Wednesday, 14 August 2013

Financial Assets and National Wealth

I've read a few posts recently including Paul Krugman and Nick Rowe talking about the Pigou effect.  The idea behind this is that falling prices increase the real value of financial assets leading to a sense of greater private wealth and hence greater spending.  Some of the discussion revolves around the extent to which the private sector treats liabilities of the public sector as ultimately it's own liability - the Ricardian Equivalence point.  Nick Rowe in particular raises the issue of the distinction between debt claims on the government, which must at some point be redeemed and private money holdings which are perpetual.

Nick thinks that central bank money should not be seen as a liability of the public sector, because it carries no right of redemption.  In his view, it therefore represents net worth of the central bank.  Whilst, there are some grounds for taking this approach, I think it is problematic, because it suggest that the gross wealth of the nation can be greater than its physical assets (plus net claims on the rest of the world).

The discussion led me to reflect that it's sometimes useful to get away from thinking of financial assets in terms of wealth and focus more on their micro role in the social framework of claims and obligations.

To look at this further, I imagined a couple of simple monetary economies.  

Each economy consist of 500 workers of all different ages.   Each worker lives for fifty years, but new workers are born as old ones die.  The only privately produced good is sacks of grain.  Each worker working normal hours produces one sack of grain a year.  The price of grain is $1 a sack, as is the price of a year's normal labour.  The town council taxes all income at 20% and pays some workers to do community work rather than produce grain.

In the first economy, all the workers work normal hours, throughout their life.  National income is $500, consisting of 400 sacks of grain (produced by 400 workers) and $100 worth of community work (carried out by 100 workers).  Total taxes are $100, which just covers the cost of community work.

This economy is illustrated in the schematic below.  Grain production is carried out by the farm, which is a collective and makes no profit.


There is no real wealth in this economy.  The grain is perishable and cannot be stored.  We have assumed a monetary economy, but for convenience we can assume that all payments are settled at the same time once a year, so there a no significant money balances.

Now consider a slightly different economy.  In this economy, workers only work during the first forty years of their life and do not work at all in the last ten years.  To cover their retirement, they work 25% harder in the first forty years.  The 400 active workers are now earning $1.25 each per year ($500 in total).  Each active worker is paying $0.25 a year in tax ($100 in total) and saving $0.20 a year ($80 in total).  This saving takes the form of buying town council IOUs in the IOU market.  After forty years, each worker has saved $8 of IOUs.  He then sells $0.80 of IOUs each year ($80 in total each year) for the last years of his life.

This second economy is illustrated in the schematic below:


There is no more real wealth in this economy than the first one.  However in this economy people hold a positive balance of IOUs issued by the government (the equilibrium balance works out at $200 worth).  The actual holders of these change over time as some people buy IOUs and others sell them but the total stays the same.  This position can continue indefinitely: it suits everyone.

So do the IOUs represent real wealth?  Well, the thing is, it doesn't really matter whether they are real wealth or not.  The point is that the IOUs play a crucial role in the social accounting framework.  They facilitate saving in an economy where real saving is impossible because there are no non-perishable goods.  They allow workers to smooth their consumption expenditure, even if their working hours are not smoothed.  The drive to achieve this temporal pattern of spending and working will impact on spending and saving, whether we see the IOUs as net wealth of the economy or not.

Although we have assumed no interest on the IOUs, we have said nothing here about whether they are redeemable or perpetual.  We will assume that the town council is free to issue more IOUs if it needs and that it will accept them in payment of taxes.  However, it makes no real difference, given the assumptions here, whether the IOUs ever need to be redeemed.  If they do, we simply assume that the town council will issue new ones to replace them.

In the first economy, a change in the overall price level will have no effect.  All transactions will simply be carried out at the new price level.  However, in the second economy, there will be some kind of effect.  A fall in general prices will raise the real value of IOUs held by workers, changing the relationship between current income and assets.  Regaining the original equilibrium can only occur through temporary changes in savings rates.

I am aware that for the purposes of this illustration, I have assumed behaviour patterns that are different to those that an advocate of Ricardian Equivalence might assume.  Likewise, I have not attempted to address the arguments that such an advocate might raise against my example.  Ultimately, I think this comes down to what one believes is the better approximation of how people really behave.  All I'm trying to do here is show how it can be useful to think of financial balances in terms of their role in the social accounting framework, rather than fret about whether and to what extent they constitute true wealth.


  1. The schematics aren't showing for me. Does anyone else have that problem?

    1. Sorry - I don't know how to fix that. They show for me even when I'm not logged in.

    2. In the nature of these things it has corrected iteself.

  2. I totally agree that your second model economy seems a sensible stable arrangement.
    Things can get messy though because those that hold lots of IOUs may actually want some of the grain growers to be unemployed so as to ensure that grain growers' wages can be bid down to reduce the general price level. That will cause IOU holders to be wealthier in real terms. Lost output due to unemployment will however also cause grain shortages and yet such insufficient supply of grain will not lead to price rises - it will instead lead to starvation of unemployed grain growers.
    I've worried about this in the post:

    1. That's good stuff. I've wondered about this issue, but haven't really come to any of my own conclusions yet. Your post is quite thought-provoking.

  3. "Nick thinks that central bank money should not be seen as a liability of the public sector, because it carries no right of redemption. In his view, it therefore represents net worth of the central bank. Whilst, there are some grounds for taking this approach, I think it is problematic, because it suggest that the gross wealth of the nation can be greater than its physical assets (plus net claims on the rest of the world)."

    Central bank money should be issued as equity not a liability. This way money is free to circulate without the implication that it has to return to issuer. The economy needs a medium of exchange. Also the people are the owners of the central bank if they created it therefore the money it issues to them shouldnt be lent to them.

    1. I was using the term liability in the sense it is used in national accounts, rather than in business accounts. In national accounts, equity is included under the general heading of liabilities. Net worth in national accounts is therefore equal to all assets less all liabilities (including equity). As liabilities (including equity) have to be recorded at the same value as the corresponding asset, the net worth of the nation is equal to its non-financial (real) assets plus its net claims on the rest of the world. I'm assuming this is the sense that Nick Rowe is using as well.

      I am aware of the argument over whether base money should be treated as equity. It's a vaguely interesting question, but I don't think it's very important. It seems to me that it's just a question of the label you give it. I don't think it tells you any more about the role base money plays. In a sense, this was the motivation for my post. In worrying about how to categorise money, I think Nick is missing the point about the role financial balances play in the social accounting framework.

    2. OK I understand what you mean.

  4. After thinking about this for several days, I am coming to the realization that two very different philosophies are represented here. The first schematic depicts an economy in which everyone plans for retirement on an individual basis. The second schematic provides for government planned retirement.

    Both systems are commonly found in nations. The interesting thing is the transition between systems. The transition takes a long time to become stable, taking at least one complete working lifetime.

    Just to mention a few of the transitional changes:

    1. Immediate transfer of wealth from younger workers to older workers. Younger workers would immediately work harder for less average pay so that older workers (who had prepared for retirement under the previous system) could get benefits.

    2. A new, extensive accounting system to record retirement credits and debits. This is likely to increase the need for government workers.

    3. If, in fact, a previous private retirement system existed in the original system, a re- balancing would probably occur. The pace of phase-in from old system to new would be very important.

    Thanks for another interesting post.

    1. I see it slightly differently. In the first scenario, there really is no retirement planning. Workers work till they drop dead. In the second, I had envisioned it as private retirement planning, but it's interesting to think about the parallels with a state pension system.

      In any event, you are right that the really interesting thing here is transition, whether that's from one scenario to the other or of either scenario in response to shocks.