A bit more on savings and investment

Steve Roth (1, 2), Scott Sumner (1, 2, 3), Bill Woolsey, and Matt Yglesias have been debating questions of saving versus investment and paradoxen of thrift. See also JW Mason in the comments here, and Simon Wren-Lewis a while back. Cullen Roche reminds us that, even under conventional definitions, the accounting identity S≡I only holds for a closed economy without government spending, and of JKH’s useful tautology S=I+(S-I). [See Update below.] I think the recent recrudation of these issues owes something to Garett Jones’ and my conversation on capital taxation, which Jones has continued and on which Matt Bruenig has weighed in.

As is often the case, I think that the protagonists agree more than we think we do. Our various allegiances — to schools or tribes or policy ideas — exploit the ambiguity of language to manufacture conflicts, through which we reassure ourselves that we are right and they are wrong. (And no, math doesn’t help much, because we must map it arbitrarily to the same ambiguous language for it to be of any use.) Now I will reassure myself that I am right and they are wrong.

I think we have all agreed, one way or another, that the K in a Ramsey model does not map easily to the financial investment whose (non)taxation we debate in the real world. If new cash or government debt can be understood as a kind of capital good, it’s not obvious that it behaves similarly to the physical capital in an aggregate production function. It might, but you’d have to do some work to persuade us. If the conjunction savings supplied, investment demanded, and “at potential” total expenditure depends upon interest rates or other financial variables that may vary independently, there is no reason to believe that privileging saving will unconditionally promote investment, qua Chamley-Judd logic. Savings supplied may not be the bottleneck.

Update: Ramanan (1, 2) and Hellestal say I’m wrong to write that “even under conventional definitions, the accounting identity S≡I only holds for a closed economy without government spending”. They make a very good case! But in doing so, they remind us of the ambiguities and limitations of this “conventional” framework. In the current conversation, we are most immediately confronted by an ambiguity surrounding the letter S. When people say that S ≡ I, they mean total savings equals total investment. But in many of the conventional equations used to discuss this stuff, S is refers only to private savings. That leaves tiny fragile minds like mine liable to confusion. Stealing a lot from Ramanan and Hellestal, in conventional accounting, savings are defined simply as the residual between what is produced and what is consumed (both by private partes and by government). Let’s consider a closed economy:

Y ≡ C + G + I //by definition [eq 1]
Y - C - G = I ≡ TOTAL_SAVINGS ≡ TOTAL_INVESTMENT //by definition [eq 2]
Y ≡ C + S + T //also by definition, but S here means private savings [eq 3]
C + S + T = C + G + I //combining equations 1 and 3 [eq 4]
S = I + (G - T) //remember S here is private rather than total saving [eq 5]

Equation 1 says production is comprised of the resources that we consume (C by definition), that the government consumes (G by definition), and whatever is left over, which is evocatively but perhaps misleadingly designated I for investment. But, as commenter Eric L emphasizes, in these accounts I is just a residual. It refers to whatever resources are not consumed (either by private parties or by government).

Equation 3 is most easily understood as a decomposition of claims on the resources produced. We choose to decompose these into the claims made by government (T), the claims of private consumers to precisely the resources they consume (C), and the claims of private parties on production extinguished by neither taxation nor private use (S). We reconcile the disposition of claims with the disposition of resources in equation 4. This tells us that private savers’ claims to production (at the moment of production, before any real investment outcomes have a chance to muddy things up) include the resources no one used (I by definition) and the resources the government used in excess of the taxes the government claimed.

To keep things clean, let’s adopt, um, a convention. When we use the word “savings” we should refer to claims. When we use the word “investment” we should refer to real resources. Let’s then separate “savings” from “investment”, claims from resources, in Equation 5:

S - (G - T) = I //subtract (G - T) from both sides of Equation 5
S + (T - G) = I //simplify [eq 6]

Equation 6 is what we should really mean when we say S ≡ I (even though algebraically it doesn’t because we mean different things by S). That is to say that total claims on unconsumed resources must equal the quantity of unconsumed resources. I, by definition, for a closed economy, represents unconsumed resources. (T - G) represents the claims government has made on resources by taxation in excess of the resources the government has actually consumed. S represents the claims on resources left to private parties after consumption and taxation. If we call the claims of the state “government savings”, the claims of private parties “private savings” and unconsumed resources “investment”, then we can write:

PRIVATE_SAVINGS + GOVERNMENT_SAVINGS ≡ TOTAL_SAVINGS ≡ INVESTMENT // [eq 7]

So, yay! This is true by definition. It is just a way of saying that balance sheets must balance. It says that total claims on resources must always be equal to the total quantity of resources to be claimed.

