How the U.S. economy’s component sectors must balance.

Sectoral Balance- Add this to the long list of things that should be taught in High School

Even more-so when you consider it is a machine where the direction in which a cog turns (or how fast) is often a function of human behavior and decision making. But the simplicity of the above multi-line graph belies an important accounting identity many Americans have never heard mentioned, even if they’re financially or economically inclined. What you are looking at is the brainchild of late British economist Wynne Godley, which he called the Sectoral Balance approach to national economies.

The data presented here is broken down into the three major components of the U.S. economy’s Gross Domestic Product- the total dollar value of all goods and services produced in the country. The blue line represents the percentage of GDP from the Private Sector (domestic non-governmental), the red line represents the same for the Public Sector (the federal government), and the green line represents the contribution from foreign trade (what economists call the Current Account, because if there wasn’t unnecessarily confusing jargon, it wouldn’t be economics).*

Any of these three major sectors can be found in deficit or surplus but the crux of the accounting identity is that the three always come to balance. So if GDP growth is positive for that period, the three sectors cannot all be in deficit. And if one or two sectors are in deficit the remainder must equal the growth in GDP and enough to cover the deficits of the other(s).

But this is a lot to take in, right? Eighty-ish years of data and there are three separate sectors balancing together which makes it slightly harder for the human brain to see the relationship in such a noisy display. So let’s take a look at a snapshot in time, the venerable 1990s.

This snapshot is an excellent way to illustrate how the balancing effect the sectors experience as they change through time. Notice the convergence of the Government (red) and Private Sector (blue) as the Clinton White House repeatedly balanced the annual budget. The result for the Private Sector is not just a significant decrease, but in fact turns negative as the Government’s savings (net lending/borrowing) increases correspondingly. It should be noted here that the rise in the surplus the Foreign Sector sees for this time period is absolutely a contributing factor. But if the Foreign Sector were flat you would see a similar effect on the Private Sector as this is definitionally what must happen for the sectors to balance - and they always balance.

For the math heads out there, here is some additional granularity on how strong this relationship is solely when viewed between the Government and the domestic Private Sector. Below is a scatterplot of those sectors’ data values, where the x-axis is the private sector data and the y-axis is the government data.

Based on the above chart it is unsurprising for me to tell you that the correlation coefficient between the Public and Private sectors is -0.94. Said another way- for every dollar the Government ‘saves’ (or every dollar it reduces its net spending) there is a 94 cent reduction of dollars available for the Private sector. To quote Godley directly- “It is not possible to reduce the government’s deficit by reducing spending or raising taxes unless the private sector’s surplus declines and/or the foreign sector’s surplus declines.” (This quote is being made in a ceteris paribus context).

The Public Sector and Private Sector approach perfect negative correlation with a correlation coefficient of -0.94

What we can learn, most importantly, from Godley’s Sectoral Balances model can be summed up with another concise quote from Godley, “...government deficits produce surpluses for the non-government sectors.” 

Remember That.

So the next time a politician or pundit explicitly or implicitly messages that the US government needs to ‘tighten its belt,’ consider what that really means for individual citizens in the US.- You, your family, your friends and neighbors, and the businesses you know and love.

* To break this down a little more scientifically- each of the three sectors’ raw data are most granularly described as ‘Net lending or borrowing’ for that sector, in economics terms. Furthermore, the actual sector data (1-3 below) are converted to their respective percentages of that period’s GDP (4 below) for the illustrative graph at the top of this post.

1. Net lending or borrowing, National Income and Product Accounts: Government - Federal Reserve Economic Data reference number - AD01RC1Q027SBEA

2. Net lending or borrowing, National Income and Product Accounts: Private - Federal Reserve Economic Data reference number - W994RC1Q027SBEA

3. Rest of the World; net lending or borrowing, Flow (Discontinued)  - Federal Reserve Economic Data reference number - RWLBCAQ027S

4. Gross Domestic Product - Federal Reserve Economic Data reference number - GDP

Data Source: Federal Reserve Economic Database - https://fred.stlouisfed.org/

Code: INSERT GITHUB LINK HERE