Arnold Kling

Flow of Funds

Arnold Kling, Great Questions of Economics
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Ever since Keynes articulated the "paradox of thrift," macroeconomists have expressed the concerns in this New York Times analysis that saving could be excessive.

"This is going to be an anemic recovery, and the increase in the saving rate is one key element as to why," said Stephen S. Roach, chief economist at Morgan Stanley. The firm expects the savings rate to jump to 2.9 percent by 2003, from 1.6 percent last year.

Wynne Godley also expressed this view.

The 90s expansion was powered uniquely and exceptionally by a huge fall in the net saving of the private sector... During this period the balance between the private sector's income and expenditure fell by 11.5% of GDP; in the third quarter of 2000, private expenditure exceeded income by an amount equal to 6.2% of GDP, never having exceeded it significantly at all during the previous 30 years or more...

The private deficit will probably recover all the way back to its normal condition of surplus, implying a continued fall in private expenditure relative to income, withdrawing 4.5%-5%, up to $500bn (342bn) from aggregate demand. But even if the private deficit were not to recover at all, my main conclusion would still stand because the US economy would remain deprived of the motor which drove it through the 90s.

This is known as "flow of funds" analysis in macroeconomics textbooks. This analysis has two components.

  1. As a matter of accounting, net private saving (personal saving plus corporate profits minus investment) plus net government saving (taxes minus expenditures) equals net foreign investment (exports minus imports). This is the flow of funds identity.

  2. If all of the other components are given, the higher the rate of desired private saving the lower the level of aggregate demand. Because actual private saving cannot exceed the amount that is determined by all of the other flows, an "excess" of desired saving reduces overall demand for output. This is the Keynesian equilibrium condition.

There are many problems with this textbook analysis. For one thing, there is no price adjustment. Excess saving does not lower interest rates or reduce the exchange rate. Thus, it has to reduce output.

My concern is with treating net private saving as an autonomous causal factor, while treating net foreign investment as given. In my view, what has been driving down net private saving and net foreign investment has been the trend toward investors having increased confidence in U.S. assets relative to foreign assets. When this trend levels off or reverses, there will be a decline in the value of the dollar, which will stimulate our exports and restrain our imports. There also will be a decline in U.S. stock prices, which will reduce investment and consumer spending. The dampening of domestic demand could very well be completely offset by a reduction in the drag on demand exerted by the trade sector. Thus, there could be a large swing toward increased net private saving without a collapse in overall economic activity.

Discussion Question. If investors start to favor foreign assets, then a drop in the value of the dollar will reduce the trade surpluses of Japan and Europe with the U.S. However, what will happen to domestic demand in Europe and Japan in that scenario?

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