But before we get all triumphalist, let’s emphasize how unhelpful this mostly is. First, it is simultaneously conventional to claim that S ≡ I and to write equations in which S refers to private savings, which is not equal to I. It is conventional to claim that the letter I represents “investment”, when in fact it represents any resources that are unconsumed. In a hypothetical, instantaneous sense, unconsumed resources mean resources available for consumption. In an actual sense, much unconsumed production (as vlade emphasizes) goes to waste. I is not “investment”, in the ordinary meaning of the word. It is simply resources that are not consumed in a certain period, regardless of what befalls them. Cars produced and not consumed become “inventory investment”. That’s fine. But electricity produced and not consumed? It dissipates as heat. Bread produced and not consumed grows moldy. The product of a university, when left unemployed, becomes less employable. Trees cut and “invested” in unsellable desert homes get accounted as investment, but fail to contribute to future production.

So we can argue. Maybe stuff that’s wasted should get embedded in C, which keeps “investment” more accurate by doing violence to the commonsense meaning of consumption. But we can’t really embed “bad investment” in consumption, because we can’t know which investment is bad. The letter Y usually gets mapped to “gross domestic product”, but if we want to sum across periods and keep our stocks and flows consistent, when we do our Period 2 accounts, we must define Y as a net product, and include any losses and misadventures that befell our old “investment” in the new period’s I. (We refer to this as a “valuation adjustment”.) Again, the use of conventional mappings between letters in the equations (“Y”) and real-world referents (“GDP”) will mislead us. Alternatively, we can keep the periods separate and let Y ≡ GDP, but then we will need to impose valuation adjustments when summing savings and investment across periods to account for actual investment outcomes.

The framework grows shabbier still when we consider an open economy. Equations 1 and 2 become

Y ≡ C + G + I + NX //by definition [eq 8]
Y - C - G = I + NX ≡ TOTAL_SAVINGS //by definition [eq 9]

But now we’ve really mixed up our treatment of resources and claims. Equation 2 defined resources unconsumed as total savings, but equation 9 redefines it as the resources we have failed to consume, but that may have been consumed by others. Hmm.

S = I + (G - T) + NX // [eq 10]

Equation 10, the open-economy analog of equation 5, is a very useful decomposition of private savings. It stands at the core of MMT-ish intuitions about how a putatively savings-hungry private sector might be accommodated, and inspires JKH’s very clean reminder that private savings represent claims on domestic investment plus some other claims that can’t be mapped to domestic investment. But it might suggest to the incautious that all exported goods are matched by domestic claims, and that those claims against foreigners are good and stable and should be valued at par. In real terms, that is almost never true. The NX component of “investment”, like the I component, is unstable, and if we carry these accounts forward in time, we’ll have to include valuation adjustments there as well.

None of this is to say that this is a “bad” accounting framework. The only thing that’s really terrible is the inconsistent conventions, under which S sometimes means total saving and sometimes private saving. The deeper difficulties would be shared by nearly any accounting framework. In the accounting of private firms, it is not easy to classify “expenses” vs “capital investment”, just like it’s hard to distinguish consumption and investment in national accounts. In corporate accounting, there are valuation adjustments and statements of “other consolidated income” to reconcile differences between values between period t and period (t+1) that cannot be accounted for by current period undistributed profits. The real world is unruly, yet accounts must be defined. The accounts must find ways to track the unruliness of reality rather than expect the world to conform to simple definitions.

However, whenever anybody tries to make a substantive point by quoting S ≡ I, they are offering no insight at all into any nontrivial question. They are saying nothing more or less than balance sheets must balance. They reveal nothing whatsoever about how. It certainly doesn’t mean that the production of new claims (“savings”) is necessarily matched by the production of new resources (“investment”). It just reminds us that, if the new claims are not matched by real resources, we shall have to devalue the claims of others if we wish to keep our accounts straight.

This whole conversation started with questions about whether the S ≡ I identity somehow implies that real-world savings vehicles are necessarily matched by investment in the Ramsey/Chamley/Judd sense. The answer to that question is unequivocally and irrefutably “no”. Real-world savings vehicles need not be matched by any investment whatsoever. Suppose I purchase shares in a mutual fund which then lends it on as consumer loans that finance vacations. In a macroeconomic sense, there is neither savings nor investment, my saving is matched by vacationers’ dissaving, resources are consumed and none are invested. S ≡ I = 0 Nevertheless, my shares in the fund would yield returns in forms like dividends, interest, and capital gains. No matter how hard you squint at accounting identities, nothing in the logic of Chamley and Judd suggests that these “investment returns” should remain untaxed. Lending to finance private and government consumption represents a significant fraction of gross financial savings, even though it contributes nothing to net savings or the aggregate investment Chamley and Judd presume.

