Financial Balances: Concepts,

Causalities, and Policy

Implications
Eric Tymoigne
Lewis and Clark College
Econ 320 Modern Money
Basic Accounting Concepts and
Some Preliminary Implications
Flow of Funds Accounts: Financial Interrelations
Domestic Private Government Domestic Rest of the
Sector (DP) Sector (G) Economy: DP + G World (ROW)
ADP LDP AG LG ADE LDE AROW LROW
FADP FLDP FAG FLG FADE FLDE FAROW FLROW
RADP NWDP RAG NWG RADE NWDE RAROW NWROW
FA: Claims on other sectors, FL: Debts to other sectors, RA: Real assets (production capacities), NW: Net worth

Within a sector:
- FAs + RAs ≡ FLs + NWs  NWs ≡ FAs + RAs – FLs for all sector s
- Inside financial wealth is zero: financial liabilities of a sector held as assets within that same
sector cancel out (“I owe you, you owe me”):
- Within domestic economy: “printing more money cannot in and of itself make an economy wealthier” (Ritter, n. 4)
- Within domestic economy: “increasing an internally held national debt cannot in and of itself make an economy poorer
[or wealthier]” (Ritter, n. 4)
- Within domestic private sector: Domestic private debt held by the domestic private sector does not add to the wealth of
that sector.
- Within government: Government debts held among government entities do not make the government poorer or
wealthier (Social Security trust fund, see later)
- Outside financial wealth comes from FA, i.e. claims on other sectors: Government bonds add to
the financial wealth of the domestic private sector and foreign sector, Claims on the rest of the
world add to the financial wealth of the domestic economy.
Across sectors:
- ΣFAs ≡ ΣFLs  FA – FL ≡ 0  ΔFA – ΔFL ≡ 0: For every lender there is borrower.
- ΣRAs ≡ ΣNWs  NW – RA ≡ 0  ΔNW – ΔRA ≡ 0  S – I ≡ 0: Economic accumulation (or growth)
has two sides, a financial side (S) and a physical side (I). They are two sides of the same coin
 Stocks and Flows
• RAt = RAt-1 + ΔRAt = RAt-1 + It: Investment adds
to the stock of real asset (Production side of accumulation).
• NWt = NWt-1 + ΔNWt = NWt-1 + St : Saving adds
to the net worth (Financial side of accumulation)
• FAt = FAt-1 + ΔFAt
• FLt = FLt-1 + ΔFLt
• FAt – FLt = FAt-1 – FLt-1 + Δ(FAt – FLt): net
financial accumulation (or net lending) adds to
net stock of financial assets
In-Depth View of Financial
Balances
 Flow of Funds Accounts: Capital Account
Derivation of Financial Balances
Domestic Private Government Rest of the
Sector Sector World
ADP LDP AG LG AROW LROW
FADP FLDP FAG FLG FAROW FLROW
RADP NWDP RAG NWG RAROW NWROW

We know that financial contracts are both assets and liabilities:

(FADP – FLDP) + (FAG – FLG) + (FAROW – FLROW) ≡ 0
Thus:
Δ(FADP – FLDP) + Δ(FAG – FLG) + Δ(FAROW – FLROW) ≡ 0
Domestic Private Net Lending + Government Net Lending + Rest of the World Net lending ≡ 0
Domestic Private Balance (DPB) + Government Balance (GB) + Rest of the World Balance (ROWB) ≡ 0

For every lender there must at least one borrower: not all sectors can be
lenders (or borrowers)
 Financial Balances in the United States (Billions of Dollars)(Source: FRB)
2000
1750
1500 Rest of the world;
Net Lender (Surplus)

1250 net lending (+) or

borrowing (-)
1000
(capital account)
750
500
Private domestic
250 sectors; net lending
0 (+) or borrowing (-)
(capital account)
Net Borrower (Deficit)

-250
-500
-750 Consolidated
governments; net
-1000 lending (+) or
-1250 borrowing (-)
-1500 (capital account)
-1750
-2000
1952Q1
1955Q1
1958Q1
1961Q1
1964Q1
1967Q1
1970Q1
1973Q1
1976Q1
1979Q1
1982Q1
1985Q1
1988Q1
1991Q1
1994Q1
1997Q1
2000Q1
2003Q1
2006Q1
2009Q1
2012Q1
 Net Borrower (Deficit) Net lender (Surplus)

