Sectoral Balances and Private Saving

With permission from Being Libertarian, I am reposting an important exclusive piece I wrote that lays out some fundamental changes in how I’ve come to understand the functioning of a fiat money economy, and its economic implications on debt, deficits, unemployment and other hugely important concepts:

In a recent post I showed how the domestic private sector’s net saving can be a helpful economic indicator. When domestic private sector net saving runs low a recession may be on the horizon. When it goes negative a severe recession if not even a depression is in the cards.

But what exactly is the domestic private sector’s net saving? It’s basically all cash, bank reserves, and government securities held in domestic accounts.

In a fiat economy, as I’ve explained in my recent post about Modern Money Theory, the government is the sovereign issuer of high powered money. The government pays individuals by crediting their banks’ reserves, it taxes them by debiting the same. If more is injected than is drained over a certain period, a surplus remains in private bank accounts, while the government has incurred a budget deficit.

Bank reserves can also be exchanged for government securities to earn some interest. Government securities essentially function like savings accounts at the Federal Reserve Bank.

This leads us to the first way for the private sector to accumulate net savings which is is by receiving bank reserves (or cash) from the public sector.

Note that in the example above I’ve left out the foreign (private and public) sector. It basically consists of individuals who possess and accept a different government’s fiat money but would like to trade with the domestic private sector here. If a foreigner wants to buy goods in the domestic private sector he sells his foreign currency ultimately to the domestic central bank (who then holds foreign currency reserves) in exchange for domestic currency, and then uses it to make his purchase.

We can conclude that the domestic private sector can obtain additional net savings when it receives more inflows of money from abroad than it spends on purchases from abroad. This is commonly referred to as a current account surplus (the foreign sector’s deficit). A current account deficit (foreign surplus) has the opposite effect: It drains the domestic private sector’s net savings. But ultimately if you trace it back all the way a current account surplus is of course also the result of some other government having spent more than it has taxed.

It is true that domestic banks also make loans which create new domestic checking accounts, essentially somebody’s savings. However, this type of creation of new savings is always counterbalanced by a loan, so it nets out to zero within the domestic economy. No net financial assets are created for the domestic private sector here.

We have now established 3 different sectors that play an important role in a fiat money economy: The public sector (the issuer of the national currency and unit of account), the private sector (the user of the national currency), and the foreign sector (issuer or user of a different currency). It should be clear from this that the separation into these 3 sectors is by no means arbitrary. It is based on the actors’ relation to the national currency.

It should also be clear from my outline above that the net balances of each of these sectors add up to zero. For example: If the country has balanced trade and the current account is at 0, the public sector’s budget deficit matches to the cent the mirror image of the domestic private sector’s net accumulation of financial assets, aka the net private saving in the country.

This sectoral balance identity can be observed in this chart that I’ve put together on

USA Sectoral Balances Chart

You can see there that the private sector’s surplus (blue) plus the foreign sector’s surplus (green) consistently equal the inverse government budget deficit (red) to the cent. You may have noticed that the private sector surplus in the blue chart above is exactly the same chart as the one I presented a few weeks ago when I explained the correlation between private sector saving and recessions.

What do we conclude from this? In order to achieve a sustained level of net private saving, which seems to be important to the health of the domestic economy in a fiat money system, a country either needs to run a sustained current account surplus, or a government budget deficit, or a mix of both. In the case of the United States, which runs a current account deficit at the moment, there is in fact no other way to accumulate net private savings than to run a government budget deficit.

This is an important mathematical identity to keep in mind when listening to public policy debates and discussions about the budget deficit and so called “balanced budgets”. Given that under a fiat regime the domestic private sector of any country has an inherent demand for net private savings, and given that under such a regime the government is by law the only supplier (monopoly supplier) of such net private savings, it is important to keep in mind that making a “balanced budget” your domestic policy objective runs the risk of depriving the private sector of that which it demands. If all governments in the world were to run “balanced budgets” there would in fact be no way at all to accommodate any territory’s private sector demand for net savings on top of making the required tax payments.