Update History:

  • 14-Apr-2013, 10:50 p.m. PST: Very long bold update, responding to Ramanan and Hellestal re S ≡ I
  • 19-Apr-2013, 6:45 p.m. PST: “insight at all to into
 
 

39 Responses to “A bit more on savings and investment”

  1. [...] Steve Randy Waldman and Scott Sumner (plus many others, linked from Steve’s post) wade in on notions of saving and investment. [...]

  2. Steve Roth writes:

    “it’s not obvious that [new cash or government debt] behaves similarly to the physical capital in an aggregate production function”

    This *exactly* what’s had me befuddled for years.

    Economists seem to talk about “capital” as if it consists of both financial and real assets, in some kind of vaguely homogeneous or contiguous glob.

    This might make sense if you think that *ownership* of a real asset (a deed, or your rights use your drill press or to eat the apples on your kitchen table) — your claim/right to control/use/sell the thing — is in fact a financial asset. In which case nobody “owns real assets.” They only own financial assets (formally or informally inscribed) that are claims on real assets.

    I really don’t think the fundamental notion of “capital” has been well- or coherently theorized, despite some centuries of quite athletic intellectual efforts.

    It’s certainly possible that it has, and I just don’t get it. Given the discussions I’m constantly reading, though, I’m pretty sure that I’m not alone.

  3. Ramanan writes:

    “the accounting identity S≡I only holds for a closed economy without government spending,”

    Don’t think JKH said that but the statement is incorrect.

    Because the definition of S in S≡I is different from definitions where S is not equal to I.

    Ambiguities can be removed by defining everything. Assume a closed economy but *with* a government sector. S for the economy as a whole (defined as the sum of all saving of sectors) is identically equal to I, where I is the sum of investment of all sectors.

    In definitions where S is not equal to I, such as

    S – I = G – T,

    it may appear that the saving-investment identity breaks down but this is because the S is the private saving and not the saving of all sectors.

    So “S≡I” is right, even with the government sector and in fact for the whole world with many countries, currencies, governments if defined the right way.

  4. Steve Roth writes:

    @ramanan: “it may appear that the saving-investment identity breaks down but this is because the S is the private saving and not the saving of all sectors.”

    Here’s where I get confused, and it may be purely semantic but even if so I think that really matters. (As I’ve said, “accounting is rhetorical, so it’s inevitably normative.”)

    As I said in my latest post, “government saving” [of money] is meaningless, akin to a bowling alley “saving up” points.

    Love to hear your thoughts on that notion.

  5. Ramanan writes:

    Steve,

    Government saving by itself is not meaningless. It is a properly defined accounting term in national accounting and flow of funds.

    Whether the government should save more – as people wrongly argue – is a very slightly different thing.

    Although counterintuitive, there are various reasons that this is a good definition. Even in Physics, there can are counterintuitive definitions such as “work”.

    I am really not a fan of this bowling alley thing. If a nation has a current account surplus and a government budget surplus and (zero fixed capital formation for simplicity) with the government accumulation of foreign reserves as a counterpart of this surplus, would you say it has not saved? No.

    I prefer national accounts to bowling alley accounting because the latter is subject to change in different contexts and sometimes in the same context.

    Also, I am not for changing definitions – which some commenters seem to argue for.

  6. Steve Roth writes:

    @Ramanan:

    If the current account is in balance, zero fc formation, and treasury is running a surplus, is it more useful to say that the government is “saving,” or that it is withdrawing financial assets from other sectors? Which imparts a better understanding? I think the latter.

    I understand that it’s not unreasonable to say that reducing government debt via T-G surpluses is government “saving,” but think it imparts a mistaken understanding of the situation to almost everyone, including many or even most economists.

    And that’s before we even get to the moral valences attached to the word “saving.” Did I mention that accounting — and accounting terminology — is rhetorical hence normative? ;-)

  7. Ramanan writes:

    Steve,

    If it is understood that the surplus is a mirror image of the deficit of the private sector, then why is government saving meaningless?

    In the situation (zero govt investment), it is true the government is dissaving. In more general situations, with investment, it isn’t necessarily dissaving. It can be in deficit and yet have a positive saving.

    I understand that people mix things up and assume that government deficits take away private sector saving and that is grossly incorrect but it doesn’t mean that government saving as a definition itself is wrong. It just means people are confused.

  8. Steve Roth writes:

    @Ramanan:

    I’m saying that the usage “government saving” contributes to or even create that confusion. If true, that’s a problem, one worth trying to correct.

