There's a lot of people wandering around the internet who are very confused about Investment = Saving. Maybe they have been mistaught, or maybe they have mislearned? I don't know. But I'm doing this as a public service, even though it's a thoroughly boring job for me. Someone's got to do it. And since I've done it almost every year for the last 33 years, it might as well be me. "Ours the task eternal" is Carleton's motto.
Let's get the arithmetic out of the way first, then I'm going to simplify, back up, and explain what it all means.
Start with the standard national income accounting identity:
1. Y = C + I + G + X – M
On the left hand side of we've got sales of (Canadian) newly-produced final goods (and services) Y. On the right hand side we've got purchases of (Canadian) newly-produced final goods (and services), divided up into various categories. Consumption, Investment, Government expenditure, eXports, and iMports.
2. S = Y – T – C
This is a definition of Saving as income from the sale of newly-produced goods minus Taxes (net of transfers, which are like negative taxes because the government gives you money instead of taking it away) minus Consumption.
Substitute equation 1 into 2 to eliminate Y and you get:
3. S = C + I + G + X – M – T – C
You can eliminate C in 3, and rearrange terms to get:
4. I – S + G – T + X – M = 0
If you simplify, by assuming a closed economy with no exports or imports, you get:
5. I – S = T – G
If you simplify further, by assuming no government spending or taxes, you get:
6. I = S
(Or, if you like, you could define S as "national saving" to include both private saving plus government saving, which is defined as T-G.)
Now let's talk about what it means.
Equation 1 is an accounting identity. It is just like saying "the number of apples sold = the number of apples bought". You can't sell an apple without somebody else buying it. That's what the words "buy" and "sell" mean. If we add up all the apples sold, and add up all the apples bought, we should get exactly the same answer. If we didn't, it means we miscounted, or had a different definition of "apple" in the two counts, or did the two counts over different time periods, or made some other screw-up. And National Income Accounting is the art of checking all the possible screw-ups we might make, and trying to make them as small as possible, so we can get as accurate a picture as possible of economic data.
For example, if you are counting apples sold by the Canadians who produced them, and counting apples bought by Canadians, you have to remember that some Canadian apples get sold to foreigners, and some apples bought by Canadians weren't produced in Canada. That's why you have to add exports and subtract imports in equation 1 to make it add up right.
Since apples sold = apples bought, and bananas sold = bananas bought, then apples and bananas sold = apples and bananas bought. If it adds up for each good, it also has to add up across all the goods. So it really doesn't matter if we add up the physical number of apples and bananas, or add up the market values of apples and bananas, or add up the market values adjusted for inflation, or what. A+B=A+B. A+2B=A+2B. 24A+32B=24A+32B. Whatever. Equation 1 is true in nominal terms, without any inflation adjustment. Equation 1 is true in real terms, adjusted for inflation. Equation 1 is even true if we adjust for inflation in some totally daft manner, just as long as we are consistent in our daftness on both sides of the equation. Of course, we get a different number for Y depending on which we choose, and some of those numbers will be more useful than others, but we should (unless we screw up) get the exact same number on both sides.
(There are lots more potential screw-ups we could make: like how exactly we define and count "Canadian" "newly-produced" "final" goods. But go read any intro economics textbook if you are interested, because it's not the main topic of this post.)
Now, I have defined Y as goods sold. Normally, we think of Y as "income", or "production". And you can think of cases where these don't seem to be the same.
For example, suppose you produce 100 apples and you don't sell them? If we want Y to measure the production of apples, and not just sales of apples, we have to remember to include apples that the grower consumes himself, or adds to his inventory of apples. "He sold them to himself, either for Consumption or for inventory Investment". That's a fudge, of course, but it's a fudge we need to make if we want Y to mean "production" as well as "sales".
Here's a second example. Suppose you have 100 apples in inventory, that were produced last year, and the price of apples suddenly goes up $1. You have just made a capital gain of $100. Shouldn't that capital gain be included in your income? Well perhaps it should, or perhaps it shouldn't. But if you want Y to mean "income", you had better not include it. Y has to be restricted to mean "income from newly-produced goods".
All the above was accounting. It wasn't really economics at all. "Apples sold = apples bought" is always true. But it tells us nothing whatsoever about what determines the number of apples traded. It is totally silent on what causes the number of apples bought-and-sold to increase or decrease. Or why it is bigger in some countries than in others. Is it the weather? Is it people's preferences for apples? Is it government rationing? Is it the rotation of the planets? There are 1,001 different theories of what determines the quantity of apples traded, and all of those theories are consistent with the accounting identity of apples sold = apples bought. Because "apples sold" and "apples bought" are just two different ways of describing the exact same number.
