In the previous post Paradox of Profits?, I mentioned how I view the paradox of profits as the confusion between production firms’ operating surplus (as defined in the SNA such as the 2008 SNA or earlier versions) and surplus on the financial account of the system of national accounts.
The paradox is highlighted by saying that at the beginning of the monetary ‘circuit’, firms inject an amount of money M and can only recover a maximum of M.
So let us think of an economy in which there is no money or banks initially and suddenly someone producers find a way to make cakes and the banking system opens simultaneously. This is admittedly an oversimplification but nonetheless useful.
Initially firms decide to make 100 cakes and price it $1 per cake. They hire labour and pay $60 as wages. For this, they borrow $60 from banks. Households is a mix of both labour and entrepreneurs.
Now households consume cakes worth $55.
Before proceeding, it is important to note that inventories will be valued at current costs. So even though firms have initially paid households $60 and recovered $55, they have still made a profit of $22. This is because 55 cakes were sold and cost $55 × 0.6 = $33.
So:
Profits = $22
I am neglecting the interest costs on loans but this is minor in comparison to the income generated by production so as to matter crucially.
That profits are $22 can be seen from the profits formula of the previous post:
Ff= C + ΔIN − WB −rlL
Having sold 55 units of cakes, firms have 45 units left in their inventory. But since inventories are valued at current costs, the multiplicative factor here is 0.6, so ΔIN = $27. So,
$22 ≈ $55 + $27 − $60 − ε
After having paid their employees, firms started out with no bank balance but soon have $55 in bank deposits. They then pay back $33 of loans, leaving them with $22 of bank deposits. At this stage household hold $5 of deposits: they received $60 and consumed $55.
So total bank deposits is $27. This is equal to the value of inventories. This is also equal to the initial loan of $60 minus the repayment of $33. So firms’ inventories are backing the loan amount.
Firms are now in a situation to distribute dividends. It is clear that they don’t have trouble paying interest to banks. (In this example but not always the case).
Another production cycle starts. Dividends will buy more cakes and make more profits for firms. Fixed capital formation can also be added in the story without any problem.
Post-Keynesians unnecessarily worry a lot about the paradox of profits. This post is on my thoughts on the paradox. In my view, there is no paradox at all. It is simply the case of not looking at all the parts of the system of national accounts/flow of funds.
Although Post-Keynesians use Kalecki’s profit equation in which the government deficit adds to profits, the statement of the paradox is for a pure credit economy. But in any case, there is none.
Let us assume that at the beginning of the ‘circuit’, production firms need an initial loan to pay the wage bill WB in advance. Households receive the wages and consume C and allocate their saving in financial assets (households don’t buy houses). The two financial assets are money and equities so:
WB − C = ΔM + ΔE
Production firms’ profits Ff is:
Ff= C + I –WB − rlL
Here, I is the gross fixed capital formation of production firms or investment, Lis the outstanding loan of firms from the banking system and rl is the rate of interest on these loans.
Now assume all investment is financed by issuing equities (i.e., ΔE = I). With a small amount of algebra:
Ff= − ΔM − rlL
So this is the “paradox”.
Now there are several things wrong with this. The simplest is that profits are actually paid to households and there’s a term for change in inventories missing in the right hand side. If profits are not paid, they are retained and investment is then financed by both issuing equities and retained earnings. So ΔE ≠ I.
There is an alternative way of stating the “paradox” which says: if firms inject money at the start of the production process, how do they recover more money at the end of the process? This seems to confuse what is known as operating surplus in the system of national accounts (such as in the 2008 SNA or earlier versions) with the surplus on the financial account.
So let us redo this. Here is the transactions flow matrix for the economy (assuming away banks’ undistributed profits):
First assume all profits are distributed (i.e., FUf= 0 and FDf= Ff).
