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 
Nick: Lots of good comments by JKH. Not sure what I can add.
I would like to underline the definition of saving as an income statement non-event, namely, money comes in, but does not go out. Perhaps it may be even more accurately defined as a cash flow event.
My employer credits my bank account with $1000. $100 I leave in the bank, and the other $900 I spend on haircuts, backscratches, antiques, lottery tickets, and shares of Goldman Sachs. I have saved $100, and I have spent, through some combination of investment (both capital and inventory) and consumption, $900. The rest of the economy has had its bank accounts credited by $900, and my bank account has been debited by $900. The $100 that remains there is taken out of circulation. Note I’m talking about financial assets here only, the antiques that I bought are real assets and I now own them, perhaps hoping to sell them for a profit in the future. Nevertheless, it is critical to differentiate actions that trigger income events (which savings does not) from actions that do not trigger income events (which savings does). Savings, is no one else’s income. If an economy wants to increase this number, it cannot, for reasons that I believe we both agree on, and this state of affairs is extremely harmful. An economy can have many reasons for wanting to increase this number, one of which may or may not be interest or discount rates. Certainly interest/discount rates are not the only reason, and in certain circumstances, they may be a very unimportant factor, swamped out by other, more important factors.
I tried defining this as “equity” earlier because if you begin with an empty balance sheet and pay in some capital, it resides as cash on the asset side, and equity on the liability side. The terms seemed to be imprecise, and it’s a shame Anon did not or could not come up with an accounting entry to capture the concept.
Adding antiques to the haircut economy increases the initial quantity of assets, but I’m guessing they are real assets. If the economy wants more but cannot have more, then there may be shuffling around of them internally, but there will be no net increase. The economy may or may not change its desire for money (at least temporarily) in the hope of somehow translating that into antiques in the future, but if they try, then we’re in the same collapse of AD condition as the number of haircuts dwindles.
ADAM P: You are correct, money is not a real asset, but others somehow interpret this to mean that money is not important. I am not accusing you of this, just using your comment to highlight this point. In Nick’s model economy, money was a financial asset, but the desire for the economy to have more of it lead to falling AD and lower real asset production (fewer haircuts). Demand for the medium of exchange is demand for something that is nominal (not real), but if it is not met, it has material negative effects on real production.
ALL: Please do note the key macroeconomic, balance sheet analysis by JKH. No matter what happens at a micro level, the quantity of savings (financial assets) in the economy does not change. You just get lower income, and lower real production. It’s stuff like this which makes it impossible to scale up micro models to the macro-economy. A household can increase the net financial assets on its balance sheet, but a sector cannot.
NICK: Finally, it would be great if the US stopped issuing bonds. That would be a way to force the issue as to what will or will not happen if the Chinese stop buying them (since if none are issued, none can get bought). I believe Mervyn from the BoE actually suggested this for gilts, although I’ve heard nothing since so maybe it did not happen. I can tell you what will happen though if the US took this step (which I think it should).
SCOTT/JKH: Are these transactions best captured in the income statement, or in the cash flow statement? Cash flow would make errors like Nick including real assets harder to make. It also keeps things close to the hard debits and credits I like to work through to make sure I’m manipulating my balance sheets correctly. But you also miss many important things in cash flow statements, so I’d love your take on this.
“I would like to underline the definition of saving as an income statement non-event, namely, money comes in, but does not go out.”
That’s a pretty good way of thinking about it as well, winterspeak. That describes the act of saving, which is a passive one.
From that position of having saved, you can start talking about taking action in terms of changing your portfolio mix of accumulated saving – e.g. switching from cash into bonds, equities, houses, etc.
JKH: let H be flow of haircuts bought, Y be flow of haircuts sold, M be stock of money, and A be stock of antiques, W be stock of assets. Let Xdot be time derivative of X.
