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The Spinning Top Economy

by Matthew Berg, New Economic Perspectives

The central insight of the sectoral balances model of the economy is that not all sectors of the economy can net-save at the same time. That means that if all those of us in the private sector in aggregate want to (on net) take in more money than we spend, then some other sector will have to spend more money than it receives. In a simple three sector version, the three sectors are the domestic private sector, the government sector, and the foreign sector.

Net financial assets of all sectors in the economy necessarily add up to zero. This is clearly true – in fact, it’s an accounting identity. Interested readers can find a more thorough explanation of sectoral balances and net financial assets here, but the essential point can be seen visually in the chart below.

The bottom of the chart is the mirror image of the top of the chart:

The same thing is also true if we break down the sectors a bit further, dividing the domestic private sector into Household, Non-Financial Firms, and Financial Firms sub-sectors, and breaking down the government sector into Federal and State & Local sectors.

In fact, the same thing would be true no matter how we might choose to break down the sectors:

Sometimes, something interesting and seemingly contradictory can happen in the economy. And when it does, it has important implications for the economy’s financial stability. That interesting thing is this:

Private sector net worth can increase even if private sector net financial assets were negative, as they were from 1997 to 2008 (except for a brief period in 2003/2004).

The reason this was possible is that net worth is dependent upon valuations, whereas accounting flows are not dependent upon valuations. One important financial asset class that enters into private sector net worth calculations are stocks.

If the market price for a stock is $90 and then I buy one share of the stock from you for $100, all that changes in the transaction itself is that I have $100 less than I had previously and you have $100 more than you had previously, and I have one more share of stock and you have one less share of stock. But what also happens is that the stock’s quoted market price increases from $90 to $100.

That means that everyone else who owns a share of the same stock thinks that they are now $10 wealthier per share of stock. The same thing happens any time the stock market goes up, writ large.

And what will the stock market do? In the words of J.P. Morgan, “it will fluctuate.” We might add that the same applies to the housing market.

In fact, there is a word in common usage for what happens when private sector net financial assets go negative but net worth nonetheless simultaneously goes up. It’s called a “bubble.”

For a while, the “wealth effect” of rising stock prices may encourage people to spend more of their income or even to take on another car loan or a second mortgage. After all, if your net worth is increasing, it seems like you can afford it! And this actually does have a animating effect on the economy during the market rise – as people spend more, their spending becomes someone else’s income, which also causes government tax receipts to rise. In a bona-fide bubble such as the Dot-Com bubble or the Housing bubble, this effect is stronger still.

But as the private sector’s financial position deteriorates, enough people eventually decide that they would like to sell at the new, higher market price. And when they do, we call that a “panic” or a “financial crisis.”

It’s like a game of musical chairs. When the music stops, there are not enough chairs (net financial assets) to go around.

So while the private sector did not net save during the Dot-Com and Housing bubbles, nonetheless when people received their monthly bank statements, quarterly portfolio reports, and annual property tax assessments, they saw that the numbers were going up. Times seemed to be good.

But to those who were looking at the underlying fundamentals – private sector net financial assets – it was clear that this prosperity was built upon a house of cards. There were not enough private sector net financial assets to support the increasingly fragile financial superstructure.

Indeed, this fundamental insight harkens back to the work of Hyman Minsky, originator of the Financial Instability Hypothesis. In 1999, Randall Wray wrote a prescient policy brief entitled, “Can The Expansion Be Sustained? A Minskian View.”

After reminding us that:

“In Minsky’s view, the floor to aggregate demand provided by a deficit’s maintenance of personal income is a key stabilizing feature of the postwar big government economy we have inherited.”

And after noting that:

“if it is true that the wealth effect has been driving consumption, it is not necessary to have a crash to kill the expansion. As Godley has argued, stock market capital gains provide only a one-time boost to consumption levels; continued economic growth requires rising stock prices.”

