For those uninitiated in the technicalities of NIPA and national accounting logic in general, this comment may seem strange. What's the issue with the Financial sector running a "nonzero" balance? As you'll see though, there are a number of ways where such an approach comes into conflict with the traditional treatment of the NIPA accounts and need readjustment if the approach I would like to take is to be seen as consistent.
As it Happens Ruggles and Ruggles, in their excellent book "National Accounting and Economic Policy: The United States and UN Systems" tackle precisely this issue. The crux of the issue Mason refers to is summarized at the beginning of the chapter:
"The approach of the United Nations System of National Accounts (SNA) to privately funded pensions and insurance is essentially a neo-classical one.Apart from the costs of operation, private pension contributions and life insurance premiums are considered to be a form of household saving, part of the accumulation of wealth by households that should appear as a category of assets on the household balance sheet. But publicly funded schemes- social security arrangements-- are not treated in this way. Entitlements under public programs are not credited to households until such time as the benefits are actually received. "
Thus, in one treatment there are private transfer payments and in the other only the government makes transfer payments. To make the difference between these two approaches clear, the two sets of T accounts below may be of some use. One Note: here subscripts (e.g. HH, MM, C etc) denote the sector making payment
As you can see from the above, by definition Institutional Investors are in financial balance at all times. Any shortfall or excess of cash flow is counteracted by an offsetting change in their obligation to households. Thus what we would otherwise consider to be the financial net worth of institutional investors is counted as part of household wealth.
From the point of view of flow of funds analysis, there are a number of problems with this type of approach. For one one's claim on "future pension obligations" is not transferrable and thus is not a financial asset as such. The fact that I'll eventually have a certain income in some undetermined future has a very different impact on current spending programs than having assets one can sell or pledge. Second, "excess" cash flow into pension funds, insurance companies etc don't guarantee me or even the household sector as a whole future payments. The conditions under which these institutions pay out are very strongly defined in contracts and aren't very sensitive to current financial surpluses. Someone looking at household wealth with these numbers included will get a very misleading picture of what's going on. Ruggles and Ruggles argue that treating them as transfer payments and thus separating out Institutional Investors net worth from household wealth is the best way of approaching this issue and I agree
So to finally get around to answering Mason's question in brief: transfer payments between private sectors change saving rates in such a way as to make Institutional Investor financial surpluses and financial deficits a consistent accounting concept.
UPDATE: I forgot to add the sectoral balance equation with private transfers
Ruggles, Nancy D., and Richard Ruggles. National accounting and economic policy: the United States and UN systems. Edward Elgar Publishing, 1999.
As I reviewed in my first post , the sectoral balance equation for one country is typically written as
One problem with this equation is the definition of (M-X), otherwise known as the external balance. In the world of MultiNational Corporations, is this balance really meaningful? For example the output that corporations transfer between subsidiaries is subject to what is called transfer pricing. It is quite famous that if someone wants to smuggle financial assets out of a company one way is to find a willing partner in another country and who overcharges you while you undercharge him. The output is then sold at market prices and something close to the difference between the “true balance” and the actual transaction values is set aside for the other party. This is of course enormously easier when both parties are in reality the same corporation. As if that wasn’t complicated enough, corporations also transfer intellectual property and financial assets between subsidiaries.
Why would entities systematically charge inaccurate prices to transfer funds out of a country? The primary reasons are capital controls and, in our modern world the most important one, tax avoidance and evasion. It is precisely these sorts of strategies that have made domiciling in another country profitable. This causes some difficulties in doing sectoral balances analysis, particularly in regards to the behavior of the corporation. They also make us systematically misunderstand balance of payments dynamics. It makes an enormous difference whether we are truly running a trade deficit with the rest of the world or whether export and import prices (as well as transfer payments disguised within property, investment good or financial purchases) are being systematically manipulated to hide foreign investment. After all, definitionally a lower current account deficit means a smaller capital account surplus . In recent literature debating the United States Net International Investment Position (the culmination of current account deficits and the revaluation of foreign owned domestic assets and domestic owned foreign assets), this has been referred to as a “black hole”. If the strong form of the “black hole thesis is true”, that the U.S. is actually running something close to trade balance, foreign holdings of treasuries and other low return assets are essentially permitting the continuation of foreign investment. Thus our NIIP may be systematically underestimated. This would help to explain why despite the supposedly large negative NIIP, foreign return on U.S. assets is systematically and greatly lower than domestic return on foreign assets.