Seems to me there are two equivalent ways of writing the individual’s budget constraint:
1. Y=H+Wdot W=M+A
2. Y=H+Mdot+Adot
Just differentiate W=M+A with respect to time, substitute it into the income statement Y=H+Wdot, and you get 2 from 1. Maybe 1 would be better than 2 if M and A are jump variables, so Mdot and A dot are not defined (they are infinite). But as you go to discrete time, or allow adjustment costs, it’s all the same. You can’t say that 1 is right and 2 is wrong. Just two different ways of saying the same thing.
“I tried defining this as “equity” earlier because if you begin with an empty balance sheet and pay in some capital, it resides as cash on the asset side, and equity on the liability side. The terms seemed to be imprecise..”
I don’t think that imprecision should be a source of concern, winterspeak. Yes, it’s a general classification, but it opens up sub-classifications according to source – e.g. paid in from a new capital issue, or accumulated via retained earnings, or in the case of a household, it’s more commonly known as household net worth. The fundamental thing to understand is that this type of equity resides on the right hand side of the balance sheet, below debt. And anything can offset it on the asset side. In the case of newly issued equity, cash is the initial offset. In the case of retained earnings, many accounting events occur along the way that change the composition of assets as retained earnings are being accumulated over time.
Winterspeak, I tackled the bond question at 12:13. Would you agree with my description?
Winterspeak: ” Savings, is no one else’s income. If an economy wants to increase this number, it cannot…”
this is not correct. An economy can, in aggregate, increase its savings if it invests in real assets. This has absolutely nothing to do with money, money needn’t even exist for this to happen.
In a decentralized economy of course financial assets facilitate the direction of resources but that is not essential to what saving actually is at the aggregate leve.
“Are these transactions best captured in the income statement”
Winterspeak, I addressed this at 1:52.
Transactions in current period output are captured in the income statement. Income is revenue. Such purchases of current period output are expenses.
Asset transactions apart from that are captured in the flow of funds statement.
The purchase of antiques is the purchase of assets, not the purchase of current period economic output. It doesn’t appear in the income statement because it doesn’t generate any current period income to the factors of production (apart from commissions at an auction, or an antique seller’s profit margin, but that’s minor relative to the capital cost of the antique itself.)
“You can’t say that 1 is right and 2 is wrong. Just two different ways of saying the same thing.”
Nick,
The budget constraint you are constructing cuts across current period income as well as starting assets as reflected in the starting balance sheet. That’s fine as long as you realize what you are doing. You’re certainly not constructing a budget constraint for current period income alone.
Accounting differentiates between time periods. Primarily it differentiates output and income activity for the current time period, versus the cumulative result of all such activity for prior time periods. That cumulative result is measured in terms of a balance sheet. The current period result is measured in terms of an income statement.
The balance sheet includes assets, liabilities, and equity. The income statement includes revenue, expense, and a measure of profit.
“Just differentiate W=M+A with respect to time, substitute it into the income statement”
There you are mixing the balance sheet with the income statement in your approach to budgeting. That’s fine, so long as you understand you’re not budgeting for current period income alone.
In my example, X is saving from current period income. Y has no current period income because X wouldn’t buy a haircut from him. But Y buys a haircut from X. Y does this by dissaving, which manifests itself in Y drawing down money resources from his balance sheet.
Again, I’m not sure what point you’re making, other than the idea that you can construct some sort of budgeting equation that allows not only for current period income, but for the resources potentially available from the starting balance sheet for the period. You can manipulate your approach to “budgeting” as you desire, but that has nothing to do with the fact that the income statement is different than the balance sheet, and that current period saving is a function of the current period income statement, and has nothing to do with the starting balance sheet.
ADAM P: An economy can increase its net holdings of real assets, of course. It can do this without money at all as you say!
I have always always always been talking about financial assets, and an economy cannot increase its net holding of financial assets. Sometimes it wants to and tries to, and the results are very bad for the real economy.
The savings I am talking about is always net financial assets. Not real assets.
