To paraphrase Churchill, accountants and economists are divided by a common language. We seem to be using the same words to talk about the same things, but we don't understand what the other is saying. This is my attempt to provide an economist's perspective on the relation between accounting and economics.
What I say here will not I think be new or controversial for economists (until I start talking about money). Accountants may find it hilariously wrong, like locals hearing tales from a traveller who can't speak the local dialect and gets everything muddled. Let's see.
Like most economists, I don't think about accounting much. Normally I only think about it when I teach the ECON 1000 bits on national income accounting and money and banking, and try to remember if assets go on the left or right side of a balance sheet (I rely on my students to remind me). I decided to write this after an interesting exchange with Winterspeak, both here and on his blog.
So, here's my take on accounting:
There are two fundamental accounting identities. Here's the first:
1. stuff bought = stuff sold
If some people bought 100 apples, some (other) people must have sold 100 apples. The "stuff" in question can be a flow or a stock, measured in monetary or real units, or whatever. If it's a flow we call it income accounting. If it's an accumulated flow, or stock, we call it balance sheet accounting. The stuff could be real goods and services, or it could be financial stuff. All accounting consists of dividing and subdividing stuff into different categories, trying to keep your head straight when doing it, so that the RHS and LHS both capture mutually exclusive and jointly exhaustive ways of dividing the same stuff. Don't miss anything out, and don't double-count.
This is an identity; not just an equation. it's true by definition of what we mean by "bought" and "sold". It's not something we could go out and test empirically. If we did test it empirically, and found the numbers weren't equal, we would figure we must have made some sort of mistake in the test, like adding things up wrong, forgetting something, defining "stuff" inconsistently, or somebody lied to us, or whatever. And because of that, it doesn't tell us anything about the world, only about how we must use words in a logically consistent manner if we are to think about the world without internal contradictions.
The equivalent sentence in economics has three different variants:
2a. stuff demanded = stuff bought = stuff sold = stuff supplied
is the complete version, though it's often shortened to:
2b. stuff demanded = stuff traded = stuff supplied
And sometimes we shorten it further still, to:
2c. stuff demanded = stuff supplied
First, 2a and 2b are logically equivalent, since the middle "=" is an identity, so that "stuff bought" and "stuff sold" are just two ways of saying the same thing.
Second, "stuff demanded" means the amount of stuff buyers want to buy, and would buy if it were available to buy. It doesn't mean "stuff bought". Same with "stuff supplied".
Third, the other two "=" are equalities, not identities. They can be empirically false, and are empirically false when there is excess demand or supply. They are only both true in full market-clearing equilibrium.
Fourth, 2b reveals that there are really two "=" in market equilibrium, where buyers get to buy what they want to buy, and sellers get to sell what they want to sell. Normally we impose the "short side rule" so that quantity traded is whichever is less, quantity demanded or quantity supplied. This means that if 2c is true, both sides of 2b will be true as well. But the short side rule is an empirical fact about markets: that exchange is voluntary. I can at least imagine cases where 2c is true, but both buyers and sellers are forced to trade either more or less than they want, so 2b is false.
By common stereotype, accountants are careful people; economists are usually sloppy people. We often get really sloppy in speaking to distinguish between 1 and 2, and between 2a or 2b, and 2c. That might be the problem. Or it might be that accountants just don't understand the difference between demand and buy, and supply and sell.
Let's take a specific example of 1. In national income accounting, we define "stuff" to be a flow of newly-produced goods. And we divide the stuff up according to who does the buying: households, firms, government, or foreigners (though we aren't altogether consistent here, because we often fudge investment, and imports are a weird category – more a subtraction from C, I, and G).
3. C+I+G+X-M = Y
(Newly-produced) goods bought = (newly-produced) goods sold.
We don't have to divide the stuff up in this way; we could divide it between goods and services; or stuff made on Mondays, Tuesdays, etc. We divide it this way if we think (or some economists think) it's useful to divide it up this way, because, for example, households, firms, and foreigners are influenced by very different things in deciding how much they want to buy. And it's economists, not accountants, who must ultimately decide what categories are useful to us. But already I'm starting to talk about stuff demanded, and economics, not stuff bought, and accounting.
The important point is this: economists can and should decide on their own ways to define the "stuff" that is bought and sold, and how to divide it into sub-categories of "stuff". We decide on a conceptual scheme that is useful to us, not to accountants. And it is useful to us if it matches our behavioural theories of how the world works. We don't have to follow the accountants' conceptual scheme, and shouldn't follow the accountants, if we have a different scheme that is more useful to us. Ultimately, we economists have to be our own accountants.
The second fundamental accounting identity is this:
4. The value of the stuff I buy = the value of the stuff I sell.
We have to be really careful with this one.
