One of the most important concepts to understand within macroeconomics is the concept of sectoral balances.
Macro can be divided into three distinct sections Government and Non-Government with the latter being divided into domestic and foreign. These divisions come from the system of national accounts (an international standard) and the way GDP is calculated.
GDP is a measure of national income, which we can conceptualise as the output we produce and the unit of account or a nations currency is the measurement we use to measure that output.
We can get more complex and analyse what we produce as contributing to the real economy and what doesn’t contribute to the productive process. The latter is what is considered economic rents (e.g capital gains) and hasn’t actually produced anything.
Broadly speaking GDP is a measure of what we produce and it is divided up between labour and capital. It omits a lot of things we as a society should place more of a value on (care work, parenting etc..) and it includes what I would consider undesirables (fossil fuel activity, environmental destruction) but never the less it is the calculation for what it is we make and what we also call ‘national income’. it is a flow over a given period of time.
Now we’ve divided ‘the economy’ into three sections – we can take the idea that someone’s spending is somebody else’s income. Government spending is non-government sector income – and foreign spending (our nations exports) is domestic sector income.
The Government deficit is a measure of spending over a given period of time. Dollar for dollar the Government deficit is equal the Non-Government sector surplus – this is just an accounting rule. What matters is context and whether total spending from all three sectors is contributing to fully utilise all available resources (including labour) within an economy.
The accounting framework I’ve taken from the textbook Macroeconomics and it is as follows
(1) GDP = C + I + G + (X-M)
Which means the 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). X are exports and M are imports. Think of it as the sum of all our production over a period of time.
Households also consume (C) save (S) and pay taxes (T) these are ‘uses’ of income.
(2) GDP = C + S + T
If we equate uses for income with with the sources of income we get
(3) C + S + T = C + I + G + (X-M)
Using some algebra we get the the sectoral balance view of national accounts. We can then divide our economy into three sectors:
- The Government Sector: (T – G)
- The Private Domestic Sector: (I – S)
- The External Sector: (X – M)
(4) (T-G) = (I-S) + (X-M) = 0
Rules of accounting state all balances must sum to 0.
Clearly, what we are interested in is the income of the private domestic sector. (That’s us!) This is how the sectors interact with each other.
A transaction between two individuals or businesses does not alter the net financial position of the non-government sector. For example, I purchase a car for a $10. My account is debited by $10 and the car dealers bank account is credited with $10. I receive my car. The net financial position of the non-government sector has not changed.
However, If a Government spends $100 into an economy and taxes $30 there is $70 in the non-government sector. The government deficit is (100 – 30 = 70) Spending by government equals income for the non government sector. (-70(blue) +70(green) = 0)
Under a fiat currency (that is by decree) all Government spending is appropriated by an act of Parliament. The Government does not source ‘funds’ from anywhere in order to spend.
Now say the government is dismayed. It doesn’t like running deficits. So it runs a surplus. In year two it spends $100 and taxes back $110. (100 – 110 = -10) A surplus of $10!
That surplus has contracted wealth by $10 in the non-government sector.
The total savings in the non-government sector, $70 from year 1, has been contracted by $10, as a result of the surplus, and is now $60.
|Government Sector||Year 1||Year 2|
|Non-Government||Year 1||Year 2|
We can see in the first year the Government deficit enabled the non-government sector to save, In the second year the desire for surplus resulted in the non-government sector decreasing their savings by $10.
If we focus purely on what we observe in the non-government sector it is far more accurate to describe a deficit as an injection and a surplus as a contraction. A government budget increases or decreases wealth in the non-government sector.
The Government can not ‘save’. Saving is an act of forgoing current expenditure to spend at a later date. This can not apply to The Government who is a currency issuer. It can always spend. $ – $ The Government deficit (injection) matches the savings of the non-government sector.
Sectoral balances are usually measured as a percentage of GDP.
In our example below, In Year 1 the Government has run a deficit (injection) of 4% of GDP and the private balance equals 4% of GDP. $-$ The Government deficit (injection) has matched the savings in the non-government sector.
In Year 2 the Government has run a surplus (contraction) of 3% of GPD and by the same amount the private balance has declined by 3% of GDP.
In Year 3 the non-government sector begins importing goods and services and runs a current account deficit (X<M) This is a leakage and a flow of funds goes to the rest of the world. It represents a foreigners desire to save our currency.
In Year 4 the non-government sector runs a current account surplus (X>M) which enables the government to run a small surplus (contraction). Current account surpluses mean foreigners are spending Australian dollars they have acquired through imports and/or borrowing.
In Year 5 the non-government sector has run a current account surplus of 4% of GDP but the Government ran a surplus (contraction) of 4% of GDP. The private sector has not been able to accumulate any net wealth.
In Year 6 the current account surplus wasn’t enough to generate full employment and the government ran a deficit (Injection) of 1% of GDP. The current account surplus (X>M) is the external sector supplying the private sector with our own currency. It receives our currency through imports.
|Year 1||Year 2||Year 3||Year 4||Year 5||Year 6|
|Government Balance |
|Private Balance (I-S)||4||-3||2||3||0||4|
|External Sector (X-M)||0||0||2||-4||-4||-3|
As a rule of accounting the sectors must all sum to zero. The Governments spending is the non-government sectors income. It is the source of net wealth. Spending within the other two sectors merely shuffles wealth.
If the non-government sector is to run current account deficits (X<M) (Australia has since 1974) The Government must replace this leakage with spending more in the private domestic sector to achieve full employment. Imports represent a desire for the rest of the world to save our currency.
The only reason a government should run a surplus (contraction) is if the current account was in surplus and generating enough income to sustain full employment and thus the Government needed to contract spending as an inflation control.
However, if the current account surplus was not enough to sustain full employment, it is vital the Government runs a deficit (injection) to achieve that end goal.
The charts below show the interaction between the sectors for Australia from 1960 to 2012. (apologies for the change in colour of the sectors) The have been sourced from CofFEE. (I apologise and I don’t exactly remember where I sourced these)
You can see the relationship between the three sectors. Since 1996 as the Government began running surpluses (contractions) and the external balance (X<M) was acting as a leakage (current account deficit) the private domestic sector began to lose net wealth.
The only way to sustain growth in this instance is for the private domestic sector to get into debt by using credit. Which I described in this post here.
The federal governments fiscal position in isolation is meaningless.
It tells us nothing about the domestic sector (us!), savings ratios, household debt and so on and so on.
We need to look at what the current account (external sector) is doing and if the domestic sector wishes to save overall the governments fiscal position needs to account for the leakages.
If the current account deficit is running at 4% (as Australia’s has averaged since about 1974) then the deficit at least needs to be >4% to account for the leakages from that sector and allow that sector to save.