How Accounting "Constrains" Economics
There’s been a running discussion of this on various blogs (sorry if I missed linking some!), inflated simultaneously by Krugman and by magisterial and mysterious commenter JKH’s “paradigm riff,” here.
That discussion has brought me to the following conclusions.
Assuming you have a coherent and accurately representative System of National Accounts*:
• Accounting, and accounting identities, do (or should) impose a constraint on our economic reasoning and predictions.
• If some piece of economic reasoning predicts something that simply can’t happen according to the accounting (things don’t add up, balance), that reasoning/prediction is wrong.
• Accounting can’t tell us whether a piece of economic reasoning is right. It can only tell us if it’s wrong.
• Accounting won’t necessarily tell us that a piece of economic reasoning is wrong. There are plenty of economic ideas out there — behavioral notions about how people (will) respond to incentives and constraints – that conform to accounting identities and balances, but are nevertheless wrong.
• Accounting tells us exactly nothing about how people will behave, nor can it cause or constrain that behavior. It can only tell us that that it’s logically impossible for them (all) to behave in a given way.
Takeaway: Conformance to the rules and balances of accounting is a necessary but not sufficient condition for economic reasoning and predictions to be correct.
Or to put it another way: Accounting is a constraint on economics, not economies.
Simple example: if somebody suggests that all countries should/can get out of depression by increasing their net exports, it’s false/bad reasoning. Because global imports equals global exports; the books can’t add up that way.
Or suppose someone says:
1. We should reduce government debt.
2. There’s not much we can do about net imports, the trade imbalance. (Exports are determined largely by international demand, and we don’t want to use trade policy to deny our people the benefits of cheap imported goods.)
3. People should save more.
This is impossible, by accounting identity. The only way to increase private savings (the stock of net financial assets) without changing imports is to increase exports or run government deficits.
People, institutions, and policy makers could certainly try to achieve these mutually incompatible goals. They could even believe that it’s possible to achieve them all. But the arithmetic of stock-and-flow accounting tells us that they will fail — and that if they believe they will succeed, they’re wrong.
* Even though I have real qualms about the conceptual structure of the current system — I find it much easier to do good thinking using Wynne Godley’s modification of that system — the current system is coherent and accurately/usefully representative. It’s coherent in that all the stocks and flows balance out, and representative in that it covers most of the important stocks and flows. No system could be perfectly representative, of course; the map is not the territory. In both systems there’s a great deal that’s not considered — nonremunerated work, for instance. But that doesn’t discredit, is peripheral to, the logical thrust of this post.
Cross-posted at Asymptosis.
There’s also the massive problem with these abstract “laws” that the real economy is very heterogenous and different actors have different affinities and predilections.
What I’ve wanted to do for years now is put together a “SimEconomy” type study of all this. I believe there is a branch of economics working on this, forget the name.
“Simple example: if somebody suggests that all countries should/can get out of depression by increasing their net exports, it’s false/bad reasoning. Because global imports equals global exports; the books can’t add up that way.”
The reasoning isn’t false or bad it only leaves out a crucial issue. One country can improve its economic condition at the expense of another competing country by raising exports. China has been doing just that for about three decades now with the aid and abetment of various deal makers in the USofA who have made their own personal fortunes doing so.
I’ll repeat (in short form) what I said in comments at EconoSpeak: to the extent that an “identity” is used to define an economic relationship, it makes economists lazy (in the most obvious way, by reducing the number of equations–identified relationships–required to resolve a system).
It would be like defining hydrogen without noting the differences of deuterium or tritium.
I’m not sure how on-topic this is, but the accounting identity
Savings = Investment
Looks like a fudged tautology.
Neither of these explanations compels me to think otherwise.
Near as I can tell, Savings is simply set to be equal to investment, not actually determined by any systematic process. This –
“Aggregate saving occurs when the nation acquires real domestic assets, such as new housing, new machinery, new factories and offices, additions to a firm’s inventory of goods, or new claims on assets overseas. And that is precisely what is meant by investment.”
– is more than a little bit circular.
Further, since banks have reserves, some savings cannot get invested, and the identity fails. Plus, some saving gets relegated to various financial instruments. “That merely swaps one type of financial asset for another without affecting the total.”
What am I missing?
Yes! Dynamic simulations, a la weather modeling.
The only such that I know of is Steve Keen’s. I’ts up and running, but still quite primitive. Some guys at the Santa Fe institute (which is into dynamic, complex systems, emergent properties, and agent-based modeling) have been making noises about one for a while, but nothing to show so far.
Notable: weather modelers have a bunch of models, and they run them against each other, compare results. That’s what we’re gonna need to do real economics, cause economies have all the complexity of a weather or ecosystem.
@Jack: “One country can improve its economic condition at the expense of another competing country by raising exports.”
The point is that they can’t all do that.
See comments thread with Vimothy on this post over at Asymptosis.
Your confusion is utterly warranted. I think “S” is almost universally misunderstood — including (especially) by economists. “S” never made sense to me; I’ve spent years trying to figure it out, finally think I’ve done so thanks *many, long* comments by and discussions with JKH.
Though I feel like I’ve labored it to death in Asymptosis posts, and comments all over, I may need to do another laying out my latest, clearest thinking.
I think you’re right that it does make economists lazy.
I would only add that I don’t think it does by necessity. Properly understood (as above), accounting identities provide a useful (requisite?) platform for rigorous and complex thinking and analysis. Problem is that most economists don’t understand accounting.
Which is the subject of my next post…
Revise: the point *made here* is that they can’t all do that.
Correct. My point is that some countries have done this very effectivley with the assistance of some members of our own financial industry. The entire episode of off shoring American industry is a good example of the process.
If you could assemble the results in one place, that would be great.
Savings is equal to investment only in a closed economy.
In an open economy savings and investment can differ because of the current account balance– if investment is greater than savings the current account must equal the difference.
This is an identy. But the interesting question is what happens to interest rates and/or the currency or economic activity to bring about this identy.
I’ve written about this topic as well:
1) Current acounting ‘launders’ causality. Although more than one person has recommended a method of tagging all finanical transations. (The names escape me at the moment.)
2) The cyclicality of interest, and of finanical reporting rewards obscurity tactics. Months, which are an artifact of the age of sail, are an arbitrary, costly and dysfunction-inducing periodicity. Weeks, quarters and years are meaningful. Months are meaningless.
3) Accounting is structured almost entirely for the purpose of minimizing taxation while maximizing borrowing capacity. To accomplish this, it relies upon artificial obscurity. This creates fragile organizations, misleading banking data, and terrible economic data. Numerically speaking, most companies run on EBITDA reports and and Operational P&L both of which accurately reflect the volitiliy of the business. Everything else is produced for external entities and presents the organization as operating on a flat curve. We have created every incentive possible to make it impossible to run a business with short production cycles (services) or which is high risk (research and development) while reporting useful information. We’ve created every incentive for a complex asset based business to overstate their position in order to obscure the risk on their balanace sheets.
4) Accounting, lending and business assumptions, as well as the models we use in economics, are rooted in the industrial era, when the economy consists disproporionatly of speculative investments, and services businesses that are more volitile and less profitable than the laws or the accounting rules will allow for.
Who said lazy is bad?
Accounting identities are like conservation laws in physics. And yes, using them can reduce the degrees of freedom of a system of equations. If you can manage that, that’s pretty good. 🙂
It’s not an identity, for one thing. It only holds under certain conditions.
“Accounting is structured almost entirely for the purpose of minimizing taxation while maximizing borrowing capacity.”
Ah, not really. The vast majority of all accounting functions have nothing to do with taxation.