Wray’s conclusion was emphatic:

“I know of no reputable economic theory that concludes that growing private sector deficits are any more sustainable than are growing public sector deficits, and Minsky would have concluded that rising private sector deficits are far more risky!”

Likewise, Wynne Godley outlined “Seven Unsustainable Processes“ earlier in the same year, in which he warned that the “negative forces” of the government’s “restrictive fiscal stance” and of unfavorable “prospects for net export demand” “cannot forever be more than offset by increasingly extravagant private spending, creating an ever-rising excess of expenditure over income.”

Godley went on to describe, oracle-like, precisely what the private sector’s deficit meant:

“The private financial deficit measures something straightforward and unambiguous; it measures the extent to which the flow of payments into the private sector arising from the production and sale of goods and services exceeds private outlays on goods and services and taxes, which have to be made in money. While capital gains obviously influence many decisions, they do not by themselves generate the means of payment necessary for transactions to be completed; a rise in the value of a person’s house may result in more expenditure by that person, but the house itself cannot be spent. The fact that there have been capital gains can therefore be only a partial explanation of why the private sector has moved into deficit. There has to be an additional step; money balances must be run down (surely a very limited net source of funds) or there must be net realizations of financial assets by the private sector as a whole or there has to be net borrowing from the financial sector. Furthermore, a capital gain only makes a one-time addition to the stock of wealth without changing the flow of income. It can therefore, by its very nature, have only a transitory effect on expenditure. It may take years for the effect of a large rise in the stock market to burn itself out, but over a strategic time period, say 5 to 10 years, it is bound to do so.”

And in the more recent past, Rob Parenteau discerned in his 2006 public policy brief, “U.S. Household Deficit Spending” that the American economy was on a “rendezvous with reality.” What did he mean by that?:

“In other words, the U.S. household sector may be engaging in what the late economist Hyman P. Minsky would recognize as a form of Ponzi finance. Since the primary financial surplus is exhausted, and household income growth is below the average interest rate paid on household debt, household borrowing against the value of existing assets is required to sustain rampant deficit spending and to service prior debt commitments (principal and interest).Without a suitable and swift “euthanasia of the rentier,” such that interest rates fall below long-run household income growth, sustaining U.S. household deficit spending is predicated on sustaining asset bubbles.”

He also outlined three conditions that could sustain “persistently increasing private sector deficits,” recognizing that though a certain amount of private sector debt could be sustainable, too much of it would spell financial instability. These conditions were the conditions for “Hedge Finance” in Minsky’s financial instability hypothesis. Decades before Parenteau spotted the bubble economy, Minsky described three types of financing that people and firms in the private sector can adopt:

  1. “Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows.”
  2. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principle out of income cash flows.”
  3. For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations.”

The meaning of this, according to Minsky, was that:

“It can be shown that if Hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of Speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.”

So, the conditions Parenteau outlined in 2006 were:

  1. “First, the long-run growth of private sector income must exceed the average interest rate on the debt owed by the sector. This is a necessary condition for avoiding debt trap dynamics; otherwise, interest expense commands an ever-increasing share of income.
  2. Second, the private sector may be deficit spending, but its primary financial balance—excluding interest expense—must be in sufficient surplus. With a primary financial surplus, income grows more than noninterest expenditures, so there is still a positive cash flow cushion before debt servicing. Less new debt must be issued to service prior liabilities.
  3. Third, if assets held by the private sector continue to appreciate in price at a sufficient rate, then it is possible that the growth in collateral values and capital gains will be sufficient to service existing debts and justify further lending, even to a sector that is rampantly deficit-spending.”

But after examining the data, Parenteau concluded that those conditions (again, the conditions for Minskyan “Hedge Finance”) were not met:

“On the analysis presented above, serial asset bubbles will need to be engineered in order to keep household deficit spending on a steep trajectory.”

In more general terms, we can illustrate what happens with the aid of MMT’s money pyramid.

