The stock-flow consistent The stock-flow consistent approach: background, approach: background, features, and objectivesfeatures, and objectives

Marc LavoieMarc Lavoie

University of OttawaUniversity of Ottawa

OutlineOutline

1.1. Background of the SFC approachBackground of the SFC approach

2.2. Main features of the SFC approachMain features of the SFC approach

3.3. Main features of the post-Keynesian Main features of the post-Keynesian SFC approachSFC approach

4.4. Limits of the SFC workLimits of the SFC work

5.5. Applied SFC spirit: The Levy modelApplied SFC spirit: The Levy model

BackgroundBackground

1.1 Keynesian and modern 1.1 Keynesian and modern (Barro GDE) macroeconomics(Barro GDE) macroeconomics

► Y = C+I+G = W+PY = C+I+G = W+P► There is no room or no role for banksThere is no room or no role for banks► What about the central bank, where does it fit?What about the central bank, where does it fit?► Individuals and firms are often netted out Individuals and firms are often netted out

(representative agent)(representative agent)► Where does personal saving go?Where does personal saving go?► What are the liability counterparts of this saving?What are the liability counterparts of this saving?► What sector provides the counterparty to the What sector provides the counterparty to the

transaction?transaction?► How are government deficits financed?How are government deficits financed?► What role play financial stocks?What role play financial stocks?

1.2 National accounting and 1.2 National accounting and flow of funds analysis 1940s-flow of funds analysis 1940s-

1950s1950s► Macroeconomics is based on the system of national Macroeconomics is based on the system of national

accounts of the UN 1953 (Richard Stone) (flow national accounts of the UN 1953 (Richard Stone) (flow national income and product accounts)income and product accounts)

► This system left out flow-of-funds and balance sheetsThis system left out flow-of-funds and balance sheets► French and Dutch national accountants bitterly French and Dutch national accountants bitterly

complained then (Denizet: irony) complained then (Denizet: irony) ► ““When total purchases of our national product When total purchases of our national product

increase, where does the money come from to finance increase, where does the money come from to finance them? When purchases of our national product decline, them? When purchases of our national product decline, what becomes of the money that is not spent?” what becomes of the money that is not spent?” (Copeland 1949)(Copeland 1949)

► The 1968 new The 1968 new System of National Accounts (SNA) System of National Accounts (SNA) remedies to all this (and again in remedies to all this (and again in SNASNA 1993). But to no 1993). But to no avail, despite the introduction of Social Accounting avail, despite the introduction of Social Accounting Matrices (SAM).Matrices (SAM).

1.3 James Tobin 1960s - 19821.3 James Tobin 1960s - 1982

►The New Haven, or pitfalls, schoolThe New Haven, or pitfalls, school► Introduces balance sheets, with several Introduces balance sheets, with several

distinct assets and liabilitiesdistinct assets and liabilities►Behavioural equations defining portfolio Behavioural equations defining portfolio

decisions, based on rates of return decisions, based on rates of return ►The debts of a sector are the assets of The debts of a sector are the assets of

another sector: Financial interdependenceanother sector: Financial interdependence►Adding-up portfolio conditions: if you desire Adding-up portfolio conditions: if you desire

less of an asset, you want more of anotherless of an asset, you want more of another

1.4 A Wall Street view: the 1.4 A Wall Street view: the American Post-Keynesians 1960s-American Post-Keynesians 1960s-

1970s1970s► Paul Davidson and Hyman MinskyPaul Davidson and Hyman Minsky► One must at least distinguish between One must at least distinguish between

money and equitiesmoney and equities► PK economics in the 1960s is like Hamlet PK economics in the 1960s is like Hamlet

without the Princewithout the Prince► Debts generate flow commitmentsDebts generate flow commitments► ““The structure of an economic model that is The structure of an economic model that is

relevant for a capitalist economy needs to relevant for a capitalist economy needs to include the interrelated balance sheets and include the interrelated balance sheets and income statements of the units of the income statements of the units of the economy” (Minsky 1996, p. 77).economy” (Minsky 1996, p. 77).

1.5 Godley and Cripps 1983 and the 1.5 Godley and Cripps 1983 and the New CambridgeNew Cambridge

► A response to monetarismA response to monetarism► Keynesians did not pay enough attention to money Keynesians did not pay enough attention to money

and other financial assetsand other financial assets► Keynesians did not pay enough attention to inflation Keynesians did not pay enough attention to inflation

accountingaccounting► Need to introduce the constraints which adjustments Need to introduce the constraints which adjustments

of money and other financial assets impose on the of money and other financial assets impose on the economy.economy.

