Macro 101 – Sectoral balance

I note today that the PM has announced the introduction of a flood levy, some policy changes and cuts of $2.8 billion dollars in government spending including a cut of the national rent assistance scheme. That last point is something I want to discuss in a future post because it will have some interesting effects on housing. All of these changes are yet to go through parliament, so there is sure to be some cringe-worthy exchanges while it does.

Today however I want to talk about this in a broader macroeconomic context.

You may not know that much about economics, and possibly even less about macro-economics.  But if there is one formula you should know,  it is the equation for sectoral balances.

Don’t get overwhelmed by the look of it. What it basically says is that there is a direct and unbreakable relationship between the government budget balance, the national trade balance and the private sector budget balance.

So what! Why is that important?

Well what it also tells you is that total change in private savings over a period are equal to private investment plus the government budget balance plus net exports over that period, and that this is always true. Although at first this formula may seem relatively unimportant, once you understand its consequences it becomes very powerful. Here is the reason.

If in an accounting period there is a trade deficit and a government budget surplus then there MUST be a private sector deficit. By private sector deficit I mean a period where there is a net loss of savings from the private sector. If this situation continues for a period of time then it leads to increasing indebtedness.

The reason this is formula is so powerful is that it allows you to make a very quick analysis about whether macro-economic decisions actually make sense and, at a high level, determine the likely outcomes of those decisions. That does not mean that this is the “magic” formula, because there may exist some other compensating factors in the economy that you are unaware of, but it certainly is a good place to start.

There are a number of recent examples of where you could have applied this formula and taken a fairly accurate guesstimate of the economic outcomes. As the unconventional economist posted yesterday, the UK has “surprisingly” double dipped. Yet if you understood sectoral balance you would have known that this outcome was somewhat inevitable with the UK economy in the state it is in.

Take a look at the balance of trade figures for the UK.

With the private sector economy already struggling the UK government decided to cut government spending. With no offsetting rise in the balance of trade ( in fact those figures are getting worse ) then the only possible outcome is that the private sector is forced to de-save.

In an economy that is already floundering and already has large private sector debt the likely outcome is that as people feel themselves getting poorer they will stop spending, attempt to save more and pay down debt.

This inevitably drives down consumption which leads to failing businesses. Unemployment then rises and surprise surprise the GDP starts to fall. We must note however that the UK figures were also weather affected so the real number may not be quite a bad as it looks. But don’t worry, the government put VAT up by 2.5% this month so they will get there soon enough.

Another place you can use this formula is within the EU to understand why Germany can run a balanced budget but when one of the non-exporting nation attempts the same thing it is economic suicide.  The politics of this interaction is something I have commented on previously.

But you can also use this formula a little closer to home.  As I said at the start of this post , and covered by Houses and Holes earlier this week, the PM wants to introduce a new tax and cut government spending to “pay” for the flood .

In response to this I note this morning that a member of the RBA said the following

Reserve Bank board member Warwick McKibbin has slammed as political opportunism the government’s planned hike to the Medicare levy to pay its $5 billion share of Queensland’s repair bill, warning that the tax increase could deliver another kick to an economy already hit by the floods.
Federal cabinet will sign off this morning on a preliminary package of measures to cover the cost to the commonwealth of repairing Queensland’s infrastructure before Julia Gillard announces the details in a National Press Club address in Canberra.

The expected rise in the Medicare levy from 1.5 to 2 per cent, if agreed, would hit middle-income earners the hardest, wiping out the gains made from the 2010-11 tax cuts for people earning between $60,000 and $100,000.

Professor McKibbin said the new tax on households would slow consumer spending unnecessarily, and he called on the government to accept a temporary increase in the deficit to cover the rebuilding.

“The worst thing you can do is to stick to a fiscal deficit target for no reason except that it’s a political target, and contract parts of the economy to raise revenue when you’ve had a shock that’s hurt the economy,” he told The Australian.