Government IOUs (money and bonds) are on the top. Then banks and non-banks leverage their own IOUs on the government IOUs.

Now, what does it look like if we flip that pyramid upside down?

Now we have Government IOUs on the bottom, serving as the base of the economy. Bank and Non-Bank IOUs are leveraged on top of those IOUs – somewhat precariously.

In fact, you can think of the economy as a spinning top rather than a pyramid. Like a spinning top, the more top-heavy the economy becomes, the greater its tendency to instability, and the more readily it will topple over and collapse in a financial crisis.

Now, what happens if, as was the case during the dot-com bubble and the housing bubble, private sector net financial assets go negative but net worth continues to grow?

In fact, the difference between the measures of net financial assets and net worth provides us with a good rule of thumb for how to spot a bubble economy. If private sector net worth is growing at a greater rate than private sector net financial assets are growing, then that means that the economy – symbolized by our spinning top – is growing more top-heavy.

So, what happens if we make the spinning top more top-heavy? You can go ask your nearest Kindergartener – it becomes more likely to topple over.

That’s not the sort of economy we need.

What we need is not an increasingly unstable bubble economy, but rather a stable and robust economy with a solid foundation of government IOUs, to prevent it from toppling over and to fight the tendency towards financial instability.

To be clear, private sector liabilities are not always and everywhere, in any quantity whatever, disaster for the economy. As with spinning tops, so too with the economy’s asset structure – it’s all about the balance. For stable and robust growth, we need an economy with an asset structure that looks more like this, with enough government IOUs at the foundation to prevent the whole edifice from toppling over. In Minsky’s terms, we need a “Hedge” economy at most, not a “Speculative” economy and certainly not an unstable “Ponzi” bubble economy:

We must sidestep a fragile and unstable economy in which unaccountable multinational wall-street bankers arbitrarily destroy the American People’s wealth according to their own whims and caprices in unsustainable bubbles. MMT advocates a robust and stable financial system founded upon a solid structure of safe net financial assets, so that we can achieve the sort of strong and sustainable growth that the American People – and, indeed, the people of all countries – deserve. But we are being hindered from achieving that goal by man-made obstacles, which we must sweep aside in order to move forwards.

The only way to get there is by understanding how the monetary system works.

Sometimes, something interesting and seemingly contradictory can happen in the economy. And when it does, it has important implications for the economy’s financial stability. That interesting thing is this:

Private sector net worth can increase even if private sector net financial assets were negative, as they were from 1997 to 2008 (except for a brief period in 2003/2004).

The reason this was possible is that net worth is dependent upon valuations, whereas accounting flows are not dependent upon valuations. One important financial asset class that enters into private sector net worth calculations are stocks.

If the market price for a stock is $90 and then I buy one share of the stock from you for $100, all that changes in the transaction itself is that I have $100 less than I had previously and you have $100 more than you had previously, and I have one more share of stock and you have one less share of stock. But what also happens is that the stock’s quoted market price increases from $90 to $100.

That means that everyone else who owns a share of the same stock thinks that they are now $10 wealthier per share of stock. The same thing happens any time the stock market goes up, writ large.

And what will the stock market do? In the words of J.P. Morgan, “it will fluctuate.” We might add that the same applies to the housing market.

In fact, there is a word in common usage for what happens when private sector net financial assets go negative but net worth nonetheless simultaneously goes up. It’s called a “bubble.”

For a while, the “wealth effect” of rising stock prices may encourage people to spend more of their income or even to take on another car loan or a second mortgage. After all, if your net worth is increasing, it seems like you can afford it! And this actually does have a animating effect on the economy during the market rise – as people spend more, their spending becomes someone else’s income, which also causes government tax receipts to rise. In a bona-fide bubble such as the Dot-Com bubble or the Housing bubble, this effect is stronger still.

But as the private sector’s financial position deteriorates, enough people eventually decide that they would like to sell at the new, higher market price. And when they do, we call that a “panic” or a “financial crisis.”