-15
-12
0
3
6
9
12
15

-9
-6
-3
1952Q1
1954Q1
1956Q1
1958Q1
1960Q1
1962Q1
1964Q1
1966Q1
1968Q1
1970Q1
1972Q1
1974Q1
1976Q1
1978Q1
1980Q1
1982Q1
1984Q1
1986Q1
1988Q1
1990Q1
1992Q1
1994Q1
1996Q1
1998Q1
2000Q1
2002Q1
2004Q1
2006Q1
2008Q1
2010Q1
Financial Balances in the United States (Percent of GDP) (Source: FRB)

2012Q1
2014Q1
GB
DPB
ROWB
National Income and Product Accounts: Current
Account Derivation of Financial Balances
National Income and Product Accounts(YD is disposable income):
YD + T ≡ C + I + G + NX
U.S. International Transactions Accounts (CAB is current account balance, NX is net
exports, NRA is net revenue from abroad including unilateral transfers, KAB is the
capital account balance):
CABUS ≡ NXUS + NRAUS
CABUS + KABUS ≡ 0
Thus:
YD + NRAUS + T ≡ C + I + G + CABUS
But S ≡ YD + NRA – T – C so:
(S – I) + (T – G) – CABUS ≡ 0
Or
(S – I) + (T – G) + CABF ≡ 0
Or
DPB + GB + ROWB ≡ 0
For every surplus there is at least one deficit: Not all sectors can be in surplus
 Financial Balances in the United States (Percent of GDP) (Source: BEA, Table 5.1)
Accumulation of Currency (Surplus)

25

20

15

10

5
ROWB
0 DPB
GB
Injection of Currency (Deficit)

-5 Stat. Disc.

-10

-15

-20

-25
1929
1933
1937
1941
1945
1949
1953
1957
1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
2013
Note: Statistical discrepancies lead to asymmetries for most years.
Government & Foreign Sector Financial
Balances
Fiscal Surplus (GB > 0)

Current Account Current Account

Deficit (CAB < 0) Surplus

Foreigners Net Save Foreigners Deficit Spend

(ROWB > 0)

Fiscal Deficit
11
 Adding the Domestic Private Balance
Fiscal Surplus

Current Account Current Account

Deficit Surplus

When DPB = 0, CAB = GB

Domestic Private Sector
Balance (DPB) = 0

Fiscal Deficit
12
 Sector Balances Map
DPB ≡ CAB - GB
DPB ≡ -ROWB - GB
Fiscal Surplus
(GB > 0)
DPB Deficit (DPB < 0) DPB Surplus
DPB Deficit

Current Account Current Account

Deficit (CAB < 0, ROWB > 0) Surplus

DPB Deficit
DPB Surplus

DPB = 0 DPB Surplus

Fiscal Deficit
13
 Increasing Domestic Private Sector Deficit Implies Declining
Current Account Balance and Rising Government Balance

Increasing DPB Fiscal Surplus

Deficit
+2%
B

+1%
Current Account Current Account
Deficit -2% -1% Surplus

A
DPB ≡ CAB – GB
DPB ≡ -ROWB – GB
At point A
DPB = -2% -1% ≡ -1% - 0%
At point B
-2% ≡ 0% - 2%
DPB = -1%
Fiscal Deficit
DPB = 0%
14
 Increasing Domestic Private Sector Surplus Imply Rising Current
Account Balance and Declining Government Balance

Fiscal Surplus DPB = 0%

DPB = 1%
DPB ≡ CAB – GB
DPB ≡ -ROWB – GB DPB = 2%

Current Account Current Account

Deficit +1% +2% Surplus

-1%

Increasing DPB
-2%
Surplus

Fiscal Deficit
15
Insights from the Financial
Balances
 First and Foremost
• Not all sectors can be in surplus at the same
time: for every net lender (surplus), there must
be at least one net borrower (deficit): A SECTOR
MUST GO INTO DEBT IF ANOTHER
ACCUMULATES FINANCIAL ASSETS.
– A domestic economy can run a CAB > 0 but then the
ROW must run a CAB < 0.
– The government may be in surplus (GB > 0) but then
either the private sector and/or the rest of world
must run a deficit (DPB < 0 and/or ROWB < 0)
 Avoid looking at a Sector in Isolation

(GIVEN CBO’s PROJECTION, Oct. 2000)

Inversed Scale: positive is deficit

These CBO projections imply continuously rising domestic

private sector net borrowing (DPB < 0 and ΔDPB < 0) and/or
continuously rising net borrowing by ROW (ROWB < 0 and
ΔROWB < 0). Never accounted for by CBO.
 Avoid looking at a Sector in Isolation

