The single most important piece of economics that everyone should know.

Sectoral balances may not sound like something you need to know, but if you will give me a moment I will try to convince you. It might change what you do.

We are all familiar with whether our bank account is in the black or the red. Sectoral balances are the same, except that now we are talking about the accounts of groups (or sectors) rather than individuals. You and me are part of the household sector. There is the goverment sector, a business sector (which is often sub-divided into financials and non-financial), and a rest of the world sector (which is related to our trade surplus or deficit).

There are few things in economics that are true so when we find one we should cling on to that. Something that is true is that the sum of  all sectors is zero. This is a simple accounting identity. Basically, someone (or sector) can only be in surplus because someone else (or another sector) has lent them the money.

If we aggregate all the sectors into only just two, public and private, then it follows summing to zero means that when we plot their respective surpluses or deficits they will be a mirror image of one another. In words, the public sectors deficit is the private sectors surplus or as vice versa, or as Stephanie Kelton puts it succinctly in this video, the governments red ink is our black ink.

To see this mirror effect, below I plot the public/private sectoral balances as percentage of GDP going back to 1987 (all data is available from the ONS website, e.g. central goverment time series). Surplus is above the line, deficit below. Most of the time, the government is in deficit and the private sector is in surplus – the governments red ink (or grey in this plot) is our black ink!

Now a related interesting question is, why is a government not like a household? Why can government maintain a deficit forever whereas households cannot? The answer is very simple. The income of a household is time limited, whereas the state goes on forever (barring occupation by a foreign power). A government can simply roll over a debt ad infinitum. The UK has debts that date back to the South Sea bubble of 1720, and it is only worth repaying them if interest rates fall below historical levels which for very old debt has become the case recently. In 2015, George Osborne proudly announced how he would be paying back some one hundred year WWI debt, but this only made sense because the economy was doing so badly that interest rates were lower than when the debt was issued.

Now let’s come to the household sector (you and me) which as we know operates on different time scales. You and me are time limited. We cannot roll over a debt for decades or centuries. In the lower plot, I show the household sector on its own. This is really interesting. As you see households are mainly in surplus – they are saving rather than spending. Only very occassionally do they slip into deficit (red) – spend more than they save. This happened around 1988. If individuals spend more than they earn then eventually they have to stop, spending falls and the economy stalls. The result of the 1988 household deficit was the recession of the early 1990s. During a recession, households are, on average, repairing their balances sheets, i.e. saving rather than spending. Consequently, during and after a recession, we see a large private sector surplus and therefore necessarily a large public sector deficit – the mirror effect. This happened in the both the mid 90s and after the recession of 2008.

Given what I have described, the most shocking part of the household data is what happens after 2016 – follow the big red arrow. We have entered a period of househould deficit of a magnitude and duration that is unprecedented in our history.

Good luck, if you think this is going to turn out well.

For further discussion, see here and here.

 

 

 

 

 

 

 

Comments

  1. Roy Gillett -

    Only a typo, I’m sure, but surely you “roll” over a debt, not “role” it over.

    1. Charles Adams -

      Corrected thanks.

  2. Andrew (Andy) Crow -

    Well, it’s not going to end well. How can it ?

    The government is going to want things to get considerably worse before they will be prepared to use their spending power for the common good. Too many fat turkeys are lining up for the plucking.

    When the markets do crash they will HAVE to do something, but until then everything is just hunky dory at the top of the financial food chain with a further feast in the offing.

    Distressed assets will be snaffled-up like truffles.

    Oh. Joy !

  3. Bill Hughes -

    With the Chinese economy threatened by Trump’s tariffs, “emerging” markets going down ie Argentine, Indonesian, Mexican currencies devaluing (not to mention Brexit devaluation!) the global and domestic economic outlook may not be rosy.

  4. Bruce Gray -

    We know how it will end, as the accumulation of private sector debt always ends with a recession or depression. The government then increases deficit spending until the private sector returns back to net savings. How long it takes for the recession to hit, how deep the recession is, or how long it takes to return the private sector to a net savings position and the economy to recover is based on many factors, especially fiscal policy, but the overall course of events is quite predictable.

    Wynne Godley, the brilliant British economist, did extensive studies on sectoral balances and even warned of the pending Global Financial Crisis back in 2004-2005 due to the massive increases in private sector debt brought on by the housing market bubble.

    1. Charles Adams -

      Yes Wynne Godley. Also Wolfgang Stuetzel.

  5. Donald Liverpool -

    This is not as bad as predicted by the OBR in their 2016 post-referendum analysis. They thought the net savings figure would be negative £34 bn for 2017. It’s actually come in at about 2/3rds that.
    Cheer up.

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  8. Bill Philipson -

    Re: “You and me are part of the household sector.”

    Him be professor in England? Him not know English grammar maybe. Me think him should write “You and I are ….”, but me not professor.

  9. joe bongiovanni -

    Why. again, are sectoral balances important to know and understand, and ……. what is it we do again with that understanding ?

    Sectoral balance is an accounting norm, an axiomatic relationship that is established in the premise of the accounting .

    1. The economy has three sectors,
    2. The sum of the trade balances of all three sectors must equal zero.

    That’s it.

    Whether the economy is $10 Trillion.
    Or, $15 Trillion.
    Or, $20 Trillion.

    So, what do policy-makers DO with the FF equation?
    Sit around and marvel at the fit ?

    Really. Is this explained anywhere. ?
    Pay more attention to FF, and then do what ?

    Try to change the balances next year?
    Why?
    What difference does any of it make?

    1. Charles Adams -

      Well it depends if you are worried about public sector deficits or not? If you understand that the public sector deficit is simply the private sectors savings, does that change the way you think about ‘the deficit’, and the way you vote? When we realise that money is simply accounting, do we understand that it is what we want to do, not money, that is important afterall?

  10. Richard Graham -

    ricardo2000 I suppose your argument depends on the definition of ‘sector’, and on what is left out of the ‘economy’. Both are far from bias-free application.

    1. Charles Adams -

      May be. The sectors are defined by the ONS following standard practice, but I would agree that there is important stuff in life that is not in their book of accounts.

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