So:
WB + rmM + Ff + Fb − C = ΔM + ΔE
Ff= C + I+ ΔIN − WB −rlL
Then assuming ΔE = I and a bit of algebra,
ΔIN = ΔM
In other words, there is no paradox at all. Ff has simply dropped out. All this means is that if households wish to hold more of their assets in deposits instead of equities, firms will be left with more inventories.
Of course, you might ask, “how have you assumed that profits are distributed when there is a paradox?”. The answer is that I haven’t done anything self-inconsistent. More consistency checks would be via constructing a dynamic model and check if it solves but assuming it does, the above static analysis is good enough. There is no paradox to begin with.
So in the above, although there was no paradox of profits, there was still a pressure on output and hence profits—if households wished to hold more of their wealth in deposits and reduce their preference to buy equities, firms will be left with more inventories and will have to reduce investment. This reduction in investment happens because of two reasons – a fall in equity prices and a fall in output leading to a fall in firms’ expectations of sales. Of course, this can be seen via writing dynamic models, and one shouldn’t rely on identities. But bank loans will be useful here and so higher preference for ‘money’ needn’t necessarily lead to a fall in output. If households wish to hold more money instead of other assets, firms may switch to bank loans and this process creates deposits.
But let’s for the moment still assume that investment is not financed via bank loans but via issuance of equities and retained earning. In this case,
WB + rmM + FDf + Fb− C = ΔM + ΔE
Ff= C + I+ ΔIN − WB −rlL
but also,
ΔE = I −FUf
and with some algebra,
ΔIN = ΔM
Again, no paradox. At all!
Now in the final case, assume that production firms use bank loans to finance investment in addition to financing it via equities. The equations are:
WB + rmM + FDf + Fb− C = ΔM + ΔE
Ff= C + I+ ΔIN − WB −rlL
ΔE = I −ζΔL − FUf
where 0 < ζ < 1is that part of ΔL used for investment expenditure. In this case,
ΔIN + ζΔL = ΔM
So if households wish to hold more deposits, firms will switch to bank loans without any drop in inventories, output or expectations, with the qualification of course that bank credit is available.
Some have suggested (via Kalecki’s profit equation) that the paradox can be resolved only because of government deficits. This is not needed at all because there is no paradox. So around the turn of the millennium, the US government had its budget balance in surplus and the nation’s current account balance of international payments was in deficit over many quarters. Yet US firms made profits and were able to distribute them.
See the data below: the first one highlights in yellow the current account balance (line 42) and the budget balance (line 49) and also the fact that the financial balances of other sectors (lines 47/48) were low negative compared to profits numbers in question (source Z.1):
(click to expand and click again)
the second one shows the net undistributed profits (undistributed profits less depreciation) (line 24), distributed profits (line 17) and depreciation (line 2) from which profits can be calculated, implying budget deficit and/or positive current account balance of payments is not needed to resolve the paradox of profits (because there is none to begin with).
(click to expand and click again)
Of course, fiscal policy was tight around the time (although the budget balance is a poor measure of this) and this led to a fall in output soon, but that issue shouldn’t be confused with the paradox of profits.
Conclusion
One does not simply confuse operating surplus and surplus on the financial account of the system of national accounts. There is no resolution of the paradox of profits because there is none to begin with.
In an article, The Profits’ Conundrum, Marshall Auerback uses Kalecki’s profit equation analysis (which is just a simple rearrangement of terms of the sectoral balances equation) to claim that corporate profits have been overstated in the United States.
Now consider the US deficit and explain how on earth we can still have profits as a record percentage of GDP. There is no way that we can have had a fall in the fiscal deficit to GDP ratio from ten percent to three percent (we are in the middle of fiscal yr 2014 remember) without some kind of significant decline in the profit share of GDP.
But NIPA says there is no such fall. All the people who use this sectoral balance analysis keep saying that the profit decline is coming which of course is nonsense. If it is to be it is here and now; we are dealing with an identity. This cannot be ignored, but it is by virtually every single Wall Street analyst.
This does pose the real possibility that we have a massive overstatement of profits.