Think about a barter exchange: I swap my 10 apples for someone's 5 bananas. The price of a bananas is 2 apples. So I sell 10 apples and buy 10 apples' worth of bananas in exchange. Those "values" are the prices at which the transactions are made, even if the bananas turn out to be rotten. Unlike the first fundamental accounting identity, which can be expressed in physical units if you want, this one can't; it must be expressed in values. (Maybe this is why accountants have so much difficulty dealing with inflation? Dunno. Maybe not.)
What about monetary exchange? If I sell 10 apples at $1 each I "buy" $10 in the medium of exchange – money. That's what causes misunderstandings, because we don't normally talk about "buying" or "selling" money. But we have to in this case.
Now let's consider the economist's version of 4:
5. The value of the stuff I demand = the value of the stuff I supply.
In other words, when I go into any particular transaction, at any price, deciding how much I want to transact at that price, I get the maths right. I don't demand $20 and supply 10 apples at a price of $1 per apple. That makes sense. The only thing that could make it false would be if people made math mistakes. It's close to an identity, but isn't quite, because empirically people do make math mistakes.
Now, what happens when I aggregate up over all transactions I make? You get: the sum of the values of my excess demands must equal zero. Aggregate over all people (and firms and governments): you get Walras' Law. The sum of the values of excess demands must equal zero. [Update for clarity: an equivalent statement of Walras' Law is: the sum of the values of goods demanded must equal the sum of the values of the goods supplied. Excess demand=demand minus supply.] If you forget to include money as one of the goods, you get (one version of) Say's Law (and it's not a version necessarily believed by Say himself, but let that pass).
Now, many (most?) economists believe in Walras' Law (or think they do). But I don't. I think it's fine to aggregate over all transactions in the accountant's version 4 (the sum of the value of excess purchases is identically equal to zero). But I don't think it's fine to aggregate over all transactions in the economists' version 5, even if everyone has perfect math, and is perfectly rational.
If we make all our purchases and sales at the same time in one big market for all goods, then Walras' Law would be right (unless somebody got the math wrong). But in a monetary exchange economy, with n-1 [typo fixed] goods plus money, there are n-1 markets. In each of those n-1 markets we make a separate decision to transact in that market, subject to any constraints we expect we might face on how much we are actually able to buy and sell in each of the other n-2 markets, if any of those markets are in disequilibrium. Clower/Leijonhuvfud/Bennassy etc..
That means n-1 separate maximisation problems, in principle. Each one of those maximisation problems will satisfy Walras' Law, but the only way we can add them all up consistently is if we recognise that there are n-1 separate excess demands for money, coming from each of those separate decisions.
So the only generally correct aggregate economist's version of the second fundamental principle of accounting is this:
6. The sum of the values of the n-1 excess demands for non-money goods, plus the sum of the n-1 excess demands for money, is identically equal to zero, provided the people doing the demanding and supplying can do math.
I have no idea what the accountants will make of 6.
Worthwhile Canadian Initiative 
Hi Nick,
How about another example . . . economists talk about something called “national saving” as if there is a “pool” of money that can support investment spending (or borrowing in general) using basic national income identities rearranged a particular way.
However, from basic double-entry accounting it is clear that such a “pool” of “funds” doesn’t exist and in fact that the causation generally runs the opposite direction from what economists assume. For instance, bank loans create bank deposits (no prior “saving” or deposits or reserves necessary), and government deficits create net financial assets for the non-government sector. Again, we’re talking about accounting of nominal transactions here (just saying that to avoid some typical criticisms that arise when we point these things out).
Best,
Scott
Hi Scott. Assume a closed economy and no government for simplicity.
The identity is Y=C+I
Define S as Y-C. We can rewrite the identity as S=I. These are just different ways of saying the same thing.
These accounting identities tell us nothing about the direction of causation. Indeed, accounting (double-entry or whatever) can never tell us anything about the direction of causation of anything.
Interpreted as an equilibrium condition, they become Y=Cd+Id, and Sd=Id, where ‘d’ means “desired”, and Sd is defined as Y-Cd.
Notice this says nothing about the supply of output. It’s only one half of a full equilibrium condition, which would read Cd+Id=Y=Ys where Ys is output supplied (i.e. the amount people/firms WANT to sell.
These equilibrium conditions don’t determine the direction of causation either. They don’t even say how we get to equilibrium or if we even will.
Now let’s add behaviour.
Simple Keynesian model: Assume Ys is exogenous, Id is exogenous, Cd depends on Y, and Y=min{Cd+Id,Ys} (aka the short side of the market determines quantity traded). Her, if we are at less than full employment, Id determines Y, and determines Sd too. Causation runs from Id to Sd.
Simple classical model: Assume Cd depends on Y and r plus exogenous stuff, Id depends on r and exogenous stuff, and r adjusts until Cd+Id=Y=Ys.
In this case, since both Sd and Id are endogenous, you cannot say that Id determines Sd or that Sd determines Id. Both are determined by the exogenous shocks to consumption and investment. If there are no exogenous shocks to investment (for example), then the exogenous shock to consumption and savings, plus the interest elasticity of investment and savings, determine Investment and saving.
