Last week (in Debt, deleveraging and crisis in the US), I discussed what happened to US debt and borrowing, prior to and since the crisis. In this post, I look at the associated pattern of income and expenditure. It looks at the macroeconomics of deleveraging or what Richard Koo of Nomura Research calls “balance sheet recessions”.
I look at this through the lens of “sectoral financial balances”, an analytical framework learned from the work of the late Wynne Godley. The essential idea is that since income has to equal expenditure for the economy, as a whole, (which is the same things as saying that saving equals investment) so the sums of the difference between income and expenditures of each of the sectors of the economy must also be zero. These differences can also be described as “financial balances”. Thus, if a sector is spending less than its income it must be accumulating (net) claims on other sectors.
The crucial point is that, since sectoral balances must sum to zero, a rise in the deficit of one sector must be matched by an offsetting change in the others. It follows that if the fiscal deficit is increasing, the sum of the surpluses of the other sectors of the economy must be increasing in a precisely offsetting manner.
These are tautologies. But the virtue of this framework is that it forces us to ask what drives what: are, for example, fiscal deficits in the US (or UK) driving the surpluses in other sectors or are the surpluses in the other sectors driving the fiscal deficit? We can obtain answers by examining what behaviour is changing. I will argue that during a big financial boom and subsequent crisis, it is the private sector’s behaviour that changes. The government responds in a largely passive way. That has certainly been the case in the US. It is not government decisions that explain the huge shift into fiscal deficit, but private sector decisions.