Monetary Realism

Understanding The Modern Monetary System…

JKH On Saving And Sector Balances (WONKISH)

Wynne Godley’s sectoral balances approach can be extremely helpful in understanding the relationship between the three sectors of the economy (private, public and foreign).  But if misunderstood, it can be extremely misleading.   The recent discussion on S=I+(S-I) was intended to clarify the position of the private sector because MMR has noticed a tendency in some MMT literature to lack clarity in describing this relationship.

For instance, when the USA runs a current account deficit and a budget deficit that does not offset the leakage in the current account the private sector position has been described as experiencing a “net loss” in some MMT literature.  But no clarification as to the specifics of this “net loss” is provided (in terms of real or financial wealth) and the reader is likely to come away from the lesson believing that the private sector position is automatically worse off if the government does not deficit spend at all times.   But this is clearly not the case as the majority of private sector real wealth creation occurs through the horizontal banking system through credit creation.  This can clearly be seen over the period from 1997q1 to 2008q2 when the government budget deficit failed to offset the current account deficit in 38 of the 42 quarters and household net worth increased by 110% while corporate profits rose by 140%.  Clearly, the private  sector did not experience a “net loss” over this period even though the budget deficit failed to offset the current account leakage.

The confusion arises from the difference between real wealth and financial wealth as well as misunderstanding saving.  A good way to think about all of this is to understand that the private sector can create real wealth entirely independent of the government.  A farmer does not need the government to turn 1 cow into 10.  But the farmer has achieved real wealth creation regardless of the government’s spending position.  What the government must generally do over time is help to facilitate the wealth accumulation process by providing the net financial assets to help the private sector monetize this real wealth.  But it’s important not to put the cart before the horse here.  It’s best to think of government as being a facilitator of wealth creation and not the driver.  Hence, our focus on S=I+(S-I) with the emphasis on the idea that “the backbone of private sector equity is I, not Net Financial Assets.”   The idea is not novel, but simply clarifies the understanding of the private sector component.

So, the private sector can achieve a “net loss” in financial wealth under the aforementioned scenario (taxes reduce your financial wealth), but the private sector can also continue to expand real wealth at the same time (create 10 cows).  In some cases such as the 1997-2008 period this can result in massive real wealth creation (yes, the housing boom and internet bubble did result in massive real wealth creation) so the key is to understand that a budget deficit that doesn’t offset the current account does not automatically result in a deterioration of the private sector’s overall financial position.  Clearly, if this position is sustained over a long period there can be potential downside effects as the balance sheet recession clearly proves, but that’s a different matter.

The other misunderstanding here revolves around the term “saving”.  If one were to focus simply on the sectoral balances equation and the idea of the “net loss” you might be inclined to conclude that I>S is automatically bad.  But that would lead to terribly misguided policy proposals and a fragmented understanding of the private sector wealth creation process.  JKH has brilliantly summed up this confusion in the comments:

“The correct economic definition of saving is disposable income not spent on consumer goods.

Individuals often save and deploy their saved income into financial assets such as stocks, bonds, and pension funds. (They may also invest saving in newly constructed residential real estate, which is separate from financial asset acquisition, of course).

Such financial assets represent direct and indirect claims on corporations and governments.

The recent blogosphere kerfuffle about saving arose in part because MMT embraces the sector financial balances model (SFB), which features the consolidation of household and corporate sectors as a unified private sector. The model treats financial claims on corporations as negative financial assets for corporations, so the consolidated result is that household saving deployed in such financial assets makes a zero net contribution to private sector saving after counterparty corporate netting. At the margin, such deployment of funds becomes a net financial asset for the household, a net financial liability for the corporation, and a net financial asset wash for the private sector as a whole.

The private sector as a whole adds net financial assets when either the household or corporate sub-sectors deploy funds from saving into the acquisition of financial claims on either the government or foreign sectors. This can occur for example with the purchase of government bonds or foreign financial assets. Saving thus used can be identified as a particular subset of saving, but by no means does it account for saving per se.

Private sector consolidation within SFB is not an indicator of saving per se. Consolidation obscures the core underlying saving dynamic of the private sector.

All private sector saving can be condensed, in effect, to a measure of household saving alone – by projecting the cumulative value of corporate saving onto the household balance sheet. This occurs when household financial claims on the corporate sector are valued by the marketplace to reflect those underlying corporate saving changes. E.g. the value of stocks tends to increase when corporations save and invest in real assets. The issue there is one of valuation translation, rather than the conceptual correctness of corporate saving being reflected at the separate level of household balance sheets as well.

MMT alludes on occasion to a definitional change for saving that it deems desirable for purposes of delineating saving as portrayed in the sector financial balances model. It sometimes describes the act of deploying the proceeds of normally defined saving into physical asset investment as spending, without associated saving. This revised interpretation of saving treats spending on consumer and investment goods similarly, with zero associated saving under such a revised definition.