One of those 1,001 theories is the simple economic theory taught in Intro Economics. Supply and demand. Quantity demanded is the quantity of apples people would like to buy, given the price of apples, their income, etc.. Quantity supplied is the quantity of apples people would like to sell, given the price of apples, their productive abilities, etc.. The demand curve shows how quantity demanded varies with price, holding other things like income etc. constant. The supply curve shows how quantity supplied varies with price, holding other things like productive capacity etc. constant. And, according to this theory, the price of apples adjusts to make quantity demanded equal to quantity supplied, where the demand and supply curves cross. At that equilibrium price, and only at that equilibrium price, all 3 quantities are equal. Quantity demanded = quantity bought-and-sold = quantity supplied. According to this theory it is the supply and demand curves that determine quantity bought-and-sold.
That theory could be wrong. That's one of the dangers of having a theory that actually attempts to explain what causes or determines the facts. It could be wrong. But if we want to explain the world, that's the risk we have to take. One can easily think of examples where this theory would be wrong. For example, if the government imposes a binding price floor on apples it will be wrong. In that case, Intro Economics would replace it with a slightly modified theory: the quantity of apples traded is determined by the demand curve and the price the government sets; the supply curve plays no role. With the price fixed above where supply and demand curves cross, quantity demanded = quantity bought-and-sold < quantity supplied. In that "semi-equilibrium" actual purchases will be equal to and determined by the quantity of apples people want to buy (demand) at the fixed price. But the actual quantity sold will not be equal to nor determined by the quantity people want to sell (supply).
And if the government instead sets a binding price ceiling on apples the original supply and demand theory will also be wrong, but in a different way. In this case, according to the Intro Economics textbook, it's the supply curve and price that determine quantity bought-and-sold. In "semi-equilibrium", quantity demanded > quantity bought-and-sold = quantity supplied. Actual purchases will be equal to and determined by the the quantity people want to sell (supply) at the fixed price.
(The key assumption in all three of the above theories is that trade is voluntary. You can't force people to buy more than they want to buy; and you can't force people to sell more than they want to sell. So quantity actually bought-and-sold will equal whichver is less: quantity demanded; or quantity supplied. Only in full equilibrium, at exactly the right price, are all three quantities equal. Otherwise we are in what i call "semi-equilibrium", where only two of the three quantities are equal, and the third is bigger than the other two.)
"Apples sold = apples bought" is an accounting identity that is always true, but tells us nothing about what determines that quantity.
"Apples demanded = apples supplied" is an equilibrium condition. It might not be true. It is part of a theory that does try to explain what determines the quantity of apples bought-and-sold. That theory might be true, or might be false. But it is a theory about the world, and the risk of being false is an unavoidable occupational hazard of trying to explain the world.
Now, that was microeconomic theory. Let's switch back to macroeconomic theory. What's that got to do with I=S?
Look back at equation 1, and assume a closed economy with no government. You get Y = C + I. That equation is exactly the same as I = S. The two are mathematically equivalent. Just different ways of saying the same thing. But Y = C + I is a lot easier to compare to the microeconomic equilibrium condition "supply = demand". So I'm going to do that first, then come back to I = S.
For an economy that produced only apples, "Y = C + I" tells us that apples sold equals apples bought (some for consumption, some to be added to stocks as an inventory investment). But that accounting identity tells us absolutely nothing about what determines the quantity of newly-produced goods bought-and-sold. It does not explain why it changes over time, or is higher in some countries than in others. There are 1,001 different theories, all compatible with that accounting identity, that do try to explain what determines Y.
Here is just one of those 1,001 theories. This theory will be found in most Intro Economics textbooks. It's the simple "Keynesian Cross" theory. This theory is very similar to the microeconomic theory above of a market for apples with a binding price floor, where quantity supplied exceeds quantity demanded. This theory says that the quantity of goods bought-and-sold will be equal to and determined by the quantity demanded, and will be less than the quantity supplied. But there's a clever macro twist. The macro twist is that the quantity of goods demanded depends on income, and income is equal to the quantity of goods bought-and sold.
This theory can be described by three equations:
7. Y = Cd + Id
Cd means "desired consumption". It's the quantity of consumption goods people would like to buy, given their income etc. Some economists call Cd "ex ante consumption". But a simpler name would be "quantity of consumption goods demanded", just like in micro. And Id is just the same, except it's "desired investment", or the quantity of investment goods demanded. And equation 7 is a "semi-equilibrium condition". It says that actual quantity of goods bought-and-sold (Y) will equal quantity of goods demanded (Cd+Id).