Winterspeak, I think we agree. Actually I think we’ve been saying the same thing the whole time, we’re not debating here, just converging on terminology.
Only a few minutes . . .very interesting discussion. Just have enough time to add that I think the “equity” measure searched for in the discussion with Anon is probably just the stock of Net Financial Assets. for the pvt sector in a closed economy, that would be equal to the national debt (bonds + currency + reserve balances – cb lending to pvt sector . . .or the stock of vertical money as we MMT’ers like to call it).
“The savings I am talking about is always net financial assets. Not real assets.”
If that’s the case (which is not surprising), important to make that clear at all times, winterspeak, at risk of repetition, but to avoid confusion.
Winterspeak,
If you’re looking for a name for the equity invested in net financial assets, why not just call it NFA equity, or MMT equity?
JKH . . . that’s what I said at 3:32 (regarding NFA).
Regarding NFA again . . . don’t know why we didn’t call it that . . . brain cramp, I think. We were focusing on a measure on the equity side, and then I had the “duh!” moment a bit later. Glad to see you see it the same way, JKH.
Scott,
Yes, agree as regards NFA.
The important thing is to be clear when the meaning intended is that of NFA equity.
Versus equity more generally, which means equity accumulated as per national accounts definition of saving.
E.g. it strikes me that Winterspeak (by his own admission) almost always if not always is intending the meaning of NFA equity. No problem there, but others may intend a broader meaning, unless notified the discussion is on different grounds.
“Glad to see you see it the same way”
Typing as you commented.
Absolutely. It’s occurred to me before, but the natural terminology seems clear now.
Winterspeak,
To be clear, if you’re constructing a macroeconomic balance sheet for NFA, the highest level entries would be:
Assets: NFA
Equity: NFA Equity
This “NFA balance sheet” would be a subsection of the entire non government balance sheet.
It’s the subsection that deals exclusively with the NFA position, which I think is the way you like to isolate it.
(The rest of it deals mostly with non-NFA equity and real investment. Most everything else should consolidate because financial assets cancel against financial liabilities.)
That’s a little more than Scott and I just discussed, but I hope he will agree.
Scott/Winterspeak,
I’d then simply refer to the two pieces I noted above as:
non government NFA equity
non government real equity
NFA equity is created by the government deficit
i.e. the government uses its leverage to create NFA equity as an addition to real equity
JKH/Scott: NFA equity is fine. It is what I mean. Unfortunately, unless you already understand all this stuff, you don’t understand what NFA equity is! I exactly mean vertical money, but if you don’t know how the monetary system works, you will have no idea what that is either!
If I could string together commonly understood balance sheet entries (like paid-in capital and retained earnings + goodwill + etc. etc.) it would be a way to engage with people from somewhere they recognize. It’s never worked out, so may be the wrong approach.
ADAM P: I think the point you are making is that an economy can always create stuff (real assets) without needing money (net financial assets, or NFA equity) at all. This is true, it’s also trivial in that no one would contest it.
The point I’m trying to make is that an economy, as a whole, cannot increase its NFA equity by itself. Most people would think of this as savings, and would regard the statement “everyone in the united states cannot save more unless the Government runs higher deficits” as being profoundly weird. If I point out that the National debt precisely equals the NFA equity (aka. net savings) of the private sector, that would seem bizarre too. The deficit is rightly thought of as the NFA equity the Govt has “paid into” the private sector to capitalize it, the same way investors “pay into” a start-up to capitalize that. This paid in NFA equity acts as the equity base that all private sector credit extension rests on, as the sector can lever (or de-lever) itself to whatever degree it wishes. It just cannot capitalize itself.
This is extremely non-trivial conceptually, and I can point you to the front page the NYTimes, or the Harvard Econ Department, or any economics textbook to demonstrate just how non-trivial conceptually it is. I can also point you to any recent speech read out by Barak Obama to highlight the danger of not understand how the economy works.
