certainly shouldn’t make policy decisions based on promoting or accommodating such an ambiguous outcome. Instead, we should craft our policies to be consistent with what we actually want, which is household financial income. (Note that this analysis necessarily excludes nonfinancial income, such as unrealized gains or losses on the value of a home.)
Reviewing equation , there are three ways a nation can improve the financial positions of its household sector. It may (i) run a current account surplus, usually by exporting more than it imports; (ii) have the government run a deficit, improving household financial position by having the government run a deficit, or (iii) increase the value of business nonfinancial assets. Approach (i) can’t work for everyone, of course. Assuming external balance, it is obvious (at least to me) that approach (iii) is ideal. Parenteau, I think, agrees:
Remember the global savings glut you keep hearing about from Greenspan, Bernanke, Rajan, and other prominent neoliberals? Turns out it is a corporate savings glut. There is a glut of profits, and these profits are not being reinvested in tangible plant and equipment. Companies, ostensibly under the guise of maximizing shareholder value, would much rather pay their inside looters in management handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.
What we have here, in other words, is a failure of capitalists to act as capitalists. Into the breach, fiscal policy must step unless we wish to court the types of debt deflation dynamics we were flirting with between September 2008 and March 2009. So rather than marching to Austeria, we need to kill two birds with one stone, and set fiscal policy more explicitly to the task of incentivizing the reinvestment of profits in tangible capital equipment.
So what is the role of approach (ii), which stimulus proponents and MMT-ers frequently advocate? Note how Parenteau phrases things: because “capitalists [fail] to act as capitalists”, because businesses are not increasing the value of their nonfinancial assets, fiscal policy must be employed to avoid “debt deflation dynamics”. Here we reach the formal limits of the sectoral balance approach. This style of analysis gives us no insight into the dynamics or distribution of financial positions within any of the categories we have carved out.
Nevertheless, consider the following (counterfactual) thought experiment. Imagine that the NET_HOUSEHOLD_FINANCIAL_POSITION is negative, and that people go nuts in a harmful way when they are formally insolvent. Suppose also that the current account cannot be brought to surplus, and that businesses cannot expand the value of their nonfinancial assets in a short time frame. Under these conditions, by running a deficit, government could create financial income for households until their net financial position turns positive and people stop behaving like antisocial lunatics. In this scenario, fiscal policy does nothing to change the real asset position of the economy. But by shifting around financial assets and liabilities, government alters the behavior of agents in the economy in a manner that improves future performance, increasing overall wealth.
In real economies, people may well behave in ways that are harmful to the economy when their financial positions are very tenuous, although their actions are more likely caused by illiquidity than lunacy. But in real economies, some people have strong financial positions while others have weak financial positions, and the sort of intervention described above would be useless if the income created by a stimulus went primarily to households that were not financially stressed. Government funds spent purchasing goods and services from existing firms, or deficits created by income or payroll tax cuts, go first to people who are already employed, or who already have financial claims on businesses, and these may not be the most stressed groups. Designing a “good” stimulus where the object is to alter the character of real behavior by shifting financial variables is well beyond the scope of this post, but it would necessarily involve distributional questions and complex behavioral assumptions. If you target a stimulus to the deeply indebted, you may improve their behavior, but damage the behavior of others who feel aggrieved that prudence went unrewarded. If it was me, I’d make flat transfers unrelated to income or employment status, so that on the one hand the program seems “fair” — the prudent benefit along with the bankrupt — yet on the other hand it is guaranteed to improve the financial position of even the worst-situated households.
What about approach (iii)? What could cause an increase in the value of business nonfinancial assets, improving household financial positions? Fundamentally, there are two ways: Businesses could borrow or use their own cash to purchase real assets from the household and government sectors (holding the public sector deficit constant), or else the value of existing business nonfinancial assets can somehow be made to increase. Parenteau suggests policies that would push businesses to purchase real assets. But note that any sort of increase in the valuation of business nonfinancial assets, including intangible assets, would be sufficient to improve the household-sector financial balance. That would include events as insubstantial as a pure inflation, but also real improvements in business productivity. Again, looking beyond where sectoral balances can take us, distribution matters. If “debt deflation dynamics” occurs primarily through households whose weak financial positions include few claims on businesses, then increasing the value of business nonfinancial assets might not help very much.
p.s. Edward Harrison offered a response to Parenteau’s piece that is very much worth reading. In particular, he focuses on the quality of business investment, a topic about which sectoral balance decomposition can tell us very little. Mechanically, low quality investment should improve the valuation of business nonfinancial assets less than high quality investment, and should therefore exert a drag on household financial balances. Harrison uses an Austrian (though not Austerian!) perspective to suggest that stimulus may reduce the quality of business investing, implying a trade-off between approaches (ii) and (iii) above.
[MMT Note] Agree or disagree, the “MMTers” are among the most interesting and provocative thinkers in the economics blogosphere. In addition to Winterspeak, I’d include Bill Mitchell, Warren Mosler, Scott Fullwiler (who occasionally writes at Economic Perspectives from Kansas City), Marshall Auerbach, and perhaps Parenteau himself in this group. I agree with much but not all of what the MMTers have to say. I have learned profoundly much from disagreeing and squabbling with them. I do hope that Kartik Athreya will someday have the pleasure.
Update 2010-07-01, 6:40 am EDT: For reasons I do not understand (my big fat finger?), this post “disappeared” for a few hours. It reverted from “published” to “draft” in WordPress. The post is back, and the comments seem to be intact, but my apologies to all for the disappearance!