There are three sectors that make up the national economy — the government sector, the private domestic sector and the external sector. The private domestic sector and the external sector can be consolidated as the non-government sector. Macroeconomics deals with these sectors in aggregate in describing the operations of the national economy as a whole based on reported data. These data are generally nominal amounts that reflect transactions involving real resources, The accounting reveals how real resources have been allocated through financial equivalents in a monetary economy. Real amounts are nominal amounts adjusted for inflation.
A basic principle of MMT is that non-government saving creates demand leakage, which can be offset by government deficits in order to prevent economic contraction due to demand lagging under output potential. Non-government saving includes both private domestic saving and saving denominated in dollars by the rest of the world (ROW).
The Sectoral Balance Approach
Income = Expenditure (def)
This means that everything that is sold is someone's income.
This implies that Y = GDP
1. Sources of national income (GDP):
Y = C + I + G + (X - M)
where Y is national income, and
GEP is Gross Domestic Product, or national output
where C is consumption of goods for that produce no return
I is investment in goods that produce a return
(Note: I is business investment, not financial investment, which is part of saving)
G is government expenditure net of taxes
(federal, state, and local)
(X - M) is the trade balance
X is exports
M is imports
2. Uses of national income:
Y = C + S + T
where S is private domestic saving
T is taxes
Equating:
C + S + T = C + I + G + (X - M)
Canceling:
S + T = I + G + (X - M)
Transposing:
(I-S) + (G-T )+ (X - M) = 0
This says that the private domestic balance plus the government fiscal balance + the trade balance sums to zero as an accounting identity.
What this implies is that the various components of the identity will necessarily shift to preserve the identity as national income is allocated differently over time. These components can and do shift relative to each other, so the equation is not a statement of equilibrium.
The Government Sector
(G - T) is the difference between government expenditure and taxation over a period. This is generally fixed by government over a fiscal period.
The Private Domestic Sector
(I - S) is the relationship of saving and investment over a period.
Domestic private income is made up of what is spent on consumption and what is not spent on consumption. Saving is that portion of income that is not consumed.
Y = C + S
Domestic private output is made up of what is sold for consumer use (no return) and what is sold for capital use (return). Capital use is business investment, which includes capital goods, improving human resources, residential real estate, and inventory. (Remember inventory. It will be important later.)
O = C + I
Income equals expenditure
Y = O
Substituting:
C + S = C + I
Canceling:
S = I
Again this is an accounting identity. It does not imply equilibrium because saving and investment are shifting quantities.
What this says is that if consumers decide to save more, then investment must rise. since inventory is a component of investment, business may then find itself holding excess inventory that it did not plan for and cannot readily sell. This is a signal of lagging demand. In this way, saving contributes to demand leakage.
This is called the paradox of thrift. Saving is good for individuals but in aggregate saving can creates demand leakage that results in economic dislocation when it leads to unwanted inventory buildup. High aggregate saving during recessions results in demand leakage that business interprets as a signal not to expand to meet demand. As result, the economy continues to underperform, with high employment and an output gap.
When unplanned and unwanted inventory builds up due to falling demand, businesses can either reduce prices or cut back production. If they reduce prices, then they will experience margin compression and profit will suffer if wages do not fall. Businesses generally prefer to cut production and layoff the least productive, inefficient, and non-essential workers, maintaining prices to the degree they are able, rather than slash prices and wages across the board to maintain employment.
When businesses cut back in aggregate, unemployment rises, worker income falls, demand contracts further, consumption drops, and recession ensues. If there is significant private debt, liquidity problems develop from reduced cash flow, and defaults and bankruptcies mount.
Private saving desire aka "propensity to save" is a given that is determined by the public at large. Private saving desire is beyond the ability of government to control or influence directly. Government can only respond to it by accommodating it, or else ignore it. Therefore, according to MMT government fiscal policy should follow the private sector by accommodating private saving desire. Ignoring changes in private saving desire will result in fiscal drag that will impede the economy.
The External Sector
(X - M)
The external sector includes the trade balance (X-M) and other transactions with the ROW, such as foreign direct investment, payment of interest and dividends to foreigners (factor income), and transfer payments such as foreign aid. This is called the current account.
The capital account is the ROW's saving in dollars.
The capital account (KA) equals the current account (CA) as an accounting identity.
KA = CA
This means that all the dollars that foreigners obtain in a period are used either for consumption of US goods, investment in the US, or are saved in US dollars.
The trade balance as part of the current account show whether trade is balance, or foreigners are either saving dollars or borrowing dollars. Since the trade balance represents the bulk of the current account, if foreigners are buying from the US in the volume that they are selling to the US, the ROW is saving dollars.