JKH: Your focus on the act of saving as being an income statement event, and then subsequent purchases (or not) of stuff as being restructuring of balance sheet assets is fine. It nicely mirrors the reserve/t-bill interaction in the banking sector. Not sure if people will realize its importance initially though.
Here is the simple haircut version.
Assume no banks and no currency denominated debt, fixed amount of currency, and fixed, flat price of $1 haircut.
If someone saves $1, does that mean the overall number of haircuts falls by 1?
Too Much Fed, yes that’s the point. In the absence of investment in real assets any aggregate attempt at savings just reduces todays income. Thus, attempts to use money as a savings medium (the excess demand for money) cause a fall in income.
Money or other financial assets can’t be used as aggregate savings. They can only be used to re-direct resources from the production of consumption goods into the production of capital goods.
“This paid in NFA equity acts as the equity base that all private sector credit extension rests on, as the sector can lever (or de-lever) itself to whatever degree it wishes. It just cannot capitalize itself.”
Full disclosure, winterspeak, I’m not with you on this, at least not until I understand what you’re trying to say. I seen this phraseology before, and it’s puzzled me.
NFA equity is a relatively small proportion of total non government equity. Most of the total is reflected in household net worth, which is currently about $ 55 trillion in the US. This number captures the measures of all types of household assets and liabilities, including the value of all financial assets held directly (e.g. bonds, stocks) and indirectly (e.g. though the value of pension and insurance liabilities, mutual funds, etc.), and the value of residential real estate. All of that captures private sector net worth (equity) to which you have to add the net international investment position of the foreign sector, which is probably around $ 3 or 4 trillion (haven’t check lately). Total non government equity in round numbers then approaches $ 60 trillion, down substantially from the corresponding number at its peak of about $ 75 trillion.
NFA equity is a subset of this $ 60 trillion. The public float on the national debt is around $ 7 or 8 trillion I think, and obviously growing. So for the sake of discussion, say NFA equity is $ 8 trillion out of a total of $ 60 trillion in equity. That’s about 13 per cent.
The collapse in total equity reflects the effects of the recession and balance sheet deleveraging by the non government sector. The government is injecting more NFA into the economy as a function of increasing budget deficits and as a means of providing leverage to offset this non government deleveraging. This provides additional income and satisfies excess demand for saving during the recession, attempting to jump start the economy back into gear.
That’s my interpretation of what’s going on.
As surface statements, I certainly don’t agree that “all private sector credit extension rests on” NFA equity. And I certainly don’t agree that the private sector “just cannot capitalize itself”. Perhaps this just reflects your writing style. But it certainly reads like a sort of tautology about the way in which total equity is an absolutely dependent function of NFA equity, which is clearly not the case. Obviously the private sector can extend credit and capitalize itself in the long run. The disproportionate shares of the equity components reflect that (in stock terms).
But if instead you mean that government NFA provision is assisting with the process of credit extension and recapitalization (in flow terms) – that, I can certainly agree with. But that’s not exactly what your words seem to suggest.
Am I just misreading your writing style, or is there a material disagreement here?
What Adam P. said. (unless, of course, the price level falls so that the real money supply expands, or the central bank increases the supply of money, until people no longer want to save more money. And the worry is, in the current context, that that might require a very large money-financed tax cut/transfer).
BTW, I think one of the reasons that economists like me stick to very simple models is that we know we are less likely to screw up the accounting that way.
The haircut example is excellent! Of course, once in equilibrium why would anyone want to save more, as there is nothing to buy but haircuts?
Unless one barber had knowledge of the coming antiques (asymmetric info). Knowing there is a fixed money supply, the only way for saving is to put a barber out of business. So, demand suppression results in lower velocity (=”savings”), reduced income, one or more barbers (probably those that believed in equilibrium) go out of business, now we have money available to buy those antiques.
I love neo-classical economics.
Very similar to our banking problem today.
