Ten Fundamental Economic (Mis)understandings
It’s all about the words . . .
by Steve Roth
Originally Published at Wealth Economics
This article was first published on Cameron Murray’s great Fresh Economic Thinking. It’s slightly revised here.
Maybe I’m just dense, but when I started studying economics roughly twenty years ago, I immediately ran into a bunch of basic concepts that just didn’t make sense to me. It was mostly a problem with economists’ words. They have different, shifting, overlapping, and contradictory meanings, that often collide even within a single sentence.
As Noahpinion says, it’s a dumpster fire. A tower of Babel.
I’m not the first to raise this flag, of course. Here’s Paul Romer in his landmark “Mathiness” paper.
Even the formal language often departs the “sense of the symbols” — and even collides with basic accounting understandings that the language rests and relies upon.1 This is true even for many “accounting-based” discussions in the heterodox econ world; some mainstream misconceptions persist there.
This article presents a set of straightforward terms and understandings that it’s taken me nigh-on two decades to assemble and fully metabolize. Each both explains and relies on others, so they’re presented here in basically random order.
Apologies for some repetition, saying the same things in different ways, but I find it’s necessary to internalize these understandings. I hope some different expressions ring true and clear for different readers.
1. “Money” is just one asset class out of many
“Money,” “capital,” and “wealth” often get all jumbled and muddled together in economic discussions. In the understandings here, money (“M assets”) is just a type or class of assets: bank account or money-market deposits.2 M2, the main monetary aggregate measure, also includes the trivial amount of physical cash that exists out there, much or most of which resides in suitcases and vaults full of $100 bills worldwide. For a sense of proportion, M assets only make up about 10% of households’ total assets.
M assets have a particular and unique defining characteristic: they’re fixed-price. A dollar in your pocket or bank account is always worth one dollar. If you’re holding M assets, you’ll never see holding gains or losses based on market-price changes. The “price” of M assets is institutionally hard-pegged to the unit of account.3
This asset class is the fixed numeric fulcrum around which the value of all other assets pivot. The buying and selling of non-money assets changes their prices in terms of M assets. The resulting holding gains or losses increase or decrease the total stock of assets.
No such valuation effect exists for M assets; asset-price changes don’t and can’t affect the outstanding stock of M assets, M2. So “the markets” have no effect on that total amount; M assets are hot potatoes that can only be transferred between account holders.
2. Spending comes out of assets, not income
That’s what spending is: transferring assets to another person’s or firm’s account in exchange for their newly-produced goods or services. If you have no assets, you can’t spend (you can’t transfer assets you don’t have). Income and borrowing just add to individual assets, which you can then spend or hold. Spending subtracts from individual assets. (Holding, obviously, doesn’t.)
It can of course be useful to analyze spending relative to income over a particular time period, at least for individual people, households, firms. You can even say that income (and borrowing) “fund” individuals’ spending; they add assets that can be spent.
But the spending itself comes out of assets, always and everywhere. You can’t “spend out of” the instantaneous moment of someone handing you a five-dollar bill — only out of the five dollars of M assets in your hand, wallet, or bank account.
3. Not all purchases are spending
To repeat: spending means paying for the newly produced goods and services of others. This is the whole basis of gross domestic product (GDP) and the “production boundary” within which GDP is defined.4
Purchasing financial instruments is different. Those are just dollar-for-dollar asset swaps of M assets for different assets. Those asset swaps are appropriately ignored in GDP. They aren’t spending.
4. Spending, not saving, is what creates wealth
When you spend, you transfer assets from your bank account to the account of another person or firm. The aggregate stock of wealth, or assets, or money is unchanged; the assets are just held in different accounts. (And The Banks can lend against those deposits whether they’re in Bank Account A, or Bank Account B. Spending, moving deposits between accounts at different banks, doesn’t change that.)
If you don’t spend — if you hold or “save” that money — it stays in your account and the aggregate stock is also unchanged. In aggregate accounting, neither spending nor saving creates assets. Spending moves money and saving leaves it where it is.5
But! When you spend more, that spending causes more production. Ask any producer why they produce stuff. This is an economic effect that doesn’t exist for holding/saving.
It’s this spending that creates more wealth, because some portion of that “real-world” production isn’t consumed. When you spend to pay a builder for a new house, the completed (and un-consumed) house is posted to your balance sheet as a new asset. You and we, collectively, have more assets. (See the three other asset-creation mechanisms in #10 below.)
Spending, not saving, is what causes production, economic activity, and aggregate wealth accumulation.
5. Your personal saving increases your wealth. It doesn’t increase our wealth.
If you spend less than your income, you have more assets, personal wealth. But your spend-or-hold decision has no direct effect on the aggregate stock of assets. This widespread misunderstanding is a classic, textbook error of composition. Individual spending decisions just affect who holds the assets, not the total quantity of assets.
Or said otherwise: There’s only an economic effect if you do choose to spend, rather than save; your spending causes production. Saving, in and of itself, doesn’t create new assets or cause economic activity. Quite the contrary, really, compared to the spending counterfactual.
