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Why Can’t People Understand National Accounting?

I was on RT’s Capital Account last night talking to Lauren Lyster about the euro zone debt crisis. At the end of the show, we came up against the deficit problem and the question about how it should be solved. I get frustrated by this topic because the whole framing of the problem presented in the media is wrong because it gets cause and effect totally backwards. The question the media asks is “how can government cut the government deficit?” The real question is “why are deficits high to begin with and what should we do about it?” And it’s this question that gets people into trouble.

I’ll let you in on a secret: before this crisis, when I thought about the budget deficit I was like everyone else in that I paid no attention to how the government budget interacted with the private and trade sector balances. This is a big error. If you do that, you treat the government budget deficit in isolation, when the reality is that the government is an integral part of an open economy with households and businesses that trade domestically and abroad. When the government balance changes, the balances for those businesses and households change too. If you are talking about deficits then, you need to know how changes in the government balance affect the rest of the economy.

Here’s the thing: when we exchange goods and services with each other, from an accounting perspective, it’s a wash; if you buy my goods, you get money and I get goods of equivalent value. If you pay for those goods with an I.O.U., with a debt, your liability, your deficit in the year we made the transaction, is exactly equal to the asset on my balance sheet and my surplus for the year. I mean this is basic accounting, folks. There’s no hocus pocus. Any person’s, any household’s, any business’s, any group’s, any government’s debt is someone else’s asset. Any person’s, any household’s, any business’s, any group’s, any government’s deficit is someone else’s surplus. Again, it’s basic accounting.

Think of it like exchange traded options and the profit and losses on the exchange. People buy and sell oil futures or soybean futures. At the end of the option period, they either have a loss or a profit and that period’s deficit or surplus is exactly offset by the deficit or surplus of the counterparties. When you sum up these deficits and surpluses they net to zero. Again, no hocus pocus. That’s how accounting works.

The same is true for national accounts. At the end of any accounting period, then, the sum of the sectoral financial balances must net to zero. The government balance – the private balance – capital account balance = 0. The government balance = the private balance + the capital account balance. See my post Economics 101 on government budget deficits for the full write-up. I credit British economist Wynne Godley for making this identity relevant to macro economics.

What does all this mean then? Put simply, the financial sector balances framework means that when the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. So, to move any sector balance in an open economy, you need to move the other two balances exactly opposite in equivalent measure. To reduce the government deficit in any period, the private balance and the capital balance must increase by the exact same amount in that period.

Thinking about government deficits this way opens a whole new understanding of what cutting deficits means for the economy. What it should mean to you is that deficits are the effect and not the cause. Budget deficits are the result of the ex-post accounting identity between the sectoral balances and should not be a primary goal of public policy. Let me give you an example.

Why are deficits so high? What I have been saying is that private debt is the problem. Debt has been a substitute for income due to stagnant wages. Now that the credit bubble’s asset price inflation has turned to deflation, people, businesses and banks have found themselves saddled with debts that are not adequately underpinned by asset collateral. Businesses have done some serious heavy lifting here and debt in the corporate sector is not a problem. But households are still over-indebted. As long as household financial assets provide insufficient collateral for the debts that depend on them, the household sector will continue to maintain a reduced level of consumption and investment as a percentage of income to deal with that debt. Businesses see this and reduce their investment too. And we get stuck in a lower-investment, higher savings world that leads to deficits.

So, in that context, attempts at austerity make things considerably worse. If the government cuts back, the private debt overhang will still be there and the private sector will simply have less money to deal with it. The household sector will still attempt to keep its net saving, its surplus, high and so government cuts will be felt primarily in the form of reduced household consumption and increased private sector defaults. In the context of a still weak banking system, that could create the kind of downward spiral we witnessed during the Great Depression as banks failed. It creates the kind of paradox of thrift that makes deficit reduction harder which we are witnessing in the euro zone as many of us including James Montier predicted.