It all depends on the model. The accounting doesn’t determine anything. (Fighting words! Sorry.)
Economics is not accounting constrained.
But accounting is a necessary clearing point for robust exchanges through economics’ intellectual central bank.
Economist … liberate thyself.
Nick,
You’re not rejecting accounting. You’re agreeing that accounting is necessary. You’re just uncomfortable with the idea of outsourcing your accounting challenge.
The problem is that if you develop your own scheme, you must demonstrate that it is logical and consistent. If anybody can identify a contradiction in your measurement system, your system will fail.
I don’t think you can develop a non-contradictory accounting system of any type that applies to economics and that does not reflect basic double entry bookkeeping.
And the whole issue of stuff demanded and stuff supplied simply requires a supplementary accounting system that deals with the contingent future. Actuaries deal with such stuff all the time. Risk analysis deals with. So deal with it. It doesn’t obviate the necessity of a decent ex post accounting system as the foundation.
JKH: “You’re not rejecting accounting. You’re agreeing that accounting is necessary. You’re just uncomfortable with the idea of outsourcing your accounting challenge.”
Yep. Exactly. Very succinct.
Is double-entry bookkeeping the same as my “second fundamental principle of accounting”? (If I buy something, I am at the same time selling something else of equal value). In economics, that’s where the budget constraint comes in. Walras’ Law is one reflection of that, when we are talking about demands and supplies.
“And the whole issue of stuff demanded and stuff supplied simply requires a supplementary accounting system that deals with the contingent future. Actuaries deal with such stuff all the time. Risk analysis deals with.”
NO, NO, NO!!
Even with no risk or future there is a fundamental distinction between quantity demanded and quantity bought (and between quantity supplied and quantity sold). This is why economists and accountants are two solitudes, speaking past each other!
Hi Nick:
Thanks for posting your model.
In Y = C + I you assume that whatever is not consumed is invested (S = Y – C). The implicity assumption here is that all bank savings are somehow channeled back into investment (plus you ignore under the mattress money, which is fine). I don’t know what operational mechanism you have in the back of your mind for how savings are channeled into investment, but it is probably some flavor of “banks lend out deposits”. This is incorrect, and may be one area where economists and accountants can have a profitable exchange.
When a bank makes a loan, it creates a receivable (asset) and a deposit (liability). It expands both sides of its balance sheet at the same time, this is the double entry bookkeeping that JKH is talking about. Notice how the act of credit extension (receivable) CREATES the matching liability (deposit). The correct causality to introduce into this accounting identity is “loans create deposits”.
If the loan and deposit happen in the same bank, it is trivial to see how this works. If the loan and deposit are created in different banks, the reserve system operationally gives the lending bank access to the reserve credited by the deposit in the other bank. We can go into this later, but please trust me for now.
So what role to deposits play in enabling bank lending? None. (More precisely, very little, as they are a cheap liability and thus reduce the banks profitability slightly). Bank deposits really are “dead money” the same way cash stuffed under a mattress is “dead money”.
So, Y = C + I + S, and we need to introduce the “S” term here because “S” does not flow into “investment”.
I don’t like introducing this concept before establishing how G-T = Y – I – C – G – T (ignoring NX) but that’s been a bust, so what the heck.
Sorry, I meant that deposits slightly INCREASE bank profitability.
Winterspeak:
The accounting identity Y=C+I means “all newly produced goods are bought, and we divide all goods bought into a mutually exclusive and jointly exhaustive pair, C and I”.
The real fudge has nothing to do with anything about banks and money (this holds true in a barter economy too), it’s in the way we treat unsold goods. If you produce something, and don’t sell it, you are deemed to have sold it to yourself. It is treated as part of I, inventory investment.
When I teach Y=C+I+G+X-M I always explain it this way to my students: “try and find a fault in it. You can’t. Because whenever you find something wrong with it, I will just re-define my terms to that it stays true. The inventory investment is one fudge. Excluding used goods is another. Excluding spending on intermediaries is another. Saying that capital gains aren’t included in income is another, etc.
It’s like the “No true Scotsman fallacy” in philosophy. (Someone says “No true Scotsman would ever molest children”. Someone gives a counter-example. He replies by re-defining what he means by a “true Scotsman”.)
It’s OK in accounting.
Will return to this later. Gotta teach on Bertrand vs Cournot. (Getting ready for my next post on framing monetary policy)!
RE: the accounting doesn’t determine anything . . . (you knew I’d reply to that!)
I think you aren’t getting the point I’m making. There are RULES of accounting that you can’t violate if you want the analysis to be relevant to a world like ours in which every transaction affects financial statements of those involved. As we’ve agreed before, too, though, just getting the accounting right is necessary but not sufficient for having a good model.
My point was not necessarily a criticism of the model you built in this post or in response to me. It was a broader criticism of the idea that prior saving (or deposits or reserves) is necessary to finance borrowing or government deficits (even when one assumes the govt sells bonds). While these views of causation are nearly universal in the field and are at the heart of many models and policy recommendations, they are inconsistent with the actual accounting.
