Wednesday, June 2, 2010

Mandatory Arithmetic

I propose that no one should be allowed to comment on current budget issues, or at least be taken seriously, unless they explicitly deal with the fundamental arithmetic, which looks like this:

GDP * (fiscal balance / GDP + net private deficit or savings / GDP) ≡ Current account surplus or deficit

I don’t care whether you say prayers to Friedrich Hayek before going to sleep at night, or whether you wake up at 3 am to make an offering at your hidden shrine to Chairman Mao, this simple identity has to hold. It is true continuously at each moment and also over any time span of interest.

Suppose your country is running a fiscal deficit, as most are right now. There are calls to reduce it. In order to have an intelligent response, you need to view the situation in light of the compulsory arithmetic. Do you see a way to reduce the current account deficit? Are you assuming that GDP will fall? Or are you expecting, or forcing, private borrowing to increase? You can’t fiddle with one term in an identity without dealing with the consequences for the other terms.

I would now puff up my chest and demand that reporters, politicians and everyone else reacquaint themselves with Econ 101, except, of course, that Econ 101, which say almost nothing about this identity or how it applies in real life, is itself a big part of the problem.


Russell said...

It's been a long time since I took Econ 101, but...

it looks to me as though you have GDP canceling out completely. Is that intentional?

GDP * (fb / GDP + net deficit / GDP)
= fb + net deficit.

So... why mention GDP? I think you may be a bit too subtle for me on this one.

Peter Dorman said...

You're right, but putting it in for some of the terms (you can choose which) permits decomposition.

ajsutter said...

Another issue with the identity is that it reifies GDP. The constituents of GDP are constantly changing, and even the broader outlines of its definition are somewhat arbitrary, excluding large portions of the economy. So while this equation is true as a tautology, it has very little synthetic content (in Kantian sense of synthetic).

Andrew Bossie said...

I cover this in Econ 101 precisely for the reasons you posted.

I don't think it would be unfair to also insist politicians and reporters take international finance where this stuff is covered.

Andrew Bossie said...

whoops... covered more in depth.