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OECD’s ‘Understanding Financial Accounts’ On The Importance Of Stock-Flow Coherent Models

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International organisations such as the UN, IMF, OECD etc., publish some good guides on national accounts and the flow of funds. I just noticed that the 2017 edition of OECD’s book ‘Understanding Financial Accounts’ has a section in appreciation of stock-flow coherent (SFC) models with a history starting with the work of Morris Copeland.

From page 407-409:

  1. Uses of financial accounts and balance sheets in economic research

Financial accounts were first modelled by Morris A. Copeland …

…

The fall of financial accounts and balance sheets and the work of Godley

In the 1960s and the 1970s financial accounts were at the centre of economic analysis. From the mid-1980s until the 2007-09 economic and financial crisis, interest in financial accounts and balance sheets more or less vanished, for a number of reasons: a growing focus on the micro-economic foundations of macroeconomics; the increasing role of monetary and credit aggregates for the conduct of monetary policy that implied a lower focus on the entire financial system; trust in the self-correcting market mechanism through price adjustments, while considering quantities – both flows and stocks – less important; the rational expectation critique of Keynesian models; a growing inclination among economists to separate monetary and real phenomena; and the problems of achieving full international harmonisation of statistics until the introduction of the 1993 System of National Accounts (SNA93).

In contrast, Wynne Godley never abandoned the idea that economic models should be founded on flows and stocks, and developed consistent models of the US economy and other countries. In his approach, modern economies have an institutional structure comprising (non-financial) enterprises, banks, governments and households. The evolution of economies through time is dependent on the way these agents take decisions and interact with one another (Godley and Lavoie [2007]) …

…

References

…

Godley, W. and M. Lavoie (2007), Monetary Economics: An Integrated Approach to Money, Credit, Income, Production and Wealth, Palgrave MacMillan, Basingstoke.

…

A New Way To Learn Economics?

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John Cassidy has a nice article titled A New Way To Learn Economics for The New Yorker on a new online introductory economics curriculum. produced by a lot of collaborators.

I went to the website which has the full book. Although there seems to be some progress, I have a strong reservation against it.

The chapter titled “Banks, money and the credit market” has a much better description on it than textbooks widely used, such as the ones by Paul Samuelson, Gregory Mankiw or Paul Krugman. On a cursory look, I didn’t find anything about the “money multiplier” model. Instead, the book says that central banks set short term interest rates and this has an effect on aggregate demand. If I missed something and if you find something orthodox, please let me know.

The chapter on fiscal policy looks like being written by fiscal hawks. There is a description of the government expenditure multiplier, which is not much different from other textbooks. There’s no mention of the more complicated nature of this process because of interactions between stocks and flows. For example, in stock-flow coherent (SFC) models, this one-step multiplier has a limited role.

Now, fiscal policy has strong effects and the book hardly does justice to any of this. It reads more like a defense of the establishment wisdom.

But it is in the area of international trade and globalization under the current rules of the game that the book is the most disappointing. The authors do tell students that it can produce “losers” but the problem of such an approach is that it doesn’t appreciate the fact that it leads to polarisation and divergences in fortunes of nations, instead of individuals. The assumption and conclusion (the same thing in most of economics!) is that if losers are compensated, fortunes of nations can converge.

This by Nicholas Kaldor, written in 1980, is change.

Not the new book, The Economy. 

As Morris Copeland emphasised, the root problem of economics is the total confusion of anyone and everyone on what money is. And his approach shows us that it’s not complicated. One just needs to study flow-of-funds or social accounting. There is hardly any emphasis of this in the book. Till then, students will remain confused and ignorant about the way the world works.

Morris Copeland’s Monetary Economics

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Morris Copeland was the discoverer (or inventor?) of the flow of funds approach. The U.S. Federal Reserve publishes the statistics every quarter but is largely ignored. Copeland was of the view that it is essential to get rid of myths in economics. He said:

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.

– in Social Accounting For Moneyflows, in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]

In an article titled, Some Illustrative Analytical Uses Of Flow-of-Funds Data, in the book, The Flow-of Funds Approach To Social Accounting, published in 1962, he has several interesting things to say about the myths prevalent even among most economists.

Page 196:

The FOF accounts help to dispel various misconceptions in regard to the role of money and of other forms of credit in the income and money circuit. Among these misconceptions are such ideas as that: (1) it is safe to assume that private nonbank cash balances are mostly consumer cash balances; (2) the banking sector is more than a mere financial intermediary, that by itself it can “create” a substantial amount of “money” that can be used to finance a substantial increase in aggregate demand; (3) a government deficit in a particular year or other period can be considered inflationary without stopping to consider whether it represents a fiscal change from the preceding period that tends to increase aggregate demand or whether it occurs at a time when the economy is operating at or near or far below full capacity; and (4) when the government seeks to raise a large amount of money through financial channels to finance a war, one can ignore the fact that an excess of nonfinancial uses over nonfinancial sources of funds for the government means an equal excess of nonfinancial sources over nonfinancial uses of funds for the rest of the economy and a consequent equal amount of money that the rest of the economy will necessarily advance to the government through financial channels.

Note: in (2) above, Copeland is talking of finance of government deficit via sale to banks as compared to sale to the general public and these two have different effects on the money stock. Same below.