While it is possible this is the case, I don’t see how this follows from the usage of Kalecki’s profit equation or the sectoral balances equation without any dynamical analysis thrown in.
While the government deficit has fallen, the household sector saving has fallen too and there has been a big rise in firms’ investment expenditure in recent times. So let us look at the data but before that derive the profit equation.
From sectoral balances we know that net lending (in the language of the U.S. Z.1 Flow of Funds report) of all sectors should add to zero.
Firms’ undistributed profits FU is the sector’s saving. So firms’ net lending is:
FU − If
where If is firms’ investment expenditure.
This should be the sum of net borrowing of all the other sectors – households, government and the rest of the world: Household net borrowing + Government net borrowing + Rest of the World net borrowing
Or, in the more usual language,
FU = If + Government deficit − Household Net Lending + CAB
where CAB is the current account balance of international payments.
Each term is a flow and has a time subscript such as −1 or 0 or 1 but I will avoid it. Now let’s compare 2013 and 2009.
We need the numbers highlighted in yellow to check what’s going on from the Fed’s Z.1 report:
(click to expand and see clearly)
Government deficit is the negative of net lending and between 2009 and 2013 this has reduced by $776.5bn. However, private investment has increased by $704.4bn and household net lending fell by $216.2bn. The change in current account balance over the period is small (line 42). So the rise in private investment and the fall in household net lending (and change in the current account balance) more than offsets the fall in the government deficit.
Also remember, reported profits is the sum of undistributed profits and distributed income of corporations. Table S.1.a has data only till 2012 but it shouldn’t be difficult to get a feel for the numbers.
(click to expand)
So the change in distributed income also has been high.
And add complications of taxes to the numbers (pre-tax vs. post-tax), the difference in profits in the last few years is even higher.
Why this exercise if you can get the profits numbers directly? To show that things do add up except for small discrepancies which are always present.
So pure rearrangements of terms of sectoral balance identity doesn’t prove the overstatement of profits as claimed by Auerback. Of course it still leaves the possibility of dynamics which lead to a contraction of aggregate demand and hence profits but Auerback’s claim is that this is purely due to accounting identities and this claim is erroneous.
Paul Krugman writes today on his blog on James Tobin’s work:
Let me offer an example of how this ended up impoverishing macroeconomic analysis: the strange disappearance of James Tobin. In the 1960s Tobin developed and elaborated a sophisticated view(pdf) [original link corrected] of financial markets that offered insights into things like the role of intermediaries, the effects of endogenous inside money, and more. I’ve found myself using Tobinesque analysis a lot since the financial crisis hit, because it offers a sophisticated way to think about the role of finance in economic fluctuations.
But Tobin, as far as I can tell, disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations. And for good reason, by the way: it’s pretty hard to derive portfolio preferences rigorously in that sense. But even so, Tobin-type models conveyed important insights — which were effectively lost.
Compare that to his article in response to another article on Wynne Godley which appeared in the New York Times – completely dismissing Godley’s work.
Three things: first Krugman claimed earlier that we needn’t look at old ideas:
But it is kind of funny to see a revival of old-fashioned macro hailed, at least by some, as the key to a reconstruction of the field
directly contradicting what he says today.
Second – obviously not having read Wynne Godley, he missed the point that Wynne’s analysis has significant improvement of James Tobin’s work.
Third, of course, Krugman’s understanding of monetary economics in general is poor, as can be seen when he gets into debates with heteredox economists and makes the most elementary errors. So it is strange he is lecturing others on this and fails once again to acknowledge heteredox economists.