Best,
Scott
“NO, NO, NO!!”
YES! YES! YES!
Quantity bought is ex post.
Quantity demanded is an ex ante contingency for quantity bought – it’s a future ex post scenario for quantity bought, under a certain condition. The condition is that the quantity demanded is exactly met by the quantity supplied (which, due to mathematical continuity in supply and demand curves, has a near zero if not zero probability of happening). The accounting entry is contingent double-entry. There are a zillion such scenarios. Just because the numbers get big doesn’t mean you can’t account for them all, at least in theory.
And accounting applies as well to systems without banks or money. You proved it with the example of unsold goods. But if you’re working with economics relative to the money system we actually have, it would be helpful to work with that as well.
“Because whenever you find something wrong with it, I will just re-define my terms to that it stays true.”
You’re just changing terminology. That’s not helpful, but the accounting requirement is that the equation works.
BTW – when I suggested that economics is not accounting constrained, I meant double entry bookkeeping shouldn’t hold you back from exploring any economic problem in the system we have today. On the contrary, I think it liberates you to do so.
Didn’t Bertrand and Cournot play for the Montreal Canadians?
“Ultimately, we economists have to be our own accountants.”
Therein lies the problem, because that’s largely what they’ve tried to do, not recognizing that a model inconsistent with REAL WORLD conventions and rules for financial record keeping of transactions is inapplicable to the real world.
Let’s go a different direction. The model you have built thus far in this thread is utilizing only income accounting identities. But the points raised by myself, JKH, and Winterspeak refer to balance sheets. So, let’s assume a model of someone taking out a loan to finance an increase in expenditure. What are the balance sheet effects for those involved of this action? Feel free to include any agents you think ought to be in the model . . . banks, investors, savers, borrowers, etc. (I do realize this is your blog, so you may not want to go in this direction which is of course entirely your choice . . . just putting the suggestion out there since it seems to be the sort of direction the commenters thus far in this thread are interested in.)
“BTW – when I suggested that economics is not accounting constrained, I meant double entry bookkeeping shouldn’t hold you back from exploring any economic problem in the system we have today. On the contrary, I think it liberates you to do so.”
Right. It’s kind of like a musician or writer thinking learning to read music or learning grammar will constrain his/her creativity. But it’s even more fundamental than that, of course.
“But it’s even more fundamental than that, of course”
Good analogy, and quite so.
There’s something in higher mathematics called “measure theory”, which is based in large part on Boolean logic. Attempting to do economics while rejecting (double entry) accounting is almost like rejecting mathematics itself at that level. Accounting is measurement.
Also, measurement includes the delineation of composition and aggregation. And so much of what is poorly understood about economics and our monetary system relates to the fallacy of composition.
“The real fudge has nothing to do with anything about banks and money (this holds true in a barter economy too), it’s in the way we treat unsold goods. If you produce something, and don’t sell it, you are deemed to have sold it to yourself. It is treated as part of I, inventory investment.”
right, because excess inventory does not produce income. And where is the money that could have bought this inventory? It’s dead money, sitting in a bank. So, the most elementary part of accounting, or heck, plain old measurement, namely “is there a transaction” is hopelessly muddled right from the get go.
This is exactly the sort of thing that accountants get right
“When I teach Y=C+I+G+X-M I always explain it this way to my students: “try and find a fault in it. You can’t. Because whenever you find something wrong with it, I will just re-define my terms to that it stays true. The inventory investment is one fudge. Excluding used goods is another. Excluding spending on intermediaries is another. Saying that capital gains aren’t included in income is another, etc.”
None of those things are “fudges”. Inventories are viewed correctly as short term investment from both an accounting and an economic perspective. And everything else you note is consistent with current period (income statement) accounting and prior period (balance sheet) accounting, and with the distinction/connection between book value accrual accounting and marked to market accounting. You’re not the one making those “fudges”, Nick. It’s an accounting system thats designed to be internally consistent. If you want to invent your own fudges – well then you’ve gone rogue – but nobody’s going to pay much attention.
Scott: “There are RULES of accounting that you can’t violate if you want the analysis to be relevant to a world like ours in which every transaction affects financial statements of those involved.” Agreed. But there is more than one set of logically consistent accounting definitions, and economists need to find the set that is most useful for them, and that depends on their behavioural theories. And if you violate ALL possible sets of internally consistent rules, then the problem is not that the analysis is not relevant; rather, the analysis is logically inconsistent, or self-contradictory.
And there is absolutely nothing in accounting, and there cannot be anything in accounting, that tells me either that investment causes savings, or that savings causes investment. That’s a behavioural statement. Take my earlier classical model, let savings be independent of the rate of interest, and investment depend on the rate of interest, and that’s exactly what we get. I.e.
