Tag Archives: 2008 SNA

Economics Without Mathematics?

Recently, Noah Smith wrote an article for Bloomberg View, titled Economics Without Math Is Trendy, But It Doesn’t Add Up.

Smith’s attitude is the following:

  1. Heterodox economics is vague and neoclassical economists are mathematical geniuses.
  2. Heterodox authors somehow manage to sneak in some model of the economy.

How about something opposite? That stock flow consistent/coherent models come close to describing the real world and neoclassical models don’t even start in the right foot? The usage of mathematics in neoclassical economics looks silly to me to say the least. Heterodox authors on the other hand have made important breakthroughs with stock-flow consistent models. In these models, the description of how stocks and flows affect each other leading to macrodynamics describing the real world is obtained.

Neoclassical models (which the phrase I use for the “new consensus”) not only doesn’t have anything as mathematical as this but it fails in the first place to identify the correct tools to describe economic behaviour.

Morris Copeland writing in Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949] said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

Morris Copeland’s work is what led the U.S. flow of funds which is published by the Federal Reserve every quarter. National accounts have also improved since their first version to incorporate Copeland’s ideas. See the 2008 SNA and the Balance of Payments And International Investment Position Manual, Sixth Edition for example.

Apart from stock-flow consistent/coherent models, models of the economy don’t even come close to describing the economy, because they miss the most important aspect: flow of funds.

So Goldman Sachs’ chief economist, Jan Hatzius for example uses this approach. See his paper The Private Sector Deficit Meets The GSFCI : A Financial Balances Model Of The US Economy, Global Economics Paper No. 98, Goldman Sachs, Sep 18, 2003.

So it is not that neoclassical economists have great mathematical tools. It’s that by failing to incorporate the framework of flow of funds, they are showing their incompetence in mathematical reasoning.

We Don’t Need No Helicopters … Hey! Economists! Leave Fiscal Policy Alone

A lot has been written on helicopter money recently. Most of them bad with a few exceptions such as one by JKH.

In my opinion, the main reason economists come up with stories such as “helicopter money” etc. is that it is difficult in standard economic theory to introduce money.

Few quotes from Mervyn King’s book The End of Alchemy: Money, Banking, and the Future of the Global Economy:

But my experience at the Bank also revealed the inadequacies of the ‘models’ – whether verbal descriptions or mathematical equations  – used by economists to explain swings in total spending and production. In particular such models say nothing about the importance of money and banks and the panoply of financial markets that feature prominently in newspapers and on our television screens. Is there a fundamental weakness in the intellectual economic framework underpinning contemporary thinking? [p 7]

For over two centuries, economists have struggled to provide a rigorous theoretical basis for the role of money, and have largely failed. It is a striking fact that as as economics has become more and more sophisticated, it has had less and less to say about money… As the emininent Cambridge economist, and late Professor Frank Hahn, wrote: ‘the most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot find room for it’.

Why is modern economics unable to explain why money exists? It is the result of a particular view of competitive markets. Adam Smith’s ‘invisible hand’ …

… Money has no place in an economy with the grand auction. [pp 78-80]

But the ex-Bank of England governor perhaps never worked with stock flow consistent models. The advantage of these models is that what money is and how it is created is central to the question of how economies work. The framework used in stock flow consistent models is not new exactly. What’s new in stock-flow consistent models is the behavioural analysis on top of the existing framework the system of national accounts and flow of funds. As Morris Copeland, who formulated the flow of funds accounts of the U.S. economy said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

– Morris Copeland, Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]

So what do we mean by helicopter money and it is really needed or useful? For that we need to go into a bit into some behavioural equations in stock-flow consistent models. One way is to use a somewhat simplified notation from Tobin’s nobel prize lecture Money and Finance in the Macroeconomic Process. In Tobin’s analysis, the government’s fiscal deficit is financed by high-powered money and government bonds:

GT = ΔH + ΔB

ΔH = γH·(G – T)

ΔB = γB·(G – T)

 γ+ γ= 1

0 ≤  γH, γB  ≤ 1

So the deficit is financed by “high-powered money” (H) and government bonds (B) in proportion γand γB

Now it is important to go into a bit of technicalities. Prior to 2008, central banks implemented monetary policy by a corridor system. After 2008, when the financial system needed to be rescued and later when central banks started the large scale asset purchase program (“QE”), central banks shifted to a floor system.

Although economics textbooks keep claiming that the central bank “controls the money supply”, in reality they are just setting interest rates.