None of what has been presented so far is a political prescription, as much as it is just basic math. This information can be utilized by people who favor big government or small government alike. Budget deficits to accommodate private sector savings demands in a fiat money system can be achieved by means of increasing government spending, but they can also be achieved by cutting taxes, the latter obviously being the preferred policy of choice for many libertarians, myself included.

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Is Austerity a “Recipe for Disaster”?

Let’s say you are stranded on an island for a week and you climb trees every day to pick up and eat coconuts, and also set aside one coconut a day.

Then over the course of the next week you don’t climb trees at all and just eat 7 out of 7 coconuts that you have stored up.

So the next week you have none left. So now you need to do with fewer coconuts during that week (=austerity) and climb some trees again (=work) to get some more.

Is it a recipe for disaster for that week to have no coconuts left to consume? Maybe it is. But the question is meaningless …

Is there anything you can do about it other than consume less and work more (= generate savings) again?

When you jump off a cliff, is the existence of gravity a recipe for disaster? Sure it is. Is there anything else you can do other than take the fall?

When you are shot in the foot and the infection is about to creep up your leg, is that a recipe for disaster? You bet it is. Is there an option to keep your leg without amputating the foot?

Unfortunately, in any of those cases, you’re SOL, my friend … and you need to accept reality in case you care to try and make the best of it.

The good news is … falling off a cliff is a lot worse than restoring discipline and prudence in your financial dealings. =)

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The Great Credit Contraction & Deflation

Lew Rockwell posted a piece by Bill Bonner which strongly supports the deflationist view:

“In a fundamental shift, consumers are saving rather than spending,” notes the Los Angeles Times.

This is the shift we’ve been talking about for months. The great credit expansion of 1945–2007 is over. Now cometh the great credit contraction.

During the bubble years, more and more credit produced less and less real prosperity. It was as if you were borrowing more and more, to invest in your business or merely to increase your standard of living, but your income didn’t rise fast enough to keep up with the interest payments.

In 2005, Americans saved nothing. Not even aluminum foil or string. Now, the savings rate is approaching 5% of disposable income – a big turnaround.

We know from logic and experience that saving money – not spending it – is the key to getting wealthier. Saving money gives you capital. And it’s capital accumulation – in the form of factories, roads, ships, buildings, machines…and raw savings – that gives people the ability to produce more. It may take a man with a shovel a whole day to dig a decent grave. Give him capital – in the form of a backhoe – and he can bury everyone in town. That’s why capitalism works. It rewards the fellow who saves his money.

Yet every yahoo economist in the year of our Lord 2009 takes news of rising savings rates like the death of Michael Jackson. If households don’t consume, they reason, how can a consumer economy grow?

The problem is that you can’t really grow an economy by borrowing and spending.

Recent history proves it. Despite the biggest splurge of borrowing and spending in history, the US consumer economy barely grew at all.

“In the five years to December 2007,” reports Grant’s Interest Rate Observer, “America’s credit market debt climbed by nearly 57%, to $18 trillion. However, in the same half-decade, nominal GDP was up by only $3.3 trillion.”

For every five dollars people borrowed, they only increased their incomes by $1. Imagine that the borrowing had an average effective interest rate of 10% (credit card debt can be much more expensive). At that rate half of the additional income earned between 2002 and 2007 had to be used just to pay the interest.

“Companies, households and banks all want to pay down debt and…prefer to hold cash rather than assets, partly because the outlook for those assets is poor and partly because after a decade of excess, everyone now looks a bit over-extended.

“This is exactly what happened in Japan during its lost decade, when a balance sheet recession, one characterized by the paying down of debt and liquidations of assets, was self-reinforcing and very difficult to stem.”

And now this from David Rosenberg:

“The ultimate question is where all this cash is going to be deployed, and we believe it will ultimately be diverted toward debt repayment.”

Let’s see. We can figure this out from the numbers above. American consumers must have added about $7 trillion in extra debt during the Bubble Epoque, 2002–2007. Now, instead of buying things, they use their money to pay it down. The average household has about $43,000 worth of income. Let’s keep the math simple by saying there are 100 million households in the United States…and that they save 5% of their income. And let’s say they use every penny of savings to pay down debt. Hey…it will only take about 30 years to pay it off! Get ready for a long, long slump.