8. Cd = a + bY (where a>0 and 0<b<1)
9. Id = Ibar
Equations 8 and 9 are the behavioural equations. They tell us what determine desired consumption and desired investment. Desired consumption is an increasing function of actual income, and desired investment is fixed at some exogenous number, called Ibar. (That's supposed to be a bar over the I, but I can't write it).
Substitute 8 and 9 into the equilibrium condition 7, to get:
10. Y = a + bY + Ibar
Solving for Y we get:
11. Y = [1/(1-b)][a+Ibar]
Now that's a theory of the world. It might be false. But if true, it explains what determines the quantity of goods bought-and-sold. It says Y is determined by desired investment (and by the parameters a and b in the consumption demand function).
And it is a simple matter of math to relate that back to I=S. Simply define "desired saving" Sd as:
12. Sd = Y – Cd
So "desired saving" means "that part of income that people do not desire to spend on (newly-produced) consumption goods". What do they want to do with it instead? It could be anything, except spend on (newly-produced) consumption goods. They might want to spend it on newly-produced investment goods, they might want to buy government bonds, or corporate bonds or shares, or buy antique furniture, or add to their stocks of currency under the mattress. You name it, and if it's something you can want to do with your income (after taxes), other than spend it on newly-produced consumption goods, it's "desired saving".
We can re-write the old semi-equilibrium condition 7 as:
13. Y – Cd = Id
And substitute the definition for Sd into the left hand side to get:
14. Sd = Id
We can read 14 as "desired saving equals desired investment". Or "ex ante saving equals ex ante investment". It is mathematically equivalent to the semi-equilibrium condition 7. It's just another way of saying "quantity of goods bought-and-sold equals quantity of goods demanded". Only now it gets rearranged to become "quantity of goods bought-and-sold minus quantity of consumption goods demanded equals quantity of investment goods demanded". Which is a bit of a mouthful.
Substitute 8 into 12 to derive the desired saving function from the desired consumption function:
15. Sd = -a + (1-b)Y
Desired saving is an increasing function of income.
Substitute the desired investment and desired savings functions 9 and 15 into the "semi-equilibrium condition" 14 to get:
16. -a + (1-b)Y = Ibar
Rearrange 15 to get
17. Y = [1/(1-b)][a+Ibar]
Which, you will notice, is exactly the same as 11. You get exactly the same results whether you start from Y=Cd+Id or Id=Sd. And of course you should, They are exactly the same semi-equilibrium condition, just re-written.
But if you start with the same semi-equilibrium condition and add different behavioural functions you will get a very different theory of the world. For example another macroeconomist would say that desired investment and desired saving also depend on the rate of interest, and that the central bank will adjust the interest rate so that desired saving equals desired investment at potential output. In which case you cannot say that desired investment determines desired saving (or vice versa) because they are both endogenous variables, and it is the central bank that determines the equilibrium level of income. And yet another macroeconomist would say that that's not quite right either, because if the central bank tries to set the interest rate too high or too low the result will be accelerating deflation or inflation, so in the long run, if it doesn't want to destroy the monetary system, the central bank can only set it at some "natural rate" where desired saving equals desired investment at the level of income determined by the long-run supply of output.
In other words, the semi-equilibrium condition Sd=Id leaves open the question of what variable(s) adjust (or is adjusted) to bring the two sides into equality. It might be Y, as the Keynesian Cross model assumes. But it might be the rate of interest. Or the price level. Or anything else.
Let me sum up the main lessons.
First, you can't get anywhere with just accounting identities, if you want to explain the world. Convert that accounting identity into an equilibrium condition, and add some assumptions about people's behaviour, and what adjusts to what, and you might have a theory.
Second. The I=S approach is exactly equivalent to the Y=C+I approach. The latter is more easily re-interpreted as the semi-equilibrium condition Y=Cd+Id, which is the macroeconomic version of "apples bought-and-sold = quantity of apples demanded", but Id=Sd is saying the exactly the same thing. (I was taught both these methods of representing the old Keynesian Cross model back in high school).
Third. The key question is not just the equilibrium condition you assume, but what variable or variables you assume adjust to make that equilibrium condition hold. What are the behavioural functions? Different behavioural functions will give you a very different theory.
Fourth. A lot of economists wasted an awful lot of time and ink getting this stuff straight 50 years ago. If you start your theory with I=S as an accounting identity, it really is your responsibility to try to explain to anyone reading the difference between I=S as an accounting identity, and Id=Sd as some sort of equilibrium condition, and why that difference matters. Because, as I said at the beginning, there's an awful lot of poor lost souls wandering around the internet who have just discovered the marvellous truth of I=S as an accounting identity, and think they have found some magical philosopher's stone that "mainstream" economists have never heard about, and that this blinding flash of divine truth will lead them to the Promised Land. It's a bit like being accosted at airport terminals by people with a glow in their eyes repeating "apples sold equals apples bought". Because that's exactly what they are saying.
