Accounting or Economics?

Poor old Paul Krugman is getting a ton of criticism for pointing out that economics is littered with accounting identities. His problem stems from the observation that if we want heavily indebted households to reduce debt by saving more, then someone else is going to have to balance this effect out by spending more. More specifically: an increase in savings means that some households or businesses are spending less than their incomes. Since someone’s spending is someone else’s income, total income and total spending have to add up to the same number. They cannot be out of balance. If there is a gap between the two because some people are now saving more, the implication is that something else has to change.

There are two ways to get the bakance back.

We can maintain the total size of the economy – the total pie so to speak – by having some less indebted people shift from savings to debt accumulation by spending more than their incomes. In which case incomes and spending come back into balance, and the pie stays the same.

Or we can shrink the total pie by having incomes drop back to the reduced level of spending.

This latter option implies a smaller economy for all, and a period of lost wealth. Such a period is a recession or a depression depending on its length and severity.

Either way, because the total of spending and incomes must be equal, by definition, whenever there is a shift by a large number of households or businesses the clear implication that there must be, somewhere, an equivalent and offsetting shift. Else the entire economy is out of balance and thus forced to shrink.

There is no more to it than this.

There is no normative content to this balancing act. It is simply a function of being neat and tidy with the accounting.

Yet poor old Krugman has been lambasted for suggesting that some people should be forced to live beyond their means just so that others, who have been spendthrift in the past, can get their acts together. This, in the view of his critics, makes him an advocate of immoral of unethical behavior.

Of course he isn’t. What he is simply pointing out that economies are difficult things to rebalance. Aggregate behavior is very different from individual behavior. Or rather, the aggregation of individual behaviors do not always add up to something we all want. And it is the effects on the aggregates that count when we discuss social welfare, unemployment, productivity and all the other statistical manifestations of ordinary economic activity.

Krugman is saying that we need to encourage those who have no stress in their balance sheets, those who can afford to take on debt in order to spend, to do so while those others get their balance sheets back under control. If we persist in all increasing our savings simultaneously we will have, by implication, to shrink incomes down to accommodate that lower level of spending.

We tend to forget that economics and accounting are so closely related. Stuff has to balance. Not as a moral imperative, but as a consequence of their identities. Just as assets and liabilities have to balance on a company balance sheet, so spending and incomes have to balance in a national economy. As do savings and investments.

This is why a prolonged period of “deleveraging” presents a very difficult policy conundrum. Not just debt is being reduced. Something else is as well.

Just to put this more in context: during those years when the Federal deficit was in surplus – remember those days? – the national debt was shrinking and causing some luminaries like Alan Greenspan to worry about what investors would do as the pool of US Treasury bonds shrank. His worry was that investors need a steady supply of high quality debt in order to balance the risk profiles within their portfolios. By squeezing down the national debt we reduce that pool and force investors to adopt much higher risk profiles. That implies more volatility. That, in turn, implies a less reliable income stream for retirees and others who rely on investments as a source of income.

Those accounting identities, whether they be spending equalling incomes; or assets equalling liabilities represent a huge constraint on the speed and ease of adjustment in an economy. It is not entirely clear that we want to reduce our debt levels too quickly, if at all. Nor is it clear how fast we should downsize our private sector debt.

It was Keynes who identified the need for economists to consider aggregate phenomena, as a result he invented what we now call “macroeconomics”. Prior to that most economic theorists had contented themselves with looking at the relationship between supply and demand at the level of an individual or a single firm. That lower level analysis is what we now call “microeconomics”.

Of course I left out another obvious way to keep everything in balance as the private sector goes through its rebalancing act. We can have the government increase its debt levels. As the private sector disgorges debt, investors are faced with a shortage of assets. They have cash they need to invest. The only place still open to creating debt to meet that demand is the government. Deficit spending can be viewed in this light. It allows the private sector to get its act together without the entire economy having to shrink much.

Oh. Then there’s the other problem: erroneous asset valuations. Since asset values are supposed to be linked with the cash flows they produce. If the cash flow shrinks – say because someone cannot make their mortgage payment – so does the asset value. In which case the accounting is all out of whack and we need to force it back into balance by way of righting down the asset value to match the reduced cash flow.

This curse of having to get things to balance is why economies are hard to get back on track. Even more so when the asset base of the economy has taken a huge hit as it invariably does at the end of a bubble.

So all Krugman was trying to say is that getting the right policy is difficult under any circumstance. Getting it right when people are fixated on austerity is doubly difficult because we are tying one hand behind our backs. Almost inevitably, austerity will produce a smaller economy. That’s fewer jobs and a lower level of wealth creation. We impoverish ourselves unnecessarily.

Which was his main point.