► Money stocks and flows must satisfy accounting Money stocks and flows must satisfy accounting identities in sectoral budgets, most notablyidentities in sectoral budgets, most notablyThe NAFA of private sector (net financial saving of private The NAFA of private sector (net financial saving of private

sector) = PSBR + current account balancesector) = PSBR + current account balance

1.6 Eichner 1989 textbook1.6 Eichner 1989 textbook

► Eichner (1987, pp. 810-838) devotes nearly 30 Eichner (1987, pp. 810-838) devotes nearly 30 pages to flow of funds analysis in the chapter pages to flow of funds analysis in the chapter on money and credit of his main book, with on money and credit of his main book, with more than a dozen tables reproducing flow of more than a dozen tables reproducing flow of funds consequences of various decisions by funds consequences of various decisions by economic agents. economic agents.

► The very first of these tables (Eichner 1987, p. The very first of these tables (Eichner 1987, p. 811) illustrates the quadruple accounting entry 811) illustrates the quadruple accounting entry principle first put forth by Morris Copeland, the principle first put forth by Morris Copeland, the US creator of flow-of-funds analysis.US creator of flow-of-funds analysis.

1.7 Providing a traverse: Godley in 1.7 Providing a traverse: Godley in the 1990s at the Levy Institutethe 1990s at the Levy Institute

► Ironically, both the Tobin and the Godley research Ironically, both the Tobin and the Godley research programs had to be abandoned in 1983, when programs had to be abandoned in 1983, when their funding was cut off.their funding was cut off. For ideological reasons (Thatcher)For ideological reasons (Thatcher) Econometric performance, due to collinearity problems, Econometric performance, due to collinearity problems,

was a mixed success at best (Buiter 2003)was a mixed success at best (Buiter 2003)► In the 1990s, W. Godley makes a link between his In the 1990s, W. Godley makes a link between his

previous workprevious work which tracks income flows and the money/debt stock which tracks income flows and the money/debt stock

through time, through time, ► and the work of James Tobinand the work of James Tobin

which focuses on portfolio choice and rates of return.which focuses on portfolio choice and rates of return.► Godley 1996 Levy Institute working paper, with Godley 1996 Levy Institute working paper, with

equities, but still without growthequities, but still without growth► Godley uses simulations to describe his models Godley uses simulations to describe his models

and tracks variables through time.and tracks variables through time.

1.8 Similar proposals 1.8 Similar proposals elsewhereelsewhere

► Various authors propose, at some point or another, to put Various authors propose, at some point or another, to put together NIPA and flow-of-funds.together NIPA and flow-of-funds.

► Bain, A.D. “Survey in applied economics: Flow of funds Bain, A.D. “Survey in applied economics: Flow of funds analysis”, analysis”, Economic JournalEconomic Journal, December 1973., December 1973.

► Roe, Alan R. “The case for flow of funds and national Roe, Alan R. “The case for flow of funds and national balance sheet accounts”, balance sheet accounts”, Economic JournalEconomic Journal, June 1973., June 1973.

► Davis, E.P. “A stock-flow consistent macro-econometric Davis, E.P. “A stock-flow consistent macro-econometric model of the UK economy – Part I”, model of the UK economy – Part I”, Journal of Applied Journal of Applied EconometricsEconometrics , April 1987. , April 1987.

► Patterson, K.D. and Stephenson, M.J. “Stock-flow consistent Patterson, K.D. and Stephenson, M.J. “Stock-flow consistent accounting: A macroeconomic perspective”, accounting: A macroeconomic perspective”, Economic Economic Journal, Journal, September 1988.September 1988.

► Dawson, John C. (ed.), Dawson, John C. (ed.), Flow-of-Funds Analysis: A Handbook Flow-of-Funds Analysis: A Handbook for Practionners. for Practionners. M.E. Sharpe: Armonk, 1996.M.E. Sharpe: Armonk, 1996.

► Klein, L. “Some potential linkages for input-output analysis Klein, L. “Some potential linkages for input-output analysis with flow-of-funds”, with flow-of-funds”, Economic Systems ResearchEconomic Systems Research, , September 2003.September 2003.