Worthwhile Canadian Initiative 
Nick,
My surface impression is that you and Scott are talking a bit past each other at one level – you’re sticking to the (S = I) “global” model, and he’s venturing into the (S – I) sector model. Maybe I’m wrong on that.
Andy is right.
In Nick’s model, S = I at all times, equilibrium or not.
Andy understands accounting.
And everybody should read his original post on the relationship between I and S.
And I think Andy’s point is a subliminal catalyst for those MMT “followers” who “jump” to conclusions about the pre-eminence of accounting importance.
BT: “Private sector net savings (S – I) are just the money added into circulation by government deficit spending and an export surplus.”
That is really wrong, unless you are using “money” in a very strange way. Suppose the government sells a national park to a household, and uses the proceeds to buy newly-produced tanks. Ignore foreigners. G-T has gone up. S-I has gone up too. But there need be no change in the stock of money in circulation. National parks are not money, by any definition. Or the government could have financed the tanks by selling bonds. Indeed typically only a very small part of government spending is financed by the creation of base money. In Canada it is roughly $2 billion per year. Roughly 0.2% of GDP. And it has stayed at roughly that sort of level despite big swings in the government budget deficit or surplus of around 10% of GDP.
Look, this is a case where I do insist on people getting the accounting right.
P.S.
The reason for the continuous operation of the identity is the inventory process, of course.
“this is a case where I do insist on people getting the accounting right”
Did the earth’s rotation just reverse?
🙂
Leigh: “I suspect this is because the definitions of S and I are not quite intuitive to non-economists (and even to some economists, perhaps).”
Agreed. I is not so bad. It’s S that’s the killer. Sometimes I think we should just drop S altogether, and instead talk about the demand and supply of: output, bonds, money, etc. It’s money that is the genuinely weird one, precisely because it doesn’t have a market of its own. An excess demand for apples shows up in the market for apples. An excess demand for bonds shows up in the market for bonds, etc., until we get to money. An excess demand for money shows up in all the markets for everything else, because all those other goods are bought and sold for money.
“Ours the task eternal” is Carleton’s motto.
I thought this was a pretty witty little kvetch until I realized it is literally true! http://en.wikipedia.org/wiki/Carleton_University. Cool.
Not that you aren’t witty, Nick. Judging by this post, you must be very good at the teaching part of your job; your students are fortunate.
In which market can one buy savings? The purchase of capital is a capital transaction that leaves savings unaffected. Same for the purchase of bonds. The only way to save is to refrain from purchasing consumption.
JKH: I was following you, and basically agreeing, up to this point:
“My surface impression is that you and Scott are talking a bit past each other at one level – you’re sticking to the (S = I) “global” model, and he’s venturing into the (S – I) sector model. Maybe I’m wrong on that.”
What’s the difference between “global” and “sector”?
The simplest case to illustrate my point about deleveraging is where G=T=I=X=M=0, so it’s a model where the only good is a consumption good, and all loans are consumption loans between households. And desired saving must be zero in equilibrium. One person can pay off his loan to another household. If the first chooses to save and the second chooses to dissave, total desired saving stays the same at zero.
“Andy is right.
In Nick’s model, S = I at all times, equilibrium or not.
Andy understands accounting.”
Actual S = Actual I at all times, by definition. In my first model, explicating Andy’s point, with the lag in the consumption function, it is also true that desired saving will equal desired investment at all times, because that model is always in short-run equilibrium. But that equilibrium will be moving over time, because of the “slow multiplier”, so it takes time to get to the “long-run” equilibrium (actually an infinite time, since convergence is asymptotic).
In the other variants of the model, where it takes time to adjust production, it is true that actual S = actual I at all times (obviously), but desired S does not equal desired I at all times, because it takes time for Y to adjust to make them equal.
“The reason for the continuous operation of the identity is the inventory process, of course.”
Not strictly. Imagine a haircut economy, so no inventories. (And no investment, for simplicity). Start in equilibrium with Sd=S=0. Then all of a sudden people want to consume more haircuts. But it takes time to hire more people to cut hair. The result is a line-up at the hairdressers. Actual S=0, but desired S is less than zero. People want to get a haircut, but can’t. Quantity demanded exceeds quantity bought-and-sold.
Hey! Sure Andy understands accounting, but don’t I understand it too (at least, for the purposes of S=I, because I know I don’t understand a lot of what real accountants do)?