In the corridor system, there are three important rates:

  1. The deposit rate: The rate at which central banks pay interest on banks’ deposits (reserves) with them,
  2. The target rate: The rate which the central bank is targeting, and is typically the rate at which banks borrow from each other, overnight, at the end of the day.
  3. The lending rate: The rate at which the central bank will lend to banks overnight.

There are many complications but the above is for simplicity. Typically the target rate is mid-way between the lower (deposit rate) and the higher (lending rate).

In the floor system, the government and the central bank cannot set the overnight at the target rate if the central bank doesn’t supply as much reserves as demanded by banks. Else the interest rate will fall to the deposit rate or rise to the lending rate. In a system with a “reserve-requirement”, banks will need an amount of reserves deposited at the central bank equal to a fraction of deposits of non-banks at banks.

So,

H = ρ·M

where M is deposits of non-banks at banks and ρ is the reserve requirement. In stock-flow consistent models, is endogenous and cannot be set by the central bank. Hence is also endogenous.

In the floor system, the target rate is the rate at which the central bank pays interest on deposits. Hence the name “floor”. There are some additional complications for the Eurosystem, but let’s not go into that and work in this simplification.

In the floor system, the central bank and the government can decide the proportions in which deficit is financed between high powered money  and government bonds. However since deposits are endogenous the relation between high powered money and deposits no longer holds.

In short,

In a corridor system, γand γB are endogenous, M is endogenous and H = ρ·M. In a floor system, γand γB can be made exogenous, M is endogenous and H ≠ ρ·M. is not controlled by the central bank or the government in either cases and is determined by asset allocation decisions of the non-bank sector.

Of course, the government deficit Gitself is endogenous and we should treat the government expenditure G and the tax-rates θ as exogenous not the deficit itself.

So we can give some meaning to “helicopter money”. It’s when the central bank is implementing monetary policy by a floor system and γand γB are exogenous.

But this doesn’t end there. there are people such as Ben Bernanke who have even proposed that the central bank credit government’s account with some amount and let it spend. So this introduces a new variable and let’s call it Gcb.

So we have a corridor system with variables G and θ versus a floor system with variables G’G’cbθ,  γ’and γ’B

The question then is how is the latter more superior. Surely the output or GDP of an economy is different in the two cases. However people constantly arguing the case for “helicopter money” are in the illusion that the latter case is somewhat superior. Why for example isn’t the vanilla case of a corridor system with higher government expenditure worse than “helicopter money”.

Also it effectively reduces to a fiscal expansion combined with a large scale asset purchase program of the central bank (“QE”). I described QE’s effect here. Roughly it works by a wealth effect on output with some effect on investment via asset allocation.

To summarize, the effect on output by these crazy ways can be achieved by a higher fiscal expansion. There’s hardly a need to bring in helicopters. Some defenders say that it is faster but that just sounds like an excuse to not educate policymakers.

Monetary Mysticism

Normally, I’d give such things a pass. But there are monetary mysticists – the Neochartalists (“MMTers”) – who make a big issue of a few monetary things. In a post on banking, Eric Tymoigne such mystical things:

Throughout this blog I will not the use the words “loan” “lender” “borrower” “lending” “borrowing” when analyzing banks (private or Fed) and their operations. Banks don’t lend money, and customer don’t borrow money from banks. Words like “advance” “creditor” “debtor” are more appropriate words to describe what goes on in banking operations.

The word “lend” (and so “borrow”) is really a misnomer that has the potential of confusing—and actually does confuse—people about what banks do.

So banks do not make loans?

But that’s not the main point in my post. It is the other claim:

  • Point 2: The Fed does not earn any money in USD

When the Fed receives a net income in USD it is not receiving any money/cash flow, i.e. its asset side is not going up. What goes up is net worth.

[highlighting: mine]

Such things are also closely related to claims by the Neochartalists that “taxes don’t fund government expenditure” or “taxes don’t fund anything”. The claim “the Fed does not earn any money in USD” is quite silly.

If you were to ever do an honest-to-goodness calculations with such things, you’ll notice that items accounts receivable and accounts payable are important things. In the simplest example, the Federal Reserve holds government bonds as assets and has bank reserves or settlement balances of banks and currency notes on liabilities. So the Fed is accruing interest on bonds it holds and has payables on interest on banks’ settlement balances. The system of national accounts 2008, has a nice explanation on para 7.115:

The accrual basis of recording

Interest is recorded on an accrual basis, that is, interest is recorded as accruing continuously over time to the creditor on the amount of principal outstanding. The interest accruing is the amount receivable by the creditor and payable by the debtor. It may differ not only from the amount of interest actually paid during a given period but also the amount due to be paid within the period.