1.9 Recent work and research 1.9 Recent work and research teamsteams

► Lavoie – Godley, JPKE 2001-2002Lavoie – Godley, JPKE 2001-2002► Godley – Lavoie, “Monetary Economics”, 2007Godley – Lavoie, “Monetary Economics”, 2007► Godley, Lavoie, Zhao, Daigle, Greenwood on open Godley, Lavoie, Zhao, Daigle, Greenwood on open

economy modelseconomy models► Lance Taylor, Barbosa-Filho etc. on SF models and the Lance Taylor, Barbosa-Filho etc. on SF models and the

business cyclebusiness cycle► Taylor, Eatwell, Mouakil on financial marketsTaylor, Eatwell, Mouakil on financial markets► Cripps, Izurieta etc. on world modelCripps, Izurieta etc. on world model► Jacques Mazier, Clévenot, Guy: financialization, open Jacques Mazier, Clévenot, Guy: financialization, open

economy modelseconomy models► Van Treeck, Le Héron, etc. on financializationVan Treeck, Le Héron, etc. on financialization► Zezza – Dos Santos, growth modelsZezza – Dos Santos, growth models► Zezza, SFC and housingZezza, SFC and housing► Macedo e Silva and Dos Santos, methodology of SFCMacedo e Silva and Dos Santos, methodology of SFC

1.10 Other related SAM work1.10 Other related SAM work

► Flaschel, Semmler, Chiarella, Franke, Charpe Flaschel, Semmler, Chiarella, Franke, Charpe and others (2000s) with differential and others (2000s) with differential equations (Keynes-Meltzer-Goodwin-Tobin equations (Keynes-Meltzer-Goodwin-Tobin model)model)

► Harvard Structuralist General Equilibrium Harvard Structuralist General Equilibrium Model (Easterly and L. Taylor) and Model (Easterly and L. Taylor) and Computable general equilibrium models (S. Computable general equilibrium models (S. Robinson, World Bank)Robinson, World Bank)

► Financial computable general equilibrium Financial computable general equilibrium models (Bourguignon, OECD)models (Bourguignon, OECD)

Main features of the Main features of the SFC approachSFC approach

2.1 No black holes2.1 No black holes► “ “The fact that money stocks and flows must The fact that money stocks and flows must

satisfy accounting identities in individual budgets satisfy accounting identities in individual budgets and in an economy as a whole provides a and in an economy as a whole provides a fundamental law of macroeconomics analogous fundamental law of macroeconomics analogous to the principle of conservation of energy in to the principle of conservation of energy in physics”. (Godley and Cripps 1983)physics”. (Godley and Cripps 1983)

► Everything must add up.Everything must add up.► The simplest way to make sure that nothing has The simplest way to make sure that nothing has

been forgotten is to construct matrices.been forgotten is to construct matrices.► This consistency requirement is particularly This consistency requirement is particularly

important and useful in the case of portfolio important and useful in the case of portfolio choice with several assets, where any change in choice with several assets, where any change in the demand for an asset, for a given amount of the demand for an asset, for a given amount of expected or end-of-period wealth, must be expected or end-of-period wealth, must be reflected in an overall change in the value of the reflected in an overall change in the value of the remaining assets which is of equal size but remaining assets which is of equal size but opposite sign (cf. Tobin)opposite sign (cf. Tobin)

2.2 The quadruple entry 2.2 The quadruple entry principleprinciple

► This principle is attributed to Copeland (1949).This principle is attributed to Copeland (1949).► Any change in the sources of funds of a sector must Any change in the sources of funds of a sector must

be compensated by at least one change in the uses be compensated by at least one change in the uses of funds of the same sector.of funds of the same sector.

► But any transaction must have a counterparty. But any transaction must have a counterparty. Therefore the above two changes must be Therefore the above two changes must be accompanied by at least two changes in the uses accompanied by at least two changes in the uses and sources of funds of another sector.and sources of funds of another sector.