JKH: “And I think Andy’s point is a subliminal catalyst for those MMT “followers” who “jump” to conclusions about the pre-eminence of accounting importance.”
So I should be blaming Andy for the MMT followers! (I must say, one of the MMT guys I was arguing with on Scott’s blog did link to Andy’s post.) Jeeez, Andy, what have you done?!
“What’s the difference between “global” and “sector”?”
E.g.
S = I for the world
S < I for the US, and the reverse for non-US.
or,
“non-government” S > I for the non-US government world, as per MMT, etc.
But I thought you were attempting to make your points regarding equilibrium etc. restricting to any case where S = I as the assumed identity
Thanks Phil! I appreciate that. It’s hard explaining this stuff in a way that’s both simple and accurate.
There’s no I in a haircut economy, so your point is moot with respect to macro I = S, (although a fair one apart from that, at the micro level)
It is Andy’s point (I assumed) but Andy’s point has shared ownership.
It would be unfair to blame Andy alone.
He is only a messenger of truth, not the originator of it.
🙂
And your haircut argument applies to the service sector as a subset of the entire economy, where the service sector is particularly defined (artificially) to have net zero I. But the inventory argument still applies to the rest of it.
meant gross zero I
The messenger’s post again:
http://blog.andyharless.com/2009/11/investment-makes-saving-possible.html
rsj: I’m gonna have to fisk you!
“In which market can one buy savings?”
Good question. Answer: in the market for newly-produced investment goods; in the bond market; in the land market; in the market for antique furniture; etc.,…..and, most importantly in no market at all, by not spending part of the flow of money you have received as income, and keeping it in your pocket.
“The purchase of capital is a capital transaction that leaves savings unaffected. Same for the purchase of bonds.”
Woah! If I decide to spend a flow of my income on a flow of purchases of machines or bonds, instead of spending it on a flow of consumption, then I have increased my saving. If I reduce my flow demand for bonds, and increase my flow demand for machines by the same amount, my saving is unchanged. If I sell a stock of bonds and use the proceeds to buy a stock of machines, my saving is also unchanged.
“The only way to save is to refrain from purchasing consumption.”
Yes.
Gregor Bush: “All old-Keysian, New Keysian, Monetarist, Austrian, RBC and neoclassical growth theory models are all consistent with S=I. S=I is not a constraint on any of these theories.”
Correction: S-I is a constraint on all of those theories. 🙂 Were it not, one of them could violate it.
“Woah! If I decide to spend a flow of my income on a flow of purchases of machines or bonds, instead of spending it on a flow of consumption, then I have increased my saving.”
No. But this to me is where your medium of exchange focus comes in very handy. Saving is what is not consumed – which typically shows up directly as medium of exchange used to settle income payments, but not used to settle consumption payments. Leaving the money in the bank is the primary example. From there, one can exchange what has been saved for other assets – anything but consumption of newly produced goods and services. But the act of saving is in what is not consumed – not in what the medium of exchange is subsequently used for instead (if anything).
JKH: “There’s no I in a haircut economy, so your point is moot with respect to macro I = S, (although a fair one apart from that, at the micro level)”
I=S also holds equally true in a world with no investment. Since both I and Id by assumption are both zero, the S=I identity and Sd=Id equilibrium condition, simply become S=0 and Sd=0. My point is not moot at all. S=I also has to work in a haircut economy.
But if you like, imagine that investment too is a service, and you can’t hold inventories of the newly-produced investment good. The farmer invests by hiring a firm to clear scrub from his land. If the scrub-clearing firm cannot increase production quickly, in response to an increased investment demand by farmers, we get desired investment exceeding actual investment, even in a world with no inventories.
We really ought to be able to tell the S=I story just as well in a world of fresh strawberries, services, and no inventories. Really, inventories are just a complicating fudge factor that prevents us seeing what’s going on clearly. What slows down the adjustment to the keynesian multiplier equilibrium is not inventories, it’s the slowness of hiring new workers and ramping up production in response to an increase in demand. That’s way more important than the accursed inventories.
@ Nick “The Greek” Rowe
Thank you. 🙂 You have answered a question I posed elsewhere last year:
If I = S, why does the term (I – S) appear in the identity,
(I – S) + (G – T) + (X – M) = 0 ?
The reply I got was more or less gobbledygook.
OTOH, if I had gotten the right answer, that to get I = S we assume that G = T and X = M, I might have thrown up my hands in disgust. As a layman, a major problem I have with public economic discourse is the unspoken assumptions.
My point is not moot at all. S=I also has to work in a haircut economy.
Point taken.
If you consider that there is no investment as a “thing”, the point is moot.
If you consider that investment is zero, your point holds.
