From the TUC

Fiscal fallacies and sectoral balances: response to the critics

19 Nov 2015, by in Economics

The last two posts on ‘fiscal fallacies’ (‘Keynes wanted government loan expenditures NOT deficit spending‘ and ‘accounting identities and the case for government loan-expenditures‘) have generated something of a debate, including on Richard Murphy’s blog (here).  Further discussion follows … including a comparison of the behaviour of these accounting relations over 1946-50 with 2010-14.

I know the National Accounts balance. I certainly am not dismissing the importance of the sectoral detail, not only these deficits/surpluses, but also the richer detail in the financial accounts and balance sheet. I am opposed to spending cuts, which I understand as causing real damage to the economy (e.g. here). I recognise that all parties to this argument have in common a strong understanding of monetary processes.

But I remain concerned that certain complexities in both the accounting and the macroeconomics are overlooked, as well as with the way the reasoning is applied to the fiscal policy debate. I recognise that my previous contribution may not have been a picture of clarity, but the problem seems primarily at the level of policy conclusions (though it is difficult to tell). I remain to be convinced that Richard handles the substance of my argument.

1. The identity itself

My first difficulty is with the definition and derivation of the so-called ‘national accounts identity’. It is stated several times in responses (differently in each and wrongly in one), and derived as follows:

GDP=C + S + T                                                                                                    (1)

GDP = C + I + G + (X-M)                                                                                 (2)

Subtracting one from the other gives the familiar(ish)

(I-S) + (G-T) + (X-M) = 0                                                                                (3)

While (2) corresponds to the expenditure measure of GDP, (1) is not a definition of GDP, corresponding to neither the income or output measure. Reasoning from (1) is certainly not national accounts reasoning; equation (3) is not a national accounts relation, though the reasoning is always illustrated with measures taken from the national accounts (like the chart in my post).

For me, the logic of the National Accounts provides a more compelling alternative derivation, beginning (for each sector) with the relevant components of the income measure of GDP (primarily wages and salaries and profits), taking into account transfer payments (e.g. tax, interest) between sectors, and subtracting the relevant expenditure components. In generic form:  resources minus uses; the ‘balancing item’ is strictly known as ‘net lending / borrowing’, rather than surplus / deficit. The identity follows because across all sectors GDP(E)=GDP(I), and then because transfers add to zero by definition, with one sector’s resource another’s use.

On the basis of national accounts definitions, (1) is a hybrid of expenditures and revenues. Most obviously (as someone points out) in (3), X and M should include flows of investment income (e.g. dividend and interest payments); more fundamentally, the G in (3) should not be the same as G in (2) – see below.  All that said, in the absence of any other formal notation (as far as I am aware), I will continue to use (3) above though with provisos as discussed below.

2. The macroeconomics of the identity

I do not want to violate accounting identities; I am interested in explaining how changes in the economy ensure the identities are maintained, or as Victoria Chick suggests, ‘how the economy gets there’. The processes are of importance: the destination may be changed during the journey; indeed, arguably understanding that is the whole point of macroeconomics.

The purpose of an increase in spending ∆G, is to revive the economy and hence increase GDP ∆Y (where ∆‘delta’ means change over any period, usually a year).

The relationship between ∆G and ∆Y is dictated by the multiplier; I would have thought that any follower of Keynes would see this as bigger than one. So ∆Y > ∆G.

According to the NA definitions, the increase in GDP is allocated to income (wages and salaries and profits) and to expenditure categories (household consumption, investment and imports). There will then be effects on transfer payments, not least income and corporate taxes and spending on benefits. All these effects will mean changes in sectoral balances for individual sectors.

Define sectoral balances as follows:

B PRI + BGOV +  B ROW = 0

(B – balance, GOVernment, PRIvate sector, RestOfWorld)

I am interested in what happens following a change in national income. So let us look at:

∆B PRI + ∆ BGOV + ∆ ROW = 0                             (4)

A change in one of these obviously means a change in another given the identity must continue to hold. But I maintain that the important action is in the flows of revenues and payments for each sector, i.e. the gross flows not the net position. As above, the fuller identity is

(∆S – ∆I) + (∆T – ∆G’) + (∆M – ∆X) = 0    (5)

Note: (i) G’ is different from G, because it includes transfer payments; (ii) the RHS strictly includes flows of income (eg dividend payments) as well as imports and exports.

The accounting identity does not mean that a change in one balance must be allocated directly to the other two balances as through equation (4). Changes in income and expenditure will be allocated through all the various revenue and payment categories (5), and it is these that must balance. The important action is in these gross flows that correspond to the increase in income and its allocation that the critics ignore (or at least do not treat analytically). Mathematically, it is possible that this allocation will be in the extreme way the critics suggest, so transfers and taxes are unchanged and the reduction in government spending is mirrored by changes in imports and private saving. But the more general case is that all the balances may change or at the other extreme, none of them. The identity will be maintained, but how it is maintained is a process, while the accounting identity (4) gives no clue as to the effect on individual sector balances.

Economically, the logic of the process by which an increase in spending increases income means increased taxes and reduced benefits and so ∆BGOV < ∆G. It does not take a very large multiplier to have ∆BGOV> 0. The changes in the other balances are therefore moderated accordingly, and depend also on wider economic conditions (e.g. QE).