► « Because moneyflows transactions involve two « Because moneyflows transactions involve two transactors, the social accounting approach to transactors, the social accounting approach to moneyflows rests not on a double-entry system but moneyflows rests not on a double-entry system but on a quadruple-entry system » (Copeland, 1949)on a quadruple-entry system » (Copeland, 1949)

2.2A The quadruple entry 2.2A The quadruple entry principleprinciple

Sources of funds: + sign; Uses of funds: minus sign

2.2B The quadruple entry principle2.2B The quadruple entry principle

2.2C The quadruple entry 2.2C The quadruple entry principle and Minskyprinciple and Minsky

2.3 2.3 Transactions flow, stock, and Transactions flow, stock, and revaluation matrices: Full revaluation matrices: Full

integrationintegration►Three matrices are needed to track flows Three matrices are needed to track flows

and stocks.and stocks.►A stock matrix (balance sheet)A stock matrix (balance sheet)►A matrix of transactions (flows)A matrix of transactions (flows)►A revaluation matrix (capital gains)A revaluation matrix (capital gains)►Each stock can be tracked by taking into Each stock can be tracked by taking into

account both the transactions matrix account both the transactions matrix and the revaluation matrix (full and the revaluation matrix (full integration)integration)

2.4 An example, a closed 2.4 An example, a closed economy with capital gains economy with capital gains

(Model LP)(Model LP)

The transactions-flow matrix The transactions-flow matrix LPLP

Assessing capital gains in discrete timeAssessing capital gains in discrete time

A full-integration matrix, A full-integration matrix, households onlyhouseholds only

2.5 Portfolio equations and the 2.5 Portfolio equations and the adding-up conditionsadding-up conditions

… … In matrix formIn matrix form

First (Tobin) vertical condition:

Other vertical adding-up Other vertical adding-up conditionsconditions

Horizontal (Godley) adding-up conditionsHorizontal (Godley) adding-up conditions

The effect on demand for the asset in question of an increase in its ownrate of interest, with all the other rates remaining constant, should not be any different from that of a fall, of the same size, in all the other rates, withthe own rate staying put.

Symmetry (B. Friedman) conditionsSymmetry (B. Friedman) conditions

An increase in the expected rate of return on bonds will generate a drop inthe holdings of bills that will be of the same magnitude as the drop in theholdings of bonds generated by a similar increase in the rate of interest on bills.

Symmetry conditions + vertical conditions imply horizontal conditions

The importance of adding-up conditions

2.6 SFC models: counting equations 2.6 SFC models: counting equations and the redundant equationand the redundant equation

► Each variable must be defined by one equation (a Each variable must be defined by one equation (a behavioural equation, a definitional equation, or an behavioural equation, a definitional equation, or an identity equation).identity equation).

► To track variables (in large models), it is best to put To track variables (in large models), it is best to put each variable on the left-hand side of one and only each variable on the left-hand side of one and only one equation.one equation.

► Each column of the transaction-flow matrix provides Each column of the transaction-flow matrix provides an identity, that can be used to define one variable an identity, that can be used to define one variable (say (say mm).).

► Each row that contains more than two terms also Each row that contains more than two terms also provides an identity (say provides an identity (say nn) {If there are only two ) {If there are only two terms, the identity is “ordinary”, i.e., obvious, and terms, the identity is “ordinary”, i.e., obvious, and the two terms need not be distinguished (Gs, Gd)}.the two terms need not be distinguished (Gs, Gd)}.

► One of these identities must be removed from the One of these identities must be removed from the simulation model, for otherwise the software will tell simulation model, for otherwise the software will tell you that the model is over-determined. This last you that the model is over-determined. This last equation is the “redundant” or “hidden” equation. equation is the “redundant” or “hidden” equation.

2.7 Constructing the model2.7 Constructing the model

► Start by assuming that all stocks of the balance sheet add Start by assuming that all stocks of the balance sheet add up.up.

► Make sure that the row identities of the transactions-flow Make sure that the row identities of the transactions-flow matrix are fulfilled.matrix are fulfilled.

► Make sure the adding-up conditions of the parameters of Make sure the adding-up conditions of the parameters of the portfolio component are verified.the portfolio component are verified.

► There is no need to start from the equilibrium.There is no need to start from the equilibrium.► Running the model will get you there, if the equilibrium is Running the model will get you there, if the equilibrium is

stable.stable.► In complex models, it may be quite long and difficult to In complex models, it may be quite long and difficult to

find a steady state (start from a simple model, and add find a steady state (start from a simple model, and add feedback relations afterwards)feedback relations afterwards)

► Once an equilibrium has been found, parameters can be Once an equilibrium has been found, parameters can be modified to examine what happens.modified to examine what happens.