Thanks Min! Another person for whom my post cleared something up. And nothing to do with MMT in this case.
There’s another way to get S=I, in a closed economy. That’s to re-define “S” as “National saving = private + government saving”, where government saving is government “income” T minus government consumption spending Gc. You also have to include government investment spending in I. It gets trickier to stretch the meanings of S and I in an open economy though.
“If the scrub-clearing firm cannot increase production quickly, in response to an increased investment demand by farmers, we get desired investment exceeding actual investment, even in a world with no inventories.”
Everything in that model is production of a service, and income is paid for that service as it is produced.
There is no inventory issue because there is no capitalization of the value of the service – because the value of the service is entirely accounted for by income, on a pay as you go basis.
If there is no capitalization, there is no investment, and no saving.
Yes, the multiplier gets slowed because production of the service is slower than desired. But that’s beside the point about I = S.
Nick,
You’re starting to re-define stuff that just gets further and further away from real world application and intersection.
JKH: the way I look at it is this: we have a flow of money coming into our pockets, part of which is income; and a flow of money going out of our pockets, part of which is consumption. Saving is the difference between those two parts of the flows in and out. The flow increase in the stock of money is the difference between the total flows in and out.
JKH: “If there is no capitalization, there is no investment, and no saving.”
I don’t understand “capitalization”. But there certainly is capital and investment in my model. The stock of cleared land is capital (OK, land+capital, if you like). The flow of cleared land (acres cleared per month) is investment.
“You’re starting to re-define stuff that just gets further and further away from real world application and intersection.”
Whaat? My father cleared 50 acres of scrub from farmland in his life. It was one of his major investments. The whole of Canadian farmland fits my model. (OK, add field drainage in there too, along with scrub clearing.) That’s a really big part of Canada’s capital stock. This is much more real world than widgets! You urban fellow you!
“JKH: the way I look at it is this:”
No. You’re redefining accepted accounting terms. We’ve been through this before, but that’s what you’re doing.
Income is not equivalent to cash inflow. Assuming income is transacted with cash flow, income is a subset of cash inflow. Non-income cash inflow includes cash receipts for sales of assets not produced in the current period.
From a generally accepted accounting principles perspective, your paradigm confuses the income statement with the flow of funds statement. And the latter is a formal accounting statement used in all financial reporting suites.
And those generally accepted accounting principles are consistent from the micro bottom to the macro top (e.g. national income accounts and Fed flow of funds accounts)
That’s what you’re doing. You’re redefining accounting according to the Nick Rowe economic paradigm.
You can do that, but it makes discussion with those who have some experience with/knowledge of real world financial accounting very difficult.
And I suspect that your resulting accounting paradigm will inevitably be internally inconsistent, which is very difficult to demonstrate holistically in a discussion like this becomes it becomes a constant frenzied cat chasing its tail thing.
I’m with JKH.
Suppose I earn $100 in income. I choose to spend $40 on consumption. At that point, I have saved $60. No market is necessary for me to go and “buy” my savings. By not buying consumption I have saved and my wealth has increased by $60.
At the same time, I may sell $100 worth of IBM stock. Now, I have driven down the price of IBM even as I save.
On the other hand, suppose I earn $100 in income and spend $100. My savings is zero. Then I buy 100 shares of IBM (on margin). Now I have purchased capital, driving up its price, but I have not saved.
The capital markets serve to price capital. They don’t have anything to do with clearing savings demands per se. Savings demands don’t even show up in those markets.
Whatever the equilibrium price of IBM stock will be, it’s not going to be a reflection of savings demands, but of the earning prospects of IBM as opposed to my borrowing rates and risk tolerance.
And one striking real world example of this is what Calculated Risk calls the “distressing gap”. They note that generally speaking new housing starts move tightly with used home sales, except recently. Recently, the price of housing has plunged so much that it is not economical for housing suppliers to build new homes. Distressed owners, often banks — are selling used houses at prices so low that homebuilders can’t compete. So here is an example of a “housing market” — our proxy for the capital market — in which the prices are lousy for the purveyors of investment goods, even though demand for housing is strong enough to move a lot of units. The net result is little housing investment, although a lot of homes are being sold.
There is no investment good market, there is no savings market. There is just one big market for capital, and the price of capital in that market doesn’t clear the demands for investment goods or the demands for savings. It clears so that households are indifferent between holding capital and holding bonds.
“But there certainly is capital and investment in my model. The stock of cleared land is capital (OK, land+capital, if you like).”
You just said all investment was a service in your model!
!!!
H E L P M E PLEASE DEAR …
RSJ is with me.
And I’m with me.
I think you’re done Nick.
