Thursday, October 28, 2010

This Is What Accounting Identities Look Like

I have been periodically raging against the ignorance of those who would slash fiscal deficits without regard to fundamental accounting identities. Such “serious” people somehow think that public and private debt levels can be lowered simultaneously, without a substitution of foreign assets in domestic portfolios (a current account surplus). It does not occur to them that one person’s debt is another’s asset—too confusing, I guess.

What this means is that, if the private sector is collectively paying down its debts, and the government tries to pare its deficits at the same time, either there is an increase in net exports to finance all of this, or it just doesn’t happen. That’s how it is with identities. Unlike other kinds of rules, they are not made to be broken.

Which brings us to this morning’s news about public finances in Europe: despite the earnest efforts of the austerians, fiscal deficits are not declining. Rather, tax receipts are going down, so that the ex post identities remain in force. As long as the private sector continues to deleverage, further efforts to produce “responsible” fiscal deficits will just lead to lower tax revenues and further spending cuts, in a downward spiral of pointless misery.

It reminds me of a bumper sticker that was popular a few decades ago: “Gravity. Not just a good idea—it’s the law.”

11 comments:

portlandian said...

This seems like a (slightly) complicated way of stating the obvious.
If people spend less (which they need to do if they're paying down debt) then someone will have less income, since they had to spend their money somewhere.
Ditto for Government debt paydown.

Then, of course, if there's more spending in the US from outside of the country, then US income can go up again.

Not really profound.

But what are the assumptions and simplifications in this model that might not hold up?

For one thing, IT ASSUMES THERE IS NO TIME. Time stands still. Money, for example, doesn't change value. Debt is nominal, after all.

Also, to look at something concrete, what happens when there's a short sale? The bank loses part of the accounting value of an asset (the mortgage balance written off) on its books. How exactly is that decreasing income or spending? The bank has more than enough to loan out, but it isn't doing it before the short sale and won't afterward. Yet the total debt is decreased. Certainly it won't have a negative impact on the income or spending of the person defaulting/short selling the home.

That's the thing about accounting. Not everything impacting the balance sheet means a change in cash flow.

Mike Sankowski said...

This is what an accounting identity looks like:

Private Savings = Government Deficits

This is the well known:

GDP = C + I + G + (NI) we all know and love

Until people realize that government deficits are necessary, we're going to be poor.

Mr. E
www.moslereconomics.com
Counter Insurgency, Deficit Terrorist Unit

TheTrucker said...

Very happy to see someone else that has been investigating Mosler. He is not (thank you Lord) and economist. He is, instead, a rational human being. His just released book is a scant 117 pages and describes the reality of the US monetary system very well.

Prologue: ----------------------------

The term "innocent fraud" was introduced by Professor John Kenneth
Galbraith in his last book "The Economics of Innocent Fraud", which he
wrote a the age of ninety-four in 2004, just two years before he died.
Professor Galbraith coined the term to describe a variety of incorrect
assumptions embraced by mainstream economists, the media, and most of all,
politicians.

The presumption of innocence, yet another example of Galbraith's elegant
and biting wit, implies that those perpetrating the fraud are not only
wrong, but not clever enough to understand what they are actually doing.
And any claim of prior understanding becomes an admission of deliberate
fraud - an unthinkable self-incrimination.

-----------------------------------------------------------------------

Sarah said...

nice post!

Belle said...

With new technology comes new face of accounting. We are now gone with those traditional ledger and record book. Matrix makes accounting easier and protected from fraud. Payroll Nevada uses the system to protect the financial asset of the company and to secure honesty in work place.

JW Mason said...

I just posted a response to this on my blog.

Short version: I agree with you that "further efforts to produce 'responsible' fiscal deficits will just lead to lower tax revenues and further spending cuts, in a downward spiral of pointless misery," but I don't think this can be deduced from accounting identities in the way you argue here. Since (de)leveraging means a change in the ratio of *gross* debt to income, it's possible in principle for the private sector to deleverage regardless of whether the government budget is in deficit, balanced, or in surplus. Your conclusion that attempts to balance the budget will be counterproductive is right, but it depends on behavioral claims, not on balance sheets.

charley2u said...

What you are really saying, Peter, is that savings are excessive. Society is saving more than can be productively reinvested. This excessive saving is causing both the budget and trade deficits.

Don Levit said...

You folks seem to be saying that deficits don't matter.
It seems to me that government needs to set the standard for fiscal responsibility.
Ultimately, governments, although, infinite in nature, are finite.
Irresponsible and reckless spending leads to hyperinflation and/or revolution.
Many governmental reports have cited that our present deficits are unsustainable.
I gather you disagree with the CBO, GAO, Treasury, etc.
I have the links and excerpts if anyone is interested.
Don Levit

charley2u said...

Don,

Peter's argument, when properly understood, is that government cannot be responsible if the private sector is not responsible. If the private sector insists on saving more than can be productively reinvested, these saving will result in excessive government spending and excessive imports.

This implies that both trade and budget deficits are perfectly sustainable for a time -- as is proven by three decades of US trade and budget deficits.

But, it also implies that the these twin deficits have to become bigger over time as the accumulation of excessive savings is added to by the accumulation of interest on public debt. The compounded aggravation of excess profits drives the both budget and trade deficits into a parabolic blow off.

This, of course, is confirmed by the Minsky Financial Instability Hypothesis. As the new equity created in the economy is exceeded by ponzi debt accumulation (and, there is no greater source of ponzi debt than government deficits) the end stage apocalyptic financial implosion occurs.

Industrial capital collapses, followed by financial capital, and the entire economy disappears at once and together.

Phyllis said...

As we discuss among ourselves the development of fiscal deficits, there are also a lot of things that should be taken in consideration such as accounting crm software and distribution accounting software. As the new technology comes, it opens for a new face of accounting. I think with the use of such technology, less error will be committed.

Inquisitor said...

Going on spending binges = responsible guys, did u herd?