Source:
Marshall 2002
 Highly politically popular, but economically
difficult or impossible, policy goals
ΔDPB + ΔGB + ΔROWB ≡ 0
Popular policy goals:
- Promote private saving (entice private sector to become more thrifty):
desire ΔDPB > 0
- Achieve fiscal government surplus (or reduce deficit): desire ΔGB > 0
- Becoming a Net Exporter (or reduce trade deficit, or improve
competitiveness, or entice foreigners to dissave): desire ΔROWB < 0,
i.e. ΔCAB > 0

President Obama: "The hard truth is that getting this deficit under control is
gonna require some broad sacrifice, and that sacrifice must be shared by the
employees of the federal government," Obama said. "After all, small
businesses and families are tightening their belts. Their government should,
too.“
 Problems
- Hard to achieve for one country (another country must be
willing to net import)
- Almost impossible to achieve among main trading partners: if
they all try to net export at most each can achieve ROWB = 0
(CAB = 0)
- Impossible to achieve by all countries (world level: ΔROWB = 0
so only ΔDPB > 0 or ΔGB > 0 is achievable)
Desired Policy in a Nation: Lowering Deficit, Improving
Trade Balance, Promoting Thriftiness
ΔGB > 0

ΔROWB > 0 ΔROWB < 0

ΔCAB < 0 ΔCAB > 0

DPB = 0

ΔGB < 0
22
 Impossible to achieve Policy Goals among Main Trading
Partners or World: Lowering Deficit, Improving Trade Balance,
Promoting Thriftiness
ΔGB > 0
ΔROWB = 0: must be true Lower deficit
at world level, likely among Desired but Impossible to
main trading partners engaged Achieve
In the previous policies

ΔDPB < 0

ΔDPB > 0
Higher thriftiness

Not desired but also

Impossible to achieve

ΔGB < 0
23
 Balanced Budget Amendment: Government Forbidden
to Deficit Spend, Limits capacity of domestic private sector to net save (DPS >
0)
Fiscal Surplus

DPS Deficit DPS Deficit DPS Surplus

Current Account Current Account

Deficit Surplus

DPS Deficit
DPS Surplus
Domestic Private
Balance = 0 DPS Surplus

Fiscal Deficit
24
 Or A Stability & Growth Pact Restraint
Fiscal Surplus

Current Account Current Account

Deficit Surplus

Max Fiscal Deficit = -3% of GDP

DPB = 0%

Fiscal Deficit
25
 The EMU Triangle: deficit limit + FX policy
constrained to Achieve CAB > 0 and DPS > 0
Fiscal Surplus

Current Account Current Account

Deficit Surplus

Very little room to also achieve

DPB Surplus

Max Fiscal Deficit = -3% of GDP

DPB = 0%

Fiscal Deficit
26
 GB < 0 15 DPB > 0 GB = -(DPB + ROWB)
GB > 0 1995-2000 average

Switzerland Japan 10

Netherlands Belgium
Italy
Finland Sweden France5
Spain
Denmark Germany
Greece ROWB > 0
Austria
0 Poland Hungary CAB < 0
UK Portugal
-15 -10 Norway -5 0 US 5 10 15
Korea
Australia
Iceland
-5
New Zealand

-10

-15
 GB < 0 15 DPB > 0 GB = -(DPB + ROWB)
GB > 0 2000-2005 average

Switzerland Japan
10
Netherlands

Belgium Germany
Sweden 5
France
Finland Italy
Norway Austria Poland ROWB > 0
Denmark CAB < 0
0
-15 -10 -5 0 UK 5 10 15
Korea US Hungary
Spain Portugal
-5 Australia Greece

New Zealand Iceland

-10

-15
 GB < 0 15 DPB > 0 GB = -(DPB + ROWB)
GB > 0 2005-2010 average

Switzerland 10
Netherlands
Japan
Germany
Sweden Austria
5 UK
Belgium
Finland France Poland Hungary
Italy US ROWB > 0
Denmark CAB < 0
0
-15 Norway -10 -5 0 5 10 15
Korea
Portugal
Australia
Spain Greece
-5