So the Federal Reserve’s assets can indeed go up along with net worth because of interest income. It will reflect in accounts receivable in assets. When an actual interest payment is received, it is a transaction in the financial account of the system of national accounts. Then, accounts receivable falls and so do liabilities but net worth doesn’t change. More generally, the Fed may also make advances to banks as the banking system as a whole can lose reserves for paying interest. There is absolute no need for the kind of mysticism that Neochartalists do.

The Phrase “Financial Intermediary” In National Accounts

A lot of times heterodox economists and bloggers complain about the usage of the phrase “financial intermediary” when talking about banks. Such as this one from 2016. The reason given is: “because loans make deposits”. In my opinion, this is counter-productive. While it’s true loans make deposits, it is irrelevant to whether banks should be termed financial intermediaries or not. In fact, that is standard usage. The System of National Accounts 2008, on para 4.101 says:

Financial corporations can be divided into three broad classes namely, financial intermediaries, financial auxiliaries and other financial corporations. Financial intermediaries are institutional units that incur liabilities on their own account for the purpose of acquiring financial assets by engaging in financial transactions on the market. They include insurance corporations and pension funds. Financial auxiliaries are institutional units principally engaged in serving financial markets, but do not take ownership of the financial assets and liabilities they handle. Other financial corporations are institutional units providing financial services, where most of their assets or liabilities are not available on open financial markets.

[italics and boldening in original]

Further 4.106 says:

In general, the following financial intermediaries are classified in this subsector:

a. Commercial banks, “universal” banks, “all-purpose” banks;

b. Savings banks (including trustee savings banks and savings and loan associations);

c. Post office giro institutions, post banks, giro banks;

d. Rural credit banks, agricultural credit banks;

e. cooperative credit banks, credit unions; and

f. Specialized banks or other financial corporations if they take deposits or issue close substitutes for deposits.

Heterodox economists use national accounts and flow of funds more often than orthodox economists who build their theory around a production function, so it is surprising that they vehemently oppose the usage of the phrase “intermediary” for banks. More importantly, the debate is not just semantics but also about “aggregate demand”. The ones who dislike the phrase “intermediary” seem to think that non-bank lending doesn’t have effects on aggregate demand. Funnily, while asserting others use the “loanble funds model”, they are themselves making such errors in their mental model.

Perhaps the term “financial intermediary” is used in the national accounts because it is centred around the production process. At the same time – of course – attention is equally given to finance. So there is nothing really to gain by trying to ban the usage of the phrase “intermediary” for banks.

Aside: IE users should upgrade their browser to IE11. 

Microsoft is going to stop support for old IE browsers. From now on, it will support the latest version only, unlike earlier when it was supporting several versions simultaeneously. So using old browsers will expose you to security risks. Websites’ codes are also browser dependent, so it is possible that my site won’t work with old IE soon. So please upgrade to IE11.

Or do something geeky. Pick up Chrome Canary or the Firefox Nightly build. But IE11 is not bad. It’s superfast.

Happy New Year!

United States’ Net Wealth, Part 2

This is a continuation of my previous post, United States’ Net Wealth. There I pointed out a new table which has been included in the Federal Reserve Statistical Release Z.1, Financial Accounts of the United States – Flow of Funds, Balance Sheets and Integrated Macroeconomic Accounts. This table in flow of funds report is B.1: Derivation of U.S. Net Wealth.

In the meanwhile, the Federal Reserve has released a note U.S. Net Wealth in the Financial Accounts of the United States which is worth your time.

In the note, the authors detail about the meaning of the measure of the “U.S. Net Wealth.” The definition is similar to the System of National Accounts 2008 (2008 SNA). The net worth of a nation is the sum of non-financial assets plus the net international investment position. The note says:

In estimating U.S. net wealth, we use direct measures of the value of households’, nonprofits’, noncorproate businesses’, and governments’ nonfinancial wealth. For corporate businesses, we use the market value of their outstanding equity shares to better capture the value of intangible assets, such as intellectual property. We then net out financial obligations between U.S. resident households, businesses, and government agencies and the rest of the world, because the concept of U.S. net wealth should exclude nonfinancial assets that are financed abroad rather than domestically, and include the value of nonfinancial wealth held by U.S. entities abroad. Taking all this together, we define net U.S wealth as the value of tangible assets controlled by households and nonprofits, noncorporate business, and government sectors of the U.S. economy, plus the market value of domestic nonfinancial and financial corporations, net of U.S. financial obligations to the rest of the world.