3. Empirics

Empirically, the obvious evidence is the post-war period (simplified and rounded for clarity).

Sector net lending / surplus, Attlee (£mn) and Coalition (£bn)


A massive government deficit was turned into a surplus in four years. In parallel, the private sector surplus increased and the rest of the world surplus was reduced to deficit. In contrast over the past five years of spending cuts, the reduction in the deficit has been minimal (and mainly down to the increase in the VAT rate). Really it is quite peculiar that BROW should increase given the climate of depressed demand fostered by fiscal policy. But in the meantime private demand has been cajoled in part by monetary action, so the BPRIV has collapsed while BROW had blown out.

(The Attlee figures are from Feinstein’s National Accounts, Table 16, ‘Combined capital account’. A little guesstimation is involved in allocating capital expenditure, but not so that it interferes with the results.)

One critic argued things are different now because the UK now has a ‘structural deficit’ on trade. But according to Feinstein’s figures, shown on the two charts below, the balance of trade is smaller now as a share of GDP relative to the position over the 1930s and 1940s.

Balance of trade, % GDP


In ‘Phil’s’ response, he takes the present rest of the world surplus as a given, seemingly immutable. The undesirability of a private deficit means the public sector has to run a deficit on an indefinite basis in order to maintain the accounting balance. I am perfectly willing to recognise that the trade position may present a significant challenge. But the experience of 1946-50 suggests not an insurmountable one. E.g. there is likely a role for a wider industrial strategy, as the TUC have long supported.

Moreover the government cannot ensure that it has a deficit by increasing spending, given the likely repercussions on taxes and benefits. Phil concedes that debt/GDP might not increase indefinitely, “that depends on the reaction on GDP” – absolutely. Others (e.g. Brian Stobie) also recognise that government cuts are not synonymous with deficit reduction, and vice-versa presumably. That’s kind of the whole point of the argument. I presume that those who think government can run a permanent deficit are operating with a very low multiplier?

4. Policy

The debate has a history, with critics pointing me to Abba Lerner’s ‘functional finance’ doctrine of the 1940s and an alleged rivalry between him and Keynes.  Lerner and other US ‘Keynesians’ proposed more extensive expansions in credit against which Keynes baulked. At this time Keynes had been fully vindicated through the sound management of the UK economy in the war. After the war, the Attlee government did not find the US approach necessary; and the UK outcomes stunning surely by any standards.

Tellingly, Keynes’s concern was the manner in which this policy position was promoted (see here). The experience of 2010 to 2015 must illustrate the difficulties faced by those promoting a progressive policy agenda, and reinforce the scale of his achievements in the 1930s and 40s. Through all his initiatives he stressed how progressive actions would conform to conventional norms, primarily on the budget but also e.g. on exchange rates and inflation. These results followed directly from his theory, but were advantageous politically. He must have looked at these alternatives as paying no regard to the public mood, and endangering the progressive goals that were the achievement of his life’s work.  Obviously today we are some way from any such progressive goals…

Finally, of course the world is very different. The majority of my work is preoccupied with the claim that Keynes’s main theories and initiatives concerned monetary policy and international financial architecture. While the Bretton Woods settlement was far from his ideal, it was less bad than anything since. The failures of the present global financial architecture should not be used to rule out fiscal initiative, but would instead suggest the need for a greater ambition all round.

2 Responses to Fiscal fallacies and sectoral balances: response to the critics

  1. Phil
    Nov 23rd 2015, 1:10 pm

    “I presume that those who think government can run a permanent deficit are operating with a very low multiplier?”

    No. Just the assumption has to do with trade multipliers — specifically, import leakages. I don’t think that you’re taking into account the trade leakages in your multiplier equations.

    Now, given your interesting presentation on the 1930s and 1940s deficit I have some explaining to do. Why has something structurally changed? Because Thatcher murdered the manufacturing sector:

    The problems in the Depression era had to do with policies (like the gold standard, WWI debt repayments and the Lend-Lease program) that could be quickly shifted. But the current problems have to do with a fundamental structural shift from manufacturing to finance. That cannot be easily cured by, say, going off gold, devaluing the currency, restructuring debt repayments or stopping borrowing armaments from the US.

    What is more, the current structural problems make it highly unlikely that an exchange rate depreciation would work at all. Indeed, the evidence now seems to show that it would do nothing. (In technical terms: in the UK the Marshall-Lerner condition is far from holding).

    Could industrial policy work? Yes. I have advocated that. But it would take years and years. And in the meantime the either the government or the private sector will have to run a deficit. There is simply no getting around this.

    Ideally the spending would have to be targeted at the export industry and at import substitution. But I just cannot see any government getting in power that would manage that in an effective way. Maybe that is pessimism on my part. But until I see it I’ll remain skeptical. Anyway, we’ve had these discussions before, and they went nowhere:

    In reality, it seems to me highly unlikely that the current account will meaningfully close unless active policy is carried on in a sustained manner for years and years. Until then, either the public or the private sector must run a deficit. And we know what happens when the private sector runs a deficit…

  2. Stephen Ferguson
    Nov 25th 2015, 12:55 pm


    Just in case you haven’t picked up on it, Bill Mitchell has responded to your and Ann Pettifor’s critique on sectoral balances…