Wednesday, 25 August 2010

Flow-of-Funds Accounting Identity

Δ(G-T) = Δ(S – I) + ΔNFCI   

  G = government spending, T = tax revenues, S = private sector savings, I = private sector investments and NFCI = net foreign capital inflows

 Translation: If our government stimulates the economy through public spending, as it is currently doing in spades, we must either save more or we have to rely on foreigners being prepared to invest in our country. There are no exceptions to this rule


 The key question is what will cause this equation to hold true? It is quite simple. We will save more if we get paid more to do so (through higher interest rates) or if we are so scared of the future that we stop spending and start investing instead.

Foreign investors are no different. Now, with the trillions of dollars being spent around the world to shore up our financial system, the fear factor alone is not going to be enough. Higher – possibly much higher - interest rates will be required to ensure sufficient savings.

Obviously, there is another option at the government’s disposal. The central bank can monetize some or all of the deficit by buying the bonds issued by the government. This line of action will keep Δ(G-T) down; hence the need for increased private savings (and/or capital inflows) drops accordingly. The problem with this approach, as an old Danish saying states, is that it is like wetting your pants to stay warm. Monetization executed on a big scale is highly inflationary in the long run, inevitably driving bond yields higher