Thursday, November 1, 2012

MAIN STREET & WALL STREET: the interrelationship between the real and financial economies

Comview conference, Melbourne, November 2012

Last year Glenn Stevens remarked that it was ‘very sensible of Australian households to be strengthening their balance sheets’. What on earth did he mean? In recent years we hear a lot of jargon in the economic debate that we usen’t to hear and that certainly wasn’t mentioned when we were at university. People keep on about ‘balance sheets’ - household balance sheets, business balance sheets, government balance sheets - and how they need to be ‘strengthened’ or ‘repaired’. Sometimes they talk about ‘gearing’, other times they talk about ‘leverage’ - households or businesses are ‘deleveraging’ we’re often told these days. We hear a lot more about ‘asset prices’, and credit-fuelled ‘asset-price inflation’ leading to ‘asset bubbles’.

We also hear a lot these days about the ‘wealth effect’ and about the household saving ratio - it was falling for about 30 years but then it rose rapidly, making life hell for the retailers. And economists take a lot more interest in the sharemarket than they used to. Say you’re worried about household debt being 150 per cent of household disposable income and someone will counter that household liabilities are just 21 per cent of household assets.

Then there’s the balance of payments. Express some interest in the trade deficit or the current account deficit and economists are just as likely to respond by talking about the capital account surplus and the balance between national saving and national investment. Say you’re worried about foreign debt and someone will say you should be focusing on our net foreign liabilities. Then they’ll say the nation’s foreign liabilities account for just 20 per cent of its assets.

The real economy versus the financial economy

So what’s going on? What’s going on is that historically, Keynesian macroeconomics focuses almost exclusively on the real economy, to the exclusion of the financial economy. There is, of course, only one economy, but it has two dimensions, real and financial. The real economy is the physical, touchable world of getting and spending, of the production and consumption of goods and services. Inflation and unemployment are part of the problems of the real economy, and we focus on these. Saving and investment are part of the real economy, but pretty much only to the extent they constitute leakages and injections to the circular flow of income.

The financial economy is the intangible world of borrowing and lending, assets and liabilities, of people with savings connecting with people needing funds to finance their investment, usually via an intermediary such as a bank, but also via direct borrowing in the financial markets. It’s the world where financial assets such as shares, bonds and foreign currencies are traded on financial markets.

The real economy couldn’t exist without the financial economy. You can’t produce goods and services without physical capital such as machines and factories, and you can’t sell them without shopping centres and offices. The acquisition of most of those assets has been financed by borrowing and equity capital. The financial markets exist to supply that funding. Just about every business has a significant amount of debt, with interest payments forming a significant expense.

Similarly, consumers come from households that need assets such as housing and consumer durables, the purchase of which is usually financed by borrowing. Households also own much of our big businesses via their superannuation saving or direct shareholdings.

Why talk about the financial economy is now so prominent

But conventional macro has taken little interest in the financial side of the economy. It has focused almost exclusively on the three dimensions of GDP: income, expenditure and production. As you probably know, the national accounts measure GDP these three different ways. In theory they’re equal; in practice measurement problems mean they never are so, in practice, the bureau of stats takes an average of the three and calls it GDP(A). And in practice, of course, macro economists focus mainly on the expenditure side of the real economy: GDP = C + I + G + X - M.

What’s changed is that, though Australia’s macro managers have had considerable success in controlling both inflation and unemployment over the past decade or two, a lot of different problems have emanated from the financial economy. That’s painfully evident right now in the rest of the developed world, but you can see it here if you go back a bit.

The severe recession of the early 1990s, which was quite protracted and saw the unemployment rate rise to almost 11 per cent, was caused by problems in the financial economy. Our banks and businesses overreacted to the deregulation of the financial sector, and we ended up with borrowing-fuelled booms in the housing and commercial property markets. The bust in the commercial market left many of our businesses far too highly geared and our banks with a lot of bad debts, to the extent that Westpac went close to falling over. What made the recession so protracted and severe was the way businesses sought to repair their balance sheets - to deleverage; or in plain English, to reduce their liabilities relative to their assets - by avoiding new expansion and cutting costs so as to repay debt. In particular, they cut costs by laying off workers. The banks repaired their balance sheets by widening their interest margin (not passing on all the cuts in the cash rate) and limiting their lending for new business projects. Note that problems in the financial economy soon become problems in the real economy. Economists separate them conceptually, but they can’t be kept apart in real life.

