MMT - Chap 1 - The Basics of Macroeconomic Accounting

 

In the Chapter, the author introduces concepts about basic macroeconomic accounting.


One person's financial asset is another person's financial liability

This is a fundamental principle of accounting. The same transaction can be an asset for one party and liability for another party. Example, when you make a time deposit with a bank, from your perspective it is an asset but from the bank’s perspective, it is a liability. When you buy something from a store, the transaction is an expense for you but it is a revenue for the store.


Inside wealth versus outside wealth

The author divides the economy into two broad sectors, the public sector and the private sector. The public sector includes all levels of government, federal and state. The private sector includes households and firms. If we aggregate all the privately issued assets and liabilities, then they should net off to zero. So, the net financial wealth will be zero if only private sector IOU’s are considered. This is called “inside wealth” because it is held entirely in the private sector. For the private sector as a whole, to accumulate net financial wealth, it must be in the form of “outside wealth”, that is financial claims on another sector.


Net private financial wealth equals public debt

Given the two-sector economy which is described above, the private sector can have outside financial wealth in form of government IOUs. So, the public sector’s liability becomes the private sector’s wealth. The author concludes that for the private sector to have net private financial wealth, the public sector needs to go into debt. So, net private financial wealth equals public debt.


If the government runs a balanced budget, where spending is equal to its tax revenue, the private sector’s net financial wealth will be zero. If the government runs continuous budget surpluses, the private sector’s net financial wealth must be negative. Thus, in the two-sector model, both private and public sector can't run surpluses at the same time. If one sector runs a surplus the other will automatically be in a deficit.


Rest of world debts are domestic financial assets

Since we live in a globalized world it would be unrealistic to ignore the “rest of the world” (ROW) sector that consists of foreign governments, firms and household. With the introduction of this sector, the private sector has an additional source for the creation of outside wealth by accumulating net claims on ROW.


Basics of sectoral accounting, relations to stock and flow concepts

The budget surplus is the same thing as a saving flow and leads to a net accumulation of financial assets (an increase in net financial wealth). By the same token, a budget deficit reduces net financial wealth. The sector that runs a deficit must either run down its financial assets that had been accumulated in previous years (when surpluses were run) or must issue new IOUs to offset its deficits.


Conclusion: one sector’s deficit equals another’s surplus

The above discussion brings us to important accounting principle that if we sum the deficits run by one or more sectors, this must equal the surpluses run by the other sector(s).


Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0


For example, let’s assume that foreign balance equals zero. When the private sector’s income is $100Bn and its spending is $90Bn then it runs a surplus of $10Bn a year. Then by the above equation, the Government sector must run a deficit of $10Bn. The $10Bn of the net financial wealth of the private sector would consist of $10Bn of domestic government sector liabilities.


Government budget deficits are largely non-discretionary

Most people assume that the government budget deficits are discretionary and hence they can be reduced. However, a closer look at the sources of increase in deficit spending during the Great Recession of 2008 reveals that the largest portion of the increase in the deficit in most countries came from automatic stabilizers and not from discretionary spending.


The government can always decide to spend more and it can always decide to raise tax rates, but it cannot decide what its tax revenue will be because it depends on economic performance which is outside the government control. This implies that budgetary outcome – whether surplus, balanced or deficit – is not really discretionary.


Sectoral balances are mostly non-discretionary; hence it is futile to target arbitrary government deficits or debt limits. In light of this, the best policy is to promote spending that will utilize domestic resources close to capacity and leads to full employment and price stability.


My thoughts after reading the chapter.

I agree with most of the author’s thoughts in this chapter. The logic of accounting for sectoral balances is easy to follow. I agree with the idea that all the sectors cannot simultaneously run a surplus and that the surplus in one sector leads to a deficit in another.


I get a feeling that the author is subtly trying to sell the idea that government deficits are a good thing and in fact necessary for the private sector to have net financial wealth. But the real question here is “Does the private sector really needs to hold the government-issued debt to be wealthy?”


I do not see any particular demand from the private sector at an aggregate level to hold government debt. The demand from particulars participants in the private sector to hold financial assets can be easily met with the inside wealth. Without taxation, there is no particular need for the private sector as a whole to hold government-issued debt.


The actual dependency is the other way round. While the individuals in the private sector can fund their spending themselves by issuing liabilities to each other, the same cannot be done by the government. The government is completely reliant on the private sector to fund itself. The primary means of funding government operations is taxation. When tax revenues are not sufficient, the only way for the government is fund itself is by issuing debt. The private sector demands government debt only because it can use it to discharge its future tax liability. Without taxation, there would be no takers for government debt.


Although government spending and deficits may be non-discretionary in an economic downturn, it is not without consequences. Higher government deficit today to soften the blow of economic downturn means higher taxation or reduced government spending in future.


Stay tuned for subsequent chapters. Please let me know in the comments section about your thoughts on this chapter. Please subscribe to my blog to get notified when I finish writing the summary of the next chapter.


Until next time,


Nirav Gala.

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