Yesterday, stocks went nowhere. Oil went nowhere. And the dollar went down as gold went up.

The reason for the dollar’s decline and gold’s rise was given in the front-page headline of yesterday’s Financial Times. China launched a “new dig” at the dollar, it says. As near as we could tell, China merely stated the obvious – that the world is going to have to find a better monetary system. The US dollar won’t be king of the hill forever. And China, which is up to its neck in dollars, would like to find a solution sooner rather than later – that is, before the dollar goes the way of all paper.

The dollar will eventually give way to inflation and devaluation, but probably not soon.

“I’m absolutely worried about inflation,” says John B. Taylor.

But it is not inflation that worries us…it’s the lack of it. Making a long story short, as long as the feds see no inflation they will continue trying to create it. In the end, they will get more than they wanted.

Though, right now, instead of inflation, we have deflation. Yesterday’s New York Times tells us that deflation in Ireland has reached 5.4% – the highest since the Great Depression of the ’30s.

You know the reasons for deflation as well as we do. The world suddenly has too many people who borrowed too much money to buy too many things they really didn’t need and really couldn’t afford. This caused the world’s producers to greatly over-estimate the “real” demand. Their customers began to disappear in 2007. Their factories are still standing.

I may add: Who says that Americans will only want to pay down the recently amassed $7 trillion in debt during this downturn. As I explained in Inflation & Deflation Revisited, the total debt load in the US is at around $60 trillion, if one includes unfunded government obligations it is more like $120 trillion. That is not to say that all that debt needs to be paid off as part of this contraction, but it is reasonable to assume that a more significant portion will have to be paid. On the other hand, his estimate of an ongoing saving rate of 5% is a bit too low.I believe US households will be saving a lot more in the decades to come, more like 10% which is a historical average.

But in general this piece is consistent with what I wrote a while ago in Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving – The Long Term Outlook:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

And how much less we will have to consume to support such level of savings I explained in True Consumption as Percentage of GDP:


…the red line is the average over the past decades to which we will have to return during this contraction, maybe consumption will go even lower since corrections always undershoot regular levels.

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US Saving Rate Highest in 16 Years

The US Personal Saving Rate just hit 6.9%:

The last time it was higher was in December 1993:

Savings are crucial to economic progress and prosperity. For the first time in decades Americans have realized this and are turning the tide. This is in line with ongoing Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving.

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The End of Consumerism

In a free society where individuals are allowed to make choices by themselves so long as they don’t infringe upon their fellow men’s life, health, and property, entrepreneurs use natural resources, transform them and/or combine them with previously produced factors of production, and turn them into either consumer goods or other factors of production. They employ workers in the process who provide the production factor labor.

They exchange consumer goods on the market against money obtained from consumers. They exchange factors of production against money obtained from other entrepreneurs.

Factors of production, once completed at some point in the future, enable entrepreneurs to produce more consumer goods during the same amount of time. But while factors of production are being built, workers and natural resources are being used in processes that don’t turn out any consumer goods. It is thus necessary to only employ workers and resources in the production and maintenance of factors of production to the extent that during this process individuals in society are willing to not consume the full output of their labor, and hence generate savings.

On top of that, it is necessary to maintain the existing stock of productive factors, lest their wear and tear cause a decline in the output of consumer products. Thus a continuous level of savings needs to be maintained by individuals in society.

Interest rates on the market give entrepreneurs an indication of the market participants’ time preference, meaning how much immediate consumption people are willing to forgo in exchange for the prospect of more future consumption. In other words, interest rates give an indication as to how much people are ready to save and thus contribute to the maintenance and new developments of factors of production.

If the the government pursues a policy of business credit expansion, the interest rate indicator is manipulated by force, as opposed to voluntary individual time preferences. The interest rate drops below the level that represents those actual preferences. If mostly consumer loans are pushed, the consumption business cycle ensues:

The Consumption Business Cycle

The central bank and fractional reserve banks create new fiat money and make it available in credit transactions to individuals who intend to use the money for the purposes of consumption. Examples would be car loans and home loans which made the US economy align its productive factors accordingly over the past decades. It is likely, but not necessary that interest rates for such credit instruments will drop initially.