I cannot think of any sudden new productivity improvements within the Australian economy, so if  I analyse these policy changes with the sectoral balance formula in mind then I can come to two conclusions. Either the government is expecting a very positive change in the terms of trade to offset the net decreases in government spending and the private sector losses caused by the flooding; or I have to assume that the government wants to make the private sector poorer.

I will leave it to you to decide which one it might be, and also whether you think this is an appropriate time for such a levy and the associated spending cuts.

I do note however, as I said would occur, that the flood outcomes continue to make there way into the broader economy and have an economic effect on people who were not even involved in the initial event.

The holiday resort on Moreton Island may be forced to lay off more than 100 staff after losing 60 per cent of its bookings in the wake of the Queensland floods.

Despite the state government’s $600,000 marketing blitz, local operators taking stock of their losses are having to sack employees.

The nationwide “postcard” campaign, which promised to minimise tourism losses and assure interstate tourists Queensland is a safe place to visit following the floods, ends tomorrow.

However, the manager of Moreton Island’s famed Tangalooma Resort, Trevor Hassard, said he was having to consider letting go about one third of his 340 staff, since images of flood-ravaged Queensland were beamed around the world.

“Unfortunately the world’s perception of southeast Queensland is that it is still under water,” he said. “People are changing their travel plans to avoid the area entirely.

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  1. Dr Delusion,

    Please forward this article to every independent PM in the Australian Parliament before Julia and the moron patrol destroy the economy.

    This is without a doubt the best explanation around as to what the levy will actually do to the economy and why.

    All the other Australian economic commentators need to come to this site to work out how to actually write about economics.

    You are all doing a fantastic job!

  2. Endrortsonhousing

    I object to a levy on income, yet again leaving assets untouched, thereby reinforcing the tax status of of the Aussie home as akin to some kind of religious icon. The way this levy is designed, if you have 50 properties, but are negatively gearing, you need not pay a CENT.
    The obsession with taxing income, but never the sacrosanct house has become a national disaster and the impact will be worse than 100 floods when it is all said and done. Insanely high house prices in Australia (actively underwritten by the taxation system and government programs) are:
    – fostering the development of a feudal system whereby there is a wealthy ruling class of property owners, developers and real estate agents ruling over an underclass of income-earning renters
    – destroying family life – forcing parents to work extra hours to pay the mega mortgage.
    In this context it is morally repugnant for a “Labor” government to impose a levy on income earners to subsidise a class of people that includes those with millions in assets in Brisbane’s wealthiest suburbs. The fair and equitable solution is obvious:
    (a) asset test any government assistance, and
    (b) provide for an exemption from the levy for those with less than $100k in assets.

  3. NineMSN run an online survey, maybe Julia and co should check it once and a while. Todays on the levy for example.

  4. Anybody else find it a little strange that a RBA Board Member comes out with the following quote “would hit middle-income earners the hardest, wiping out the gains made from the 2010-11 tax cuts for people earning between $60,000 and $100,000”

    Hello, when they voted in Nov for a rise, knowing fully well the banks would go a lot higher. Sure, a $5 to $20/m tax isnt anywhere as near as painful as a 0.4% rate rise.

    Not that I agree with the levy, but having somebody like that suddenly caring about the population is a little amusing. Or is it, he annoyed that his banking mates aren’t getting a little extra cream next time around

  5. I’m apolitical on this one (I’d rather have higher taxation & more social services, but hate Labors implementation of anything!), however my initial impressions on this were that a tax/levy would be good. I’m still trying to form my own opinion but it looks like your saying that a bunch of roads etc were damaged and need repairing, and the resulting spending will not increase productivity (although it may decrease if not fixed). So this needs to be done and is going to cost a big bunch of money.

    The question is whether it comes from public or private debt. Your formula says that if we cut govt spending & have a levy (and trade balance remains constant), then (PS-PI) must go down. Ie savings decrease and/or private sector investments increase. (net private sector deficit). Makes sense as somebody is paying for the flood repairs and you ain’t getting any extra cash spinoffs from more exports.