  9. Ramanan writes:

    Steve,

    My point being people struggling to count doesn’t make the Pythogaras theorem invalid. In the same way, S≡I not incorrect with S and I defined carefully. It seems to contradict with “S – I = G – T” but that is because the two Ss are different.

    In fact, if one claims that government saving is not a valid concept, one runs into all sorts of self contradictions.

  10. Tom Hickey writes:

    The issue seems to relate to ordinary language meaning versus technical meaning.

    Terms like “saving” and “debt” have cognitive-affective connotation in ordinary language that creates bias against government constructively using its policy space during economic contractions in order to stimulate effective demand to close the output gap and reduce unemployment. That is is an issue doesn’t seem to be controversial. What is controversial is substituting non-technical language that more nearly approximates the actual situation so has to gain public support for countercyclical economic policy.

    Technical language is in place whose rules needs to be observed. Terms that already have a well-defined technical meaning should be used precisely in technical contexts, here with reference to accounting balance being in surplus or deficit. On the other hand, government is said to be “saving” or “spending.” Saving” is the residual of income not consumed. Is government spending consumption or investment, or is there a difference between government consumption and investment.

    Observing the technical meaning all the time basically cedes policy choice to the fiscally conservative side that uses the ordinary language bias toward saving and suplus and against deficit and debt as a propaganda weapon to influence policy toward fiscal conservatism and austerity as a remedy for economic contraction. That seems unreasonable to many who have a liberal policy interest, for whom observing technical purity at the risk of losing the policy debate is tantamount to ceding the framing to the other side.

    Best to keep the uses separate, realizing that terms have different connotation in ordinary language terms and technical usage, and this is can adversely impact understanding and motivation of non-technicians, biasing a case to the degree that poor policy and management decisions are taken.

    The problem is navigating between being too loose in terminology to be correct, thereby creating an opening for attack, and being too technical to get the point across in order to move the policy ball forward.

    I think everyone that is a party to this debate from the Post Keynesian side in agreement on the accounting, at least for the most part. The challenge is putting together a presentation that understandable to non-technical folks that also is correct technically. Obviously, those on the other side will attempt to retain their lock on the framing due to connotation of terms that bias the debate their direction.

    So this is not justs about monetary economics and accounting. It has much wider political implications.

  11. JKH writes:

    Tom,

    Good comment. But I disagree.

    Cutting to the chase, I think the MMT presentation would be strengthened considerably by doing the opposite.

    The basic question MMT has to answer and the only really important question is – why is it a good thing for the government to run deficits (under any situation of your own choosing)?

    That is a very answerable question.

    Show that it’s a good thing – instead of disguising what the thing is.

    Tackle the challenging of answering the substance of the question head on – instead of avoiding/fleeing its appearance.

    The right answer will end up being much stronger – and much more marketable in the end.

    MMT has made a mistake in not doing this, IMO, while employing specious sugar coated language transformation instead. The inescapable perception and suspicion is that MMT is conducting language trickery in answering the question, instead of more directly destroying wrong thinking objections to the substance of it with the right economic logic.

  12. stone writes:

    When there are campaigns to cause more saving, I think it is crucial to put a spotlight on WHAT is being “saved” or attempted to be saved in the real economy as a manifestation of the advocated increased financial saving. Above all such saving is of claims over “man-hours”. The problem is we can’t store up “man-hours” and transport them into the future. Any unused man-hours are permanently lost. We simply need to point out the squanderous idiocity of trying to save up time and transport it to the future.

  13. Peter N writes:

    These discussions seem to be clearing up a lot of confusion, much of it coming from using the same word to mean several different things. Some points along these lines (which I hope I’ve got right):

    1) In NIPA accounting S = I is an APPROXIMATE accounting identity. Given a 0.25% discrepancy between income and expenditure, certain problems are non-issues. For instance, if I dig a hole and bury $100 or I burn $100 am I saving, and if so, where does the corresponding I come from? Since the discrepancy > $25 billion the answer has to be de minimis non curat NIPA. If everyone in the US buried $100 we’d only be missing less than $300 million in quarterly GDP and less than 0.1% of the currency in US circulation.

    2) As noted above NIPA S = I, and the sectoral S = S + (S – I) refer to differently calculated S and I. NIPA deals with value added and models a barter economy. You can’t accumulate financial assets in a system that ignores exchanges of capital assets. And neither S refers to saving in the sense it’s used by non-economists.

    3) It’s not clear how the Fed and fractional reserve banking fit with the combined S = I + (S – I) and (S – I) = (G – T. The money passing through the system is largely bank deposits and base money and deposits are fungible. How does credit money get into the system?