Assume Ys exogenous, Id(r), Cd(Y,exogenous shock to time preference), and let r adjust until Cd+Id=Y=Ys, then savings (or, more exactly, the exogenous shock to the willingness to postpone consumption), DOES determine investment. And if the accountants say that that violates accounting principles, then those accounting principles are wrong!
“Therein lies the problem, because that’s largely what they’ve tried to do, not recognizing that a model inconsistent with REAL WORLD conventions and rules for financial record keeping of transactions is inapplicable to the real world.”
Interesting. So you are putting forward a theory where “framing” has real effects? In other words, one set of accounting conventions (one language for describing the world) will results in a different real equilibrium from a different set of accounting conventions, even when those equilibria are described by an outside accountant using the same set of accounting conventions? We need to distinguish between the accounting conventions used by economic agents, and the accounting conventions used by economists to describe and explain the behaviour of economic agents. In other words, even if tastes, technology and everything physical were the same across two countries, if those two countries had different accounting languages, the real equilibrium would be different. Of course, at one level one hopes that would be true, because otherwise the whole accounting profession would be a total waste of resources. But does that mean that economists have to use the same accounting conventions as the people they study? What happens if we want an economic theory of a country where people get the accounting wrong?
JKH: “You’re just changing terminology. That’s not helpful, but the accounting requirement is that the equation works.”
But I was just trying to explain to my students how accounting works!
“The condition is that the quantity demanded is exactly met by the quantity supplied (which, due to mathematical continuity in supply and demand curves, has a near zero if not zero probability of happening). The accounting entry is contingent double-entry. There are a zillion such scenarios.”
OK, so you’re a disequilibrium theorist. OK. But if Qd is less than Qs, Qd determines Q. If Qd is greater than Qs, Qs determines Q. If you believe markets are competitive, then roughly half the time it’s the first, and half the time it’s the other (under New Keynesian monopolistic competition, it’s mostly demand-determined, unless there’s a very big shock). But to say “quantity bought=quantity sold, which is all accountants ever say (sorry, it’s half of what accountants ever say, I had forgotten the second fundamental principle) tells you absolutely nothing about what determines quantity transacted. That’s true in Canada (where most quantities are demand-determined), Cuba (where most quantities are supply-determined), and even true on Mars!
Pheeew! I should have left you accountants fighting among yourselves! Now you’re all fighting me. HELP! Where are the economists?
I must return to Winterspeak’s point on savings. Because that is a point on which economists DO get confused. But later.
JKH: My point in responding to Nick was that he insists on treating things that produce income the same as things that don’t. I think this is (at least one of) the core problems with how economics has chosen to do it’s “accounting”, ie. not account very much at all.
As you and I have discussed, inventories are properly accounted as investment, but it may be good or bad!
Just a sanity check making sure we’re on the same page.
BTW w, inventory does produce income. The firm borrows from the bank to make the inventory investment, which results in income payments to the factors of production of that inventory, which becomes money and income saved in the bank because that money hasn’t yet been used to buy the inventory as product. The end result is that the bank loan has created the deposit, and inventory investment has created income and saving. That’s in accordance with PK monetary causality. (Martha says thats a good thing.)
Referring to C+I+G+(X-M): “we divide the stuff up according to who does the buying: households, firms, government, or foreigners”.
Actually, we don’t. To be more precise, this breakdown divides stuff up according to how it is used……except G, which is about who uses it. This has always struck me as inconsistent.
I sometimes wonder if Americans in particular might take a more positive view of government economic activity if G was not specifically identified in macroeconomic discussion, but rather allocated between C and I. It might help to make the point that, in a democracy, governments are effectively a tool of the people, which they can use to provide services and investment that are best organised collectively, such as defence and building flood protection levees, for example. Reading some comments on US economics blogs like econbrowser, one could get the impression that G is synomymous with “misappropriation” or “waste”. In my view, this attitude to government activity contributed to the financial crisis, but that is another story.
And reallocating G would drive the MMT followers nuts.
But what I just wrote is entirely consistent with the importance of accounting as a foundation for the correct logic in economic relationships.
Good point, Rebel. That’s why we need to know how the accounting works to get the intended classification right. Then you can work on changing the classification if its improvable, but it must end up being accounting consistent.
Wow! Consider this question: “does inventory produce income?”
An economist would address that question by trying to talk about the role of inventories in making production easier, so that more goods can be produced with the same amount of resources. (OK, a Keynesian might address it by trying to talk about the role of inventories in aggregate demand, and distinguish between desired and undesired inventory investment).
It’s NOT an accounting question! It’s got absolutely nothing to do with accounting! To try to answer a question like that by resort to mere accounting conventions is like some form of scholasticism! Can accounting tell us how many teeth a horse has? You can define income so that it does or doesn’t include inventories. But that’s irrelevant to the causal effect of inventories.
Nick,
You’re making the mistake of talking about accountants, which is a deflection from the issue, which is the value of accounting in an economic context. If I took the same approach to the value of economics by associating it with economists, I wouldn’t be writing this (sorry … I mean that in general economist sort of way, Nick.)