As Godley points out on a number of occasions, he himself owed his formalization of portfolio choice and of the fully consistent transactions-flow matrices to James Tobin. Godley was most particularly influenced and stimulated by his reading of the paper by Backus et al. (1980), as he writes in Godley (1996, p. 5) and as he told me verbally several times. The discovery of the Backus et al. paper, with its large flow-of-funds matrix, was a revelation to Godley and allowed him to move forward. But as pointed out in Godley and Lavoie (2007, p. 493), despite their important similarities, there is a crucial difference in the works of Tobin and Godley devoted to the integration of the real and monetary sides. In Tobin, the focus is on one-period models, or on the adjustments from the initial towards the desired portfolio composition, for a given income level. As Randall Wray (1992, p. 84) points out, in Tobin’s approach ‘flow variables are exogenously determined, so that the models focus solely on portfolio decisions’. By contrast, in Godley and Cripps and in further works, Godley is preoccupied in describing a fully explicit traverse that has all the main stock and flow variables as endogenous variables. As he himself says, ‘the present paper claims to have made … a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition’ (Godley, 1997, p. 48). Tobin never quite succeeds in doing so, thus not truly introducing (historical) time in his analysis, in contrast to the objective of the Godley and Cripps book, as already mentioned earlier. Indeed, when he heard that Tobin had produced a new book (Tobin and Golub, 1998), Godley was quite anxious for a while as he feared that Tobin would have improved upon his approach, but these fears were alleviated when he read the book and realized that there was no traverse analysis there either.
One of Augusto Graziani’s best papers was The Theory Of The Monetary Circuit, Économies et Sociétés, 24 (6) (June), pp. 7–36. The paper is available at the UMKC course site here.
One description of money is looking at payments as triangular transactions. Graziani says that for money to exist, three conditions have to be met:
since money cannot be a commodity, it can only be a token money;
the use of money must give rise to an immediate and final payment and not a simple commitment to make a payment in the future; and
the use of money must be so regulated as to give no privilege of seignoriage to any agent
(image credit: Xerxes Books, from whom I obtained the copy)
In his book, he actually draws a diagram of a circuit – on the inside covers and on page 245:
The circuitists’ motivation for using the phrase “circuit” was a circular flow starting with credit but Copeland was in total opposition of the usage of the phrase “hyrdraulic/s” and the misleading notions that this latter phrase conveys about money. Hence he proposed the phrase money circuit. Check his book on why this is so for details. I will at some point write about Copeland’s arguments.
The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.
I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.
– Morris Copeland, inventor of the Flow Of Funds Accounts of the United States, in Social Accounting For Moneyflows, in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]
So the news is that Eugene Fama shares this year’s Economics Nobel with Robert Shiller and Lars Hansen.
Instead of going into Fama’s main work, I thought I will point out Fama’s quackery on national accounts and flow of funds – which economists are supposed to know but is rarely the case.
In an article from 2009, Bailouts and Stimulus Plans, Fama again puts down fiscal policy in a rather comical way. Fama starts with the sectoral balances identity:
There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),
PI = PS + CS + GS (1)
In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole.
There is so much muddle to start the analysis. The above is incorrect to start with because “private savings” automatically includes corporate savings. Perhaps this error is a typo but going through his analysis doesn’t support the hypothesis that he even knows the equation right. Incidentally government saving is not government surplus in standard terminology. He seems to think these are equal.
Another error in the above equation is that the left hand side should include government investment as well.
Anyway …
Fama continues:
Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment.
There are so many incorrect things with this. First, there is a reverse causality in the saving/investment identity. Investment creates saving. Second, Fama seems to think that government deficit reduces private saving but the identity itself is suggestive of another interpretation. If I write it as (in the context of a closed economy):
S = I + G – T
where S is the private saving, I is private investment and G and T are government expenditure and tax receipts, respectively. It then becomes clear that government deficit – instead of reducing private saving, creates private saving.
Even more worrisome is his statement “the money must be somewhere” – as if the stock of money is an exogenously fixed quantity. A fiscal expansion (meaning higher governmen expenditure and/or decrease of tax rate) can increase the stock of money in two ways. First is direct – if there is a government deficit with the fiscal expansion and banks purchase a fraction of government debt, the stock of money increases. The second is via a rise in domestic demand which will lead to higher borrowing by the private sector from banks thereby increasing the money stock. Of course there are other effects too via the non-bank private sector asset allocation decisions etc.