[emphasis, boldening: mine]

So what table B.1 does is that it uses non-financial assets for all sectors except when shares of companies are publicly traded.

There is however an issue here. Value of equities outstanding needn’t be a good measure. This is because firms issue both debt and equity. Imagine the case of a corporation which has a debt/equity mixture of 9:1.

Suppose the balance sheet is like this (in the SNA/IMA format):

Assets
Non-financial assets: $1 bn

Liabilities and Net Worth
Market value of bonds issued: $900 mn
Market value of equities issued: $90 mn
Net Worth: $10 mn

I am assuming that “non-financial assets” is the correct value of both tangibles and intangibles, which is $1bn here. But because of debt securities, the value of equities ($90 mn) is highly unlikely to touch $1bn. In other words, the total outstanding value of equities issued by the corporation is hardly a measure of non-financial assets in this case. Applying this idea further, it can be concluded that we need to keep track of the debt securities of the corporation as well. In summary, table B.1 needs to be updated conceptually.

United States’ Net Wealth

The latest release of the Federal Reserve Statistical Release Z.1, Financial Accounts of the United States – Flow of Funds, Balance Sheets and Integrated Macroeconomic Accounts or just “flow of funds” has a new table B.1: Derivation of U.S. Net Wealth.

According to the release:

A new table on the derivation of U.S. net wealth (table B.1) has been added to the summary section of the “Financial Accounts.” The calculation of U.S. net wealth includes the value of nonfinancial assets (real estate, equipment, intellectual property products, consumer durables, and inventories) held by households and nonprofit organizations and noncorporate businesses. For the federal government and state and local governments sectors, only structures, equipment, and intellectual property products are included; values for land and nonproduced nonfinancial assets are not available. The measure of U.S. net wealth also includes the market value of domestic nonfinancial and financial corporations, and is adjusted to reflect net U.S. financial claims on the rest of the world. This definition of U.S. net wealth differs from the sum of the net worth of sectors shown in the Integrated Macroeconomic Accounts (IMA). A forthcoming FEDS Note will provide additional information.

United States Net Worth

click to expand, and click again to zoom

According to it, the United States net wealth was $79.69 trillion.

It’s important to understand how this is reached. Normally we divide the world in various sectors: households, production firms, the financial sector, government and the rest of the world. In real life one adds more nuances to all this. So for example, in the table above, we have a sector “non-financial non-corporate businesses”.

Now, there are two types of assets: non-financial assets and financial assets. Non-financial assets are things such as houses, machines and so on. Financial assets are things such as currency notes, bonds, equity securities and so on.

In the system of national accounts (e.g., the 2008 SNA), all financial assets have a counterpart liability. So financial assets = liabilities for the world as a whole. It’s of course not true for a nation because assets and liabilities between residents and non-residents do not cancel out.

There is one complication, however: equity securities. The 2008 SNA treats equity securities as liabilities of corporations, just like debt securities. This is despite the fact that a company isn’t bound by law to pay dividends to holders of equity, unlike the case for debt securities or loans (for which interest is needed to be paid periodically and also the principal upon maturity).

All economic units have a net worth. This is the difference between assets and liabilities. So,

Assets = Liabilities + Net Worth.

Since equities are treated as liabilities in the 2008 SNA, the net worth of firms can in fact turn negative. This might happen if the price of equities is high.

So it is easy to derive the net worth of a nation. Resident economic units’ liabilities held by resident economic units cancel out and one is left with non-resident units’ liabilities to residents (i.e., resident units’ assets “held abroad”) and residents’ liabilities to non-residents.  This is the net international investment position.

So, as per the 2008 SNA (and the Balance of Payments Manual, 6th Edition),

Net Worth of a nation = Non-financial assets held by residents + Net International Investment Position

The Federal Reserve however does not do the same for flow of funds. It does not treat equities as liabilities.