Mona Ali, New School Graduate and Assistant Professor at SUNY New Paltz, has two very interesting recent papers on this issue titled respectively "Dark matter, black holes and old-fashioned exploitation: transnational corporations and the US economy." and "Global imbalances and asymmetric returns to US foreign assets: fitting the missing pieces of the US balance of payments puzzle”. She covers many important issues in balance of payments (so please go read both those papers). However, what I want to focus on is her commentary on “systematic” mismeasurement of u.s. trade deficits because of multinational activity:
“These new and rapidly growing types of off-shoring activities may artificially inflate the US deficit. In fact, a declining trade balance might very well be consistent with higher profitability for US multinationals (Milberg 2006; Milberg and Schmitz 2011). Thus, to view the current account balance simply as the ‘passive outcome’ of movements in the capital account – as does a sizable swathe of the contemporary global imbalances literature – is misleading. Godley (1995) debunks financially motivated explanations of the trade deficit because of their disengagement from the disaggregated firm-level decisions that influence the trade balance. However, Godley-type structuralist trade models where a country’s trade deficit reflects a loss of competitiveness also fail to account for international outsourcing.”
This is of course a simplification. There are a great many corporations with a variety of percentages are owned by foreign sectors and vice versa. Ownership of a company’s debt can also involve influence over managerial decisions. Nonetheless there is no satisfactory “shades of gray” definition so here I will be treating plurality or greater ownership of equity shares as a “domestically owned” corporation. If we have to choose between not analyzing domestic ownership of foreign corporations and analyzing them with perhaps an overestimation of the U.S.’s NIIP so be it. Unfortunately, national statistics in a multinational world are always going to be not quite suited to the task at hand.
Nonetheless, there are strong advantages in accuracy this kind of approach provides. First of all, intra-company transfers disappear in this approach. Thus we don’t have to deal with the headaches of trying to figure out the true market value of Disney and Apple’s intellectual property transferred between subsidiaries. Nor do we have to deal with complicated intracompany insurance schemes or, god forbid, financial derivatives. These are still important, however they can no longer affect (at least directly) the financial surpluses or deficits of individual sectors. This also provides a clear why of understanding balance of payments issues. The result of such an analysis for the United States might reveal that
This sort of analysis actually has a long pedigree in post Keynesian economics. In a paper from the 1970s entitled "Financial Interrelations, the balance of payments and our crisis" cites and discusses Victoria Chick’s paper "Transnational enterprises and the evolution of the international monetary system" (this paper appears to have never been published). The strongest statement on this issue comes from foundational Post Keynesian economist Paul Davidson (who also cites Victoria Chick). In a chapter of the first edition of “International money and the real world” entitled "Multinational Corporations and International Transactions." he says:
”In other words, the existence of multinational corporations (MNCs) who maintain production and trading activities in many nations, can affect, via decisions which are internal to the firm, the accounting magnitudes which measure the balance of trade of any nation during any period. These decisions involve accounting transfer pricing transactions among subsidiaries which are chartered in various nations. These transfer prices need not have any equivalent value magnitude in real world markets. Hence, extreme caution must be exercised before interpreting any balance of trade statistics as symptomatic of a fundamental national disequilibrium, rather than an accounting imbalance due, in large part, to decisions of MNCs' comptrollers to take advantage of different regulations or tax laws in various national jurisdictions...National balances of payments have therefore become, in some significant measure, an appendage of MNC decisions on income distribution and liquidity needs within the MNCs”
It is very difficult tell what these modifications to the sectoral balances approach would mean for measurements of balance of payments deficits, surpluses and Net International Investment Positions. This essentially “GNP” conception of balance of payments would certainly reduce the United States NIIP, but by how much is very debatable and is subject to how accurate data on MultiNational corporate activities. It may even be possible, with adequate data, that such a measure would mean a balanced balance of payments. I haven’t yet dug into the data issues so I don’t know how close to such a measure we could get. Michael Hudson’s “Financial Payments Flow Analysis” is a masterful approach to producing a flow of funds balance of payments measure that shares a similarity to what I’m discussing. However, his work shows just how much careful effort needs to be put in such a project and my impression is it has only gotten more difficult since the late 1960s. At the very least, I hope readers keep the complications of MultiNational corporations involved when doing sectoral balances analysis.