Not going in much details for now as I write a lot about it and in any case there is Post-Keynesian monetary economics on this. My aim was to show how an economics Nobel Prize winner is clueless about basic economics! The prize is to be awarded to people who have made great contributions to society but we have an example of someone – Fama – who pushes fiscal contraction with clueless analysis of national accounts.
The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.
I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.
– Morris Copeland, inventor of the Flow Of Funds Accounts of the United States, in Social Accounting For Moneyflows, in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]
Alas monetary myths continue to exist. The above referred handbook was published in 1996 starting with Copeland’s 1949 article and the editor of the book John Dawson himself had an explanation of why myths continue to exists despite some brilliant work such as that of Copeland. In page xx, Dawson says:
the acceptance of… flow-of-funds accounting by academic economists has been an uphill battle because its implications run counter to a number of doctrines deeply embedded in the minds of economists.
In a recent blog post blog post Paul Krugman is dismissive of Wynne Godley’s approach to macro modeling and instead appeals to some Friedmanism. Perhaps Dawson’s quote explains why this is so. However it may not be the only reason, given how Krugman has shown some tendency to be heteredox in recent times but his latest post ends all doubts and we can say he is highly orthodox. And that other reason is professional turf-defence.
Also, Krugman was writing in response to an NYT article Embracing Wynne Godley, an Economist Who Modeled the Crisis highlighting the importance of Wynne Godley’s work. That article was by a journalist who was perhaps unaware of the history of Post-Keynesianism. But Krugman himself dodged Godley’s work as “old-fashioned” – as if there is something fundamentally wrong about old-fashion and as if economics should proceed by one fashion after another.
A bigger disappointment is that Krugman failed to acknowledge that there has existed a heteredox approach since Keynes’ time. As Wynne Godley and Marc Lavoie begin Chapter 1 in their book Monetary Economics:
During the 60-odd years since the death of Keynes there have existed two, fundamentally different, paradigms for macroeconomic research, each with its own fundamentally different interpretation of Keynes’ work…
And Krugman’s usage of the phrase old-fashioned hides the fact that this is so.
Back to Copeland. In the same article Social Accounting For Moneyflows, Copeland is clear about his intentions and the direction he is looking:
When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent? What part do cash balances, other liquid holdings, and debts play in the cyclical expansion of moneyflow?
Copeland’s analysis was not simply theoretical. It led to the creation of the flow of funds accounts of the United States and the U.S. Federal Reserve publishes this wonderful data book every quarter. Although, Copeland was simply looking and proceeding in the right direction, it can be said that a more solid theoretical framework to build upon Copeland’s brilliant work was still waiting at the time.
Of course, in the world of academics, there already existed two main schools of thought very hostile to one another. Keynes’ original work contained a lot of errors and for most economists, a bastardised version of Keynes’ work became the popular understanding. It was however the Cambridge Keynesians who founded the school Post-Keynesian Economics who believed they were true to the spirit of Keynes and this led to a parallel body of extremely high-quality intellectual work which continues to this day – and still dismissed by economists such as Paul Krugman. Of course, in this story, it should be mentioned that there was a Monetarist counter-revolution mainly led by Milton Friedman who was trying to bring back the old quantity theory of money doctrines and was “successful” in permanently distorting the minds of generations of economists to date. Greg Mankiw is quite straight on this and according to him, “New Keynesian” in the “New Keynesian Economics” is a misnomer and it should actually be New Monetarism.
Interestingly, one of Morris Copeland’s ideas was to show how the quantity theory of money is wrong. According to Dawson (in the same book referred above):
[Copeland] himself was at pains to show the incompatibility of the quantity theory of money with flow-of-funds accounting.