But one has to be careful about double counting. It’s easy to sum up non-financial assets of all economic units, such as as done by the SNA. But in the flow of funds, with the special treatment on equities, we shouldn’t use corporate businesses’ non-financial assets. If you read the explanation and see the table B.1 carefully, corporate businesses’ assets have not been added, only “non-corporate businesses'” non-financial assets have been added. Since equities are not treated as liabilities in the sense of debt securities, the market value of corporations is needed to be added. This is line 13 in Table B.1.

There is one complication however. Even though equities is not treated as liabilities, that held by foreigners is treated as liabilities. Otherwise, one can have a source of inconsistency. Suppose equities held by a non-resident economic units is not treated as liabilities. Suppose foreigners sell $1bn of equities and purchase T-bills with that. This will mean that the net wealth reduces. Which doesn’t make sense. Hence, one is forced to treat foreigners’ equity holdings as liabilities. So the foreign aspect of the whole calculation is the same as as done in the SNA and one needs to include the net international investment position of the United States which is line 24. (minus $5.47 trillion).

So that basically summarizes the calculation of the United States net wealth as per the Federal Reserve flow of funds report.

How does this compare with the SNA measurement? Some tables in the report are only updated to 2014. So let’s use those numbers.

Flow of funds’ net wealth for 2014 = $77.89 tn (Table B.1, line 1).

Now, go to Table S.2.a. These tables use SNA definitions. Add lines 76-81.

This gives us a value of $87.34 trillion.

However the Z.1 report has an error in the way SNA/IMA way of calculating net worth. Line 77 in Table S.2.a is incorrect. There’s double counting. It uses the SNA/IMA concept of net worth but instead calculates it using the FoF concept. One should subtract line 29 in table B.101 which is $10.04 trillion. Hence the US net worth in the SNA definition is $87.34 trillion minus $10.04 trillion which is $77.30 trillion.

So in short, the net worth of the United States as per the flow of funds definition at the end of 2014 was $77.89 trillion and according to the SNA/IMA it was $77.30 trillion.

What does all this mean? Hmm. Not to easy to answer, except saying that familiarity with the system of measurement helps in understanding how the economy works. Which measurement is better – the new table B.1 or S.2.a? Doesn’t matter.

I am thankful to commenters in this blog post by Steve Randy Waldman, especially JKH and Marko.

Part 2 here United States’ Net Wealth, Part 2

Click Bait Monetary Economics

Some economic commentators, in trying to point out the importance of government deficits and debt, go for the overkill.

Exhibit:


Sorry for picking Steve Roth, who is generally a nice person. But this is counterproductive. If you see the comments below, a commentator who claims to be a trained accountant also agrees with Steve Roth. The bait involves saying that this argument is “technically right”. It can be technically right for several reasons but outright misleading and commentators should stop doing this. So it could be true because the act of bank loan making itself creates an asset and liability equally, so there is no increase in net assets of either households or the private sector as a whole by just one transaction. But this is not just the argument. The argument seems to be that it doesn’t increase household net worth at all even if another transaction is involved, such as a house purchase because a firm sells the house not a household and in national accounts firms are distinct from households. So much click baiting.

In this post, I show how a household’s net worth rises on sale of a house. Let’s assume that I (Household 2) am a sole proprietor of a house building firm (Firm P) and hence the ownership of the firm is not publicly traded in a stock exchange. Suppose I sell a house worth $1mn to you (Household 1). The house is sold from my firm’s inventory of houses and becomes a sale. You buy this after taking a loan from Bank A.

Now, we need some good national accounting. A good way is to just pick up Wynne Godley’s stock-flow consistent models in which he values inventories at current cost of production. See Godley and Lavoie’s book Monetary Economics, Edition 1, page 29.

Let’s suppose the current cost of production is $400,000.

Now we need another concept: own funds at book value from the 2008 SNA, Paragraph 13.71d-e:

d. Book values reported by enterprises with macrolevel adjustments by the statistical compiler. For untraded equity, information on “own funds at book value” can be collected from enterprises, then adjusted with ratios based on suitable price indicators, such as prices of listed shares to book value in the same economy with similar operations. Alternately, assets that enterprises carry at cost (such as land, plant, equipment, and inventories) can be revalued to current period prices using suitable asset price indices.

e. Own funds at book value. This method for valuing equity uses the value of the enterprise recorded in the books of the direct investment enterprise, as the sum of (i) paid-up capital (excluding any shares on issue that the enterprise holds in itself and including share premium accounts); (ii) all types of reserves identified as equity in the enterprise’s balance sheet (including investment grants when accounting guidelines consider them company reserves); (iii) cumulated reinvested earnings; and (iv) holding gains or losses included in own funds in the accounts, whether as revaluation reserves or profits or losses. The more frequent the revaluation of assets and liabilities, the closer the approximation to market values. Data that are not revalued for several years may be a poor reflection of market values.