JKH: “You just said all investment was a service in your model!”
Well, what would you call the activity of clearing scrub from land? I would call it a “service”. The important point is that the firm that sells the scrub-clearing services cannot build up an inventory of scrub-clearing while waiting for a farmer to come along and buy it. A firm that produces machines can build up an inventory of machines waiting for a factory to come along and buy them.
And if you really don’t like scrub-clearing, what about software engineers who work at a firm programming all their computers? That’s investment, and a service.
Jeeez! Why do you find this stuff so hard? 😉
JKH: “That’s what you’re doing. You’re redefining accounting according to the Nick Rowe economic paradigm.
You can do that, but it makes discussion with those who have some experience with/knowledge of real world financial accounting very difficult.”
But I have to throw away GAAP. Look at how GAAP handles inflation!!! Carleton’s land is still down on the books at its 1948 purchase price! There is no way I could build a coherent economic model that conforms to GAAP.
Ganging up on Nick:
“your paradigm confuses the income statement with the flow of funds statement”
Yes — exactly! Nick, you’ve made this point before: If you don’t spend your money on X, you must spend it on Y — but the argument here is that when I spend money on the purchase of capital, that need not be counted as income by anyone else in the economy (unless they were in the business of producing and selling capital). Hence the homebuilder example.
The other example of this distinction is the little circular economy I gave, in which everyone owes money to the person on their left, sells output to the person on their right, and buys output from the person on their left. In that case, if everyone decides to take 1/2 of their income and pay down some of their debts, then even though the same cash-flow is circulating, income drops by 1/2, because the repayment of debt does not appear on the income statement. It’s not an income event even though everyone “does something” with all of their money (e.g. there is no hoarding of cash).
And come to think of it, this was the same point that Scott F. was making earlier. You have now 3 people ganging up on you about the distinction between cash-flow and income, as well as the distinction between income events and balance sheet events. I suspect Andy H. is on our side, too, but may be too polite to say it. 😛
Nick,
If scrub clearing adds value to the land, then that value is capitalized when the scrub clearing is finished.
The resulting capital value of the land is NOT a service.
It is investment, the same as inventory investment.
Your example capitalizes the labor expense into the value of the land. It’s no different than how labor adds to capital value more generally.
But the resulting capital value itself is NOT a service. It IS investment.
Nick,
There was an interesting post somewhere on the internet, quite applicable to our discussion, that started out this way:
“There’s a lot of people wandering around the internet who are very confused about Investment = Saving.”
Wondering whose wandering.
JKH: “My suggestion was not that economic theory must conform to accounting identities, but that economic analysis must conform to it, including all forecasting and risk analysis.”
Nick Rowe: “Agreed. Certainly. (But if the forecast comes from a model that conforms to accounting identities, then the forecast will automatically conform to them too.)”
It seems to me that one major problem today is that policy makers in general seem ignorant of the necessity to conform to accounting identities. Instead, they make proposals that violate them or require unusual or unlikely conditions in order to meet them. (It is not always possible to make sense out of policy proposals, so we cannot be entirely sure of that. ;)) If economists of all stripes are cognizant of these identities, why does the economic profession en masse not speak up about such policy proposals?
Scott
I believe Warren Mosler has written that the national debt = private savings. In what way is that incorrect?
Nah! You’re all confused!
First, you need to stop talking about the “flow of funds“. What the heck are “funds”? You need to talk instead about the flow of money — the medium of exchange. Because it is money that we buy and sell stuff with. If we talk about demand and supply, and buying and selling, in a monetary exchange economy, we are talking about the flow of money.
Second, of course the purchase and sale of newly-produced goods (“income”) is just one of the things we do with money. And only in a very simple model like Paul Krugman’s babysitting coop, where there is one good (babysitting services, that cannot be inventoried, I note) plus money is the flow of money identical to the flow of income. In a more complex model, where you add a second non-money non-newly-produced good, usually called “bonds”, then there are two markets, and the flow of money in only one of those markets represents income.
But the simple babysitting model is still useful. It reveals some important truths that sometimes get missed in more complex models. And, empirically, the demand for money (I’m talking stock, of course) does seem to depend strongly on income. (Though I wouldn’t preclude taking a broader view, and saying the demand for money depends on all transactions, not just income, as in the transactions approach MV=PT, as opposed to the simpler MV=PY.)
Nick,
It might be useful to distinguish between those intermediate services that are capitalized as investments, and those final services that are produced as consumer goods/services.
Your example is that of a service that is capitalized as an investment. The same thing happens in the production of new housing, for example. But the final GDP calculation shows the value of the house or in your case the land improvement as an investment good. The service input is intermediate.