As its name implies, the Asian financial crisis of 1997-98, which led to a sharp recession in most of East Asia, had its origin in the financial side of those economies. Most had property booms fuelled by foreign capital inflow; when the foreign capital started rapidly flowing back out, countries had to devalue their fixed exchange rates. Many businesses that had borrowed in foreign currencies now found their loans and interest payments far higher than their assets. Their economies entered a sharp recession. In new phenomenon called ‘contagion’, foreigners who lose confidence in the prospects for one country tend to spread their doubts to neighbouring countries.

This brings us to the global financial crisis and the world recession it led to - which, for the countries of Europe, hasn’t ended. Again as the name implies, the causes of this recession were financial. The huge extent to which China and some other Asian countries’ saving exceeded their investment led to them running up large reserves of foreign exchange, which were then lent cheaply to the developed countries, particularly the US. This excessive supply of cheap funding led to excessive consumption, home building and borrowing by US households, which became quite highly leveraged - that is, their debts grew relative to the value of their assets. At the same time, deregulation, weak supervision and ever-increasing use of derivatives caused banks in the US and Europe to become far too highly leveraged. As well, most governments continued their longstanding practice of running budget deficits in good times as well as bad.

(‘Gearing’ and ‘leverage’ are the same: the use of borrowed capital to buy assets, thus magnifying the return to equity capital while asset prices continue rising, but magnifying the loss when asset prices start falling. Gearing is the British and Australian term; leverage is the American term.)

When, inevitably, the US house-price bubble burst, the whole financial house of cards collapsed. The sharp fall in house prices caused some households to experience ‘negative equity’ (their liabilities now exceeded the value of their assets) and others to pull their horns in and seek to ‘deleverage’. As always, this touched off a multiplier effect where fear of unemployment causes households to cut their spending and get their finances in order but this, in turn, causes the very increase in unemployment they were afraid off, touching off a further round of contraction.

While this was happening in the household sector, the banks were getting into trouble. Their excessive gearing meant it took only small levels of bad debt to wipe out their capital and bring them close to bankruptcy. Individual banks realised the other banks were in trouble, so the banks as a whole refused to lend to each other, forcing central banks to fill the gap, providing huge short-term credit to all banks. Some global financial markets actually ceased to operate for a time. The banks also became reluctant to make new loans to business. Though the problem began in the US, it quickly spread to the European banks, eventually exposing the structural weaknesses in Europe’s monetary union.

After the collapse of the investment bank Lehman Brothers in September 2008, the US Government had to bail out many banks, buying some of their now-toxic financial assets and injecting equity capital. Governments in Britain and Europe had to do something similar. Delay in approval of the US rescue package added to the rout on US and global sharemarkets, which had begun falling when the problem started to emerge about a year earlier.

Every media-publicised announcement that a bank had failed or almost failed in the US or Europe prompted another loss of business and consumer confidence around the world. In the US and, more particularly, Europe, government borrowing to bail out banks and reflate economies, when added to decades of deficit budgeting, caused government debt levels to soar, thus prompting a ‘sovereign debt crisis’ - the fear governments are so heavily indebted they may default on their debts (an event which, as Reinhart and Rogoff demonstrate in their modern classic, This Time Is Different, has happened far more times than we remember).

How and why the world has changed

In the post-war period we got used to recessions that arose from problems in the real economy. Typically, inflation problems would arise as demand grew faster than supply (production capacity) and shortages of skilled labour led to excessive wage rises. The authorities would respond with tighter monetary policy, hoping to achieve a ‘soft landing’ but overdo things and causing a recession.

Clearly, our last recession in the early 90s, the Asian financial crisis and the latest, global financial crisis were all very different from that, coming out of the financial side of the economy. Essentially, they were products of the bursting of credit-fuelled asset-price bubbles.

