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