In 1999 Wynne Godley penned “Seven Unsustainable Processes” where he, based on a new-Keynesian concept of sectoral financial balances, predicted the forthcoming recession. Godley pointed to seven unsustainable processes within the US economy that rendered it vulnerable to sudden shocks. More specifically, Mr. Godley found that the US boom of the 1990s was based on;
- fall in private saving into ever deeper negative territory,
- a rise in the flow of net lending to the private sector,
- a rise in the growth rate of the real money stock,
- a rise in asset prices at a rate that far exceeds the growth of profits (or of GDP),
- a rise in the budget surplus,
- a rise in the current account deficit,
- an increase in the United States’ net foreign indebtedness relative to GDP
We would add that the flow of lending to the private sector was based on unsustainable growth in the money supply which were both caused and paradoxically backed by asset price inflation. In other words, the net flow into the private sector could not be maintained without an ever more accommodative central bank. Only lending based on real prior savings have a sustainable foundation.
An increasing current account deficit was, and still is, also a direct consequence of fiduciary media creation which feeds into the global Eurodollar system; backed only by the implied covenant of good faith and fair dealing of a fractional reserve banking system. It has nothing to do with a saving glut from China or any other place, but was essentially recycling of the very same “dollars” emitted out of the American banking system.
And last, we obviously don’t suggest that a federal budget surplus could cause a recession in itself, but rather note that the surplus was also a direct consequence of the dollar inflation present at the time.
While Mr. Godley’s interpretation of the sectoral financial flows are mainly flawed, his observations were timely; thus the concept deserve further scrutiny. Mr. Godley’s work has also been used to the absurd by Financial Times writers, such as Martin Wolf and Wolfgang Munchau, in their poorly hidden agenda for more fiscal profligacy and monetary folly.
That said, used with caution, sectoral balances can give us an idea of what is going on inside an economy in terms of where imbalances are building and by extension indicate what to expect and how it might play out.
A sectoral financial balance assume that one man’s liability is another man’s asset, so in aggregate they will per definition sum to zero. In its broadest version the concept operate with only three sectors; government, foreign and private.
The starting point is the tautological Keynesian version of GDP as Y = C + I + G + (X – M) which can also be expressed as Y = C + S + T, where S is total saving and T is total taxation. In other words, total production must by definition equal to household consumption, investment and government claim to resources, adjusted for net exports.
Please note that we do not say that a change in neither C, I, G nor X-M causes increased production as demand apologist tend to do, we only say that production must equal its use at any given time if inventory changes are taken into account.
You should also note that what goes for gross domestic production is nothing more than a measure of total money spent on goods and services during a specified period of time, and are therefore the broadest measure of monetary inflation available. Hence the ability of central banks to cause “growth”, which must not be confused for prosperity.
Since both equations above equal Y, we can substitute to get C + S + T = C + I + G + (X – M) and rearranged we get (S – I) = (G – T) + (X – M) which enable us to do the calculations.
Source: Bureau of Economic Analysis (BEA), Bawerk.net
Our observations; within the Bretton-Woods gold exchange standard a semblance of monetary prudence was kept intact and fiscal profligacy had to be funded through taxes.
We are well aware of the fact that Federal Reserve did not strictly adhere restrictions imposed on them through gold ties, especially after the Great Society bread and circus program got going; still most countercyclical policies were conducted through the budget as opposed to today where monetary, or military rather, Keynesianism is the go-to solution for all conceivable socio-economic ills.
With the collapse of Bretton-Woods the Eurodollar market exploded and with it the US current account went deep into negative territory.
When Volcker was pushed out in favour of Greenspan, The Maestro’s longing for belongingness combined with interest rate targeting freed from all shackles to barbarous relics in a world of global price deflation, the world was presented with a perfect recipe for financial disaster.
In its first stage, the boom of the 1990s, the private sector made an unprecedented move into a negative financial balance, funded by Greenspan and a “deregulated” bank system (we hate to use the word deregulated here since what really happened was a concerted effort to expand fiduciary media production, id est. increasing leverage in the fractional reserve banking system).
A fiat funded boom always comes to and end (dot-com crash) and then the private sector tries to re-establish a positive balance based on the revelation that prior financial euphoria was nothing more than irrational folly. Dot came and went.
