For a while now are these two macro-economic equations have been bugging me:
(1) GDP = C + I + G + (X-M)
and its corollary, which doesn’t have such nice shorthand variables:
(2) Domestic Private Sector Financial Balance + Governmental Fiscal Balance - Current Account Balance (i.e. Trade Deficit or Surplus) = 0.
Equation 1 states that a country’s GDP equals the total of private consumer spending, private investment, government spending, and the trade balance of exports less imports. Equation 2 is derived from 1 and among other things says – in short – that reducing public debt implies a combination of increased personal borrowing or increased trade surplus. Everyone is on the debt-reduction bandwagon, but since private individuals and companies are not currently keen to borrow and since not every country can increase exports at the same time, we have a problem.
But the thing that’s been particularly bothering me about these equations is the claim that they are not bits of economic theory, but simple accounting identities; that if they were not true, half a millennium of double-entry bookkeeping would have to be thrown out of the window. If you receive, for example, John Mauldin’s often stimulating newsletter, you will have seen this argument made several times.
As an accountant, I am well aware of the beauties of double-entry bookkeeping. I’ve studied them in theory and practice. But we have to realise two important things.
First, it is a closed system. Its truths are true by definition. Bookkeeping defines both the objects measured and how they are measured. In particular, it measures money or money equivalents. The relationship of these measured things with the real world is genuinely problematic. And this isn’t a gag about esoteric accounting standards. Broader notions such as Social Return on Investment (SROI) are gradually entering the mainstream. Whilst they often, understandably if questionably, aim to monetise non-monetary outcomes, the real challenge of SROI is to come up with an accounting system that tells us about a much broader range of realities than double-entry bookkeeping will ever manage.
Secondly, we must avoid the tendency to think about national economies as if they were just large companies doing their double-entry. The language of ‘UK plc’ and ‘America, Inc.’ is telling here and the obsession with reducing the deficit because of what the debt markets think is part of this. We end up putting the national economy on same footing as a company calculating its interest cover and capital ratios when seeking funds for investment or working capital.
National economies change slowly. So why should the interest rate paid by Greece be higher today than it was a year ago? Why should the US dollar have fallen strongly against other major currencies and now be rising? Why did the oil price fall by two thirds from its high in June 2008 and why has it now bounced some of the way back up? What did these movements have to do with real supply and demand? What economic fundamentals are involved?
We already know the answer: none. These price movements, reflecting what the markets ‘think,’ are almost entirely speculative, have no productive use, and, above all, don’t involve much thinking. States need to ask themselves what market prices are relevant to national economic decisions affecting realities such as employment, productivity, and growth.
There’s another aspect worth flagging up which I may come back to another time. It is about what, in terms the national economy, is actually happening when one cuts the deficit. The corporate model of economics again sends us the wrong way. A company can reduce its debt in various ways, maybe by liquidating excess assets, retaining profits, renegotiating with creditors, or using an insolvency procedure. These are all formal processes within a limited system. The parties affected are generally known in advance and the financial effects can be quantified. But national economic policy (whether to reduce a deficit, allow inflation, set taxes, build infrastructure, or indeed anything else), redistributes resources amongst all manner of parties, many of whom are unknown or disadvantaged. The outcomes are always uncertain. How those decisions are made and who is able to influence them is central to getting them even approximately right.