6. “Investment” is not investment
“Investing”—the technical term of art in economics—is investment spending. It’s purchasing (paying people or firms to produce) new long-lived, real-world stuff, both tangible and intangible. That’s the buildings, vehicles, machines, software, infrastructure and things that last into the future and continue to provide value.
Those long-term goods aren’t consumed within the accounting period, so their value gets posted to balance sheets in an accounting-markup event that creates new assets.
The common, vernacular usage of “investing”—purchasing financial instruments from their current owners—isn’t spending. It’s just dollar-for-dollar swaps of already-existing assets: giving cash assets to someone in exchange for stocks, bonds, or real-estate titles. The buyer and the seller adjust their asset-portfolio allocations into different asset classes. That’s it.
7. “Investment” is not saving
If you have some M assets that you want to swap for different assets (ETF shares or whatever), you’ve already saved. That’s why you have the M assets. Swapping them for other assets is not saving.
8. The choice is not spending versus buying portfolio assets
You often hear that an income recipient can either spend on goods and services, or on financial securities. But swapping M assets for other financial securities is not spending.
When you receive new M assets so you have more assets, you can choose to spend them (thus reducing your assets), or keep holding them. If you decide to hold those assets, you have to decide whether to reapportion the mix of your asset portfolio. That’s a completely separate, orthogonal decision to whether to save/hold them in the first place. Nobody asks themselves, “should I buy a fancy car or vacation tonight, or should I reallocate my portfolio”?
Spending, at least on goods to be consumed, reduces individuals’ assets. Purchasing existing (non-M) assets doesn’t; it’s not spending. People aren’t making a choice between two forms of spending.
9. Spending turnover and portfolio turnover are different things
When households in a given year turn over (more of) their assets in spending to purchase new goods and services, that causes more production of new goods and services (and creates new assets based on the increased stock of un-consumed goods). When they just swap existing assets — portfolio turnover or “churn” — it doesn’t. It just readjusts the asset mix in different portfolios.
Portfolio turnover, though, is a key financial mechanism that enables individuals’ spending out of assets. Because, sellers demand M assets for purchases. Those who want to spend can swap their stocks, bonds, and real-estate titles for M assets. For most assets this only requires a few mouse clicks.
This is basically just mechanical: they’re able to spend out of their assets because they have M assets that sellers demand. Their trading counterparties, who want to hold and accumulate assets, get to swap their M assets for assets that deliver returns.
Spending turnover directly causes production. Portfolio turnover, churn, is just a mechanism enabling individuals’ spending out of assets, and portfolio reallocation.
10. One person’s income is not necessarily from another person’s spending
The opposite is often stated as a truism: “one person’s spending is another person’s income.” It’s obviously true; spending is transferring M assets from one account to another. It at least implies that spending always equals income, and vice versa.
But spending is not the only source of new assets Not nearly. New accounted assets are constantly created through investment spending a.k.a “capital formation,” government deficit spending, bank lending, and asset repricing/revaluation (holding gains). I’ll explain these four mechanisms in an upcoming post. For a preview, see here.
If all income came from spending, so spending and income were equal (and saving equals income minus spending), there would be no saving. The saving rate would always be zero.
That last sentence is perhaps the key conundrum that I struggled with for so many years.
Thoughts from my gentle readers are, as always, deeply welcome.
Notes:
1 Economists receive ~no formal training in accounting, much less the specialized field of national accounting that’s the very fundament of empirical macro. They’re expected to pick it up through osmosis, or “on the job.” At Harvard, U Chicago, and MIT, to name three, accounting (and business) classes don’t even count as electives for undergrad econ degrees.
2 John Hicks succinctly expresses that widespread confusion in his 1946 Value and Capital, in the opening paragraph of Chapter 13, “Interest and Money” (p. 163). Some deposit instruments, he says, are “usually not reckoned as securities, but included as types of money itself” — as if they can’t be, and aren’t, both: money and a type of asset/security. (It’s not clear what “types of money itself” even means. Almost all M assets are bank deposits; there’s only one significant “type” of money.)
3 That price-pegging is guaranteed and enforced by multiple private and public institutions, notably including but not limited to deposit insurance for bank accounts. A very significant recent example: When the $65-billion money market Reserve Fund/Primary Fund (not insured by the FDIC/FSLIC or any private bank-insurance institutions) “broke the buck” on September 15, 2008, only offering 97 cents in commercial-bank deposits for $1 in money-market deposits, the U.S. Treasury stepped in within 48 hours to guarantee and prop up the $1 share price of all money market funds. (The funds paid a required fee for this temporary but mandatory insurance, dissolved in September 2009.) In practice, in normal times and even extraordinary ones, $1 in M assets always “sells” for $1 — by definition here, but more importantly by institutional enforcement. Fixed-price is M assets’ sine qua non — the thing that makes them what they are.
4 Spending (and its obverse, receipts) is what national accountants actually survey, observe, and measure to calculate GDP. “Production” is conceptually imputed from that: If there was $20T in spending, $20T in goods must have been produced. (See Fred graph here; the small discrepancy is just net exports.) That production is then characterized as the “real” thing. (This before even considering inflation adjustment to calculate “real” real production over time.)