New Zealand
-10

-15
Probably Not Well Understood
 Bloomberg article: “Sweden Shows
Europe How to Cut Debt”
“The value of monetary independence is the first and most important Swedish lesson. Sweden stayed
out of the euro system when the currency was introduced in 1999, and in the past several years,
the government has used this monetary flexibility to the full. ” (yes monetary sovereignty helps
usually)
“Sweden’s second lesson: Fiscal stimulus isn’t a necessary condition for economic recovery. Through the
course of the recent recession, the government’s cyclically adjusted budget stayed in surplus. […]
Fiscal policy still helped to cushion the recession and support a recovery -- not with discretionary
stimulus, but through so-called automatic stabilizers, which are relatively strong in Sweden.” (Yes:
fiscal surplus declined via stabilizers and helped private sector to net save more. However, fiscal
surplus is only possible because current account balance is highly positive to allow both private
sector to net save and government to be in surplus)
“Lacking a currency to devalue and interest rates to cut, members of the euro system would only
worsen their recessions if they squeezed fiscal policy as tightly as Sweden did.” (Yes and no:
someone else in Europe has to be willing to net import, impossible if all countries want to net
export => if everybody desires to net export two paths: currency war to improve export (not
possible in eurozone), or massive austerity to reduce imports (eurozone), but end result is still
that someone will be net importer is someone net exports, at best net export reaches zero for
everybody. If countries persist in their desire, austerity or currency war will continue)
“It helped Sweden that the most recent slump, unlike that of the 1990s, was export-led […] This
suggests a third lesson, political rather than economic: Fiscal conservatism can be popular.” (Yes,
fiscal surplus was achieved only because net export was achieved, which allowed private sector
to save at the same time as government was in surplus)
 Achievable economic policy goals, but less
politically popular today
Achievable policy goals:
- Promote sustainable private domestic spending: private sector spends but S stays positive and
private debt is Hedge finance (see Minsky later): usually DPB > 0
- Let the fiscal balance do the adjustment at the federal level: ΔGB undetermined but GB < 0, i.e.
usually deficit is the norm (Must have monetary sovereignty, see later)
- Let the current account balance adjust and find mechanism to avoid too large increases in
surplus or deficit: ROWB < 0 or > 0 but avoid too large increases in deficit or surplus (This is
the main challenge in this policy agenda)

The goal is to promote internal economic development through full employment and price
stability. Two paths to this:
- First best (hard politically): fixed exchange rate, world clearing system, make countries
with current account surplus do the adjustment by forcing them to spend or face the
fact that surplus will be erased (debt elimination) (Keynes’s Bancor Proposal)
- Second best (easier to do): low interest rate relative to growth rate, flexible exchange
rate, capital control, recognize that some countries must be net importers given their
economic structure or given their role in the international monetary system (US is the
supplier of dollars to the rest of the world, and rest of the world usually wants to net
save dollars so US must run current account deficit)
 Sensible Policy Goals: Let GB be, Promote Sustainable
Investment, Net Import if needed but promote internal
development first over export-led growth
ΔGB > 0

ΔROWB > 0 ΔROWB < 0

ΔCAB < 0 ΔCAB > 0

DPB = 0

ΔGB < 0
33
 Achievable Policy Goals: Let GB be, Promote Sustainable
Investment, Net Import if needed but promote internal
development first over export-led growth
GB > 0

ROWB > 0 ROWB < 0

CAB < 0 CAB > 0

DPB = 0

GB < 0
34
 Conclusion: Economic Desires and National
Accounting Rules
• Economic units have desires/goals they want to achieve.
• National accounting rules shows that some desires are not compatible, or extremely hard to achieve.
• Regardless of the amount of economic adjustments—devaluation, change in interest rate,
aggregate income fluctuation, etc.—some desires can never be achieved and it is highly destructive
to continue policies that aim at achieving incompatible desires.
• It is best to set policy goals and desires that are compatible with accounting rules.
• Accounting rules can be combined with nature of monetary system to draw some important
conclusions:
– Private domestic sector should avoid being a net borrower: leads to financial instability (See
Minsky later) => avoid policy that promote desire to net dissave
– Monetarily sovereign federal government usually needs to be in deficit (unless net export can
be achieved, but see below): always able to service debt denominated in its currency (see
monetary sovereignty later) , allows domestic private sector to net save
– Some economies need to be net importers and must have a current account deficit:
– Limited economic development and resources => in that case foreign aid instead of private
lending is the way to go.
– Provide the international currency (United States): ROW wants to net save dollars
– Given that some countries need to be net importers, others need to be net exporters: there may
be a need to clear debt overtime if it accumulates too fast, and to set interest rate low relative
to growth (see sustainability conditions later).
Developing a theory: Preliminary
Discussion of Causalities
 Keynesian Theory
The previous identities hold for any theory, they are pure
accounting records.
For theory, one must draw some causal relations among the
variables:
- Aggregate spending generates aggregate income so investment causes
saving: I  Y  S.
- Change in debt leads to change in financial assets, i.e. ultimately all
economy activities start with bank credit: ΔFL > 0  I  S  ΔFA > 0
(later we will see how the bank credits are created)
Some behavioral assumptions must also be made:
- G is more or less discretionary (i.e. set by policy goals): transfers are
not discretionary
- T is not discretionary: T = tY, and Y is endogenous
- Private expenditures are mostly discretionary (Go back to Macro)