Meanwhile, in the 1960s and to the end of his life, James Tobin tried to connect Keynesian economics with the flow of funds accounts. While a lot of his work is the work of a supreme genius, he couldn’t manage. Perhaps it was because of his neoclassical background which may have come in the way. According to his own admission, he couldn’t connect the dots:
Monetary and financial data, so far as they are based on institutional balance sheets and prices in organized markets, are abundant. Modern machines have made it possible to improve, refine and expand the compilation of these data, and also to seek empirical regularities in financial behavior in the magnitude of individual observations. On the aggregate level, the Federal Reserve Board has developed a financial accounting framework, the “flow of funds,” for systematic and consistent organization of the data, classified both by sector of the economy (households, nonfinancial business, governments, financial institutions and so on) and by type of asset or debt (currency, deposits, bonds, mortgages, and so on). Although many people hope that this organization of data will prove to be as powerful an aid to economic understanding as the national income accounts, this hope has not yet been fulfilled. Perhaps the deficiency is conceptual and theoretical; as some have said, the Keynes of “flow of funds” has yet to appear.
– James Tobin in Introduction (pp xii-xiii) in Essays In Economics, Volume 1: Macroeconomics, 1987.
After having written a fantastic book Macroeconomics with Francis Cripps in 1983 and which has connections with the flow of funds, Wynne Godley thought he had to try hard to unify (post-)Keynesianism and the flow of funds approach which James Tobin was trying. Wynne Godley had the advantage of being close to Nicholas Kaldor who very well understood the importance of Keynes and was himself an economist of Keynes’ rank. Godley also had the advantage of having worked for the U.K. government and doing analysis using national accounts data and advising policy makers. Wynne Godley is the Keynes of “flow of funds” which Tobin was talking about!
A recent blog post by Matias Vernengo on Wynne Godley is extremely well-written.
In his later years (and his best), Wynne Godley worked with Marc Lavoie, one of the faces of Post-Keynesianism and one who had previously made highly original contributions to Post-Keynesianism and this led to the book Monetary Economics. Marc’s earlier work was also highly insightful and he highlighted – in the spirit of Morris Copeland – how poorly money is understood by economists in general and it was natural he and Wynne would meet and work together.
One of the things about Wynne Godley’s approach is how to combine abtract theoretical work and direct practical economic issues. This actually led him to warn of serious deflationary consequences of economic policy in fashion before the crisis.
Wynne has long been aware of the stupidity of models when you ask them to say something useful about practical policy problems. He has spent a fruitful career trying to make models more sensible and using them to support his policy analysis even when they are obtuse. As we have seen, this quest has led him to many foxy innovations.
But there is an enduring hedgehog aspect as well. Wynne has focused his energy on combining the models with his acute policy insight based on deep social concern to build up a large and internally coherent body of work. He has disciples and is widely influential. One might wish that he had pursued some lines of analysis more aggressively and perhaps put a bit less effort into others. And maybe not have written down so damn many equations. But these are quibbles. His work is inspiring, and will guide policy-oriented macroeconomic modellers for decades to come.
In this post, I have tried to provide the reader with references to go and verify how flow of funds1 cannot be separated from Keynesian Economics – Keynesian approach in the original spirit of Keynes, not some bastartized versions. It is as if they were made for each other2. While it is true that like other sciences, Macroeconomics is always work in progress, it doesn’t mean one should bring fashions such as inter-temporal utility maximising agents (read: future knowing economic actors) in the approach which Paul Krugman prefers.
1My usage of “flow of funds” is more generic than the usage which distinguishes income accounts and flow of funds accounts and hence my usage is for both.
2The ties between the flow of funds approach and Post-Keynesiansism is argued in Godley and Lavoie’s book Monetary Economics from which I have borrowed a lot.
Correction
I am mistaken about Jonathan Schlefer’s background. He is in academics.
The United States Statistical Release Z.1 now has a new look and more data. It now includes the Integrated Macroeconomic Accounts.
According to the Integrated Macroeconomic Accounts site (which was available separately but online only):
These tables present a sequence of accounts that relate production, income and spending, capital formation, financial transactions, and asset revaluations to changes in net worth between balance sheets for the major sectors of the U.S. economy. They are part of an interagency effort to further harmonize the BEA National Income and Product Accounts (NIPAs) and the Federal Reserve Board Financial Accounts of the United States (FAUS).
