Sunday, 16 June 2013

Accounting and Economics



I've got into a couple of discussions recently about the relevance of accounting to economics, so I'd thought I'd put my views down here.

The first point is that any model or other analysis in economics should be accounting consistent.  By this I simply mean that things should add up without any black holes or inconsistencies.  Each item of expenditure should be someone else's income; changes in stocks should relate to flows within the appropriate timeframe.

This is a pretty important point - if a model doesn't pass on this, it's just wrong.  However, I don't actually think this is a particularly big problem.  I see models from time to time that definitely fail this test, but most don't, or at least they don't appear to have anything that is necessarily inconsistent.
 
However, it's this latter qualification that leads on to what I think is the bigger point.  This is not one of absolute requirement, but one of style.

Models should be about providing insight.  To be able to do so, they need to have ways to illustrate the connection between all the various quantities.  Even in very simple models, the full consequences of the interaction between variables can be quite obscure.  For me, models that do not pay much attention to the accounting, even if they are actually fully consistent, often miss important insights.

I would say that there are very few models of monetary economics that would not benefit from having their implicit accounting structure explicitly set out.  The ideal tool for this is the social accounting matrix: at the very least a balance sheet and possibly a flow of funds.  These show at a glance the form of the simplified economy within which the model is constructed and how the various quantities relate to each other.  They are not sufficient on their own, of course, but they can provide a great deal of insight before one even starts to look at agent choices and behaviour and they help us see the results in a more comprehensive context.

Setting out the model this way also helps us relate it to the real world.  However conceptual a model, at some point we want to be able to relate it to actual economies and hard data.  Setting out the model variables in a form that corresponds to national accounts gives us an immediate head start in doing so.

And really that's it.  Accounting can help us understand the economics better, but it doesn't tell us everything.  It still leaves most of the questions to be answered, but hopefully it allows us answer them with the benefit of a greater insight into the way everything hangs together.

3 comments:

  1. The first point is that any model or other analysis in economics should be accounting consistent. By this I simply mean that things should add up without any black holes or inconsistencies. studio commercialista milano

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  2. You state "I see models from time to time that definitely fail this test, but most don't, or at least they don't appear to have anything that is necessarily inconsistent". Are you familiar with the article "An important inconsistency at the heart of the standard macroeconomic model" by Wynne Godley and Anwar Shaikh?

    In this article, Godley and Shaik state "The source of the problem lies in the apparently innocuous assumption that all of the real net income of the business sector (the real value of the net product) is somehow distributed to households. In the case of wage income, this is straightforward, since firms pay workers for their labor services. But when we ask how profits are to be distributed, we find that within the logic of the model they can only be distributed in the form of interest payments on the bonds issued by firms, for there is no other instrument available in the model.Firms borrow money from households
    by issuing bonds, and are then obliged to pay interest on them at the rate determined by the model. The difficulty is that these aggregate real interest payments will generally differ from aggregate real profits.
    This in turn implies that household income (wage and interest income) must generally differ from business income (wages and profits)."

    In other words, the outflow from the business sector to the household sector is not the same as the inflow in the household sector from the business sector: a flow inconsistency. In other words, the standard macroeconomic model is not stock-flow consistent.

    I am curious to hear your opinion on this point.

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    Replies
    1. Thank you that reference. I wasn't aware of that paper, but I will have a careful look at it. Interestingly, the point it makes with regard to money neutrality seems to be similar to a point I made in this later post http://monetaryreflections.blogspot.co.uk/2013/11/some-peculiar-dynamics-with-long-term.html

      It may be that I underestimate how common accounting inconsistency is. Mostly, when I have looked through papers with models (mainly of the New Keynesian type), they seem to consistent, but it is hard to be sure because of the way they are set out.

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