A proper ex post accounting framework is the sine qua non of an economic theory that can even be decent at the most minimal of standards.
What you must understand also that the ex post dimension is required not just for ex post measurement. It is also a constraint on CONCEIVBLE outcomes for ex ante theorizing. If I was making a nasty statement about economists at this juncture, it would have something to do with their propensity for ex ante theorizing without a safety net – i.e. without a robust accounting framework.
“It’s NOT an accounting question!”
You’re “F****N” right it’s an accounting question!!! I just did the entries for you @ 5:30!!!!
Rebel: “Referring to C+I+G+(X-M): “we divide the stuff up according to who does the buying: households, firms, government, or foreigners”.
Actually, we don’t. To be more precise, this breakdown divides stuff up according to how it is used……except G, which is about who uses it. This has always struck me as inconsistent.”
Rebel: you are right. Except we are even more inconsistent than that. Sometimes we distinguish C and I according to who buys it (e.g. cars), sometimes we don’t (new houses are I, even if households buy them). If we were really strict, almost everything we buy should be I, not C. Even a restaurant meal is an investment in keeping me happy for a few hours.
“But to say “quantity bought=quantity sold, which is all accountants ever say (sorry, it’s half of what accountants ever say, I had forgotten the second fundamental principle) tells you absolutely nothing about what determines quantity transacted.”
Nick, this strikes me as some sort of corollary to the hammer and nail problem. You’re rejecting accounting on the basis that it doesn’t address all the problems in economics. That’s silly. I’m rejecting your rejection of accounting on the basis that it is a necessary part of economic analysis. It’s not a sufficient part, or economics would only be accounting, which is equally silly, but is what you are suggesting should be the burden of proof.
NICK: “And there is absolutely nothing in accounting, and there cannot be anything in accounting, that tells me either that investment causes savings, or that savings causes investment.”
See JKH at 530. Others are saying essentially what I would say, so I’ll stay out for now instead of muddying things further.
Thanks for engaging on this issue, Nick!
JKH: Excellent point — I had not considered that treatment. Makes sense though.
JKH: And gosh-darn it, moved to obscenities! You are usually so unflappable ; )
winterspeak: I did attempt self-censorship, however feebly. Nevertheless, a slightly too heated response. Sorry, Nick. Perhaps the following soothing interlude will patch things over – a rather nifty example of the power of accounting in understanding the monetary system and government deficits:
http://neweconomicperspectives.blogspot.com/2009/11/memo-to-congress-dont-increase.html
Nick has been an absolute champ, and shown us to be the uncouth ruffians that we are. At least someone on the internet has some grace!
Simpleton questions.
On part 5. Sum of excess demands = 0. The values of excess demands = 0. I’m not getting this.
If everyone wants more. How does it equal 0?
And then n+1 is goods + money.
And there is n-1 markets. Shouldn’t there be n markets. What is the -1 and -2?
Thnks.
edeast: well-spotted. The n+1 should read n-1. Typo. I’ve fixed it.
I’ve also added an update for clarity. “excess demand” means “demand minus supply”. So an equivalent but clearer definition of Walras Law is: the sume of the values of goods demanded must equal the sum of the values of goods supplied.
You guys are fine! I figured this would be a LOUD argument!
OK. Time to tackle the “Savings Problem”.
Warning: my views are perhaps weird from the perspective of most economists. Even weirder, I might actually line up with Winterspeak on this one: the only type of “savings” that does the damage (in the paradox of thrift/recession sense of damage) is savings in the form of money (the medium of exchange). Think stuffing cash under the mattress!
Lets start with a very simple model. No foreigners, no government. No investment. The only two goods are haircuts and money. There are no inventories of haircuts. They get produced and sold at the same time. You can’t cut your own hair, and there’s a tabu on cutting the hair of someone who has cut your hair recently, so you must use money as a medium of exchange. Money is a fixed stock of currency. No banks.
Start in equilibrium: demand for haircuts=haircuts produced=haircuts supplied. Desired saving=0
Suddenly everyone wants to save more. The only form of saving is money. Each individual can get more money by buying less harcuts, but this is impossible in aggregate, since the stock of money is fixed. (Fallacy of composition, etc.) At the initial equilibrium, there suddenly appears an excess supply of haircuts matched by an equal excess demand for money. (Each person wants to buy $1 less haircuts than he produces per month, and grow his stock of money by $1 per month. Production of haircuts (=income) falls, and as it falls demand for haircuts falls further, as people try to save. Assume the price level is fixed.
Eventually income falls so much that people decide the stock of money they hold is what they want to hold, at the lower level of income. Each person operates in 2 markets (barbershops): one where he sells haircuts and one where he buys haircuts. At this unemployment equilibrium, there is an excess supply of haircuts matched by an excess demand for money for people trying to sell haircuts to other people. But no excess demand for haircuts and no excess supply of money for people buying haircuts from other people.