The structure of these tables is based on the internationally accepted set of guidelines for the compilation of national accounts that are offered in the System of National Accounts 2008 (SNA). The estimates that are currently displayed are based on the data that were available in the NIPAs and FAUS on September 21, 2017. See “Financial Accounts of the United States (Z.1)” for more information.
So now you can look at things such as households’ capital gains easily from the Z.1. Such as from the table below:
I came across this article (via a Tweet from Stephen Kinsella): Accounting As The Master Metaphor Of Economics by Arjo Klamer and Donald McCloskey which discusses how the framework of national accounts has been pushed to the background in economic analysis over the years.
It is a nice read – although boring in a few places. I found this reference to John Hicks’ 1942 book The Social Framework: An Introduction To Economics in the above article and managed to get a copy – although a used one but with almost no usage. As described in the Klamer-McCloskey’s article, Hicks’ textbook really goes into details of national accounts and he seems to have had a great intuition of how it all works.
Hicks’s book gives a nice introduction to how important national accounts are in understanding and describing the production process and economic cycles.
Here is a scan of two pages on the balance of payments – the topic I like the most.
(click to enlarge)
Hicks understood how weak balance of payments can cause troubles. Of course, it took the genius of Nicholas Kaldor to realize the supreme importance of balance of payments in the determination of national income and expenditure. Leaving that aside, the text has nice ideas and discussions on how stocks and flows feed into one another.
John Hicks is famous for an entirely different reason – the IS/LM model. Later he accepted it was a huge mistake, but put it mildly: “… as time as gone on, I have myself become dissatisfied with it”. But economists still keep using it and keep erring.
Also, Hicks was to soon abandon/forget his own social accounting approach as per Klamer-McCloskey’s article. Perhaps, not really.
In an extremely important paper, Wynne Godley said:
To come down to it, the present paper claims to have made, so far as I know for the first time, a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition. My belief is that nothing the paper contains would have been surprising or new to, say, Kaldor, Hicks, Joan Robinson or Kahn.
John Hicks also had another nice book called A Market Theory Of Money written in 1989. Here is a great insight (also the view of Kaldor) from Page 11, Chapter 1 named “Supply And Demand?” on how to create a dynamic Keynesian theory of determination of national income and expenditure:
… The traditional view that market price is, at least in some way, determined by an equation of demand and supply had now to be given up. If demand and supply are interpreted, as had formerly seemed to be sufficient, as flow demands and supplies coming from outsiders, it is no longer true that there is any tendency over any particular period, for them to be equalized: a difference between them, if it were not too large, could be matched by a change in stocks. It is of course true that if no distinction is made between demand from stockholders and demand from outside the market, demand and supply in that inclusive sense must be equal. But that equation is vacuous. It cannot be used to determine price, in Walras’ or Marshall’s manner. For what matters to the stockholder is the stock that he is holding: the increment in that stock, during a period is the difference between what is held at the end and what was held at the beginning, and the beginning stock is carried over from the past. So the demand-supply equation can only be used in a recursive manner, to determine a sequence (It is a difference or a differential equation); it cannot be used directly to determine price, as Walras and Marshall had used it.
which is the now famous sectoral balances identity! Incidentally, it also includes Kalecki’s profit equation. In the above “Foreign Investment” shouldn’t be confused with Foreign Direct Investment flows in the financial account of the balance of payments. The authors define it as:
… equal to income generated by receipts from abroad less current expenditure abroad.
So can we call the profit equation SMK equation? 🙂
James Meade and Richard Stone were pioneers of national accounts. Incidentally, James Meade wrote a famous textbook on balance of payments.