In my view, austerity is a failed paradigm. Clearly, government shouldn’t have wasteful programs to begin with. So there should be no need to cut them to cut a deficit. Moreover, the deficit is the result of an ex-post accounting identity between private savings, and capital account and government balances. It makes zero sense to target the effect (deficits) instead of the cause (excess credit growth and malinvestment). In plain English that means the policy prescriptions are the economic input and the deficit is the output. Focus on the policy and policy goals, not deficits.

The way I look at this crisis puts me into Ray Dalio’s camp. The right narrative for what has happened is that the depression has been the result of significant malinvestment that was built up during the so-called ‘Great Moderation’ as a result of loose monetary policy at the Fed and other central banks in a world awash in fiat money. The real policy question should be how to eliminate the malinvestment and reallocate capital investment to useful productive enterprises without creating a deflationary spiral. When credit is written down, GDP drops and people are thrown out of work. That can be mitigated. It is bank runs that create deflationary spirals. So the answer is to write down assets and recapitalise the banking system quickly rather than dragging it out. The goal should be to allow increased savings and debt and debt interest reduction to combine with increased income to accelerate the deleveraging process without causing runs.

I named my blog “Credit Writedowns” because I anticipated an historic wave of credit writedowns in the global banking system which would lead to a wave of deleveraging, systemic risk, and bank failures — in short, a massive financial and economic bust to rival the Great Depression. My hope had been to draw attention to the systemic risk associated with the deleveraging process necessary to purge these excesses. But since I began writing here four years ago, it has become clear to me that the goal of most policy makers is to avoid the pain of deleveraging by any means necessary. Their goal has been to extend and pretend, dragging it out, resisting credit writedowns and resisting recapitalising the banking system.

But debts that can’t be repaid, won’t be. Rather than resist this process, policy makers should embrace it and mitigate the downside.

This post originally appeared at Credit Writedowns and is posted with permission.

17 Responses to “Why Can’t People Understand National Accounting?”

Bonnie GoodellMay 29th, 2012 at 8:38 pm

"To reduce the government deficit in any period, the private balance and the capital balance must increase by the exact same amount in that period." Don't you mean "To reduce the government deficit in any period, the private balance and the capital balance must DECREASE by the exact same amount in that period." ?

LCRMay 29th, 2012 at 8:45 pm

You lost me when you left out the word "leverage". This is the biggest mistake all economists make when understanding debts. You mention deleveraging as a necessary fix, but then toss it our as undoable.

Lending in the bank sector and wall street financial business is essentially bad leverage. There is malinvestment due to easy money creation. I suppose we can argue for ever the utility of the Federal reserve, but I firmly contend the Federal reserve is at the heart of malinvestment and government profligacy.

An economy can not grow in any sustainable sense without private savings, and the US is very close to a negative savings rate (off you look at the savings rate for 200,000,000 Americans it is almost negative, the only reason it is positive at all is that the top 25% actually do save). The grossest malinvestment possible is actually the expansion of the government's books. There are no productive government assets. Military spending is not productive, the postal service running at a loss is not productive, Medicare is not productive, Medicaid is not productive, social security is not productive.

AndrewMGarlandMay 29th, 2012 at 10:42 pm

To Edward Harrison ,

I agree with Bonnie.

Further, US deficits and increased borrowing are not the result of an accounting identity. The US borrows money mostly to increase spending. The net borrowing is the deficit. The amount lent to the US equals the amount borrowed.

Where is the revelation in this?

