Revisiting the sectoral balances model in Japan
On a number of occasions, I have pointed to the sectoral balances model of finance to help demonstrate what happens when the government sector runs a deficit or a surplus. A recent article in the Financial Times by Martin Wolf on Japan’s woes highlights this subject and demonstrates how government deficits balance private sector saving. But are the sectoral balances the only factors here? Let’s take a look.
Financial sector balance model
The crux of the matter is that just as money flows (the capital account) must balance with goods and services flows (current account) for the overall economy, so must it between sectors of the economy. This balance should make intuitive sense; after all, the definition of trade is the transfer of your goods and services in exchange for an equivalent money value of currency. You give/receive the good and services and your trading partner within/outside of the domestic economy gives/receives money equal in value to the goods. From a sector perspective, this means that the government’s running a deficit on goods and services axiomatically translates into the rest of the economy’s running a surplus.
When I wrote about this in November I said:
Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).
Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector. Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus. Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.
What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.
Scott Fullwiler has a good graph depicting how the private sector surplus/deficit moves in concert with the public sector deficit/surplus, the difference being the current account deficit:
We can look historically at how these sector financial balances have moved over time. Figure 2 shows how closely the private sector surplus and the government sector deficit have moved historically, which isn’t surprising given they are nearly the opposing sides of an accounting identity. The difference between them, more visible starting in the 1980s, is the current account balance.
Figure 2: Historical Behavior of Private Sector Surplus and Government Sector Deficit as a percent of GDP
Below, I am now providing figure three from Fullwiler’s post at reader request, as it shows the current account deficit as the missing link since the 1980s.
Unless the increasing current account deficit switches direction violently, this can only mean that reducing the government’s deficit reduces the private sector’s surplus. Net-net, the government’s decreased deficit spending will decrease savings in the private sector. And no deleveraging can occur if savings in the private sector are reduced.
Is that what we want? Reduced private savings means continued high private sector leverage. In the U.S., the private sector has much greater debt burdens relative to the size of the economy than the federal government does. You would think we want the private sector to reduce leverage more than the public sector.
Obviously, the Administration’s policies are not designed to promote private sector savings or deleveraging. They are designed to promote spending. And, as you know, recent statistics show that the current account deficit is increasing, not decreasing.
Japan’s financial sector balance
If this point isn’t clear, the FT article makes the same point about Japan – a model for what could be coming to the U.S. as they have struggled with economic depression for two decades.
What has gone wrong? Richard Koo of Nomura Research points to “balance sheet deflation”. According to Mr Koo, an economy in which the overindebted devote their efforts to paying down debt has the following three characteristics: the supply of credit and bank money stops growing, not because banks do not wish to lend, but because companies and households do not want to borrow; conventional monetary policy is largely ineffective; and the desire of the private sector to improve balance sheets makes the government emerge as borrower of last resort. As a result, all efforts at “normalising” monetary and fiscal policy fails, until the private sector’s balance-sheet adjustment is over.
The sectoral balances between savings and investment (income and spending) in the Japanese economy show what has been happening (see chart). In 1990, all the sectors were close to balance. Then came the crisis. The long-lasting impact was to open up a massive surplus in Japan’s private sector. Since household savings have been declining, the principal explanation for this is the persistently high share of corporate gross savings in GDP and the declining rate of investment, once the economy went “ex growth”. The huge private surplus has, in turn, been absorbed in capital outflows and ongoing fiscal deficits.
Mr Koo argues that those who criticise the fiscal deficits miss the point. Without them, the country would have fallen into a depression, instead of a prolonged period of weak demand. The alternative would have been to run a bigger current account surplus.
The problem with Koo’s prescription
Martin Wolf notices a flaw in Koo’s arguments though. It is the enormous public sector debt burden (3x the U.S. level on a debt to GDP basis). But, there is also high corporate savings and low investment returns which are graphed above with the sectoral balance. Wolf then concludes:
Japan’s experience strongly suggests that even sustained fiscal deficits, zero interest rates and quantitative easing will not lead to soaring inflation in post-bubble economies suffering from excess capacity and a balance-sheet overhang, such as the US. It also suggests that unwinding from such excesses is a long-term process.
This is half-right in my opinion. Fiscal deficits, zero rates, and QE have not led to soaring inflation in Japan in large part due to overcapacity. Correct. But, the reason that unwinding from such excesses is such a long-term process is because the excess capacity is still there.
Hello? It’s been two decades for god’s sake. All of this stimulus in Japan has been geared toward maintaining the malinvestment status quo. The Japan Air Lines bailout just this week demonstrates this. This bailout in a sector with overcapacity problems is no different than the GM and Chrysler bailouts in the U.S. If the Japanese were serious about unwinding excesses, they would allow bankrupt companies to fend for themselves. Failure is a part of capitalism too. And when zombie companies are bailed out it lowers investment returns for everyone else and, thus, decreases capital investment. If the Japanese wanted to solve their problems, they would liquidate excess capacity. Instead they are trying to increase demand to meet the excess supply. It won’t work.
The United States is on the same path as Japan. If the U.S. doesn’t learn from Japan’s mistakes, it will end up in a permanent depression too.
What we can learn from Japan’s decades of trouble – Martin Wolf, FT