Saving by the ROW also constitutes demand leakage, since the amount spent on imports that is not offset by exports is money not spent on US output in the period.
Sectoral Balances Sum To Zero As An Accounting Identity
Recall that
(I - S) + (G - T) + (X - M) = 0
where (I - S) is the private domestic balance
(G - T) is the government fiscal balance
(X - M) is the trade balance
What this means is that the government fiscal balance is the inverse of the non-government balance (private domestic balance plus the external balance).
This implies that a private domestic surplus (net saving) and a trade deficit (ROW saving in dollars) necessitates a government fiscal deficit to offset this saving to keep the equation in balance at the present level of output, employment, and saving desire. If government fails to do this, then either output will adjust downward to balance the equation at a lower level, or the private sector will have to save less, or the trade deficit will have to decrease, or some combination of these adjustments.
When aggregate non-government saving increases, then less is spent than produced and inventory rises involuntarily. Then other components of the equation must adjust to maintain the identity, which as we have seen, reduces to an identity between income and expenditure.
Either the budget deficit increases, or the economy (GDP) contracts, or private sector borrowing increases, or the external deficit decreases, or some combination thereof.
The conclusion of MMT is that the non-government balance, which the government does not control, determines the appropriate size of the government fiscal balance in order to maintain full employment and price stability. The goal of MMT is to maintain equilibrium at full employment and price stability by using fiscal policy iaw the principles of functional finance, i.e., injecting net financial assets (NFA) into non-government though fiscal deficits to address demand leakage and withdrawing NFA through taxation to address inflation.
Note: This summary of the sectoral balance approach is only a part of MMT and it does not treat the role of debt in the economy, since the use of credit does not appear in the national accounting equations. The use of credit is also essential to MMT, which grows out of Hyman Minsky's analysis of financial instability. Because the private sector is revenue constrained, private sector borrowing becomes unsustainable over time. This happens when the budget is in surplus and net exports do not offset it. Then the private sector goes into deficit and dissaves in aggregate. "Budget surplus" sounds good to those not understanding sectoral balances. But if the budget surplus is not offset by net exports, then it results in private borrowing in aggregate, which is inherently unstable over time.
References:
Bill Mitchell: Barnaby, better to walk before we run
Posts
14 comments:
Good stuff, Tom!
While this is good and well, how do you respond to the objection raised by Re: The People:
and I will confess that I am somewhat sympathetic to his/her argument.
Quote:
Having proven beyond all counter-argument that the debased dollar is only fictitious money, and, moreover, only a weapon wielded by Wall Street to bludgeon the worker into submission – to threaten her with starvation should she not reduce her consumption beyond already intolerable limits – our simpleton proponents of MMT, whose stupidity apparently knows no bounds, and who treat the entire world of money as if it were as simple and stupid as they are – who, apparently, cannot conceive what lies plainly in their sight: that money is and has always been a weapon of class domination - propose to use this weapon, which has only ever been used against the worker, on the worker’s behalf!
When issues like this come up, Randy Wray reminds us that both Bill Black and Michael Hudson are members of the Kansas City School, and they have consistently addressed this problem. Randy himself has also been in the forefront of speaking truth to power regarding solutions to the crisis having been loaded against workers.
However, the work of Michael Hudson is particularly a propos since he has been writing about this for decades. His solution is taxing away economic rent.
Speaking of rent-seeking, it was Keynes who said, "Euthanize the rentiers." And Hyman Minsky, under whom Randy studied and who is one of the guiding lights of MMT, has also been critical of financialization as inherently unstable.
Bill Mitchell proudly affirms that he is in the tradition of Marx and Kalecki rather than Keynes, since that was is own historical path. I don't think anyone that follows Bill could think that he is not very aware of the class problem and that he views MMT as an antidote within capitalism.
The fact is that capitalism is called "capitalism" because it favors capital over labor. As long as capitalism persists, the only hope is to get it on a short leash through the political process, which is theoretically possible in a liberal democracy, although admittedly difficult give the influence of money on politics.
In my view, the greatest contribution of MMT lies in providing operational knowledge about how the monetary system and monetary economics work. Armed with this knowledge, voters can conceivably change things at the ballot box. Warren's 7 Deadly Innocent Frauds is a great contribution from this point of view.
Moreover, MMT shows how under the present monetary system direct issuance of currency by government is the simplest and most efficient way to proceed. In a democracy, government at least theoretically functions as an expression the will of the people through their elected representative, whom the people get a regular opportunity to replace.
The real question to ask is why workers in a liberal democracy continually vote against their own best interests, in obvious contradiction of the assumption that rational actors mare motivated to maximize utility.