FYI, there is an implied transaction flow in accounting entries – from credit to debit. Examples: pay rent with cash: CR cash > DB rent; purchase inventory with cash: CR cash > DB inventory; borrow cash: CR loan > DB cash; receive cash for sale: CR income > DB cash. The credit is the “source” or transaction origin, the debit is the “resting place” of the transaction.
Also, since accounting has no relevance, lets consider:
C + I + G + X – M = Y
Eliminating government and foreign trade:
Y = C + I
What about accounting?
Debit Accounts = Credit Accounts
Assets + Expenses = Liabilities + Equity + Revenue
A + E = L + Eq + R
Lets rearrange:
R = A + E – L – Eq
A little cleaning up:
R = E + (A – L – Eq)
Revenue = Expenses + net(Assets – Liabilities – Equity)
Income = Consumption + Investment
Look similar?
pebird said: “The haircut example is excellent! Of course, once in equilibrium why would anyone want to save more, as there is nothing to buy but haircuts?”
What about someone wanting to retire?
Adam P said: “Too Much Fed, yes that’s the point. In the absence of investment in real assets any aggregate attempt at savings just reduces todays income. Thus, attempts to use money as a savings medium (the excess demand for money) cause a fall in income.”
What if the rich are using excess corporate profits to save?
Nick’s post said: “What Adam P. said. (unless, of course, the price level falls so that the real money supply expands, …”
So if price deflation is 2% and the nominal fungible money supply is flat, then the real fungible money supply is plus 2%? Correct?
With that scenario, will people use the fungible money supply to save?
Plus, if there are savers, price deflation is to be avoided, and real GDP (quantities) needs to increase then the fungible money supply needs to increase? Correct?
Nick’s post said: “… or the central bank increases the supply of money, until people no longer want to save more money. And the worry is, in the current context, that that might require a very large money-financed tax cut/transfer).”
I don’t think the term money should be used. It should be either currency or currency denominated debt. With that in mind, what is the difference in these scenarios?
1) price deflation of 2% and the fungible money supply is flat
2) price inflation of 2% and the fungible money supply grows by 4% with currency
3) price inflation of 2% and the fungible money supply grows by 4% with currency denominated debt
“What about someone wanting to retire?”
If you don’t have money and the only thing money buys is haircuts, then you let your hair grow or perhaps you don’t have hair anymore.
Or, you have a couple of friends that cut your hair for free, if there is sufficient excess barber capacity.
Come on, think through this.
It sure is interesting that the equation of exchange predates national income accounting, and yet in modern terms its treated as being related to GDP! rather than its classical definition as being related to aggregate transactions (actually much more sensible).
I don’t recall the history well here. Is there a narrative that does along with this?
Jon: that is interesting. You can sort of think of V in MV=PT as the parameter needed to reconcile a balance sheet with an income statement?
But I think double-entry bookkeeping goes back a long way, and probably pre-dates MV=PT, even though national income accounting is more recent, as you say.
Winterspeak, “everyone in the united states cannot save more unless the Government runs higher deficits” seems weird to me (even with your definition of saving). What about the rest of the world in this?
Also, please explain what “vertical money” is. I clearly do not know how the monetary system works!
JKH: We may have a material difference in opinion. Let’s see.
Traditionally, you measure “leverage” by seeing what the non-equity liability to equity liability ratio is. So 10:1 leverage means you have 10 units of non-equity liability, and one unit of equity liability. Balance sheet size is 11 units.
So, look at a combined Govt, non-Govt balance sheet. It nets to zero, of course, but the Govt sector pays NFA equity into the non-Govt sector. So, if you look at just the non-Govt sector, there are these equity liability accounts that do not have an in-sector liability match. The asset they match would be cash, I guess, or at least some sort of bank deposit.
The non-Govt sector cannot create an accounting entry by itself. Any financial asset created in the non-Govt sector must have a corresponding liability within the sector, so it has to net out to zero (within sector). I think we are agreed here.