It’s like a game of musical chairs. When the music stops, there are not enough chairs (net financial assets) to go around.

So while the private sector did not net save during the Dot-Com and Housing bubbles, nonetheless when people received their monthly bank statements, quarterly portfolio reports, and annual property tax assessments, they saw that the numbers were going up. Times seemed to be good.

But to those who were looking at the underlying fundamentals – private sector net financial assets – it was clear that this prosperity was built upon a house of cards. There were not enough private sector net financial assets to support the increasingly fragile financial superstructure.

Indeed, this fundamental insight harkens back to the work of Hyman Minsky, originator of the Financial Instability Hypothesis. In 1999, Randall Wray wrote a prescient policy brief entitled, “Can The Expansion Be Sustained? A Minskian View.”

After reminding us that:

“In Minsky’s view, the floor to aggregate demand provided by a deficit’s maintenance of personal income is a key stabilizing feature of the postwar big government economy we have inherited.”

And after noting that:

“if it is true that the wealth effect has been driving consumption, it is not necessary to have a crash to kill the expansion. As Godley has argued, stock market capital gains provide only a one-time boost to consumption levels; continued economic growth requires rising stock prices.”

Wray’s conclusion was emphatic:

“I know of no reputable economic theory that concludes that growing private sector deficits are any more sustainable than are growing public sector deficits, and Minsky would have concluded that rising private sector deficits are far more risky!”

Likewise, Wynne Godley outlined “Seven Unsustainable Processes“ earlier in the same year, in which he warned that the “negative forces” of the government’s “restrictive fiscal stance” and of unfavorable “prospects for net export demand” “cannot forever be more than offset by increasingly extravagant private spending, creating an ever-rising excess of expenditure over income.”

Godley went on to describe, oracle-like, precisely what the private sector’s deficit meant:

“The private financial deficit measures something straightforward and unambiguous; it measures the extent to which the flow of payments into the private sector arising from the production and sale of goods and services exceeds private outlays on goods and services and taxes, which have to be made in money. While capital gains obviously influence many decisions, they do not by themselves generate the means of payment necessary for transactions to be completed; a rise in the value of a person’s house may result in more expenditure by that person, but the house itself cannot be spent. The fact that there have been capital gains can therefore be only a partial explanation of why the private sector has moved into deficit. There has to be an additional step; money balances must be run down (surely a very limited net source of funds) or there must be net realizations of financial assets by the private sector as a whole or there has to be net borrowing from the financial sector. Furthermore, a capital gain only makes a one-time addition to the stock of wealth without changing the flow of income. It can therefore, by its very nature, have only a transitory effect on expenditure. It may take years for the effect of a large rise in the stock market to burn itself out, but over a strategic time period, say 5 to 10 years, it is bound to do so.”

And in the more recent past, Rob Parenteau discerned in his 2006 public policy brief, “U.S. Household Deficit Spending” that the American economy was on a “rendezvous with reality.” What did he mean by that?:

“In other words, the U.S. household sector may be engaging in what the late economist Hyman P. Minsky would recognize as a form of Ponzi finance. Since the primary financial surplus is exhausted, and household income growth is below the average interest rate paid on household debt, household borrowing against the value of existing assets is required to sustain rampant deficit spending and to service prior debt commitments (principal and interest).Without a suitable and swift “euthanasia of the rentier,” such that interest rates fall below long-run household income growth, sustaining U.S. household deficit spending is predicated on sustaining asset bubbles.”

He also outlined three conditions that could sustain “persistently increasing private sector deficits,” recognizing that though a certain amount of private sector debt could be sustainable, too much of it would spell financial instability. These conditions were the conditions for “Hedge Finance” in Minsky’s financial instability hypothesis. Decades before Parenteau spotted the bubble economy, Minsky described three types of financing that people and firms in the private sector can adopt:

  1. “Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows.”
  2. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principle out of income cash flows.”
  3. For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations.”