Why are financial crises and financial-side recessions now more common? Because the deregulation of financial markets makes credit far more accessible and often cheaper to households and firms, thus making it easier for credit-fuelled asset-price booms to emerge. Because, at least in some countries, and at least until now, the era of financial deregulation has seen banks and their innovations inadequately supervised by the authorities. Because financial globalisation has increased short-term capital flows between countries, thus increasing the likelihood of problems in one country spreading to others. And because the globalisation of the media means news of disturbing developments in one country now spreads almost instantaneously around the world, adversely affecting business and consumer confidence.

Another part of the story is that, whereas central banks have finally mastered the art of controlling goods-and-services inflation via independence and inflation targeting, thereby greatly improving demand management, their efforts seem to contribute to booms in asset prices - problems the central bankers admit can’t be countered with conventional monetary policy.

But how has the world changed? What are the consequences of recessions that arise from the financial side? They tend to be more severe and to last a lot longer. This is because ‘deleveraging’ or ‘balance sheet repair’ is an essentially deflationary process which, in economies that are already weak, take months or years to bring about. Similarly, efforts by governments to deleverage take a long time. Should governments attempt to speed up the process by cutting their spending or increasing taxes at a time when the economy is already weak, their efforts are likely to prove counterproductive - as we’ve seen in Europe recently.

A second reason financial-side recessions are more severe and protracted is that they often involve a version of a liquidity trap, in that interest rates are already very low when the recession starts. Since interest rates can’t fall below zero, there’s little room for conventional monetary stimulus. In any case, banks are often too preoccupied with repairing their own balance sheets to want to increase their lending, notwithstanding the low interest rates obtaining. All this greatly limits the effectiveness of monetary policy, pushing more of the initiative onto fiscal policy. But, where governments have themselves over borrowed in the good years leading up to the financial recession, their ability or willingness to apply fiscal stimulus is also limited, as we’re witnessing at present in the US and Europe. The next step is reluctant resort to ‘quantitative easing’ (another new bit of jargon).

I’m sure you know that ‘QE’ is a euphemism for what we used to call ‘printing money’. Of course, just like most money created by the central bank, this is not physical cash but numbers in bank accounts. What you may not know is that it involves central banks expanding both sides of their balance sheet. They buy government bonds (sometimes newly created bonds direct from the government, sometimes second-hand bonds from the ‘secondary market’) or other assets (such as mortgage-backed securities) and pay for them with extra money they have created. The money issued by the central bank is a liability of the central bank, whereas the securities it buys are an asset. Thus both sides of their balance sheet are increased.

The ‘wealth effect’ economists worry about more than they used to represents a form of feedback from the financial economy to the real economy. It occurs when households’ feelings about what’s happen to their wealth (their assets and liabilities ie their household balance sheets) affect their decisions about how much of their income they should save and, therefore, how much is left for consumer spending. When asset prices (particularly house prices, but also superannuation balances and direct shareholdings) are rising strongly, households are likely to feel wealthier, and thus see less need to save rather than consume. When assets prices aren’t rising, or maybe superannuation balances are falling, households are likely to feel less wealthy and thus save more and consume less. You’d get the same effect when the economic outlook became more threatening and households became concerned about the extent of their debts. It’s possible the ageing of the population - that is, the higher proportion of households in or nearing retirement - will make the wealth effect a more powerful influence on the real economy.

As for the increasing tendency of economists to explain the current account deficit in terms of national saving and investment, it’s a financial-side way of examining the balance of payments.

The accounting side of the story

Another reason we hear a lot more about balance sheets these days is that there are a lot more of them about. Some years ago, the UN Statistical Commission decided to switch both the system of national accounts and government finance statistics from a cash to an accrual basis. This means the (annual) national accounts now include a national, whole-economy balance sheet and a balance sheet for the household sector. We also have balance sheets for the federal and state governments.

To get a clear understanding of the distinction been the real and financial economies you have to remember there are two kinds economic variable: flow variables and stock variables. Flow variables show the size of the flow of some item (such as income or expenditure) over a period of time (usually a month, a quarter or a year); stock variables show the amount of some item (such as assets or liabilities) at a point in time(usually the last day of the period eg June 30).