Now let’s add one more good: antiques. Antiques are not produced. Fixed stock of antiques.
Start in the original equilibrium, then suppose people want to save more. They can either save in antiques, or in money. Suppose they want to save in the form of antiques. Excess supply of haircuts matched by an excess demand for antiques. People TRY to buy antiques, but fail, because nobody wants to sell. They re-evaluate their demands for haircuts and money in the light of this quantity constraint in the market for antiques. If they decide they still want to save, but save in the form of money instead, we go back to my earlier example, with no antiques. If they decide they have enough savings in the form of money, they MUST decide to buy haircuts instead of buying antiques, and there is no recession. Excess demand for antiques, matched by an excess supply of money in the antique market. But it has zero consequences elsewhere.
For antiques, substitute bonds, bank loans, whatever. It doesn’t matter, unless it’s the medium of exchange.
The only form of excess desired savings that does the damage is an excess desire to save in the form of the medium of exchange.
Is that what you were trying to say Winterspeak? If so, you were absolutely right!
More accurately, I should have said: “The only form of excess desired savings that does the damage is an excess desire to save in the form of the medium of exchange, or one that spills over into an excess desire to save in the form of the medium of exchange.”
Quite right Nick… and this is one reason that paradox of thrift is an extremely dated concept. People don’t hold money, they hold demand deposits… but even better they hold claims on productive assets (stocks). This is far cry from the 30s where savings really did predominately mean stockpiling money away at home.
NICK: I think so, but I need to think through your antique example further.
In your haircut example, we are on the same page. You have prices fixed, so eventually, people just become satisfied with their lower level of income. The model shows that this can be at any level, so you can have any level of employment in the economy of AD to stabilize. All of this is true.
As we have no Govt able to deficit spend, and no private credit extension, the stock of money remains fixed and it can either be transacting, or it can be out of circulation. Note that, in our real economy, putting money in a bank account and/or buying a Treasury bills takes money out of circulation just as effectively as putting it under a mattress. If you put your money in a bank, it gets taken out of circulation, and if the bank buys a Treasury bill with its reserves, it changes the term structure of that out-of-circulation money, but nothing more.
Nick,
I recognize your antique example from a previous post. I have no idea how your 7:55 comment relates to anything that I’ve seen from Winterspeak here, but I’ll leave that up to the two of you. And I also have no idea what point you’re making. It’s simply a collapse in demand and income due to hoarding of money. What’s that got to do with the topic of your post?
JKH: Yes, I’m going back to stuff I was arguing months ago, about the role of the medium of exchange in allowing the possibility of a general glut. In some weird way, I have a hunch that many arguments over accounting for savings and investment are tied in with what I was arguing back then.
And I’m also following a hunch about what I thought Winterspeak was maybe saying in some comments on the “deflationary spirals” post, and in his 1.49 post here. Just a hunch. But if I can re-interpret what someone might be saying into something that sounds right to me, I try it out and see if they bite.
Sorry. Not a very clear answer to your question, JKH. That’s because my mind’s not as clear as it should be.
If he bites, I might try to build investment into my little model, to see in what sense increased desired saving does or does not lead to increased actual investment. But that means adding loans, plus a durable good.
“Last week, Harry supplied 40 hours of labour, but sold none; he was unemployed.”
Sounds weird, doesn’t it?
There would perhaps be less confusion between acountants and economists if Anglophone economists were more like Francophones.
“Last week, Harry offered 40 hours of labour, but sold none; he was unemployed.”
Nick,
I think your intuition is in part right about clearing up this confusion. Namely, that Winterspeakian Savings is more akin to conventional Demand for Money to a monetary disequilibrium theorist than the more common definition of Savings. In fact, someone could come on this board with very plain-vanilla ideas about monetary disequilibrium as encapsulated by your simple model and use the same kind of accounting-based logic to argue that Savings should be defined as “saving in money” as opposed to S=I. For that person, you would have fully closed the gap, but I don’t think you have here.
Because my sense is that Winterspeak cares about demand for money plus government liabilities as opposed to merely demand for money. This is why I think his definition of “Savings” would more helpfully described as the Net External Investment Position of the private sector with respect to the public sector, to borrow an idea from international trade accounting. Of course, the difference between the demand for money and the demand for “net external investments” becomes blurred in a liquidity trap even to traditional monetary disequilibrium folks, so there will inevitably be common ground. By I think there will be more uncommon ground, and I think it will be hard to draw out unless you talk about a model with a fiat currency and government deficit spending – though I also think it is possible for you to get there (maybe slightly more circuitously) by adding investment to your model as you suggested.
Nick,
I thought we were talking about accounting and economics.
Here’s the accounting for your haircut economy (I’ll keep the recession theme you carried over from your earlier post):
The national income equals the national output, which is the value of total haircuts sold.
I have no idea where your money came from, because it’s your example, but that fixed money supply constitutes the only asset and therefore the only wealth in this economy. It is representable on a national balance sheet as nominal money on the asset side and net wealth (or equity) on the other side. It doesn’t matter whether this money is gold bars or some “net financial asset” manna from heaven (or from some previous but now non-existent government).