    4) Even if all transactions were in cash G – T – B would equal 0 (where B is government borrowing). If cash is a financial asset, then exchanging cash for bonds can’t increase the supply of financial assets. Of course the Fed can, but that’s not what the model says AFAICS.

  14. Ramanan writes:

    Peter N,

    “In NIPA accounting S = I is an APPROXIMATE accounting identity.”

    Because the sum of saving of all resident sectors of an economy is not equal to investment to begin with even theoretically!.

    The difference is the current account balance of payments.

    Also not true for an individual sector.

    But the identity is true for a nation as a whole (*if* it were not open).

    The identity is true for the world as a whole (with a qualification that it would break if we trade with people in Mars).

    Statistical discrepancy is a slightly different issue. The arguments above are about situations where statistical discrepancies are low – so it is a theoretical debate.

    “For instance, if I dig a hole and bury $100 or I burn $100 am I saving,”

    Burying and burning are different things. In the first, your net worth doesn’t change due to the act and in the second, it does.

    There isn’t a corresponding I because the act of saving arose when you decided to not consume not because of your digging a hole and burying. Had you consumed more, your saving would have reduced and producers would have seen a fall in inventories.

  15. Peter N writes:

    “Because the sum of saving of all resident sectors of an economy is not equal to investment to begin with even theoretically!.

    The difference is the current account balance of payments. ”

    I’m aware of this I’m assuming G-T and X-M are 0 for the purpose of argument.

    “Also not true for an individual sector.”

    The assumptions above isolate the private sector and make S = I stand or fall on its own.

    “Statistical discrepancy is a slightly different issue. The arguments above are about situations where discrepancies are low – so it is a theoretical debate.”

    That’s part of the point. You can’t confound actual NIPA in the real economy with idealized NIPA in a toy economy. If you do, you have to be clear which you mean and demonstrate that your conclusions transfer. A discrepancy between GDP and GDI would seem to be on point.

    Obviously S = I is a meaningless identity (that is a pure residual) in the limit as we shrink the time period. There has to be some process which makes it become meaningful over a sufficiently long period. Even so it can never be exact, because the necessary accounting is a theoretical impossibility. You’re mixing numbers from cash and accrual accounting. Any correction for this has to be approximate.

    “Had you consumed more, your saving would have reduced and producers would have seen a fall in inventories.”

    That’s the story, but without a Walrasian auctioneer it can’t be right as an exact mechanism. If you assume inventories are carried at cost and are part of I and assume that my act of saving is exactly simultaneous with the inventory becoming surplus, then an all seeing auctioneer can perceive an identity. Of course, I might have been planning to have my gutters cleaned, and decide to do it myself instead.

    A story about how S becomes I on average in the long term and what the long term actually is would be interesting. A completely contrived identity based on counter-factual assumptions isn’t.

    Try this one. I take Schrodinger’s cat out of the box and replace it with $100. The existence of the money is now indeterminate. I suppose the status of the inventory is also indeterminate. You just can’t let anyone observe the inventory until I open the box or you’ll disentangle the states.

    The real controversy that underlies this theoretical debate is whether and how saving finances investment. If people didn’t disagree about this, nobody would care about this stuff.

    I’ve seen several attempts to solve this using GAAP accounting. This is the one that was easiest for me to find a link to.

    http://www.social-europe.eu/2012/11/saving-does-not-finance-investment/

  16. Ramanan writes:

    Peter,

    “I’m aware of this I’m assuming G-T and X-M are 0 for the purpose of argument.”

    Yeah but then why bring in NIPA which has real life data in which neither G-T is zero nor X-M?

    “You can’t confound actual NIPA in the real economy with idealized NIPA in a toy economy.”

    Yes, but I did say, saving for a nation as a whole is not equal to investment. (But true in the model case where the economy is closed).

    “Obviously S = I is a meaningless identity (that is a pure residual) in the limit as we shrink the time period.”

    S=I is true for the world as a whole in any period such as a quarter. (Assuming unambiguous definitions)

    “That’s the story, but without a Walrasian auctioneer it can’t be right as an exact mechanism. If you assume inventories are carried at cost and are part of I and assume that my act of saving is exactly simultaneous with the inventory becoming surplus, then an all seeing auctioneer can perceive an identity. Of course, I might have been planning to have my gutters cleaned, and decide to do it myself instead.”

    My description doesn’t need a Walrasian auctioneer. Any consumption reduces inventory. Okay lets say inventories are valued at current costs of production. The purchase of the consumption good will increase firms’ profits which is immediately retained. Retained earnings is saving for firms.

    “A story about how S becomes I on average in the long term and what the long term actually is would be interesting. A completely contrived identity based on counter-factual assumptions isn’t.”