5 Saving (think: holding) is a flow measure — income minus spending tallied over a period of time. But paradoxically, it’s explicitly a non-flow, by its very nature. It’s a measure of new assets from income that don’t flow anywhere, just the remainder or residual measure of two actual flows, income and spending.
Roth
when i first studied economics sixty years ago I was turned off by the basic assumptions that were presented to me as etermal truth and looked to me like misleading assumptions about human behavior and values that would lead to bad policies in terms of the well-being of humans and countries.
I think…no idea if i am right…that what you are presenting here may be of value in keeping “what we are talking about” in formal discussions about economic theory. may be perfectly good and necessary and even lead to better outcomes in terms of well being etc,,,but i have my doubts about that. i don’t think most people can or will keep straight in their minds the distinctions and “precisions” that you are trying to make. this may not matter. “most people” don’t count for much at the high end of abstractions. i’ll wait and see if i can see any effect at ground level on politics and people’s actual understanding of what they are doing or letting what is being done to them.
but by all means keep at it, you may be on to something that i will be the last person to understand. i get lost trying to understand what GDP acounting says about Social Security…they seem to regard it as “transfer payments” of no economic value. But do they treat savings accounts, interest generally, and insurance payments the same way? they should, because that is exactly what SS does. money is a flow. beginnings and endings are more or less arbitrary but what we call them influences the way we think about them and the politics that determine real world outcomes. i have no idea if that will make any sense to you. it does to me in the very narrow part of economics i understand. but i see no evidence that Congress understands anything, or cares. it’s all about what lies get the votes.
@Steve,
Nice post.
I don’t pretend to be an economist, but I’ve been a credentialed, practicing scientist for 42 years. What I know about science is that anyone claiming that scientists “proved” anything knows nothing about science. Science doesn’t deal in proof, it deals in the weight of evidence. I never trust anyone who uses “scientists” and “proved” in the same sentence. I’ve always thought the same was true of economics. All conclusions of science and economics are provisional. I’ve always left the “proof” to religious dogma.
I failed to n0tice the word, or concept, “proof” in the post. if it appears in my comment it must have been a typo of the kind i suffer from.
but i would like to point out that “science” does depend on mathematics, which does deal in “proof.” which tends to be more important in some sciences at least than double blind randomized control studies. both are subject to the problem of hidden assumptions and unknown facts.
i think “religious dogma” is a red herring.. which, again, seems to have nothing to do with this post.
I think it’s a good idea to clarify the meanings of common terms in economics. Most of them have precise meanings that are different from their colloquial meanings. This happens a lot. Look at the discussion of the word “proof” in this comments section. Philosophers of science. mathematicians judges in criminal courts use the word “proof” to mean different things.
It would be a good idea to distinguish flows and accumulations up front and emphasize that actual production or product – I may be using the terms wrong – involves goods and services. In fact, that might be a good starting point for any discussion since everything else, money, financial assets, investment, corporations and so on are, in the end, all about providing people with goods and services. Money and financial assets are just part of our society’s scheme for managing them.
I also like your idea of moving accounting to the center. Scientists put conservation laws at the center, and this provides a basis for evaluating and understanding everything else. If I remember my accounting correctly, there are asset accounts and flow accounts and a variety of transactions that transfer assets between them. (In double entry bookkeeping, these always occur in pairs.) Putting all those pieces together in an accounting framework would really be enlightening.
P.S. Ages ago I ran a soda buying cooperative for a student organization. We’d buy soda in returnable bottles and sell it at a slight markup. We let people maintain accounts, had a cash box and so on. I had to learn accounting on the fly to keep everything straight. Full and empty bottles were assets. Account balances were liabilities. Somehow or another I did a good enough job to pay an ice cream party dividend every so often.
kaleberg,
(that’s spell check, not me)
yes, it’s a good idea to know what you are talking about..and agreeing about it at least with the other people trying to talk about the same thing. but i have no trouble telling the difference between “work” as a physicist means it, and “work” as used in everyday language.
on the other hand, when you talk about “goods and services” you are in danger of forgetting that “the best things in life are free” and destroying the best things in the pursuit of “more” goods and services.,
and anyway Congressmen and “non partisan experts” use words in a way intended to deceive. since it is nearly impossible to keep in mind all the things that go into the reality that a word points at, I think it is unlikely the politicians have anything to worry about in terms of our catching on.
i think it likely the project to carefully define words used by real experts in honest scientific collaboration is subject to the same problem of unknown facts….which in some cases is likely to be fixable by the nature of the scientific project itself…not to be confused with claiming “scientific proof” at the same time denying that science claims “proof.”
(“science” does not. scienceists often do.)
well, spell check caught up with me..or itself. or the editor did. it’s hard enough to make sense without someone coming after you and changing what you are writing about.
spell check insisted that i meant kale berg and wouldn’t let me change it. then, after i went home and forgot about it. it, or the editor, realized i meant Kaleberg. I can hardly wait for AI to start fixing my mistakes before I make them. but wait: we already have human AI.