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.

Endogenous Money and "Out of Thin Air" Money

I often hear comments confusing the endogeneity of money with the idea that banks create money "out of thin air".  Although these two ideas are connected, that are not the same and one does not imply the other.

In particular, there seems to be a belief that an essential feature of money being endogenous is that banks can make loans without needing deposits first.  This is not correct.  Even if loans were only made out of previously deposited funds, monetary growth would still be determined in substantially the same way.

We can illustrate this with a little thought experiment.

Imagine that a law is passed under which banks are strictly prohibited from making loans by crediting deposits.  Any new credit must involve the bank handing over physical cash to the borrower.   People could still make payments by bank transfers from their current accounts, but not if it involved going overdrawn.  Instead, such people would have to borrow physical cash from the bank, then deposit it into their current account, before drawing on it.

In such an arrangement, it would be impossible for a bank to make a loan without having first taken a deposit (or received cash through some other means like stock issuance).  Does this mean that the loans are now constrained by deposits?  No, at least no more than it did before.

In the example above, the bank pays out cash in place of allowing an overdraft (using cash from a previous deposit).  The cash is then deposited back with the bank, so the borrower can make transfers from it.  This leaves everyone in exactly the same position as if the bank had simply credited the borrower's account.  The bank now has the cash again to make another loan, and then another, ad infinitum.

It makes no difference to this argument if the borrower deposits the cash with another bank.  The only way that cash will not flow back to the banks is if the non-bank public decides to start hoarding it and there's no reason to suppose that they will automatically do so in response to an increase in lending activity. 

This latter point is no different to the way things work in the real world, where banks make loans by crediting accounts.  The ability to do so without limit depends on the public retaining their new money in the form of bank deposits.  If the public suddenly decided to start hoarding cash, withdrawing the balance of their newly created deposits, banks would cease to be able to make new loans.

In our thought experiment, as well as in the real world, it is the interaction between banks and borrowers that is driving money creation.  Regardless of the actual mechanics of making loans, it does not require a spontaneous decision by depositors to increase savings for an expansion in the money supply to occur.  The endogenous nature of money does not depend on the fact that banks can make loans without having taken deposits first.

The reasons for the growth or otherwise of private money lie in the budget decisions of economic agents, not in payment mechanics.  Money growth is a result of the pressure created by when the equilibrium between non-banks wanting more debt and banks prepared to take on more risk implies a higher level of loans.  Even if deposits must proceed loans, that pressure is still there and balances will move towards the equilibrium position.

I have glossed over practical issues, because I don't think they affect the argument, but I should say something on these.  Obviously, having to make all loans in cash would raise some practical considerations.  It would also mean that the amount of cash holdings of banks and non-banks would probably need to be significantly larger than is currently the case.  If the monetary authorities attempted to constrain lending by restricting the supply of cash, this could potentially slow up the pace of money creation, even if it did not change the final equilibrium.  However, this is not very different from using monetary base control methods in the real world.

The way banks create money "out of thin air" is certainly a useful thing to understand, but in terms of considering the endogeneity of money, it is nothing more than a red herring.

Modelling QE

This post outlines a theoretical model I've used for looking at the mechanical process by which QE impacts on the economy.  It is based on the UK economy and draws heavily on Tobin's portfolio approach to financial markets.*

The model is best understood by examining the balance sheet matrix on which it is based, a stylised version of the UK's financial balance sheet.  Although highly simplified, it still retains sufficient granularity to bring out the required mechanics.

	H'holds	PNFCs	MFIs	BoE	Gov't	RoW	Net
PNFC securities	Sh	-S				Sw	0
Gilts	Gh			Gcb	-G	Gw	0
RoW securities	F/x					-F/x	0
Deposits	Dh		-D			Dw	0
Loans	-Lh	-Lf	L				0
Reserves			R	-R			0

PNFC = private non-financial corporation

MFI = monetary financial institution (bank)

BoE = Bank of England

RoW = rest of world 

Asset prices and yields are driven by portfolio allocation functions for Households and RoW.  These are based on Tobin's, providing a demand for each asset based on the yields on all assets and an overall budget constraint.  The model then solves by bringing the market for each asset class into equilibrium, within the balancing constraints of the matrix. Three "price" variables need to be found: the price of private securities, the price of gilts and the exchange rate.  As each of these variables affects expected future returns, there is a high degree of inter-dependency.

The financial model sits within a simple Post-Keynsian style model of the real economy.  This is only intended to map out the long-run response path of the economy, which provides the feedback for expectation formation. Expectations place a crucial role in the model, and therefore issues such as whether the QE is expected to be temporary or permanent have a significant impact on the results.  Expectations are initially based on rule-of-thumb estimates, but the model includes an algorithm which enables yield expectations to be iteratively mapped to actual outcomes out to a distant future point.

Because the model is based on portfolio preferences, the spread between single period asset yields varies with the supply of those assets.  This means that traditional arbitrage model (whereby long term rates are a compound of expected short-term rates) does not in general hold, although there is a fair degree of correlation. Yields and prices can vary even in scenarios where the short-term rate is permanently fixed and even when the QE is only a temporary measure.

The structure of the model is explained in a little more detail below. 

Sectors

All sectors of the actual economy are represented.  Financial institutions that are not MFIs are treated as part of the household sector.  The BoE is treated separately from private MFIs.  Public corporations are treated as part of Government.

Assets

Marketable securities are grouped into three classes: PNFC securities (equity and debt securities of UK PNFCs), gilts and RoW (rest of world) securities.  The latter includes all foreign equity and bonds, whether private or issued by foreign governments.

The value of each of these asset classes depends on some measure of price.  For PNFC securities and gilts, value is the number of securities multiplied by a price index.  For RoW securities, the value is the (exogenous) foreign currency denominated value divided by the exchange rate.

The last three asset classes: deposits, loans and reserves do not have a variable price.  The return on each is based on an interest rate which is assumed to be determined exogenously by central bank policy.  Deposits from RoW is intended to represent a net figure, i.e. sterling deposits from abroad less sterling loans / deposits placed abroad.

In the real world, UK MFIs have substantial non-sterling assets and liabilities (greater than their sterling positions) but these are assumed to be matched and therefore ignored.  Likewise, non-sterling liabilities of PNFCs are ignored.  PNFC cash is netted off against loans.

Portfolio Allocation Functions

Household demand for each asset is based on a portfolio allocation function, using single period expected rates of return.  RoW has as demand functions for PNFC securities and gilts based on single period expected returns in the three marketable security classes and trend GDP.  Demand for sterling deposits is based on trend GDP and the relation between the (exogenous) foreign interest rate and the expected equivalent return on sterling deposits after expected exchange rate movements.

The functions require expected next period values for: the distribution on PNFC securities, the price of PNFC securities, the price of gilts and the exchange rate.  The same exchange rate expectations are used for expected deposits returns and for expected return on RoW securities.

Simulations

QE simulations involve an exogenous increase in gilts held by the BoE, matched by an increase in reserves. This increase in demand for gilts (or reduction in supply available to the rest of the market) increases the price and reduces the expected yield.  Portfolio re-balancing by households and RoW leads on to higher equity prices and a lower exchange rate.

Market prices respond immediately (even beforehand if expectations are allowed to reflect prior knowledge of the purchase).  The impact on the real economy is slower.  This involves (within the model) private sector spending response to increased wealth and reduced long-term rates, as well as exchange rate effects.  The increase in reserves is not modelled as having any direct impact on lending, as MFIs are not treated as reserve constrained.

* A General Equilibrium Approach to Monetary Theory, J. Tobin, Journal of Money, Credit and Banking (Feb, 1969)