Page 197:

It is not easy for us today to imagine what it must have been like to try to understand the workings of our economy in the absence of social accounting information. The workings of those aspects that involve financial transactions seem to have been particularly difficult to understand. Indeed, I think we can say that in the absence of financial transaction social accounting information various misunderstandings were permitted to develop. Let me mention three:

  1. One of these relates to the role of trade credit in the business cycle. This is a subject that probably received somewhat less attention than it deserved fifty-odd years ago, but it seems to have greatly intrigued H. J. Davenport, and he came up with this curious conclusion about the contraction of credit during a commercial crisis— “Side by side with the diminution of bank credit there is taking place an enforced and inevitable expansion of credit relations between producers and consumers, producers and middle-men, and between middle-men and consumers.”
  2. During World War I Secretary of the Treasury W. G. McAdoo, among others, was greatly concerned about the possibility that the huge wartime increase in the demand for funds would drive interest rates sharply up. As a matter of fact, interest rates did rise but by no means as sharply as McAdoo had anticipated. Railroad bond yields rose from 4.12 per cent in April 1917 to 4.42 per cent in November 1918. During World War II the yields on long-term United States bonds actually declined.
  3. There is a view still entertained by quite a number of economists that an increment in the currency and deposit liabilities of the banking and monetary system creates a net addition to the total sources of funds available to finance purchases of GNP and so, a net addition to aggregate demand.

Page 207:

There is still another type of misconception that I hesitated to mention in my opening remarks because it is of a rather subtle nature. I would like to comment on it briefly at this point. Let me indicate its nature by quoting from George Leland Bach’s Economics. An Introduction to Analysis and Policy:

When private spending on consumption and investment falls short of high production and employment levels, the government can increase total expenditures by spending more than it currently collects in taxes. At the extreme, it can finance this net addition by creating new money so as to assure a net addition to private spending. Or it can borrow existing funds from the public, hoping to draw on funds that would not otherwise be spent …

Conversely, when total private spending is too high, with resulting inflation, the government can withdraw funds from the income stream by taxing away more than it spends. At the extreme, it may simply hold or destroy this net surplus. Or it may use the surplus to pay off government debt, hoping that the bondholders will not rush out and spend the funds they receive.

This policy statement seems to imply three propositions that a good many economists have accepted, propositions the validity of which I want to question. The three propositions are:

  1. A federal government nonfinancial deficit makes for an increase (or surplus makes for a decrease) in aggregate demand.
  2. A federal government nonfinancial deficit financed by an increase (or a federal nonfinancial surplus resulting in a decrease) in currency outside banks plus demand deposits adjusted makes for a larger increase (or for a larger decrease) in aggregate demand than a deficit financed by the sale to the public of (or a surplus that is used to retire publicly held) interest-bearing federal obligations.
  3. In considering the effect of a federal deficit (or surplus) on aggregate demand we can afford to neglect the difference between a deficit brought about by an increase in government expenditures and one brought about by a decrease in government receipts (or between a surplus brought about by a decrease in government expenditures and one brought about by an increase in government receipts).

So you see Morris Copeland was the clearest monetary economist at his time.

More Liquidity?

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The holy grail of macroeconomics is to integrate the real and monetary sides of economics. One needs a good balance between the two: one shouldn’t be too much on one side.

In a recent article, Monetary Policy in a Post-Crisis World: Beyond the Taylor Rule for INET, Perry Mehrling correctly identifies the flow of funds approach and Morris Copeland. He says:

Maybe time to look back at Copeland, reconstructing his money flow approach for the modern world? That’s where I’m placing my bet.

Although, his article seems right in lots of parts, it seems to identity purely monetary factors in identifying solutions to the problems of this world. Mehrling says:

From a money flow perspective, there are logically only three sources of funds for agents who find themselves in deficit on the goods and services account. They can dishoard (spend money balances), borrow, or sell some asset. In the argument sketched above, I have suggested that post-war institutional developments have followed a course emphasizing first dishoarding, then borrowing, and then selling, i.e. monetary liquidity, then funding liquidity, then market liquidity. All three are now in play, but the new one is market liquidity. That’s the one that broke in the global financial crisis, and that’s the one we need to fix in order to get the system working again.

While the first part of the argument is correct, I am not sure how fixing “liquidity” is needed to get the system working again. In my reading of Mehrling, he comes across as someone who stresses too much on the monetary side of things and this is another example of it. What do we need to do to fix liquidity exactly? More central bank asset purchases?

The solution to the problems of the world can come about if there is a coordinated fiscal expansion combined with balance of payments targets, to say the least. I am not sure how liquidity fits into this. After the financial crisis which started in 2007, this may have been the case: what was needed was providing liquidity to the financial system. In the U.S., Euro Area and the rest of the world, central banks have helped to provide liquidity to ease financial conditions. But right now—at least in the advanced world—interest rates are low and just lowering them further won’t help increase production. And the same with “liquidity”.

Hence I am unclear about Merhling’s solutions. It’s monetary hippyness.

Augusto Graziani And The Theory Of The Monetary Circuit

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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:

  1. since money cannot be a commodity, it can only be a token money;
  2. 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
  3. the use of money must be so regulated as to give no privilege of seignoriage to any agent

The phrase “money circuit” was actually first used by Morris Copeland – the discover of flow of funds in his book A Study of Moneyflows in the United States

A Study Of Moneyflows In The United States - Morris Copeland

(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 Main Money Circuit

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.

Flow Of Funds And Keynesian Macroeconomics

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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.

Lance Taylor (in A Foxy Hedgehog: Wynne Godley And Macroeconomic Modelling) had a nice way to describe Wynne Godley:

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.