    No average. It is true for the whole world in any system such as one quarter or even in continuous time.

    “The real controversy that underlies this theoretical debate is whether and how saving finances investment. If people didn’t disagree about this, nobody would care about this stuff.”

    The more important point is people confuse the terminology itself and the identities.

  17. Ramanan writes:

    Btw, that Social Europe article you quote is generally right. The author seems Post-Keynesian which I am very familiar with. In PKE they say, investment creates saving and so on.

    However Fabian’s claim that “saving never finances investment” is not the right way to put across the idea “investment creates saving”.

    There are two things:

    1. Saving financing investment
    2. Investment creating saving.

    These two are not inconsistent with each other.

    Let us say a firm issues equities or bonds to raise funds. To be fair, the firm may borrow temporarily from banks and later issue securities to say households and/or other sectors. In the former saving is financing investment. The subsequent expenditure by firms for fixed capital formation indeed was financed by households. So economists describe this by using phrases such as initial finance and final finance.

    The actual error of the loanable funds model is that it ignores the fact that “investment brings forth its own saving”.

  18. Peter N writes:

    “Yeah but then why bring in NIPA which has real life data in which neither G-T is zero nor X-M?”

    Because you can’t discuss S and I meaningfully unless you have some unambiguous definition of them. If you conflate multiple definitions, your results are meaningless. NIPA definitions are reasonably clear, and much of the discussion of saving occurs in the context of GDP, for which NIPA is the natural choice

    It’s easy enough to correct for G-T and X-M.

    “To be fair, the firm may borrow temporarily from banks and later issue securities to say households and/or other sectors. In the former saving is financing investment.”

    Why is this saving financing investment? A bank can create money and does.

  19. Ramanan writes:

    “Because you can’t discuss S and I meaningfully unless you have some unambiguous definition of them. If you conflate multiple definitions, your results are meaningless. NIPA definitions are reasonably clear, and much of the discussion of saving occurs in the context of GDP, for which NIPA is the natural choice”

    Nope. My definitions are clear and unambiguous. In fact I specifically mentioned in a comment above that the Ss are different. Now I cannot always keep defining things again and again – especially because the commenters I have been discussing this have done so in many places over various blogs.

    Also read comment #3.

    And it is specifically I who is pushing to remove ambiguities.

    But if you want, here it is:

    http://www.concertedaction.com/2013/03/21/the-saving-investment-identity/

    In other words, your confusions are not my problem.

  20. Ramanan writes:

    “Why is this saving financing investment? A bank can create money and does.”

    Yes banks create deposits but firms also borrow from households directly or indirectly.

  21. Peter N writes:

    Your link is certainly a model of clarity compared to most others, however:

    1) There are a whole raft of NIPA rules that define exactly what counts as investment and what doesn’t. These are far from intuitively obvious and I have strong doubts that people discussing this are all using the same rules.

    2) It matters whether you’re doing value added accounting or full flow of funds. Some people make no distinction here.

    3) The identification of saving as a residual is not the same thing as calculating saving from GDI and investment from GDP. One of them is an accounting identity the other is more of a reconciliation constraint. There are also generally smaller (but not always so small) discrepancies calculating the identical quantities from flow of funds and GDP. The BEA is working on a set of Integrated Macro Accounts, which I hope will clear up a few things.

    http://www.slideserve.com/adin/nipa-flow-of-funds-accounts-integration

    “Yes banks create deposits but firms also borrow from households directly or indirectly.”

    Absolutely. Retained earnings seems to be the main source, but firms sell (and buy back) both stocks and bonds, borrow from banks, raid pension funds, accept vendor financing, factor receivables, swap assets, repo, create special purpose vehicles and God knows what else. That’s what you hire a CFO for.

    The bank money issue is important, however and more than a bit controversial. Here’s one of the latest attempts to bring it into sector accounting. Keen got smart and teamed up with a Canadian expert in economics math to clean up his loose ends and strange terminology. It really just amounts to the proposition that bank money appears in GDP when it is spent, even though the borrowing itself doesn’t.

    If this flow were to suddenly reverse you would expect to see some effect. Not, to my mind, a very controversial proposition. IMA should settle this.

    http://www.youtube.com/watch?v=UzxQcTOs4JA

  22. stone writes:

    Peter N @15 “The real controversy that underlies this theoretical debate is whether and how saving finances investment. If people didn’t disagree about this, nobody would care about this stuff.”

    Do you agree with Warren Mosler’s point that saving is merely the accounting record of investment and “investment” includes unsold excess inventory that perishes and goes to waste?