So, the way I think about it is that the Govt pays in the initial equity (NFA equity) that the non-Govt sector can then expand balance sheets on top of through non-Govt sector credit extension. The non-Govt sector can extend additional credit, if it chooses, or uncreate credit. But it cannot increase its NFA equity. The analogy is of starting a company, paying in some initial equity (which shows up as cash and equity) and then the company can take on debt on top of that to expand its balance sheet. If the non-Govt sector wants to increase its NFA equity, it cannot do that by itself because it cannot create NET financial assets.
Clear? Do we disagree?
I very much agree that the quantity of NFA equity is small in comparison to the total size of the non-Govt sector balance sheet. In Australia, I believe the situation is more extreme, while in Japan the non-Govt sector probably has a much larger % NFA equity component. Also, I will repeat again, that this is just for financial assets, not non-financial assets. If you look at household net worth, and take out real estate, I think that number will drop considerably. My guess is that most households probably do not have significant net worth outside of their houses.
RebelEconomist: “Horizontal money” is financial assets created within the non-Govt sector, so non-Govt sector credit extension. It’s called “horizontal money” because it’s just expanding balance sheets by creating assets and off-setting non-equity liabilities. There is no net financial asset creation (there cannot be).
“Vertical money” is net financial asset creation where the Govt creates net financial assets in the non-Govt sector by deficit spending. This short up in NFA equity on non-Govt balance sheets.
You can agree whether this model makes sense or not, but that is what Chartalists are talking about when they talk about vertical and horizontal money.
Winterspeak,
Thanks for the explanation of horizontal and vertical money, which sounds reasonable. And my question about the rest of the world?
I do not disagree with the chartalist view of money at all. In fact, I have been aware of it for years, and think it offers useful insights into the nature and value of fiat money. I just am not convinced that it offers anything as new or powerful as its prophets and their disciples claim.
pebird, I am trying to think this thru so let me rephrase.
What about someone saving so they can retire so they can demand haircuts but do not have to supply any?
Sound better?
RebelEconomist:”And my question about the rest of the world?”
FYI:Scott Fullwiler once wrote about incorporating it here.
Rebel Economist: “Rest of the world” is just another non-Fed Govt saver (or currency user). When I say “Govt” I mean the Fed Gov, as it can issue currency. Everyone else, for that currency, is a currency user, whether they are a household, state Govt, or foreign Govt. As a short hand I refer to them as “private sector”.
So does the government debt = the non government savings? Cause the market cap of the tsx > the government debt. That’s not including private companies, and bonds. Has someone run the numbers?
That’s what I thought, winterspeak. So you have consolidated out the US piece of the global imbalances. Does it not concern you that this makes such analysis rather irrelevant?
edeast said: “So does the government debt = the non government savings?”
How about does currency denominated debt of the gov’t plus currency denominated debt of the lower and middle class = the savings of the rich?
Rebeleconomist: I’m not sure what you mean when you say that “consolidating out the US piece of the global imbalances… makes such analysis rather irrelevant”. I think it’s very relevant for certain questions, and I think other questions (like “what will happen if China stops buying Treasuries!”) are fundamentally irrelevant — which this analysis makes clear!
JKH: Thinking more about an earlier post of yours. You distinguish between reshuffling assets and saving, saying that the act of saving brings assets (and equity liability) onto the balance sheet (and is an income statement activity) while changing the composition of those assets (buying stock, selling real assets etc.) comes after.
Not sure I’m 100% OK with this, as you can change the composition of your assets in every way through private section credit extension, whereas adding to NFA equity is uniquely a savings activity, and impossible at a sector level.
Did I understand you wrong?
The conversation has moved far beyond this, but I still think that it is worth noting:
Nick Rowe: “By common stereotype, accountants are careful people; economists are usually sloppy people.”
Nick Rowe: “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.”
JKH: “You’re just changing terminology. That’s not helpful, but the accounting requirement is that the equation works.”
Nick Rowe: “But I was just trying to explain to my students how accounting works!”
