The economy's financial flows are a closed system

In the previous post, I mentioned that the sectoral balance approach is based on the premise that the government deficit is equal to the private sector's surplus, and vice versa. Just to be clear, this does not mean that we must disregard the inflow and outflow of funds to and from the foreign sector. Quite the contrary, the foreign sector plays a key part in Canada's economy. Take, for instance, the chart below depicting net lending for each sector of the economy since 1990 (double-click on chart to expand). In the chart you can see that the foreign sector supplied significant funds for investment to the Canadian economy in the early 1990s, in 1998, and again starting in 2008. During most of the period between 1996 and 2007 (1998 being the only exception), it was Canadian savings (i.e. government surpluses and corporate savings) that contributed to financing foreign borrowing.

In the chart you can also see the deterioration in the financial position of the household sector since 1992. In the decades prior to 2000, the traditional role of the household sector was to lend funds to the rest of the economy. However, since 2002 the role of primary lender has now been taken over by the corporate sector. The chart also shows that the deterioration in the household sector and the rise in the corporate sector's financial position coincided with the rapid reduction in the government sector's deficit position.

The chart is also useful for showing how the deficit (surplus) of one sector is always offset by at least one other sector's surplus (deficit). Take, for instance, the year 2001. In that year, foreign sector borrowing (net lending deficit) equaled the sum of the government and corporate sector surpluses. A similar situation also occurred in 2003 when the only sector with a surplus (corporate sector) equaled the sum of the net lending deficits of the household and foreign sectors. This also occurred earlier in 1994 and 1995 when government sector borrowing equaled the sum of the net lending surpluses of all the other three sectors. As Statistics Canada explains in this study,

Surplus sectors net lend to other sectors, and deficit sectors net borrow from other sectors...At the economy-wide level, the sectors' net lending or borrowing positions sum to zero - such that all aggregate saving has been allocated to aggregate investment. (p. 6)

So what does this all mean? Well, for starters, it means that government deficits are not always harmful. On the contrary, government deficits can be essential for a healthy economy. In the early 1990s, it was the large government deficits that enabled the household sector to stay in a surplus position while Canada was a net borrower to the foreign sector. Since 2009, Canada has witnessed a similar dynamic: the large government deficit is helping the household sector improve its financial position in the context of an economy facing a massive combined foreign sector and corporate sector surplus.