Suppose person X sells one haircut and that is his total income. A recession starts when X sells a haircut as a producer, but doesn’t buy a haircut as a consumer. He saves that money from his income. This automatically forces another person Y to have bought a haircut as a consumer but not to have sold a haircut as a producer. Think about it. It is logically impossible otherwise.
Suppose Y has no other income. Then Y’s total income is negative. This means that Y has dissaved – i.e. Y has negative saving. (The proper definition of saving is income that is not used for consumption; i.e. saving = income – consumption.) Furthermore, Y had to have had that same amount of money as pre-existing wealth, or he would never have been able to buy the haircut, because he had no income. Y spent that pre-existing money on his haircut. So Y’s dissaving is reflected by a reduction in his money wealth – i.e. a reduction in a balance sheet asset.
Suppose everybody else in the economy still buys and sells one haircut.
Then the economy shrinks from the case where X would have bought a haircut. The economy shrinks by one haircut. Saving at the micro level has caused dissaving at the micro level. Aggregate saving is still zero, and of course aggregate investment is zero. This is the mechanism for a recession in an economy that cannot experience an inventory recession because there is no investment.
So the net result of this recession is that the economy shrinks by one haircut, and the distribution of wealth has shifted by the nominal amount of money corresponding to that one haircut. X has become wealthier by the same amount of money that Y has become poorer.
Let’s talk about the ability of the lower/middle class and the gov’t to make the interest payments on all the currency denominated debt to the rich domestics and the rich foreigners.
Let’s talk about the ability of the lower/middle class and the gov’t to make the interest payments on all the currency denominated debt to the rich domestics and the rich foreigners.
Sorry if this is a repeat.
Nick said: “OK. Time to tackle the “Savings Problem”.
Warning: my views are perhaps weird from the perspective of most economists. Even weirder, I might actually line up with Winterspeak on this one: the only type of “savings” that does the damage (in the paradox of thrift/recession sense of damage) is savings in the form of money (the medium of exchange). Think stuffing cash under the mattress!”
What about excess corporate profits in a demand constrained economy?
Nick said: “Start in equilibrium: demand for haircuts=haircuts produced=haircuts supplied. Desired saving=0
Suddenly everyone wants to save more.”
How about a few want to save and can sucker the rest into currency denominated debt?
How about relating excess savings and retirement?
Nick said: “For antiques, substitute bonds, bank loans, whatever. It doesn’t matter, unless it’s the medium of exchange.”
Does it matter if it is a financial asset (something bought for a return on savings) vs. a real good?
Nick said: “At the initial equilibrium, there suddenly appears an excess supply of haircuts matched by an equal excess demand for money. (Each person wants to buy $1 less haircuts than he produces per month, and grow his stock of money by $1 per month. Production of haircuts (=income) falls, and as it falls demand for haircuts falls further, as people try to save. Assume the price level is fixed.”
winterspeak said: “You have prices fixed, so eventually, people just become satisfied with their lower level of income.”
Does that mean quantity(ies) fell?
Nick:
In the haircut only economy, if a single person decides to pass on a haircut (and save the dollar) it means someone else loses the opportunity to give a haircut and is thus out of the dollar as income. You transfer some of the money from one person in your economy to another, but sector-level net financial assets stay the same. Sector level net savings stay the same too. If everyone decides they want to save, then all haircuts stop, but again, net financial assets stay the same, and net savings stay the same. Money has just stopped circulating, but it’s still there (as savings).
I think I am 100% inline with JKH.
In your description, people started to want to save for “some reason” and then decide to stop trying to save for “some other reason”. This is fine, the economy can run with any quantity of haircuts happening or not happening. The more people want to save, the fewer haircuts will happen. There can be a situation where everyone is saving, letting their hair grow long, and 2 people swap $1 a haircut back and forth, back and forth. At every instant, there will be the same quantity of money and saving in the economy, but the distribution will change depending on who bought the haircut last, and sector-wide income will fall of course. This would be a high unemployment state, certainly a bad (harmful) outcome. The ACTUAL savings level is the same, but since it is lower than the DESIRED savings level you get reduced AD, less real output, less consumption, and high unemployment.
I think I am missing the point of your antiques example. It seems like they can either give up trying to save in antiques and go back to trying to save in haircuts (and we are back to square one) or they give up trying to save in antiques and continue trading haircuts. At a sector level, there is no way to increase the number of antiques.
P.S. The fixed money supply represents the wealth of the economy. You can think of it as cumulative or prior saving inherited from Nick the Grand Wizard. Annual saving is zero at any level of income. Therefore, nominal wealth remains unchanged over time. The national balance sheet doesn’t change, just the micro distribution of it. If the inherited currency is fiat, you can think of it as the net financial asset position as well. But currency could be gold or anything, depending on the verities endowed by the Wizard.