The meaning of this, according to Minsky, was that:

“It can be shown that if Hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of Speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.”

So, the conditions Parenteau outlined in 2006 were:

  1. “First, the long-run growth of private sector income must exceed the average interest rate on the debt owed by the sector. This is a necessary condition for avoiding debt trap dynamics; otherwise, interest expense commands an ever-increasing share of income.
  2. Second, the private sector may be deficit spending, but its primary financial balance—excluding interest expense—must be in sufficient surplus. With a primary financial surplus, income grows more than noninterest expenditures, so there is still a positive cash flow cushion before debt servicing. Less new debt must be issued to service prior liabilities.
  3. Third, if assets held by the private sector continue to appreciate in price at a sufficient rate, then it is possible that the growth in collateral values and capital gains will be sufficient to service existing debts and justify further lending, even to a sector that is rampantly deficit-spending.”

But after examining the data, Parenteau concluded that those conditions (again, the conditions for Minskyan “Hedge Finance”) were not met:

“On the analysis presented above, serial asset bubbles will need to be engineered in order to keep household deficit spending on a steep trajectory.”

In more general terms, we can illustrate what happens with the aid of MMT’s money pyramid.

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3 Responses to The Spinning Top Economy

  1. Sigmund Silber says:

    I am not quite buying the accounting relationships. My brokerage account marks to market daily. Our tax assessor marks to market periodically and I believe most commodity trading accounts mark to market on a real time basis.
    So I have some difficulty seeing the difference between Private Sector net worth and Private Sector net financial assets.
    I think the problem may be semantics. It seems to me that you are talking not about assets but about money balances.
    Of course that creates other issues such as currency that is lost and counterfeit money etc. As you may know the US does not keep track of the serial numbers outstanding on Federal Reserve Notes. They do not know which bills are out there. When they retire a bill they do not eliminate that serial number from a database. So there could be thousands of Federal Reserve Notes out there with the same serial number. Of course no more than one would be legitimate.
    Although in theory only the FED can create money, any bank can modify its books. It is not legal but who is to stop it?
    But mainly I am concerned about wealth and tangible assets not being considered by MMT.
    An economic that only considers money to me is incomplete. When a humongous oil reserve is discovered has that no impact? In MMT, it seems not to. Of course one of the M’s in MMT is Monetary. I get that.
    We have a national debt but the US owns a lot of property. Does not the value of that property make a difference? The US owns the frequency spectrum.
    It is a little bit like the gold standard. Our fiat money is no longer backed by gold but it is backed not only by the money placed into the private sector (I follow that) but by tangible assets. Yes converting a non-monetary asset into money does not change the amount of money in the private sector or government sector if that transaction was made by the government. But if I owe $16T and have $32T in tangible assets few would think I have a problem especially if these tangible assets were in any way liquid.
    So I really think the pyramid needs to include tangible assets and natural endowments to be totally useful.

    • derryl says:

      @Sigmund Silber
      Sigmund wrote, “So I have some difficulty seeing the difference between Private Sector net worth and Private Sector net financial assets.”
      Net worth is a notional calculation of potential money; net financial assets are actual money that is counted. I have $300k of money in the bank. That quantity of money doesn’t change no matter what the market does. I have $300k “worth of” stocks in my brokerge account. But if the market drops by 10% then I only have $270k worth of stocks. I can only convert the potential ‘value’ of my stocks into realized value, into “money”, if somebody pays me money for the stocks. I can’t spend the stocks just like I can’t spend my house. First I have to convert the value of my assets into money by selling the assets, then I can spend the money. “Worth of” is not money. Only money is money.
      The problem with assets that have notional values of “worth” is that if people who have assets decide in a herd they want to sell their assets, then the price of assets drops as supply that is for sale rises. So it is not possible for “all” owners of Microsoft or Apple stock to actually sell their stocks at anywhere near the current ‘valuation’. Those current owners comprise the lion’s share of the demand for those particular stocks, and if they no longer wish to own them they will find that there aren’t many others who wish to own them either, except at very steeply discounted prices. When it comes time to try to convert the ‘value’ of your net worth into actual money, into net financial assets, you might discover that your “realizable” net worth is far less than you thought it was. Your assets may sell for far less than the notional amounts they are currently valued at.
      List some share of one of your stocks for sale at “market” rather than “limit” price, and you will see that your stock sells for less than the currently quoted price virtually every time. If it weren’t for the HFT “market maker” buyers of last resort, there might be NO buyers for your stock at any price. Market valuations remain high ONLY so long as large numbers of the current owners of those assets don’t try to convert the ‘value’ into actual “money” by selling the assets.
      That’s the difference. Money is liquid wealth. Assets are liquifiable wealth. But to liquify means to sell, to convert into money, and that’s not as easy and automatic as some people assume. Net financial assets is an arithmetic addition/subtraction of how much money you have minus how much money you owe. You’re counting real things, actual dollars you have an you owe, not potential dollars that you might be able to get if somebody will buy your assets from you. The balance of your savings minus debts is your net financial worth (positive or negative).
      Net worth is a theoretical calculation of the ‘value’ of your assets. But value is a subjective human psychological phenomenon, subject to herd movements up and down and sideways. ‘Value’ gives little indication of actual “price”, which is the real sale of an asset in which some party who has money gives you his money in exchange for your asset.
      Prices are always in “money”, because economic exchange involves buying and selling, trading an asset for money (selling) or trading money for an asset (buying). Money is the ENTIRE demand side of every economic transaction. Money is real dollars that can be counted, added up. Value is somebody’s perception, hope or fear, of what an asset might actually sell for. You can spend your money. But you can only spend your “net worth” after somebody first buys your assets from you by paying you money.
      Incidentally, the classical, neoclassical and Austrian schools of economics share this common fundamental error: they treat value as if it is money. They treat “adding value” as if planting one potato and harvesting 10 potatos, which has added 9 potatos “worth of” economic value, somehow also adds “money” that somebody can use to purchase that added economic value. In fact “worth of” adds no money. I just grew some spuds, not magic money trees. But the above named schools of economics treat our economy as if producing economic value automatically produces money that can be used by consumers to buy that economic value. That would be true if we were all peasant farmers and small craftsman who bartered tin pails for slabs of bacon.
      But we don’t barter. We buy and sell with money. And none of the mainstream schools of economics acknowledges this basic fact. And none of them knows where money comes from (banks create money by making loans). This is why none of those schools understands economics. When consumers have no money to buy a vast excess of economic goods that have already been produced and are currently for sale, the mainstream schools tell us the solution is to produce more goods more efficiently; or to export all our real output to get money from other nations. None of them understands money, so none of them recognizes a money problem when they see one. Consequently all of their diagnoses of the nature of our economic problems are wrong, and all of their prescriptions for solutions won’t work.

  2. If Sigmund insists on mixing static non-currency assets with static currency assets on the liability side (i.e., debt interest), he has to also accept the effect of dynamic non-currency assets on dynamic currency assets on the source side as well.
     
    In short, our fiat currency is ultimately backed by public initiative.  Yes, the cost of coordination is the highest cost, in any complex system, Walter Shewhart formally noted that 80 years ago. However, the return on coordination always swamps the cost of coordination.  Evolving life on earth first noticed THAT about 3.5 billion years ago.  Nothing’s changed yet, Sigmund.  
     
    Coincidentally, there’s now an economist in Darwin who seems to understand that cultural Adaptive Rate is a fiat currency, fiscal spending phenomenon. :)  I rather think that Wallace would approve.
     
    Here’s my advice to staid, “equilibrium” economists & accountants.  If you can’t stand the thermo, stay out of the dynamics. :)