2.8 Closures2.8 Closures► The same model can be closed in several The same model can be closed in several

different ways.different ways.► This can involve bumping and inversing several This can involve bumping and inversing several

equationsequations► For instance, a 2-country model can be closed For instance, a 2-country model can be closed

with the assumption of a fixed exchange rate, with the assumption of a fixed exchange rate, which is held constant because:which is held constant because: A central bank accepts to purchase/sell any foreign A central bank accepts to purchase/sell any foreign

asset at the constant exchange rate (endogenous asset at the constant exchange rate (endogenous foreign reserves)foreign reserves)

Interest rates are let to move freely to keep the Interest rates are let to move freely to keep the exchange rate constant, while foreign reserves stay exchange rate constant, while foreign reserves stay constant constant

Government expenditures are let to move freely to keep Government expenditures are let to move freely to keep the exchange rate constant, while foreign reserves stay the exchange rate constant, while foreign reserves stay constantconstant

Main features of the Main features of the Post-Keynesian SFC Post-Keynesian SFC

approachapproach

3.1 Market-clearing vs 3.1 Market-clearing vs buffersbuffers

► In neoclassical economics, markets clear through In neoclassical economics, markets clear through price changes.price changes.

► In post-Keynesian economics, markets clear either In post-Keynesian economics, markets clear either because quantities supplied are assumed to adjust because quantities supplied are assumed to adjust to demand within the period or because of buffers. to demand within the period or because of buffers. The price mechanism in our models only plays a The price mechanism in our models only plays a clearing role for stock market equities.clearing role for stock market equities.

► SFC models normally have a buffer for each sector:SFC models normally have a buffer for each sector: Stocks of inventories and loans for producing firmsStocks of inventories and loans for producing firms Money deposits for householdsMoney deposits for households Bills held, or advances from the central bank, for private Bills held, or advances from the central bank, for private

banksbanks Bills issued for the governmentBills issued for the government

3.2 Supply-led vs demand-led 3.2 Supply-led vs demand-led modelsmodels

►Our models are essentially demand-Our models are essentially demand-led.led.

► It is possible to introduce supply-led It is possible to introduce supply-led effects (Phillips curves, and so on)effects (Phillips curves, and so on)

►One could also introduce other supply One could also introduce other supply effects, such as reduced capacity effects, such as reduced capacity when producing firms default on some when producing firms default on some of their loansof their loans

3.3 Optimization vs reaction to 3.3 Optimization vs reaction to disequilibriadisequilibria

► In neoclassical economics, optimization In neoclassical economics, optimization under constraints rules.under constraints rules.

► In PK SFC models, economic agents often In PK SFC models, economic agents often have stock-flow targets (inventories to have stock-flow targets (inventories to sales ratio, wealth to disposable income sales ratio, wealth to disposable income ratio, capital adequacy ratios, …).ratio, capital adequacy ratios, …).

►Economic agents react to these Economic agents react to these disequilibria by trying to close the disequilibria by trying to close the discrepancy discrepancy

3.4 Contributions of the SFC 3.4 Contributions of the SFC approach to PK theoryapproach to PK theory

► A coherent formalization of Minsky’s financial A coherent formalization of Minsky’s financial fragility hypothesis (formalizing the current fragility hypothesis (formalizing the current crisis?)crisis?)

► A coherent formalization of the stock marketA coherent formalization of the stock market► A systematic introduction of stock-flow norms A systematic introduction of stock-flow norms ► The full integration of real and financial analysesThe full integration of real and financial analyses► The integration of money as a flow (as in circuit The integration of money as a flow (as in circuit

theory) and as a stock (Keynes, portfolio choice) theory) and as a stock (Keynes, portfolio choice) ► The ability to consider historical time, as in Joan The ability to consider historical time, as in Joan

Robinson, by tracking variables through time Robinson, by tracking variables through time

Limits of current SFC Limits of current SFC workwork

4.1 It can be cumbersome4.1 It can be cumbersome

►As soon as more realistic models are being As soon as more realistic models are being considered, the number of equations rises considered, the number of equations rises very quickly.very quickly.

►A partial way out has been suggested by A partial way out has been suggested by Mouakil (2006), by ignoring all “ordinary” Mouakil (2006), by ignoring all “ordinary” identities.identities.

►But still, models remain large.But still, models remain large.►Continous time vs discrete time or Continous time vs discrete time or

differential equations vs difference equationsdifferential equations vs difference equations

4.2 The need for calibration4.2 The need for calibration

► In our book (Godley and Lavoie 2007), we In our book (Godley and Lavoie 2007), we made (nearly) no attempt at calibration.made (nearly) no attempt at calibration.

