Economic Reform Australia Blog

The sectoral accounting equation

The sectoral accounting equation is (I – S) + (G – T) + (X – M) = 0    
where (I – S) = private sector balance,  (G – T) = public sector balance,  (X – M) = foreign sector balance.

The term (I-S) represents productive investments (I is total investment, S is total savings).  In monetary terms it may be identified with transaction money M1, which is the money used within the productive economy.

All newly created bank money appears firstly as an increase in M1 (i.e., it is created within transaction deposits).  However a large part of that money migrates into savings deposits (on an ongoing basis).  Available statistics reveal that in times of economic growth (characterised by a modest level of inflation) an influx of new money increases I and S at about the same rate.

However in times of economic contraction, production will be diminished and savings will increase, and there will be less demand for credit by the productive sector.  In these circumstances (I-S) will decrease.  Assuming for the sake of argument that the level of imports and exports does not change significantly (i.e., assuming that an export-led recovery is unlikely), we find that in order to avoid a period of deep and protracted recession the ONLY solution is for the government to spend money into the economy.

Attempting to run a budget surplus in these circumstances is grossly irresponsible — perhaps insane would be a better description.

John Hermann

  • JCT

    You say that in times of economic contraction “the ONLY solution is for the government to spend money into the economy”. Surely another solution is to encourage an increase (or at least stem the decrease) in (I-S) through any of a variety of channels – for instance by reducing interest rates thereby discouraging saving and stimulating the sluggish private demand for credit that you mention? Similar effects could be achieved through eg changes to the tax regime (eg increasing savings taxes, reducing taxes on small business) and through other regulatory changes (reduction in red tape) designed to stimulate private activity.
    Now, I’m not saying one way or the other whether I support these measures more/less than the government spending route you espouse, I’m just surprised to see you claim that the latter is the “ONLY” way that government can influence output, which seems to ignore the very important role and myriad tools (of which I mentioned a few) igovernment has for influencing the private sector (I-S). Have I misunderstood?

  • Yes, you are right .. it was phrased wrongly, and should have read ” … the ONLY solution is for NET government spending to increase.” Obviously if taxes on productive activity happen to be reduced, then the net effect is the same as would have occurred if spending on productive activity had been increased.

  • JCT

    You say that in times of economic contraction “the ONLY solution is for the government to spend money into the economy”. Surely another solution is to encourage an increase (or at least stem the decrease) in (I-S) through any of a variety of channels – for instance by reducing interest rates thereby discouraging saving and stimulating the sluggish private demand for credit that you mention? Similar effects could be achieved through eg changes to the tax regime (eg increasing savings taxes, reducing taxes on small business) and through other regulatory changes (reduction in red tape) designed to stimulate private activity.
    Now, I’m not saying one way or the other whether I support these measures more/less than the government spending route you espouse, I’m just surprised to see you claim that the latter is the “ONLY” way that government can influence output, which seems to ignore the very important role and myriad tools (of which I mentioned a few) igovernment has for influencing the private sector (I-S). Have I misunderstood?

  • Yes, you are right .. it was phrased wrongly, and should have read ” … the ONLY solution is for NET government spending to increase.” Obviously if taxes on productive activity happen to be reduced, then the net effect is the same as would have occurred if spending on productive activity had been increased.