The accounting entries are simple (I am considering increases/decreases here, so “= +” is understood as an increase in the thing on its left.)

For Household 1:

Assets

Liabilities and Net Worth

House = +$1mn

Bank Loan = +$1mn
Net Worth = +$0

For Bank A:

Assets

Liabilities and Net Worth

Loan to Household 1 = +$1mn

Deposits of Firm P = +$1mn
Net Worth = +$0

For Firm P:

Assets

Liabilities and Net Worth

Deposits = +$1mn
Inventories = −$0.4mn

Own Funds = +$0.6mn
Net Worth = +$0

For Household 2:

Assets

Liabilities and Net Worth

Own Funds at Firm P = +$0.6mn

Net Worth = +$0.6mn

So, my (Household 2’s) net worth has risen by $600,000 by selling you (Household 1) a house.

I have in this example, intentionally chosen a privately owned firm to score a point. If the firm had been publicly owned, the house sale would have increase the firm’s net worth and my (Household 2’s) net worth would increase when the firm’s net worth reflects in the share price (which is not immediate). But I just had to show one example. It’s not just academic – many firms are family owned.

Steve Roth’s claim are similar to claim made by Neochartalists who claim that the private sector can only save if the government runs deficits and so on. All counterproductive.

The case for fiscal expansion can be made quite strongly, but not by these click bait claims.

Respect For Identities

The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say nothing about causation.

– James Tobin, 1997, p. 300, ‘Comment’, in B.D. Bernheim and J.B. Shoven (eds), National Saving and Economic Performance, Chicago: University of Chicago Press.

This is such a nice quote by James Tobin. Almost all economists, orthodox or heterodox would agree with it I believe.

In practice, however, economists confuse identities for behaviour and causation no end. They even confuse identities themselves. But it now seems that some think that usage of national accounting identities produces erroneous conclusions.

In a series of posts, (here and few posts before), David Glasner, the author of the blog Uneasy Money — Commentary on monetary policy in the spirit of R. G. Hawtrey, seems to be suggesting that letting identities go is the way forward for macroeconomic modeling.

Glasner says:

There are two reasons why defining savings and investment to be identically equal in all states of the world is not useful in a macroeconomic theory of income. First, if we define savings and investment (or income and expenditure) to be identically equal, we can’t solve, either algebraically or graphically, the system of equations describing the model for a unique equilibrium.

[boldening and emphasis added]

So it seems that using accounting identities in your model would lead to inconsistencies. I and a few other commenters have tried to convince Glasner of his errors in series of posts.

Some people seem to think that identities do not tell anything. The truth is not so straightforward. Identities constrain outcomes. Any macroeconomic model which does not use identities as constraints may produce non-possible states of the world.

Brad deLong confronted Glasner on Twitter with this point:

click to view the tweets on Twitter.

If you have time, interest and energy, please convince Glasner that accounting identities cause no issues in macroeconomic modeling.

Credit And Economic Growth

In a new column for Bloomberg, Noah Smith questions the intuition that credit fuels economic growth.

He says:

It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.

The academics have good reason for being skeptical.

His reason (in short) is the following:

It’s pretty obvious how credit drives my personal household consumption. If I borrow, I can get a nice big TV and a new car, but eventually I’ll have to skimp to pay it back. In a way, the consumption-fueled borrowing binge is an illusion of wealth — after all, borrowing doesn’t increase my salary. Pleasure today means pain tomorrow.

Notice how Smith’s argument uses a lot of national accounting and flow of funds concepts: consumption, borrowing, wealth, repayment (of loans) and so on. The interesting thing is that one can use the system of national accounts and flow of funds to create models which show precisely the opposite of what Smith is saying. The best place obviously to look out for is the book Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth by Wynne Godley and Marc Lavoie which has models called stock-flow consistent models or SFC models. It is however difficult to write down a simple SFC model in a blog post, so I will try to highlight how it works in words but refer the reader to these models.