    If everyone who currently wants a new computer instead saves their money and uses it to buy APPL stock, then that will manifest as investment in the form of warehouses full of unsold computers that in say 18 months time go to landfill. APPL will then cut back on staff, halt R&D and we will get further “investment” in the form of the unsold inventory of whatever those staff would have bought had they not just lost their jobs.
    Whether APPL will decide to invest in new technology development (rather than returning profits as share buybacks)depends on whether people are going to buy computers etc. I got the impression that essentially all financing for new equipment/technology/training etc came from retained earnings of firms. The financial markets are largely about ownership being exchanged between people not about financing investment. Please correct me if I’m wrong.

  23. Ramanan writes:

    Peter,

    I generally prefer SNA 2008 which clearly integrates stocks and flows. It is not the full flow of funds but the latter is an extra dimension.

    Yes retained earning is a big source for investment – an instance of saving financing investment!

    Although I like Steve Keen, I am not a fan of his accounting.

  24. stone writes:

    PeterN@21 ” Retained earnings seems to be the main source, but firms sell (and buy back) both stocks and bonds, borrow from banks, raid pension funds, accept vendor financing, factor receivables, swap assets, repo, create special purpose vehicles and God knows what else. That’s what you hire a CFO for.”

    Are any of those capital structure schenanigans actually anything to do with financing investment rather than simply swinging the stock price hither and thither so as to juice stock option returns for management/ ensure earnings get transmitted to activist shareholders rather than “dumb money” shareholders such as pension funds etc ?

  25. Peter N writes:

    ” The financial markets are largely about ownership being exchanged between people not about financing investment. Please correct me if I’m wrong.”

    There largely about making finance as complicated as possible and then profiting from the generated rents and inefficiencies. The financial sector hasn’t been this big as a percent of gdp since 1932.

    I don’t know Mosler’s stuff well enough to comment. I thought the Simon Wren-lewis link in the article was quite reasonable.

    @Ramanan I’m not sure what you don’t like about Keen’s accounting (at least now that he’s decided to go double entry), but he has teamed up with a Canadian expert in economics math M. R. Grasselli, who has cleaned up a few things. He has an interesting video on Youtube using Keen’s stuff to find the basins of attraction in cases of austerity.

    http://www.youtube.com/watch?v=_qcXR5P3rck

  26. [...] for people who aren't capable of changing definition. Normally I'm a fan of Steve Waldman, and he writes this post where he records the latest dust-up about definitions. At this post, we're well into the stage [...]

  27. Eric L writes:

    you can’t discuss S and I meaningfully unless you have some unambiguous definition of them.

    Yes, and this is especially the case for I. In particular, the definition of “investment” used by economists is: any spending which needs to be classified as investment in order to make the GDP equations add up correctly.

    More specifically, investment = spending by business on that which they do not turn around and sell. So if a business buys a machine and does not sell it, that spending is investment. Likewise if a business engages in production but then finds they can’t sell their inventory, the spending on that excess production was investment, and if they manage to sell it at a later time then it becomes disinvestment, but if say a new product is a flop and excess inventory is sent to the dump, then all the money that was wasted on it is considered investment. Likewise if a business spends money to put a golden throne in the CEO’s office, that’s investment. And of course money you spend on going to college is not investment; because that would be an unnecessary complication to the GDP equations. After all, all household spending adds to GDP, so no need to break that down further, just call it consumption. But most business spending does not contribute to GDP due to the need to avoid double counting the value of intermediate goods, so a special name is needed for that part of business spending which is included in GDP: “investment.”

  28. Eric L writes:

    If we take Chamley-Judd seriously as a way to model what it models, there are still two good reasons to dismiss it. One is that growth through capital accumulation results in a Solow steady state, whereas growth over the long term requires growth in total factor productivity, and they provide no model of how that can be improved. At best they are offering advice to the developing world; their model has no relevance to mature economies.

    The second reason is that it does not address the specific policy choices we consider when it comes to taxing capital. The main capital preference in our tax code is the reduced tax on capital gains. Chamley and Judd do not put such a tax in their model; that is because they do not model reselling capital at all, so there are no capital gains to tax! The tax they consider is more like a dividend tax. Except that eliminating taxes on dividends would result in a huge distortion of capital allocation toward big businesses over small. And that’s unavoidable — a small business owner or farmer’s capital income cannot be distinguished from their labor income. Favoring capital gains can apply to both small and big business, but it favors the latter more and encourages investors to choose growth stocks over dividend stocks, making the stock market bubblier. The tax code Chamley and Judd want can’t be written. So their work is used to excuse a tax code that distorts our capital allocation, and it’s not clear that we should expect the alleged benefit of shifting some expenditure from consumption to capital to outweigh the cost of that distortion.