rodeneugenMay 30th, 2012 at 12:23 am

Very right about "public deficit=private savings", but then you have several problems you did not mentioned.
1) Whole your model speaks about Cash flow, Public Deficit= Private Savings, what about the balance sheet? The depletion of the asset value, caused by wrong investments?
2) What if the private savings is external of your currency? The government looses its independence to regulate trade deficit.
3) To much deficite-savings, reduces the Currency Value=Depreciation of the currency. It can be visible as inflation and depreciation or hidden, as the mountains of government reserves hold by foreign governments. US bonds in Chinese+Japanese safes.
4) Rightly said by LCR, the US has not only public deficit but also negative private savings. How is it possible according to your model?
a. Point 3) above
b.US economy creates continuously new asset values, that are commercialized to foreign investors, like new start up publicly traded companies. This of course causes huge inequality in the income. This is why in USA economy is the biggest inequality in income in the western world and not so much because of the tax system, in contrary, in Europe my be the tax legislation more progressive than in USA, but the tax leakage is so common, (because of the independence of tax collection of each individual country, including Lichtenstein, Cyprus. etc.) that it is hard to speak about progressiveness.
c. The real estate market of USA is continuously creating new values, because of growing population and growing economy. From while to while (lately every 20 years) this market collapses, and erases the private investors asset values, and reducing the public debt, since reduced Asset Value= Reduced Liquidity, and the government can supplement this lack of liquidity by printing money, and that's what is happening now in USA and gradually in Europe too.

The conclusion, at the end of the party the bill has to be paid. How the USA will pay its bill for 35 years of public deficit and reduced private savings? Probably by inflation or currency depreciation or both, or if we are lucky with some NewApple company shares.

ErikwimMay 30th, 2012 at 8:13 am

The start and finish of your article are logically inconsistent. The start: 'If you pay for those goods with an I.O.U., with a debt, your liability, your deficit in the year we made the transaction, is exactly equal to the asset'. The finish: 'But debts that can’t be repaid, won’t be'. If the start is true, then just sell the asset and repay your debt. If the latter is true then in the transaction the asset sold was worth far less then the debt created. In my view this last statement is the one that creates the problems. That means a good part of debt created has too few assets on the other side of the balance sheet, to begin with. That means your basic accounting equation does not hold.

rodeneugenMay 30th, 2012 at 10:14 am

And it is called loss that goes against depreciation of the asset value. And then the banks have problem with collaterals and don't give credit, and then comes chapter 11. Luckily it doesn't apply for governments except of the Greek government. At the end of the day there is no alternative to do the correct and responsible decisions. Like the decision to take loans and invest it to ouzo will cause you next day hangover.

MRWMay 30th, 2012 at 9:47 pm

Wrong. You did not understand the "national debt." The US does not borrow anything. It is a sovereign non-convertible fiat currency. It doesn't have to borrow anything. And it doesn't/

What is technically called the "national debt" are the amounts in foreign governments savings accounts at the Fed. These accounts are called 'treasury security' accounts. Foreign governments move their money, which is in checking, into a savings account to earn interest. When they cash out these savings account on any given 15th of the month–no different than CDs–it is called 'paying off the national debt'. It's a phrase. Call the Fed and ask.

AndrewMGarlandMay 31st, 2012 at 12:22 am

To MRW,
http://en.wikipedia.org/wiki/United_States_public…
=== ===
The United States public debt is the money borrowed by the federal government of the United States at any one time through the issue of securities by the Treasury and other federal government agencies.
=== ===

Wikipedia is not the final word in many things, but it presents a clear description of US borrowing (selling bonds).

Your use of "wrong" is very definite, but what are you talking about? Possibly you can expound further on how the US Treasury doesn't borrow anything.

llisa2u2May 31st, 2012 at 9:26 am

Let me quote you: "The real policy question should be how to eliminate the malinvestment and reallocate capital investment to useful productive enterprises without creating a deflationary spiral." You are so right, that concept is very difficult to understand……Policy is being substituted and misdirected into fractional political posturing that really produces no practical policy action to impact bottom line everyday economic transactions.

KeaneMay 31st, 2012 at 4:41 pm

Isn't the FED really just the enabler of the real culprit? Without the reserve fractional banking system, depositors would know up front if they were warehousing their deposits or investing them "at risk". The FED just enables leveraging in the banking center and promotes the idea that everyone has the ability to withdraw funds which are actually tied up in both 'good' and 'bad' investments. Every time we have an otherwise healthy contraction in the biz cycle, the skirt is raised on the system and we all get to see it for the house of cards it is. Then we call in uncle Ben or before that uncle Alan to make it all 'better'. I'm not calling for the abolition of fiat or anything like that. Could we start by moving toward a banking / monetary system that's honest and transparent?

