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

  1. Jeff says

    “If the Japanese were serious about unwinding excesses, they would allow bankrupt companies to fend for themselves. Failure is a part of capitalism too.”

    Everybody understands this. However, Governments like to stay in power and the people of Japan would have thrown out the LDP long ago if a reduction in capacity (with the implied unemployment) was allowed to happen. I don’t think the DJP will let the failed collapse and shoot itself in the foot politically either. Remember, in Japan, the company is a part of your identity and life (as, BTW, I think it should be) and many expect to be there for life.

    So, no I don’t have a policy prescription, but I think saying Koo’s argument is wrong misses the obvious. While it’s clear that the situation is long term unstable, it’s also clear that kicking the can down the road like GoJ (and now the US) are doing is the best political option anyone has thought of. Hopefully someone else is in office when it can no longer be sustained… as Edward said previously, the status quo works for the policy makers.

  2. haris07 says


    I read this article from Marshall yesterday

    What he is saying (or maywhat I am implying, perhaps incorrectly) is that instead of “financing” deficits by issuing sovereign debt (which pays interest), the government (in Japan as far as the article is concerned, but upon a change of law, could also be in the US I suppose) could just credit bank reserves with printed money (or the electronic equivalent) thereby solving any sovereign debt financing issues voila! I have a few questions and was hoping you could shed light:
    1. Am I reading this right?
    2. If it was so easy, why doesn’t everyone who issues debt in their own fiat currency do it? Corollary to this question is what effect does this have on the currency value?
    3. Of course, the answer to “2” above is what happens to the currency value and “inflation”? As long as there is significant over capacity, is inflation a concern (Marshall argues it is not)? Again, why doesn’t the Japanese government just QE their way to finance fiscal deficits directly and put an end to this “what happens when interest rates rise” question altogether? Then, of course, the question is what do those fiscal deficits actually accomplish – do they lead to productive and sustained projects or are they wasted on bailouts/malinvestments.
    4. Versus US, the big difference lies in that US runs a current a/c deficit while Japan of course has been running surpluses all the time. Can the US “finance its deficits” the same way?

    Bottom line, I am trying to get your thoughts on the Marshall piece and why couldn’t Japan just continue for decaded to “finance” their fiscal deficits by just stopping the charade of issuing debt and just credit bank reserves and not even bother with the question of “what happens when long term rates rise”?

    1. Edward Harrison says

      He’s right and I posted on this as well. Read my commentary from November here:

      1. haris07 says

        Thanks Ed, still trying to get up the curve on understanding all this and contemplating whether Japan would be the best “contrarian long” bet now – at least for a short term (before inflation rears its head). Looks like the JGB long rates maybe a continue to be a conundrum for a while!

        Thanks for posting on such arcane stuff – now if only I can get to the practical investment implications of this and all of the stuff you post!

  3. Matt Stiles says

    This is the question. I said it from the very beginning of the crisis (before, actually): “This can take either two years or ten. Your choice.”It is either:1) a stagnant depression-like gradual recapitalization of the current overleveraged corporations. 2) bankruptcy and liquidation of the guilty (and many innocent bystanders as well). #1 takes a decade or longer. While it occurs, productive assets fall into disrepair, unemployed workers lose their skills and the standard of living deteriorates slowly. When it is finally completed, the productive base of the economy is drastically handicapped. #2 takes a few years. High unemployment results. But when it is over, we have much more of our productive and human capital intact. Moreover, their ownership has changed. So what do we want to destroy in order to deleverage? Paper assets or productive and human capital?I couldn’t give a rat’s ass about the political implications. The entire basis for democracy is that those who are elected will act in the best long-term interests of the people which they serve. If they won’t do that for selfish reasons, then we have no practical use for democracy. A depression is a feature, not a bug (no, that’s not masochism – merely a step forward toward a foundation whereupon a better future can be built)

  4. Dan says

    “Instead they are trying to increase demand to meet the excess supply. It won’t work.”

    When you put it that way, it sounds almost as a planned economy. Then again, what else can all this interventionism be called?