However, for the Keynesian eye the ongoing recession is not a healthy market clearing process, but something that must be fought. And fought it is. A housing bubble is promptly formed to incentivize households to go on another spending spree ultimately pushing all three financial balances into negative. A larger bubble bursts when the economic agents once again tries to re-establish their financial balances to a more sustainable pattern.
The most perverted thing is that even after making the exact same mistake several times over, the current policy is still to get the private financial balance into negative territory to maintain the serial bubble economy. And in a couple of quarters our money masters will have succeeded with the inevitable result of another, even larger, correction in the not too distant future!
And it gets even worse. The private financial balance can be written as (S – I) = (P – B – E – T) + (H – C –Ires – T) where P represent the corporate sector and B its bond issuance and E equity placements. H is households less its consumption and residential “investments”. T is still taxes to fund the government sector. The calculations are shown in our second chart
Source: Bureau of Economic Analysis (BEA), Bawerk.net
In “normal” times household surpluses were invested in productive capital, yielding a decent return for savers and growing the overall economy. Starting with the Greenspan frenzy US corporations, incentivised by cheap money, bubbly stock markets and a “new economy” became heavily distorted. The boom burst and capital was lost through misallocation. The 2000s bubble on the other hand was driven by a relentless deterioration in household’s financial balance sheet. As always, the bubble inevitably bursts and both households and corporations tries to repair their financial balance sheets. Unfortunately, the monetary mantra is well ingrained and through excessive central bank intervention financial balances are once again deteriorating. At first glance it looks sound though, with corporations investing the surplus from households just as the good old times, but we just learnt that US Corp. spent 104.1 per cent of their profits on share repurchases and dividends in the first quarter. In other words, they are using cheap debt to anything but productive investments.
It is important to note that we are looking at imperfect aggregates when analysing sectoral financial balances. The Keynesian loves aggregates to the point where they call for a complete division of postgraduate studies: departments of macroeconomics should not even teach microeconomics, or vice versa, because macroeconomists must be protected “from the encroachment of the methods and habits of mind of microeconomics”( Source) and have become completely oblivious to the fact that macroeconomics is just the sum of individual actions.
Some pundits, such as Martin Wolf and Wolfgang Munchau, deride the German ordoliberalists for pursuing a strategy of deleveraging. They claim it is impossible to lower overall debt, cause any improvement in private financial balances must by definition, as shown by the equations above, be met with a corresponding deterioration of the public balance sheet.
This sounds plausible enough, but must be wrong because if it were true that overall debt levels could not fall, they couldn’t rise either. And we know for a fact that they have risen exponentially over the last three decades.
The problem with aggregates is that they hide important details. A financial balance only shows the present claim on goods and services, but disregard the stock of future claims building up.
Take a simple example with an economy consisting of two persons and two periods. In the first period the first person would like to study to improve his skill set. To do that he enters into an agreement with person #2. Person #2 will provide person #1 with one bread per day for one year while person #1 spend his time studying. During the first year, person #1 will have a negative financial balance, while person #2 has a positive balance.
After one period there will be a stock of future claims to 365 breads. In other words, the economy has debt equal to 365 breads, or 50 per cent of GDP (assuming person #2 produced two bread per day, one for person #1 and one for himself)
In the next period, year 2, person #2 can take a sabbatical and live off his accumulated assets. Person #1 would thus provide one bread per day as repayment. The financial balances have turned.
Note that in this simple example economic output is unchanged, debt rises and then falls back to zero. There is no need for person #2 to go into debt for person #1 to decrease his.
If person #1 used his time wisely he would have studied something useful. Then his investment would be productive and it could help grow the economy. He might be able to produce four breads per day and not only pay back his debt, but increase living standards and make room for ever more productive investments ad infinitum.
In a serial bubble economy monetary policy must always push financial balances into negative, but this is like pushing on a string because it is not a sustainable equilibrium. However, in the process demand patterns shift and the structure of production follows suit. When the money flows stops, the malinvestments are exposed, but rearranging capital is time consuming and the economy enters into a recession as the market tries to clear itself.
Once again we find ourselves in a situation where aggregate financial flows looks unsustainable due to monetary interventions. We all know what happens next.