The good news, however, is that under capitalism, workers have actually done a lot better than they have under any previous system. Radical socialism had its chance under communism in a number of locales, but it was unsuccessful because, like capitalism, it got hijacked by an elite that managed to get control of the apparatus of the state.
Given history, the problem is not money it is government. Government may be a problem, but even a bad government is better than anarchy. Anyone who doubts that can go to Somalia to check it out.
Also Scott Fullwiler - The Sector Financial Balances Model of Aggregate Demand and Austerity
Quote:
My ultimate goal here will be to graphically demonstrate her point.
The sector financial balances model of aggregate demand (hereafter referred to as the SFB model) is based on the same basic macroeconomic accounting identity explained in Stephanie’s posts:
(1) Domestic Private Sector Net Saving = Government Sector Deficit + Current Account Balance
We prefer this particular arrangement of the accounting identity because it recognizes that the financial flows in the economy are a closed system—one sector’s surplus/deficit is by accounting identity offset by the opposite for another sector or a combination of the other two.
Tom,
Re: your reply to my comment
One of the things I find lacking in the MMT advocates, is a coherent tax policy.
Often, they come across as "Taxes are bad unless government spending leads to inflation" -- this attitude alienates many progressives, and allows the right wing much leeway in pushing more goodies to the fabulously wealthy!
While the MMT advocates are looking at reducing total tax receipts when they say a tax cut, this is taken by almost everybody to mean a tax cut on the top income tax brackets. This policy position has the rather atrocious result of making the rich even richer, and the money being saved rather than spent, and if spent, it is spent (invested!) in speculative asset acquisitions.
It is extremely important, even from purely theoretical reasons to reinstitute the top tax brackets of the early 1950's. In practice, such a policy if combined with removing income taxes and other payroll taxes for the bottom 80-90% would be extremely energizing for the currently demoralized progressive majority that sits on the sidelines at voting time. At the same time such taxes would reduce rent seeking activity. At the same time, the government could offer inflation indexed savings bonds for small savers -- say upto $1M by social security number. (We should do a policy paper on that! Maybe I will work on it.)
Along with the monetary sovereignty,MMT advocates have to specifically address the issue of the increasing economic divide between the bottom 90% and the top 1%
That's what taxing economic rent is about.
"One of the things I find lacking in the MMT advocates, is a coherent tax policy."
I like what Tom's saying about taxing rents, while the concept is broader than simply taxing land, this California land value tax initiative does keeps it real.
http://www.prospercalifornia.com/frequently-asked-questions/
Green taxes are politically more feasible to pass at the federal level than a land value tax (man, that would drive states nuts). Vermont has been looking at ways to shift taxes from income and sales to pigovian "green taxes" (on pollution, water usage, etc).
http://www.uvm.edu/giee/?Page=research/greentax/greentax.html
I think an MMT-friendy federal tax reform would be one that easily allows for a fiscal stance adjustment depending on financial conditions. This could be done by creating a floating payroll tax holiday tied to monthly unemployment rate (e.g. 9.1% U3, 91% tax holiday).
Or to keep the Fed governors busy after interest rates are locked at 0 (itself a huge deal fiscally, we're projected to spend $5 trillion in net interest this decade,), the Fed could mark up (and eventually, down) their existing miniscule financial transaction fees to drain bank reserves as conditions warrant.
Fed user fees + net earnings rebate to Tsy = a tax system so efficient that not even Congress has to lift a finger. :o)
Clonal, take a look at Warren's proposals, posted at Daily Kos by Joe Firestone here. It specifically addressed progressives concerns with tax cuts.
Tom,
I did look at Warren's proposals, and I find them lacking. While he does partially address the issue of reducing the burden of taxation on the the "not wealthy" -- However, in there he says that the purpose of taxation is to create unemployment. That is a statement I vehemently object to.
One of multiple purposes of taxation is to reduce inflation -- which at a stretch, a very great stretch could be taken to mean "create unemployment."
One of the other purposes of taxation is prevent the inordinate accumulation of wealth. This goes to the direct taxation of "rentier income" This he proposes to do with the additional regulation of the financial sector.
I believe that such an approach is grossly insufficient. Unless Warren plans to abolish the use of monetary interest, and restrict ownership in productive enterprises, I do not see the wealth disparities reducing.
There was a reason for the existence of the 91% tax bracket in the "Golden Age" of the American Middle Class 1950-1964.
Once the mechanics of wealth accumulation and how income/wealth disparities occur and prosper, the necessity of such high taxation becomes obvious.
e-mail me, and I will explain the mechanics with the appropriate references.
Clonal "However, in there he says that the purpose of taxation is to create unemployment. That is a statement I vehemently object to."
I believe that Warren's point is that the purpose of taxation is to give state money value in that people must obtain it to pay their obligations to the state. Giving state money value allows the state to transfer private resources for public use.