AleARJune 1st, 2012 at 5:19 am

You are wrong, the only non productive spending is military, in fact very unproductive, given that the machines built by military are destroyed when activated and they also destroy everything around them. But running postal service, medical aid, transportation, social security at a loss adds productivity as a hole to the society. Having a well trained and healthy workforce, alleviating the cost to sustain the eldery people for the families, frees money to be allocated in productive activities by people. There's a loss in government accounting, but this must increase the productivity of the society, resulting in a net gain.

GuestJune 2nd, 2012 at 1:18 pm

Money that government issues represents governments IOU. No-one can borrow back their own IOU's, not even the government. Therefore popular usage of word "borrow" is simply wrong when it comes to government bond sales.

AndrewMGarlandJune 2nd, 2012 at 11:14 pm

To Guest,

() A person CAN borrow back an IOU. Fred might offer to pay MIke 10% to delay payment of a debt. That would be borrowing it back.

() Cash is not the same as government debt (bonds). If you doubt this, try to buy groceries with Treasury bonds.

You might be able to use Treasury bonds to buy some items, but the seller would apply a discount to the face value of the bond and a further discount for the risk of holding the bond or the costs of converting it into cash.

In the same sense, you could buy something by trading your car for it.

() What word do you use for what the Treasury is doing when it sells bonds at less than face value, effectively paying interest? "Borrowing" fits. What other word does?

PyriteJuly 23rd, 2012 at 5:37 pm

Erikwim,

You make a very good point about the assets being worth less than the debt created. That goes right to the heart of the matter. I like to ask the question, "When you loose money on an investment was most of it lost in the purchase or when the price finally went down?" Since you count the asset and the loan your answer indicates that the loss occurred at the purchase with the loan.

But, the accounting equation does hold because of the definition of accounting. Accounting is historically based. Accountants took that pragmatic view that they can not accurately predict the future, unlike the economists. Accounting records give a record of past transactions.

So, the asset is recorded on one side as what was paid for it. (This is historical value) The loan and possibly additional cash used to pay for it is recorded on the opposite sides equaling the price of the asset. That is a historical statement. The two sides balance.

When the loss is realized there would be an other accounting entry treating the loss as a transaction that would balance the accounts and the accounting equation.

Now, if in the future, it comes to pass, that the house could only be sold at a lower price. The new price difference is deducted from the asset on the contra side (right) of the asset account and then because it is a expense or loss of capital the same amount is entered as an expense (contra capital) on the left. (Expense account is a temporary contra sub account of capital, it is cleared to capital thus reducing capital at the end of the accounting period.)

So, the accounting record is past tense.

How ever, if you were smart enough to know that the property was not worth what was paid when the deal was done one would split up the price between two accounts "asset value" and "amount paid over value" known as the Goodwill account. But, most people do not consider it that way. This is still a historical record, that balances the accounting equation.

Renee SantosMarch 27th, 2013 at 3:21 am

The answer is simple really – accounting of that magnitude is a little too complex for the average person. It's something to be meticulously studied before being completely understood – let alone mastered.

MasonAugust 16th, 2013 at 4:05 pm

Quite nicely described why people can’t understand nation accounting!! Since long time accounting profession is demanding and modern time this profession demand is pretty high. Nowadays most students are curious to make a career by doing a accounting based job. In-fact I've completed training over accounting in IT Sligo to have a bright future dealing with accounting jobs. This post mentioned information very inspiring and hopefully many people will admire this post for great specifications. Thanks.
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Emre Deliveli is a freelance consultant, part-time lecturer in economics and columnist. Previously, Emre worked as economist for Citi Istanbul, covering Turkey and the Balkans. He was previously Director of Economic Studies at the Economic Policy Research Foundation of Turkey in Ankara and has has also worked at the World Bank, OECD, McKinsey and the Central Bank of Turkey. Emre holds a B.A., summa cum laude, from Yale University and undertook his PhD studies at Harvard University, in Economics.

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