But on that basis, it would only be consistent to extend the implied revised definition of “non-saving” to include the use of normally defined saving proceeds to acquire financial assets. In either case, funds that have been saved according to the normal definition of saving have been “spent”, which would allow for consistent abandonment of the idea that saving has been the source of such spending. (Indeed, MMT has occasionally referred to central bank acquisition of financial assets and associated creation of reserves as “spending”.)

The problem here is that the correct definition of saving precisely specifies the passive act of not spending on consumer goods. It does not specify how the proceeds of such saving should be used, whether to acquire real or financial assets. Saving is described in proper accounting terms as funds sourced from income by virtue of being saved from income. The eventual deployment of that source of funds is described properly as a use of funds – whether such deployment and use occurs in the form of a bank deposit, a bond, a stock, newly produced residential real estate, or newly produced plant and equipment. The deployment or use of funds is separate from the act of saving itself.

In summary, the consolidated private sector account obscures, not only the view of saving as it materializes within a given accounting period in bifurcated fashion across household and corporate sectors separately, but also the view of total private sector saving as it is projected fully into the household balance sheet, when captured as a cumulative measure over a sequence of such accounting periods. As a result, the consolidated private sector presentation within the sector financial balances model obscures the measurement of the core component of saving.”

I hope that clarifies the thinking here.  And a big thanks to JKH for offering his thoughts here.


Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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61 Responses

  1. Ben Wolf says

    “But this is clearly not the case as the majority of private sector real wealth creation occurs through the horizontal banking system through credit creation.  This can clearly be seen over the period from 1997q1 to 2008q2 when the government budget deficit failed to offset the current account deficit in 38 of the 42 quarters and household net worth increased by 110% while corporate profits rose by 140%.  Clearly, the private  sector did not experience a “net loss” over this period even though the budget deficit failed to offset the current account leakage.”

    I think part of the problem is that MMT doesn’t discuss running government deficits as a form of non-legalistic market regulation. While wealth was generated during the period you discuss in absence of deficits sufficient to make up financial leakage, the bursting of those credit-driven bubbles also destroyed great wealth, which is the expected outcome from the perspective of government failing to facilitate real wealth creation by issuance of sufficient NFA’s to satisfy private sector demand. In other words the private sector is the generator of real wealth but lacks the means to sustain it without government intervention to support its desires.

    One of the lessons here (I think) is that government must provide sufficient facilitational wealth to supress credit demand to a sustainable level.

  2. Ben Wolf says

    That’s why I support government contribution of NFA’s in the form of a guaranteed income to each household. It eliminates the distortive effect of spending through large programs and enhances the freedom of each american to pursue their interests as they see fit. In fact given the realities of our monetary system a minimum income is one of the most logical method of enhancing individual quality of life.

  3. Michael Sankowski says

    yep, we’re just trying to get a little bit better here.

  4. Michael Sankowski says

    This is one of the points of MMT where I do have a big disagreement. There seems to be this assumption that a sufficient issuance of NFA by the government will pre-empt private sector credit bubbles from forming.

    This link isn’t proven or even always true. It’s probably partly true.

  5. Michael Sankowski says

    lol – this is exactly how I think. In the end, we’re tying to get real world richer and everything else is a distant secondary concern.

  6. Michael Sankowski says

    Hi Obsvr-1 thanks for the support.

    “Every time a company allows for terms of 30,60,90 days on receivables they are creating short term credit in the system — this is billions of dollars. Some companies convert this into traditional credit from the banking sector by factoring their receivables — but at the end of the day there is a tremendous amount of credit cycling in the market which is funding business operations.”

    This is entirely true – and I’d note this is entirely outside of the regulatory powers of govt.

    I don’t know if I support using market based regulatory/incentives to try and oversee banks. Steve W brings up banks are nearly impossible to determine solvency and are necessarily opaque. This structure makes using the strengths of markets difficult.

  7. JKH says


  8. Detroit Dan says

    I meant “Private sector saving” (a flow of funds) (c:

  9. Detroit Dan says

    An observation on the wonkishness of this post. When Paul Krugman says that a post of his is wonkish, it is generally beyond my comprehension. The framework he (and most neo-liberal economists) uses to explain the workings of the economy is unnecessarily complicated.

    On the other hand, the MMT/MMR equation that we are describing as wonkish is really quite straightforward:

    Private sector savings = investment + fiscal deficits + trade surplus

    I find this so much easier than IS/LM. Basic economics does not need to be so complicated, and that is one of the great advantages of MMT/MMR…

  10. Obsvr-1 says

    because it is was denominates all other forms of value. It is the most liquid of all assets and what is “legal tender” as mandated by the gov’t. Every exchange in asset must effectively transition into the vertical “dollar” and thereby allow the money changers to hook a rent off the transition. Certainly there are exchanges the occur outside of the vertical money exchange, but outside of the gaussian distribution. The tight coupling between the horizontal and vertical is well guarded by the cartel that controls the game.

  11. JKH says

    Thanks, Joseph. Excellent point re inventory declines, which I overlooked.

    I think of it sometimes as all consumer goods that hit the store shelf are initially investment, for some period of time at least in theory, until sold to end buyers. The actual case would depend on accounting periodicity, etc.