Of course the way this is presented doesn’t make the connection between the financial account and current accounts. The sectoral balances was usually written by Wynne Godley as:
NAFA = PSBR + BP
where NAFA is the net accumulation of financial assets of the private sector, PSBR is the net public sector borrowing requirement, and BP is the current account balance of international payments. More on this connection below.
How it is to be derived in a stock-flow consistent framwork of Godley/Lavoie? If you click on this search Transactions Flow Matrix, you will find some blog posts on the background. First, we construct a flow matrix like this:
The last line is essentially Kalecki’s profit equation.
The above construction however raises an important question. Godley and Lavoie’s textbook (Chapter 2) quotes a famous 1949 article of Morris Copeland on this:
When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?
Copeland’s work was highly successful and established the flow of funds accounts of the United States in 1952.
Here is a republished version of the article (via Google Books):
click to preview on Google Books’ site
Incidentally, Copeland was motivated to prove the quantity theory of money wrong when he did this work! Also Godley/Lavoie point out that John Dawson (the editor of the above book) says:
the acceptance of…flow-of-funds accounting by academic economists has been an uphill battle because its implications run counter to a number of doctrines deeply embedded in the minds of economists.
in an article from the chapter The Conceptual Relation Of Flow-Of-Funds Accounts To The SNA of the same book.
Over time, the system of national accounts (with its first version in 1947) has used some of the concepts of flow of funds accounting and now the framework is much more wider than usual textbook guides of national accounts. The flow of funds still retains importance because it has information which the system of national accounts such as (2008 SNA) doesn’t handle.
How does one look at this in a stock-flow coherent framework? Simple, we need a full transactions flow matrix – which not only includes income/expenditure flows but also financial flows. The following is how it looks like for a simple model:
Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another.
In one of my recent posts, Saving Net Of Investment, I went into gross saving versus saving net of consumption of fixed capital. I showed how depreciation – or more appropriately, consumption of fixed capital – is treated in the flow of funds accounts.
Since the transactions flow matrix is a powerful tool for visualizing flow of funds, the question is where depreciation makes an appearance. The following table created by me using shows how for a simple economy.
FIGURE 1. Transactions Flow Matrix (click to enlarge)
Here “Firms” is a shorthand for all production firms as a sector and I took the consumption of fixed capital of firms only for illustration purposes. (Else I would have needed to break the households’ accounts into current and capital accounts – eating up space).
Investment here is gross investment and consumption of fixed capital makes its appearance in the line 3. It is a negative item in the current account and a positive item in the capital account. So it more of a book-keeping device but an important one because depreciation is not unimportant. The definition of profits is that of Wynne Godley and is slightly different from National Accounts. Also, while undistributed profits is a source of funds, CFC is also!
So undistributed profits (FU) and consumption of fixed capital (CFC) are both sources of funds. (Positive signs denote sources of funds and negative – uses of funds). This can be confusing because depreciation is a negative for net worth. The reason is that, as I have mentioned before, revaluations need to be done before end of period stocks are calculated. And it is where consumption of fixed capital will make a reappearance – subtracting from net worth due to a reduction in the value of nonfinancial assets.
It is important to keep in mind that equities are also sources of funds as the last line (above Σ) shows. So net saving (undistributed profits for firms) and consumption of fixed capital add to changes in net worth. (Note: Net is net of consumption of fixed capital here and not net of investment!).
This can be seen from the UK Blue Book 2011.
FIGURE 2. UK Blue Book 2011 Accumulation Accounts (click to enlarge)
A Digression
What is the origin of the confusing phrase “net saving” – saving net of investment? I believe it came from Nicholas Kaldor himself who originated the sectoral balances approach. Here’s from The Scourge Of Monetarism, 1982, pp 48-50:
The PSBR in any year can be defined as the public sector’s net de-cumulation of financial assets (net dissaving) which by accounting identity must be equal to the net acquisition of financial assets (net saving) of the private sector, home and overseas; which in turn can be broken down to the net acquisition of financial assets of the personal sector, of the company sector, and the overseas sector (the latter is the negative of the balance of payments on current account).