What Warren does say is that taxation creates unemployment as a consequence because it withdraws money from nongovernment, which means that total income is not available to purchase all that the economy produces. Unemployment automatically arises when the state enters the picture.
Therefore, unemployment is a problem that the state creates by its existence and therefore is bound to address as an aspect of its functions. It does this by deficit spending in an equal or greater amount than what it withdraws, the constraint being inflation.
But it also matters how the state withdraws net financial assets created by deficits with taxes. Ina capitalistic society wealth accumulates at the top and tax policy needs to address that. Regulation can also level the playing field. Both regulation and targeted taxation are required.
I like Michael Hudson's idea of taxing economic rent to discourage rent-seeking and not taxing productive gain to encourage productive investment and income from production. Warren agrees with taxing land rent but not monopoly rent or financial rent, which he thinks can be more appropriately dealt with through regulation.
Tim,
Paradoxically, higher top tax margins and thus increased taxation can cause an increase in employment as well as increases in wages. Not necessarily from National Income identities, but rather as a result of human behavior.
In the "Golden Age," when the top tax margins were 90%, CEO net taxable incomes were roughly 20 times that of the lowest paid workers in the organization. Today, when the top brackets are at 35%, the net taxable incomes are about 300 times.
The rich will rather give their money away, than have it taxed. This increases employment, wages AND philanthropic contributions. In other words, if I can't keep it, I would rather earn brownie points with my employees, and get kudos for my charitable work!
From the National income equations, higher income tax brackets may actually lead to a decline in government income tax revenue.
That's taxing economic rent. Arguably, the president's job is the most challenging and demanding. Any income received over the president's annual salary is economic rent and should be taxed at a progressively higher rate.
Tom,
The problem is not just economic rent -- it is also the pattern of economic exchange inherent in a free market economy -- that leads to tremendous inequality.
Free markets only work when the playing field is level, and everybody is equally endowed. As soon as wealth disparity and concentration of resources crops up, then free markets will cause a rapidly increasing inequality.
See a small article by Mark Whittington a 2002 third party congressional candidate from SC.
A Model Economy Proves The Statistical Bias of Capitalism
See also his comment which gives more detail.
Also Whittington's first pass Boltzmann-Gibbs curves
See also
Why it is hard to share the wealth
and
An analytic treatment of the Gibbs-Pareto behavior in wealth distribution
Abstract: We develop a general framework, based on Boltzmann transport theory, to analyze the distribution of wealth in societies. Within this framework we derive the distribution function of wealth by using a two-party trading model for the poor people while for the rich people a new model is proposed where interaction with wealthy entities (huge reservoir) is relevant. At equilibrium, the interaction with wealthy entities gives a power-law (Pareto-like) behavior in the wealth distribution while the two-party interaction gives a Boltzmann-Gibbs distribution.
Th at's why capitalism is called "capitalism." It favors capital over labor. Socialism favors labor over capital.There is a constant dialectic between the two. Social democracy is an attempt to integrate them as is The Third Way. The problem now is that the world is moving more in the direction of laissez-faire, which is resulting in social unrest as workers get crammed down. Many see the outcome as being revolution. Of course, the outcome of a revolt is not guaranteed. Could just as well be greater repression.
As I have been saying forever, until the US gets the money out of politics and closes the revolving door, nothing much will change, and if it does, the rich will just gradually take it back as they did after the New Deal. This is essentially a corrupt system.
Harvard economics professor Stephen A. Marglin has written a book entitled, The Dismal Science: How Thinking Like an Economist Undermines Community, which explains how the microfoundations of neoliberalism are based on an extreme version of methodological individualism, which all but guarantees, the outcomes we are experiencing. since it denies social relationships as being important in economic modeling.
We don't need ad hoc fixes to the current economic paradigm. We need a new paradigm based on more realistic assumptions about human choice and action. The rational actor presumption of REH and EMH is just erroneous. Economic microfoundations need to be based on a rational social actor instead of a rational actor as representative agent pursuing maximum utility as an individual on the basis of perfect knowledge in perfect markets.
MMT is based on methodological localism, being an instance of institutional economics. The fix therefore needs to involve institutional change based on a new macro paradigm grounded in rational social action that takes uncertainty and reflexivity into account as essential for adaptation to changing circumstances as the global economy develops.
As ti is now, the priority of the US is global hegemony under a neoliberalism that is controlled by its elite and their cronies globally. See Michael Hudson's Super Imperialism. The desired outcome is a new feudalism of wealth and power, which is ever the objective of elites. The rationale that "justifies" it is trickle-down, the idea that without the elite in charge everyone is worse off than otherwise. This is the elite version of Pareto optimal.
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