    1. Edward Harrison says

      That’s definitely right. It’s excessive faith in policy makers over markets.
      Yes marketable fail, but 9 times out of ten they are the better solution.

      Sent from my mobile phone

  5. gaius marius says

    i think japan is troubling because there’s demographically little prospect for domestic growth. so japan must grow exports to really grow into its excess capacity. deficits and currency policy have been used to avoid liquidation, but also to keep japan a mercantilist exporter. that of course makes it vulnerable, as was the US in the 1930s, to the economic collapse and stagnation of its end markets.

    but also, japan’s endless deficits have had the intended effect. corporate sector leverage as a percentage of GDP was at a 30-year low in 2005. that’s the plan for the US as well, i imagine, if the political willpower is there.

    i think of japan as now being in an entirely different crisis than it was from 1990-2005. its corporate delevering is over. its now faced with the more traditional cyclical peril of all mercantile states, in combination with this new antigrowth phenomena of population collapse. the former aspect will correct in time; the latter is pretty new, though, and i wonder how the growth model will be forced to change.

    1. Edward Harrison says

      @dafowc Your comments on population collapse bear remembering because we can’t look at policy in a vacuum. The fact is you can’t increase aggregate demand to meet capacity in an aging population. And given the worrisome demographics in Europe, this is something Europeans need to think about as well.In the U.S. , we have our own baby boom retiree problem coming – and that also means that trying to stimulate demand without cutting overcapacity is going to run up against these demographic issues.

  6. Mao says

    hi Ed, thanks for this post, I noticed Wolf’s essay as well and didn’t completely agree, but wanted to know what others thought. I’m glad I came across your review.

    Actually I didn’t think it was surprising (as Wolf says) that Japan proved vulnerable — the simple reason is that while the corporate sector was repairing its balance sheet (as the govt had to borrow to support aggregate demand, and the household sector funded the govt, thus accounting for all three sectors of the economy), the industrial structure reverted to its weak Yen, export dependent policy. When the crisis hit, US consumption died, so exports died, the carry trade reversed and the Yen strengthened, which hit Jap exports and economy.

    I agree that Japan needs to boost consumption, but who is supposed to consume? Household sector can’t — having drawn down savings to fund govt borrowing through the last 2 decades, and the govt — due to inefficient fiscal stimulus — is in debt.

    I agree with Wolf — the corporate sector has to do it, by investment. But if domestic demand is weak, it has, still, unfortunately, got to be exports. So: do we revert to the weak Yen, export driven industrial structure of the past? But surely that would be reverting to status quo global imbalances. Weirdly, while Wolf cautions against global imbalances, he appears to be supporting a weak Yen here, to enable imported inflation. But isn’t this also mercantilistic? Surely you can’t have it both ways.

    No, I think the answer is that while Jap corporates have got to spend, so as to be able to hire workers and sustainably close the output gap — which is I think the real reason for Jap deflation, rather than just input costs, which is what arguing for a weaker Yen implies is the deflationary source — they also need to find investment channels that have genuinely positive ROIs based on market forces, and not just because they have cheap capital. Jap corporates need to find new markets, invent new technologies, and export them — a sustained successful effort at this will generate employment, income, and slowly recuperate domestic consumption.

    This means that we are back to finding non-US, but also non-Japan even if Asian, sources of consumption. I think it is wrong to lump Jap consumers in with Asian consumers broadly when talking of structural changes to economic structure.

    Finally, I don’t understand Wolf’s comparison of Japan to China. I agree there is a relevant comparison, but I don’t think he has it right. Japan’s mistake was not in failing to get its consumer policies right, it was in getting its industrial subsidy policies wrong — and the weakened consumer was a long term collateral damage from the speculative fall out and weak employment/income as a result of misguided investments. Likewise, the lesson for China, I think, is in not letting its industrial policy of cheap exports get out of hand — (i) this policy is renewedly pulling in lots of forex reserves that is partly causing the bubble, (ii) as the ROI on export dependent industries falls, these industries require laxer and laxer monetary policy and credit standards to support them (as per Japan), leading to side effect asset price speculative bubbles.

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