😉
Winterspeak,
There may be quite a difference in the way we view things at a high level, including a disagreement or disconnect on the nature of non government equity in total. (I can’t tell for sure whether it’s the words you put together that I disagree with, or the analysis itself.) Non government net financial assets is an important strategic component of the full piece, but it’s fairly straightforward from an accounting perspective. I think we mostly agree on that. The larger accounting framework that positions NFA in the context of the totality of economic equity is more challenging.
Your response suggests this view of total economic equity is something you don’t relate to. I don’t see where you’ve responded to many of the points I’ve made. I think you have a good feel for net financial assets/equity of the non government sector with the government, but I don’t think you have translated that unique piece coherently to a view of the larger picture. The only thing I can do is more or less repeat some of my analysis, because while we probably have a mutual understanding of the nature of the non government NFA position, I have considerable difficulty with some of the statements you’ve made in the larger sense.
The balance sheet of any non government economic unit consists of assets, liabilities, and equity. This works for households, corporations, and the foreign sector. Balance sheet equity is somewhat separable from the idea of whether or not a financial claim in the form of a stock has been issued on that equity position. While equity claims are obviously not issued by households, they have balance sheet equity or net worth positions essentially comparable in basic accounting to those of corporations. And the balance sheet equity of a corporation is conceptually distinct from its specific stock value representation in the sense that alternative measures of the same thing are possible – e.g. book value on the balance sheet as reported, replacement value for the net assets to which the stock corresponds, or breakup value on liquidation. The balance sheet equity position is what the corporation itself has generated. The stock market evaluates that position as a translation of it to a traded financial asset.
It is obviously true that net financial assets contracted entirely within the non government sector sum to zero. But the fact that this accounting mirror imagery is a wash for financial assets between non government counterparties doesn’t mean such financial asset values can’t and don’t factor into the value of non government equity in total. As a simple example, suppose a household holds corporate bonds as part of its net worth or equity. Those bonds are eliminated on asset-liability consolidation when one takes the standard MMT view of the non government sector. And that is obviously correct from a non government sector accounting perspective, insofar as the bonds and other financial assets are concerned. But the fact that a corporate bond is eliminated on accounting consolidation doesn’t mean that the household’s corresponding net worth (the household version of equity) is eliminated. The bond is simply a financial asset representation whereby the future cash flows expected to be generated by the corporation from its real resources in servicing its bond obligations are mirrored in the household equity position that reflects some type of valuation of those future cash flows. The ultimate wealth or equity position lies in the claim of the household on those cash flows, not in the mirror image accounting elimination of financial asset representations on macro consolidation. Indeed, this sort of representation of household equity or net worth is done routinely through the Fed flow of funds Z1 report. Moreover, that measure of household worth, plus foreign sector net worth, is an exhaustive measure of non government equity in total, by construction, because any corporate contribution is reflected in the value of the other two sectors using the value of their financial claims on the corporate sector. Perhaps you are not familiar with the standard sector balance sheet equity or net worth decompositions in that report.
More generally, following directly from the example above, non government equity in total can be represented as the sum of net assets of the household sector and the foreign sector. This refers to net assets in the general sense of the standard accounting mode of assets less liabilities, which of course is equity. This is because, similar to the bond example above, all corporate sector financial obligations (liabilities and equity) are ultimately reflected either directly or indirectly on a consolidated basis as household or foreign sector financial assets. Corporate sector financial liabilities that interface directly with the household and foreign sectors are specifically included in such a representation, because it includes all corporate issued debt and equity or other obligatory value (e.g. pension liabilities) as transmitted via financial claims to the other two non government sectors. Finally, residential real estate and consumer durables are non-financial assets that contribute as well to non government equity. Regarding the actual portfolio composition of the household and foreign sectors, and to repeat the kind of analysis contained in my previous comment, there’s currently about $ 35 trillion in net financial assets of all types held by US households (that’s net with all sectors; not just the government sector). Add to that about $ 18 trillion in residential real estate, some consumer durables, and some foreign sector net financial asset holdings, and you get about $ 60 trillion in total non government equity or net worth. Furthermore, the combination of household and foreign net financial assets in total approaches $ 40 trillion, of which about $ 7 or 8 trillion is the net financial asset position with the government.