What I’m going to explore in this post is whether “money manager capitalism”, as Minsky defined it, impacts the behavior of various sectors and in particular what it has to tell us about the private sector balance. This post will be running through a lot of sectoral balance concepts and accounting. For those familiar with MMT and the stock-flow consistent approach, these will be familiar. Nonetheless, I will be reviewing them below.
It may seem obvious that the private sector’s financial balance would persistently be positive, thus necessitating persistent budget deficits , but it is not actually clear that this would generally be the case. Why is the private sector accumulating surpluses? The standard response in MMT social media is that the private sector “desires to net save”. I do not think this gets us very far. First it is our job to explain these “desires”. Second, the private sector of the U.S. (or any other economy) is huge with a myriad of differently structured organizations. In this context assigning such a “human passion” to explain such an important macroeconomic phenomenon seems problematic. Third, many people “desire” a great many things; they often aren’t able to accomplish them. I personally desire to “net save” equal to 5% of next year’s GDP. Unfortunately, I do not think my “desire” will become a reality. This silly example is meant to emphasize the point that we have to look at how sectors or particular sub sectors make decisions and understand how those decisions result in certain recorded financial surpluses or financial deficits at the end of a recording period. To be clear, I don’t think people have been “wrong” to use such turns of phrase, just that to do a more in depth analysis requires putting them aside.
In this context the greatly underappreciated paper “Household and Enterprise Saving and Capital Formation in the United States: A Market Transactions View” by the great economist couple Nancy and Richard Ruggles is crucial. They argue that once you reorganize the NIPA accounts so that households invest in houses, cars and other “durable consumer goods”, while removing insurance premiums and pension contributions from household savings, households on average over the post-war period invested roughly as much as they saved. They found the same to be true for non-financial businesses for the most part, with the notable exceptions of mining and publicly regulated utilities. Thus the big private sectors running persistent financial surpluses were Institutional Investors ie those sectors controlled by money managers. It is this phenomenon that I want to focus in on and its effect on the behavior of sectoral balances.
In the popularized version of Keynes’s “argument”, it is commonly said that he thought governments should run surpluses during booms and deficits during recessions. The purpose of this is to be in balance on average. Post-Keynesians and others rightly ridicule this simplified story, especially because it makes governments seem like they have more control over their deficit position than they do. Nonetheless, the Ruggles and Ruggles analysis suggests that something like that may be possible in a closed economy with households, non-financial corporations, and governments. Households and non-financial corporations would invest more leading to rising tax revenues, drops in government expenditures (especially on transfer payments) and ultimately saving below investment. Conversely they would cut their investment expenditures in recessions, leading to drops in incomes, drops in tax revenues and rises in government transfer payments. Intuitively, we can see that this process would lead to roughly balanced sectoral balances, sans the business cycle being overweighted to either boom or depression, over long periods of time if these were the only sectors of the economy.