When I pick up my dry cleaning, the service is not capitalized. It is a final consumer good/service and part of the final GDP calculation.
The latter is the sense in which I would generally view services in the context of I = S, at the macro level, and for purposes of our discussion.
I have no problem with the flow of funds being viewed by WCI as the flow of money, or the flow of the medium of exchange.
That shouldn’t be the source of any confusion.
And whether or not it is has nothing to do with the correct decomposition of these standard accounting statements into interpretations of things like income, expenses, investment, and saving.
JKH: Can the firm that sells scrub-clearing services to farmers build up a stock of unsold inventory of land-clearing services? No. So that is an example of a newly-produced investment service where there are no inventories. So a sudden big increased demand by farmers to invest results in desired investment exceeding actual investment, even with no inventories to involuntarily decummulate. That was the point of my introducing that example.
The whole economy is moving towards a service economy. We have to get our heads around stopping thinking of the typical component of GDP being some physical manufactured widget, with widget-producers having unsold stocks of widgets waiting in boxes for buyers. It would be better to start thinking of an economy where most of GDP is produced to order. Haircuts are the simplest example. The haircut isn’t produced until the customer walks in the door and places an order.
“Jeeez, Andy, what have you done?!”
In my defense, things don’t seem to work out very well if we let economists just talk about the economics while taking the accounting for granted. We end up with Eugene Fama insisting that a fiscal stimulus can’t possibly be expansionary because the savings to finance it have to come from somewhere. It’s true, sort of, in certain models, but the reasons for it are subtle. As a matter of accounting, it’s blatantly false, although the reasons wouldn’t necessarily be clear to someone without a knowledge of national income accounting. There is something to be said for forcing economists, when they’re talking to a general audience, to do the accounting first before they do the economics. I’m not sure I approve of economists’ just casually “doing it with models.”
Gizzard: “Scott
I believe Warren Mosler has written that the national debt = private savings. In what way is that incorrect?”
I’m going to take that one, even though it was addressed to Scott.
My guess is that Warren was either making special assumptions, or was speaking a little loosely (which is OK, because we all need to do that).
In a closed economy, with no investment, and where the government holds no assets, it would be true that the accumulated stock of the past flows of private saving (people sometimes use the word “savingS” to distinguish the stock from the flow) would equal the government debt.
If the government owns assets, then you have to distinguish gross from net debt, which I always find it hard to remember. If there’s investment, you need to remember that some private savingS are held as capital. If it’s an open economy, some private savingS are loans to foreigners (could be negative, of course).
Otherwise I think what you say Warren said is correct. (Unless I’ve missed something).
“The whole economy is moving towards a service economy. ”
The whole economy is moving towards consumption being delivered and sold as services. But there are enormous supply chains with huge amounts of capital investment and multi-year lead times required before those services become available to be sold.
Microsoft spends 2 years developing a version of Office, then 1 year testing it (enterprise software is hard to test), and then makes it available as an “on-demand” download. That does not mean that we are in a haircut economy with the good being “produced” on-demand.
A friend of mine worked wrote specialized software for CT scanners. It was a small German start up that was later purchased by Siemens. They used to laugh about selling the same software to the U.S. for 10x what they charged European customers. Anyways, it takes about 1 year of development, and then 2 years of testing. The software is then loaded onto a workstation and a period of training occurs. And, of course a year or so is spent selling it to various customers.
Then you walk into your doctors office and get the “on-demand” CT scan. So service yes, but investment is even more important and the lead time between initial investment and realization of sale are much longer. It is just that in those intermediate steps, you do not see half completed widgets in a warehouse somewhere.
Andy: “We end up with Eugene Fama insisting that a fiscal stimulus can’t possibly be expansionary because the savings to finance it have to come from somewhere.”
Yep, that’s an example of a (non-MMT) economist mistaking an accounting identity for an equilibrium condition.
My own views on this are peculiar, of course, because I say that it is only monetary exchange that makes Id=Sd false in any interesting way (i.e. false in a way that would cause recessions if Sd exceeds Id).
rsj: the way I think about what you are saying there (which I agree is important) is that when a firm invests, it does so based on its expectation of the flow of future demand for the future services that current investment will be able to produce. That’s sort of what I had in mind in my upward-sloping IS curve posts.
“Yep, that’s an example of a (non-MMT) economist mistaking an accounting identity for an equilibrium condition.”
It depends on how you interpret it. Both Greg Mankiw and Scott Sumner interpret Fama to be talking (not very clearly) about an actual equilibrium condition. If that’s the case, then the confusion is the result of his not being explicit about the accounting, which is still presumably being done correctly in the background.