Here’s how in a simple model:

  1. Consumers decide to borrow more and banks respond by granting them loans.
  2. Consumers spend the funds received on consumption goods.
  3. Since loans make deposits, it’s not as if someone forgoes consumption to lend as neoclassical textbooks say.
  4. Firms see their inventories go down and respond by increasing their inventories by producing more.
  5. For producing more, firms hire more labour and pay salary/compensation.
  6. People newly employed spend their income and there’s further rise in production as firms produce more when seeing a higher demand for their products.
  7. Higher production leads to a rise in productivity and wages/household incomes of the already employed rise in response (although not necessarily the case).

So we have a higher output than what we started with and higher national income.

One can take several issues with this and this is one reasons models are really helpful and pinpoint what’s going on. This is the reason I referred to the book by Godley and Lavoie above. So for example, one can ask: what if the rise in the national income and output is just a rise in the nominal value but that it’s possible that prices have changed and that the real output hasn’t changed. This of course needs a model of prices and inflation but a familiarity with stock-flow consistent models will make you realize that it is an extreme assumption to think that the real output hasn’t risen in the sequence of events highlighted above.

The second thing is the above “model” in words had just banks lending to households whereas in the real world, credit (as in any credit, such as firms borrowing) is via credit markets of which banks are only one part. This issue is not so simple to argue out, but it can be shown that it really doesn’t matter (in the first approximation). I do not know how to quickly argue it out in short here but will leave that for now.

Of course the above model can be misleading. For example, if households take a lot of debt, debt repayment burden will hit and cause a slowdown as households’ consumption will drop and this may lead to an economic slowdown. This point may look similar to what Noah Smith is saying, but that is not the case. One can imagine an economy starting with a GDP of 100 and growing to 120 in some time period and then slowing down to 118 because of the debt burden. Also the above model was implicitly a pure private sector model and in general one has both the government and the overseas sector adding more complications. Again more reasons why having a proper mathematical model for such things is important.

Another critique of Smith (in my mini-exchange of tweets with him on Twitter) was that SFC models do have behavioural assumptions. I agree, but my point was that there’s no reason to dismiss the argument “credit fuels growth” by purely theoretical arguments. If at all, the system of national income and flow of funds make it more convincing that credit is important.

Of course none of this means that policies should be promoted to ease credit conditions always and try to create a boom and what Smith says is somewhat true – there can be pain later, so it is important to consider fiscal policy, balance of payments and so on but the story told here is quite different from the one told by Noah Smith.

Paradox Of Profits?, Part 2

In the previous post Paradox of Profits?, I mentioned how I view the paradox of profits as the confusion between production firms’ operating surplus (as defined in the SNA such as the 2008 SNA or earlier versions) and surplus on the financial account of the system of national accounts.

The paradox is highlighted by saying that at the beginning of the monetary ‘circuit’, firms inject an amount of money M and can only recover a maximum of M.

So let us think of an economy in which there is no money or banks initially and suddenly someone producers find a way to make cakes and the banking system opens simultaneously. This is admittedly an oversimplification but nonetheless useful.

Initially firms decide to make 100 cakes and price it $1 per cake. They hire labour and pay $60 as wages. For this, they borrow $60 from banks. Households is a mix of both labour and entrepreneurs.

Now households consume cakes worth $55.

Before proceeding, it is important to note that inventories will be valued at current costs. So even though firms have initially paid households $60 and recovered $55, they have still made a profit of $22. This is because 55 cakes were sold and cost $55 × 0.6 = $33.

So:

Profits = $22

I am neglecting the interest costs on loans but this is minor in comparison to the income generated by production so as to matter crucially.

That profits are $22 can be seen from the profits formula of the previous post:

Ff  = C ΔIN  WB  rlL

Having sold 55 units of cakes, firms have 45 units left in their inventory. But since inventories are valued at current costs, the multiplicative factor here is 0.6, so ΔIN  = $27. So,

$22 ≈ $55 + $27 − $60 − ε

After having paid their employees, firms started out with no bank balance but soon have $55 in bank deposits. They then pay back $33 of loans, leaving them with $22 of bank deposits. At this stage household hold $5 of deposits: they received $60 and consumed $55.

So total bank deposits is $27. This is equal to the value of inventories. This is also equal to the initial loan of $60 minus the repayment of $33. So firms’ inventories are backing the loan amount.

Firms are now in a situation to distribute dividends. It is clear that they don’t have trouble paying interest to banks. (In this example but not always the case).

Another production cycle starts. Dividends will buy more cakes and make more profits for firms. Fixed capital formation can also be added in the story without any problem.