►More effort could be put in calibrationMore effort could be put in calibration►More effort could be put into empirical More effort could be put into empirical

work.work.►Are new time series techniques adequate Are new time series techniques adequate

to deal with the old problems of to deal with the old problems of collinearity encountered by Tobin and his collinearity encountered by Tobin and his associates?associates?

The Levy model of the U.S. The Levy model of the U.S. economyeconomy

5.1 Financial balances5.1 Financial balances

In Godley’s approach, the analysis of In Godley’s approach, the analysis of financial balances gives clues to where the financial balances gives clues to where the economy is going in the medium term.economy is going in the medium term.

The NAFA of private sector (net financial The NAFA of private sector (net financial saving of private sector) = PSBR + current saving of private sector) = PSBR + current account balanceaccount balance

(S – I) = (G – T) + (X – IM + NFY(S – I) = (G – T) + (X – IM + NFY))

5.2 The “New Cambridge 5.2 The “New Cambridge hypothesis”hypothesis”

In the 1970s, Godley and his group used this identity as the In the 1970s, Godley and his group used this identity as the basis for a model of the UK economy. For the private sector as a basis for a model of the UK economy. For the private sector as a whole, the difference between saving and investment is equal to whole, the difference between saving and investment is equal to the net acquisition of financial assets (NAFA), which in turn are the net acquisition of financial assets (NAFA), which in turn are equal on (the increase in) liabilities of the government or the rest equal on (the increase in) liabilities of the government or the rest of the worldof the world

NAFA = GD + CABNAFA = GD + CABThis approach was unconventional, since it merged households This approach was unconventional, since it merged households and business analyzing the private sector as a whole.and business analyzing the private sector as a whole.The “New Cambridge hypothesis” was that NAFA was stable, The “New Cambridge hypothesis” was that NAFA was stable, relative to GDP, and this gave rise to a theory for “twin deficits”, relative to GDP, and this gave rise to a theory for “twin deficits”, i.e. any imbalance in the foreign account was matched by an i.e. any imbalance in the foreign account was matched by an imbalance in the government account.imbalance in the government account.In the face of crisis which called for an expansionary fiscal In the face of crisis which called for an expansionary fiscal policy on Keynesian lines, it was thus necessary to adopt policy on Keynesian lines, it was thus necessary to adopt measures to counter the implied widening of the current account measures to counter the implied widening of the current account imbalance (some kind of protectionism).imbalance (some kind of protectionism).

5.3 The “New Cambridge 5.3 The “New Cambridge hypothesis”hypothesis”The “New Cambridge hypothesis” was based on The “New Cambridge hypothesis” was based on

empirical grounds (see Mata, 2006 for a nice empirical grounds (see Mata, 2006 for a nice reconstruction of the debate at the time), and the reconstruction of the debate at the time), and the evidence in favor of the stability of NAFA/GDP vanished evidence in favor of the stability of NAFA/GDP vanished after some years, so that the approach was after some years, so that the approach was progressively neglected.progressively neglected.

This approach is still at the heart of Godley’s empirical This approach is still at the heart of Godley’s empirical work. It is not, however, grounded in the stability of work. It is not, however, grounded in the stability of NAFA, but rather on how financial balances are moving, NAFA, but rather on how financial balances are moving, with a strong emphasis on with a strong emphasis on boundariesboundaries for balances. for balances.

Since each balance also measures the net increase in a Since each balance also measures the net increase in a sector net debt, values of the balances above a given sector net debt, values of the balances above a given level point to instability in stock-flow ratios which may level point to instability in stock-flow ratios which may trigger either some adjustment or a crisis.trigger either some adjustment or a crisis.

Similar assessment, Bê Duc and Le Breton 2009, ECBSimilar assessment, Bê Duc and Le Breton 2009, ECB

5.4 The fundamental identity in a closed 5.4 The fundamental identity in a closed economy (Krugman 2009, via GoldmanSachs, economy (Krugman 2009, via GoldmanSachs,

via Levy): via Levy):

(S – I) = (G – T)(S – I) = (G – T)

GDP

PrivateSurplus

Public Deficit

PrivateDeficit

PublicSurplus

Private Financial Balance

E

D R

B

Less investmentMore saving

E starting pointD without automatic stabilizers (1930s)R with automatic stabilizer B also with stimulus plan

PublicBalance

5.5 Levy model projection 5.5 Levy model projection 20072007

5.6 Household Debt5.6 Household Debt

One of the reasons One of the reasons for the projection for the projection was the was the unsustainable path unsustainable path of household debt of household debt relative to relative to disposable income, disposable income, along with the along with the dynamics of the dynamics of the price of homes.price of homes.