This is easier to understand when we look at the structure of these sector’s spending decisions. Both households and non-financial corporations invest to acquire capital goods required for their continuation. Households invest in houses to live in, cars to get around in and items like washing machines because they expect their lifetime cost to be much lower than a lifetime of renting. Non-financial corporations invest to create capacity to produce more, to replace depreciated assets and to increase specific infrastructures required to continue doing business. Recall that paying off debts are a form of saving in NIPA. Thus individual households and corporations either run up financial surpluses to make a large investment good purchase (ie run a gigantic financial deficit for one period) or they make a large investment good purchase on credit and save by paying off their debts.
Either way at the individual level this appears as financial surpluses interrupted by a discontinuous and discrete tremendous financial deficit. Since these decisions in the aggregate don’t happen all at once and are spread unevenly over many different periods, the large dissavings to purchase investment goods are more or less counterbalanced by the fixed contractual payments many other households and corporations are making and/or the savings being built up to make an internally financed purchase. In other words at the aggregate sector level these sector’s saving and investment should be near each other. Thus there are reasons to expect that over long periods of time these sectors average financial balances would be near balanced. This is because both households and corporations income and investment are sensitive to the business cycle. This leads us to a thesis- those sectors whose expenditures and income have large room to react to business cycles will see their financial balances be in rough equality over a long period of time.
Below is a simplified disaggregation of the private sector to focus on two things, Ruggles and Ruggles analysis of businesses and households and the anomalous role of Money Managers and the institutions they control in financial sectoral analysis. Representing all private sectors as they exist in the NIPA accounts would be a time consuming and unnecessary process for these purposes. The point I would like to make is capable using the accounting identity below.
The defining feature of the institutional investors money managers control is that their income and expenditures are tightly contractually defined. Households and non-financial corporations are more or less obligated to “make contributions” of a certain level during any given year and it is very difficult for the state of the economy to change these obligations (sans bankruptcy and the freezing of pension plans or the like). In addition, the assets that institutional investors hold are for the most part contractual obligations such that there is very little flexibility in adjusting payments to financial conditions sans mass bankruptcy. On the spending side, these organizations are both obligated to make certain levels of required payments and obligated to hold financial assets as “reserves” for future payments. This again would require mass institutional investor bankruptcy to change as a sector.
Thus in the absence of government deficits households and/or corporations would be pushed to run deficits to support the balance sheets of institutional investors which of course would eventually lead to mass bankruptcy. As Minsky showed so well in his other work, large automatic stabilizer spending and taxation programs are designed to avoid this outcome. In other words, the structure of the economy and institutional investors is tilted away from institutional investor capital losses being the adjustment mechanism and towards continued financial surpluses through government deficit spending.As a result, these sectors whose expenditures and income are strongly insensitive (but not completely insensitive) to the business cycle will have a tendency to accumulate financial surpluses over long periods of time.
Ruggles and Ruggles wrote their paper around the same time as Minsky started to develop his “money manager capitalism” analysis. As noted earlier, Minsky’s thesis was not just that these large institutions were changing the behavior of the economy and financial assets, but also they were changing corporate behavior. In particular they generated stronger uncertainty at the firm and plant level. Thus we may expect that corporations are less likely to invest in the same business cycle situations as earlier and thus may be expected to run financial surpluses over many business cycles in the future. We won’t know until a strong boom gets going. Either way, the central fact is that it is large sectors like institutional investors that has biased the private sector to running financial surpluses over the long run.
In my research into the antebellum financial system, this is a process I closely researched. It is very difficult to gather data but my strong sense from reading up on these periods is the process by which savings banks, insurance companies etc started being chartered tilted the economy more towards private sector financial surpluses as time went on. Large losses were likely taken in crisis periods in the “balance sheet simplification” process Minsky identified in his work. Nonetheless capital losses likely didn’t come close to balancing out the surpluses and as government budgets became more important this process was intensified. The way business cycle insensitive sectors impact financial dynamics and financial net worths need closer examination in the future and need to be at the center of our stories for why governments as a whole can’t balance their budgets over the business cycle.