The key chart
Lesson #2
CMMP analysis focuses on the relationship between the financial sector and the wider economy i.e., households (HHs), corporates (NFCs), government and the rest of the world (RoW). The second lesson is that the core services provided by banks – payments, credit and savings – produce a stock of contracts that can be represented by financial balance sheets. These balance sheets link each of these economic agents over time and form a quantitative, objective and logical analytical framework.
A fundamental principle of accounting is that for every financial assets (FA) there is an equal and offsetting financial liability (FL). By definition, net financial wealth (NFW) is therefore equal to the sum of FAs less the sum of FLs. If we take all private sector FAs and FLs, it is also a matter of logic that the sum of all the assets must equal the sum of all the liabilities.
The key implication here is that for the private sector to accumulate NFW it must be in the form of claims against another sector i.e., governments, the RoW, or a combination of the two.
In the current climate of rising government deficits, this insight is crucial to debates over whether deficits: (1) are evidence of overspending; (2) a burden on future generations; and/or (3) crowd out private investment. The fact that the answers given to these questions are generally incorrect only goes to show how poorly the relationship between the financial sector and the wider economy is understood. It also explains why official economic forecasts can/often do fail common sense tests (lesson #3).