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.