5.5.77

5.8 Levy model – private sector 5.8 Levy model – private sector expenditureexpenditure

The crucial equation is the private The crucial equation is the private sector expenditure function, which – sector expenditure function, which – under a standard assumption in under a standard assumption in new new Cambridge Cambridge models models à à la Godley – la Godley – implies a long-run stock-flow norm.implies a long-run stock-flow norm.

PXt = c0 + c1YDt + c2FAt-1 + Zt

Where Z is a vector of stationary variables which influence the propensity to spend out of income

5.9 Levy model – capital 5.9 Levy model – capital gains etcgains etc

More specifically, Z includes:More specifically, Z includes: The “real” price of equitiesThe “real” price of equities The “real” price of housingThe “real” price of housing The flow of Household borrowingThe flow of Household borrowing The flow of Business borrowingThe flow of Business borrowing

5.10 An interpretation of the 5.10 An interpretation of the crisiscrisis

For the U.S., it became clear, in the second half of the For the U.S., it became clear, in the second half of the 1990s, that the private sector had started to reduce 1990s, that the private sector had started to reduce systematically its NAFA, getting into debt. The “new systematically its NAFA, getting into debt. The “new economy” period could then be interpreted as debt-economy” period could then be interpreted as debt-fuelled growth, as suggested in Godley (1999), implying fuelled growth, as suggested in Godley (1999), implying an ever-growing current account deficit (for stable fiscal an ever-growing current account deficit (for stable fiscal policy).policy).

The current financial crisis could have started in 2001, The current financial crisis could have started in 2001, with the burst of the stock market bubble. However, the with the burst of the stock market bubble. However, the drop in private sector borrowing, and the consequent drop in private sector borrowing, and the consequent recession, was countered by an expansionary fiscal recession, was countered by an expansionary fiscal policy which filled the gap in aggregate demand, but policy which filled the gap in aggregate demand, but kept household debt (and foreign debt) growing. At the kept household debt (and foreign debt) growing. At the time Godley started to insist on the need to take policy time Godley started to insist on the need to take policy actions to counter the foreign imbalance.actions to counter the foreign imbalance.

5.11 The housing bubble5.11 The housing bubble

The following chart shows how imbalances will The following chart shows how imbalances will get reflected in the NAFA. For most of the post-get reflected in the NAFA. For most of the post-war period, household saving was higher than war period, household saving was higher than residential investment, and mortgages were residential investment, and mortgages were typically covering only part of capital typically covering only part of capital expenditure.expenditure. However, starting in the 1980s, the propensity However, starting in the 1980s, the propensity to save has dropped with mortgages taking on to save has dropped with mortgages taking on an increasing part of new home purchases. In an increasing part of new home purchases. In the 2000s the housing bubble started, as the 2000s the housing bubble started, as signaled by new mortgages exceeding signaled by new mortgages exceeding residential investment.residential investment.

5.125.12

5.13 Business NAFA5.13 Business NAFA

The relation between business The relation between business investment, retained profits and investment, retained profits and borrowing has been less clear-cut in the borrowing has been less clear-cut in the last few years. last few years. An increased access to borrowing has An increased access to borrowing has not been used to finance an increase in not been used to finance an increase in investment, but rather for financial investment, but rather for financial investment (buying back equities).investment (buying back equities).

5.15.144

5.15 Conclusions and policies5.15 Conclusions and policies

►Fiscal policy is needed to close the gap in Fiscal policy is needed to close the gap in aggregate demand generated by the aggregate demand generated by the collapse in private sector borrowingcollapse in private sector borrowing

►A huge fiscal stimulus will imply a rising A huge fiscal stimulus will imply a rising government debt relative to GDP. However, government debt relative to GDP. However, within an SFC framework, debt and deficit within an SFC framework, debt and deficit ratios converge in the long run, even with ratios converge in the long run, even with high interest rates.high interest rates.

►What is not solved by the fiscal stimulus is What is not solved by the fiscal stimulus is the external imbalance, which will again get the external imbalance, which will again get worseworse