In a business, the flow variables are collected together in the profit and loss statement, where the flows of expenses incurred during the period are subtracted from the flows of income earnt during the period to give the profit or loss for the period. The stock variables are collected together in the balance sheet, where total liabilities at the end of the period are subtracted from total assets at the end of the period to give the business’s ‘net worth’ at the end of the period.

For an economy, the conventional national accounts are equivalent to the profit and loss statement, while the new balance sheet is equivalent to a business balance sheet. That is, the conventional national accounts show the flows of income, expenditure and production in the economy during a period, while the national balance sheet shows the stocks of manmade, natural and foreign assets, less the stock of foreign liabilities, to give the national economy’s net worth at the end of the period. (Note that, within the nation, debts to other Australians are matched by the financial assets of other Australians, and so cancel out.)

The point to note is that it’s the flows during a period that bring about the change in stocks between the start and end of the period. If, for example, the net public debt increased from 100 to 120 between the end of period 1 and the end of period 2, this tells us government expenses exceeded government revenue during the period by 20 - that is, the government ran a deficit in year 2 of 20.

This is relevant when we say that Keynesian macro management focuses on the real economy largely to the exclusion of the financial economy. It focuses on the flows in the national accounts - or the budget - but ignores the stocks building up in the balance sheet. So Keynesians care whether household consumption is growing faster or slower than household income, but don’t take much interest in whether household net worth is rising or falling. They care whether government spending exceeds or underruns government revenue - that is, whether the government is running a deficit or a surplus - but they don’t much care what’s happening to the net public debt.

This neglect helps explain how most of the governments of the North Atlantic economies managed to go for decades building up huge stocks of government debt, which left them very badly placed to cope with the fallout from the GFC. It also helps explain why so few economists saw the GFC coming. They didn’t notice, for instance, that in the US, much of the growth in consumption and the economy in the years leading up to the GFC was, in a sense, phoney - it was financed not by rising household incomes but by rising household debt.

The trouble with the excessive focus on the real economy is that while what happens to the levels of stocks may be ignored in the short to medium term, if they are ignored for too long and allowed to build up to unsustainable levels they will eventually precipitate a financial crisis.


In a financially deregulated and globalised world, macro economists can no longer get away with limiting their interest to the real economy - to flow variables - and taking little interest in balance-sheet, stock variables. When financial imbalances build up, the ultimate blow to the real economy - and the lives of real human beings - can be extensive.

Technical note: much of what accountants call the ‘ratio analysis’ used commonly by economists was developed in the days before the preparation of collective balance sheets. In those days, the only stock variables produced in the national accounting process were levels of debt - public debt, household debt, foreign debt. When economists wanted to study those debt levels they compared them with the only other variables available, flow variables. Hence the practice of comparing household debt with household disposable income, or the net foreign debt with nominal GDP.

But accountants know that comparing stock variables with flow variables involves comparing apples with oranges. Ideally, stock variables should be compared with other stock variables, and flow variables with other flow variables. Before the advent of balance sheets this wasn’t possible, but now they exist economists need to change their practices to take advantage of the more relevant data available to them.

For instance, novices are greatly disturbed to hear that household debt is equivalent to 150 per cent of household disposable income. But such a comparison is largely meaningless. It implies that a day may come when someone is required to repay their mortgage, but prohibited from selling their house to satisfy most if not all of the debt. When would anyone ever be suddenly asked to repay their mortgage purely from their income? What matters is how the household’s assets compare with its liabilities (a stock-stock comparison) and, within this, how the present market value of the house compares with the size of the loan attached to it; and how the household’s cost of servicing the mortgage compares with its disposable income (a flow-to-flow comparison).

Similarly, it makes more sense to compare the nation’s foreign debt (or net foreign liabilities) with its assets (stock-to-stock), then compare the cost of servicing our net foreign liabilities (which is the net income deficit in the current account) with the nation’s income (nominal GDP) or with export earnings (both flow-to-flow).