    Mr reserve bank guy wants to pay for repairs out of public debt. As far as I can see, there isn’t much difference: instead every Australian owns the debt that instead must be paid off over time (a possible advantage?) with the business tax rate chipping in too.

    Apart from the politically sensitive topic of *who* is paying for the flood damage, is there really much difference between a levy/spending cuts (paid for by select citizens according to income) or a public loan, paid for by everybody over time?

    I’m just not so sure on transferring private debt (and risk) to the public balance sheet like the Americans (and Irish etc). Or is that role of govt in assuming debt a topic for another day….?

    • This is exactly the trap our politicians fall for every time. What Mr reserve bank guy said was..

      “Professor McKibbin said the new tax on households would slow consumer spending unnecessarily, and he called on the government to accept a temporary increase in the deficit to cover the rebuilding.”

      Increase the deficit NOT increase government debt.
      Most people, including our current MPs as far as I can tell believe the Neo-Conservative myth that Governments must fund deficits by borrowing. But that is not the case with a Fiat Currency. The Federal Government can in fact just spend the money and not borrow a cent. This reallocates resources, potentially driving prices up and having an inflationary effect but it doesn’t require borrowing.
      Notice that the equation above does not include Public savings/debt at all. But I’ll leave it to someone a bit more experienced to explain why that is.

  6. I can understand the premise that if government increase taxes and decrease spending, people become poorer. It makes sense and it generally intuitive. But why is wealth measured as Savings – Investment? Shouldn’t wealth be measured as savings + income – investment? Or be some function of net real incomes? Why is it only savings? Able to explain it a little more?

  7. This a political issue more than an economic one. The Government would rather take 1.8 billion from us, waste 30% in bueuracracy, give back about 1.4 billion and then take credit for ‘doing something’ and ‘rebuilding QLD’.

    Left leaning governments hate when the voluntary action of a civil soceity exposes the Government as being useless.

    This is abot power and control, nothing to do with economics

  8. If anyone is looking for a explanation of the derivation of the sectoral balance equation I recommend they visit Bill Mitchell’s MMT blog.

    And Yes hrvoje I am a “fan”. Although I wouldn’t phrase it that way ( In fact I wouldn’t call it MMT ).

    I am someone who actually understands how a modern FIAT sovereign currency is supposed work to advantage the people of that economy and also understand the macro-economic relationship between all sectors of the economy.

    I have posted quite a few articles discussing my approach to this, which is an extension of MMT, the most recent is here

    You can search the blog for others.

    Rowan in response to you

    “Apart from the politically sensitive topic of *who* is paying for the flood damage, is there really much difference between a levy/spending cuts (paid for by select citizens according to income) or a public loan, paid for by everybody over time?”

    It is a good question, and I would give two answers depending on my audience.

    This is the answer I would give to someone who didn’t understand how a modern economy with a FIAT currency works.

    “It is a question of timing. When the private sector has just suffered a shock then hitting them with an additional tax is a double whammy. If the government wears the cost initially then they can pass it on at a later time when the private sector is better prepared to accept the debt”.

    This is the answer I would give to someone who did.

    “Governments never need to “pay” any money back. They are the monopolistic issuer of their own FIAT currency, which is simply a tool to create resource utilisation. The discussion of government surpluses and deficits is meaningless, the focus should be on sustainability, productive capacity, employment and social calm with the aim to provide a better standard of living for all citizens.

    When the private side of the economy has regained its productive capacity then the “money” can flow back to the government via taxation, if and only if, at that time the economy requires it to efficiently utilise the resources available.”

    I will be addressing some of the risks of loading up the private sector with additional taxation at this time, in part 2.

  9. Great article. And yes I hate the term MMT – its not a theory its the actual way our monetary system works.
    I wish economics students were taught this at school/uni – our education system is a shambles