With that said, the following statements you’ve made don’t make a lot of sense to me:
“So, if you look at just the non-Govt sector, there are these equity liability accounts that do not have an in-sector liability match. The asset they match would be cash, I guess, or at least some sort of bank deposit.”
“So, the way I think about it is that the Govt pays in the initial equity (NFA equity) that the non-Govt sector can then expand balance sheets on top of through non-Govt sector credit extension.”
“The analogy is of starting a company, paying in some initial equity (which shows up as cash and equity) and then the company can take on debt on top of that to expand its balance sheet. If the non-Govt sector wants to increase its NFA equity, it cannot do that by itself because it cannot create NET financial assets.”
As I explained in the previous comment, it’s misleading to suggest that non government net financial assets with the government are the structural basis for leverage within the non government sector. That seems to ignore nearly $ 50 trillion in non government equity that is separate from the $ 7 or 8 trillion of equity corresponding to its net financial assets with the government. This $ 50 trillion in equity value has nothing to do with and is unaffected by the accounting observation that net financial assets within the non government sector net to zero. The equity value of the non government sector is not affected by this zeroing out accounting consolidation effect.
As noted before, net financial assets provided by government deficit financing are obviously useful as a response to non government demand for net saving, particularly when the latter sector shows weak demand for goods and services. The stimulus provided by government expenditure in doing so obviously helps fill that goods and services demand gap. And in doing these things the government is leveraging its own financial capabilities as an offset to the deleveraging that is going on in non government balance sheets. I believe this is all standard MMT. But to suggest that the “net financial asset equity” or NFA equity, as I coined the term earlier, is some sort of structural equity foundation for the non government sector, when the existing equity base of the non government sector without it exceeds $ 50 trillion, is simply a distortion of the proportionate presence of the two equity components. You periodically make a statement along the lines that you only “care” about net financial assets of non government with government. I think this narrow approach contributes to error in some of the more general statements you make about equity. So it appears we disagree on this subject of equity in a rather fundamental way, unless you’d like to revise the way you’re analyzing it and/or describing it. While I think you have a good feel for net financial assets/equity of the non government sector with the government, I don’t think you have translated that piece coherently or consistently to a view of equity in the larger picture. BTW, I regard absolutely nothing I’ve written here as being inconsistent with MMT. Anybody who wants to suggest otherwise is welcome to explain how they believe that is the case.
And what about the state equity on the balance sheet of the US non-state sector – ie the fact that the people ultimately own, and are responsible for, their own state sector? That would be one reason not to consolidate foreign and US sub-sectors of the non-state sector.
Rebeleconomist: Still not sure what you mean. If the Chinese choose to hold US$, that is their prerogative. The US Govt is ultimately responsible for the US$, just as the Chinese Govt is ultimately responsible for the yuan, no matter who is holding it. But you still need to know how is holding it and be honest in your accounting.
Many countries operate with mixed currency economies, it really isn’t that strange. The US does not, although Canada might to a certain degree (it would not surprise me if there are a fair number of US$ circulating up there).
JKH: Give me time to process. I’m glad we’ve uncovered this area of disagreement.
JKH: Still digesting your comment. let me ask you this.
Suppose you closed out all non-Govt financial positions. So, corporations bought back their stock, households repaid their debt, etc. etc. What financial assets would remain in the private sector?
Of course prices would go crazy if you went through this procedure, so just tell me what line items would remain. Remember, I don’t care about real assets.
I mean that, since the people ultimately own their state, the state cannot really create net financial assets by deficit spending on purchases from its own people (assuming that the citizens’ equity stake in their own state is a financial asset).