Some individuals may now enter into these new credit transactions and use the new money to consume goods that they wouldn’t have consumed before. But they didn’t do so by reducing their savings, nor did anybody else sacrifice consumption to make this money available. It was created out of nothing. No additional consumer goods have been produced.

The prices for the goods demanded will begin to increase. Entrepreneurs will respond by abandoning the production of some additional factors of production and turn out more consumer goods instead. So long as more credit is channeled into the system, prices will continue to increase while entrepreneurs try to catch up. Fractional reserve banks will begin to earn more interest revenue and expand their operations and resource usage.

Businesses that produce consumer goods will report higher profits, while profits for businesses producing factors of production and basic materials will lag behind. A myriad of consumer goods based businesses will spring up over time. The alignment for immediate consumption vs. more/better future consumption continues so long as individuals continue to be able to pay interest on the credit transactions performed and expect to be able to do so in future.

But as explained above, making interest payments and paying off debt is only possible in the long run if the workforce, as a whole over time, becomes more productive per unit of labor. But the opposite occurs. Productivity per labor unit will be lower than the additional consumer loans appeared to indicate, since in an unhampered system credit can only come out of savings (which means someone somewhere forgoes immediate consumption, making room for more factors of production). After a certain period, the amount of debt and interest payments will become higher than consumers can afford. In addition, due to lower interest rates, a lot of rather risky loans were made to individuals that would not have occurred in the unhampered state. Individuals will begin to default on their interest payments.

They start realizing that they need to consume less and save more in order to not have this happen again. Their demand for additional credit drops sharply. Their demand for money to pay off the debt and/or generate savings rises.

The fractional reserve banks will begin to slow down the creation of additional credit. They begin reporting losses on existing consumer debt.

As excess consumption comes to a halt consumer prices begin to fall, businesses aligned for the production of consumer goods will see declining profits, some will start reporting losses. They realize that they will have to abandon some projects since the demand for consumer goods starts to fall back to sustainable levels that match everyone’s time preference and expectations. The desire to consolidate one’s finances takes priority over everything else.

This is what is currently happening in the United States. The end of consumerism really means the end of capital consumption. It means that people realize that they need to save more and consume less, so as to provide for economic progress and more efficiency in the future, and to restore balance to the economy as a whole. It means that people have understood that too much of the existing capital stock has been consumed and has deteriorated.

This is the causality that the majority of pundits and economics professors that one can hear talk every evening on the news simply don’t understand. All their theories and policies are ignoring this one crucial fact: That Americans are done consuming for the foreseeable future. The end of consumerism isn’t just a temporary ditch. It is here and now and it won’t go a way for a long long time. It is a once in a lifetime occurrence. This is why it is so hard to grasp and to accept. But it is very simple to understand when one approaches it with sane common sense. How many more Starbucks branches do we need in the streets of New York? How many more gas guzzling cars should each family posess? Three, four, ten …? How many more different brands of detergents, shampoos, toothpastes, and consumer electronics products do we really need?

Now, it is important that the reader doesn’t get this wrong. I do not oppose consumption. In fact, the entire material wealth of a person is ultimately determined by how much he can consume. Consumption, present or future, is what all humans ultimately work for. But if, in an environment of government induced credit expansion, people consume more than is sustainable in the long run so long as the music still plays, they need to cut back for a certain period once the music stops playing. If we had never embarked on the disastrous path of credit expansion and government intervention, if all factors of production were allocated as efficiently and effectively as possible, if the government had confined its scope to the protection of each individual’s life, health, and property, we would today be able to consume a lot more than we currently can.

Unfortunately this is not the situation we are in here and now. We do not live in a perfect free world. We need to respond to the reality around us rather than deny it. It is time to cut back and restore sanity and balance. Individuals have realized this and are doing the right thing. The government has not understood this fact at all. It is trying to keep alive failed businesses that should release resources for more demanded projects. It is trying to make up for the “lack of consumption” in the private sector. All these attempts will fail miserably. All they will accomplish is to slow down the corrective phase and turn it into a decade of agony.

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