The Most Important Graph of the Year

Gavyn Davies Financial Times December 22, 2010

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From the standpoint of a global macro economist, this is my nomination for the most important graph of the year. (See the end of this blog if you wish to suggest alternatives.) It explains why the world’s largest economy, the US, has defied the pessimists by mounting a decent recovery in 2010. It also explains the behaviour of the government deficit, and show why it has so far been easy to finance this deficit. And, most importantly, it shows why the US lost the Ryder Cup. (Well, actually it doesn’t, but you can’t have everything.)

The graph shows the financial balances of the three sectors which comprise the US economy – the private sector, the government sector and the foreign trade sector. The financial balance of each sector is equal to its income less its total expenditure. A financial surplus indicates that the sector is a net acquiror of financial assets, while a deficit indicates that the sector is running down its net assets (or increasing its borrowing) to finance its activities. Because the three sectors cover all of the activities of the US economy, at home and abroad, their financial balances must sum to zero.

The first point to note is the dramatic reversal which has taken place in the past 3 years in the private sector’s financial balance. This sector includes both households and corporations, and in most economies it tends to record a small surplus most of the time. This was true in the US until the late 1990s, when the household sector started to run a financial deficit. Basically, rising equity prices, and then rising house prices increased personal wealth, and this induced households to reduce the amount they saved out of current income. As a result of this deficit, the private sector’s leverage ratio (the stock of outstanding debt/income) rose to record levels.

After 2007, falling house prices and the financial panic caused both households and companies to slash their spending relative to their income, and to generate excess cash. The shift in the private balance was a remarkable 14 per cent of GDP, and the consequent collapse in spending caused the recession. Meanwhile, the extra cash was devoted to paying down net debt, so the leverage in the private sector balance sheet started to decline. This process continued to gather momentum until the early part of 2009.

Since then, the private sector has allowed its financial surplus to decline slightly. Expenditure has risen a little faster than income, and this has allowed the economy to recover. But because the private sector remains in surplus, and is generating excess cash, it is still able to devote this cash to paying down debt.

All this is familiar, but the key point to note is that a recovery in the economy is compatible with a continuing improvement in the debt ratio. Many people have claimed that these two things are not compatible, but that is wrong. A decline in the financial surplus (a flow variable) can be fully consistent with a fall in the debt ratio ( a stock variable). In fact, the pattern we are now observing in the US has been observed before in post-crisis economies, and it can persist for several years. If it does, the recovery will continue.

Next, observe the link between the private sector financial balance and the government balance. They are almost mirror images of one another. In fact, by definition, they are exact mirror images, except for the behaviour of the foreign sector balance. This relationship is therefore almost a tautology, but it still reminds us that one of these balances in effect “causes” the other.

I do not want to open a complex discussion on the direction of causation at present. So I will just claim that it seems fairly obvious that the massive deterioration in the government deficit after 2007 was caused by the swing into huge surplus in the private balance, which is what triggered the recession. This was far more important than changes in government policy, such as the Obama stimulus plan.

Up to now, it has been easy to finance the huge government deficit because the private sector’s financial surplus has generated enough surplus cash to buy much of the treasury’s bond issuance, though more recently the Fed’s programme of QE has picked up some of the slack. If the government deficit remains high as the private sector surplus declines – because of an extension in tax cuts, for example – then we can expect the treasury to face more difficulty in funding its deficit, without higher bond yields.

The graph also suggests that future of the government deficit will be largely determined by the decisions which the private sector makes about its own financial balance. Government policy can certainly make a big difference to the speed of improvement in the fiscal deficit but, like it or not, a large part of the outcome will be determined by the private sector, not by the government. I am not sure that this excuses or even justifies the size of the government deficit, but it is an important factor to bear in mind when we are considering the practicality of fiscal consolidation.

I therefore nominate this graph as the most important macro graph of the year. But if you have any other contenders, please comment below or email them to me at gavyndaviesft@gmail.com, and I will respond to any significant alternatives received before year end.

A blog on macroeconomics, economic policymaking and the financial markets.

Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.

He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.

The Most Important Graph of the Year

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