  29. JKH writes:

    Re your update:

    “To keep things clean, let’s adopt, um, a convention. When we use the word “savings” we should refer to claims. When we use the word “investment” we should refer to real resources.”

    Hmm… I have a quite different interpretation.

    As preliminary, I think it is essential – and I think you may agree with this – that there must be a robust primary connection of some sort between the idea of saving and the idea of investment. For example, if investment is treated as just another form of spending, then one stumbles upon the unhelpful conclusion that global saving (at least as a flow variable) is identically zero, which is not very productive. Yet it was this sort of loose literal slippage in the interpretation of ‘spending’ in the more restricted context of the private sector that became one of the motivations behind the S = I +(S –I) emphasis.

    Proceeding from there, I think your notion of “claims” confuses the meaning of a term which in my view should apply directly to balance sheet stocks, and not so much to expenditure/income flows.

    Y = C + S + T is a flow equation

    When that flow equation concludes at the end of the period in a stock residue, S becomes savings.

    I think that’s the point at which the word “claims” should enter the analysis.

    (Stock claims may also exist in the form of tax liabilities, and C contracts, etc. but that isn’t really intended to be captured in equation 3)

    Then, having reached the realm of stock analysis, there is a further problem in my view.

    In describing balance sheets, I used LHS and RHS for left and right hand sides respectively.

    LHS (assets) = RHS (liabilities and equity).

    Saving is a flow that adds to RHS stock equity.

    Saving accumulates over time to savings, which corresponds to the value of RHS equity.

    RHS equity itself is not a claim. It is typically value at book for corporations. That may be reflected in equity claims valued at market. But the equity claim is distinct from the RHS balance sheet entry. As far as households are concerned, RHS equity (net worth) is more typically valued at market, but it does not exist as a separate financial claim.

    Consider household balance sheets further. Saving is reflected directly as the value of RHS equity. It is only reflected indirectly as some aggregate subset of value on the LHS of the balance sheet – an amount that is often an indeterminate subset (in substantial composition) of a gross combination of real assets (e.g. residential real estate) and financial claims.

    Therefore, household savings are AN AMOUNT that may include a commingling of both real assets and financial claims. Most importantly, for any entity, savings is an amount that is actually logically distinct from an identifiable composition of the assets that correspond to that amount, be those real resources or financial claims. This may seem excessively abstract, but restricting savings to the more direct notion of claims as opposed to real resources is problematic. It wouldn’t be if household balance sheets consisted only of financial claims, but that is not the case. This is why that in the case of the broader private sector, I was very careful to say that in respect of S = I + (S – I), there is AN AMOUNT of saving (a subset of S) that is equivalent to AN AMOUNT of investment (I) – not that saving can be equated to investment in substance or that in this case there is a precise mapping of what funds what in terms of that internal decomposition (a point on which I still owe a response to Steve Roth).

    To identify saving as either real resources or financial claims is to confuse the LHS and RHS sides of the balance sheet. Working the logic through and across all sectors will demonstrate that this logical distinction is a necessity for accurate and coherent economic and accounting measurement. It is fundamental to the essence of what must be defined as a residual flow that cumulates into the right hand side of the balance sheet versus the substance of what is on the left hand side of the balance sheet in the form of real assets and financial claims.

    “However, whenever anybody tries to make a substantive point by quoting S ≡ I, they are offering no insight at all to any nontrivial question.”

    Maybe. Maybe not. It’s not so trivial when clarifying the essential role of financial intermediation. But I’d agree on a relative basis that the decomposition of private sector S is arguably more illuminating by comparison.

    “They are saying nothing more or less than balance sheets must balance. They reveal nothing whatsoever about how.”

    I don’t think that’s an ideal argument. See:

    http://www.asymptosis.com/reading-mankiw-in-seattle.html#comment-8575

    “The only thing that’s really terrible is the inconsistent conventions, under which S sometimes means total saving and sometimes private saving.”

    Right. That’s the real problem in these discussions. My vote would probably be for keeping the S notation as private sector saving, while developing new notation that maps consistent relationships between domestic S and domestic I, global S and global I, and domestic I as funded from a subset of global S (i.e. including the capital account surplus).

    Regarding valuation – I tend to think of the aspect of reconciling book and market values as quite secondary to the more important issues of logic that surround the subject of S and I. Book valuation tends to be useful as a device for capturing periodic flow contributions to economic activity, such as GDP. Market valuation is useful for capturing the balance sheet situation in terms of accumulated stocks. It’s all quite manageable through proper accounting design and connections.

    Regarding investment as a residual – yes I think this is a good approach. But it is still investment in the sense that it is the business sector that is producing the stuff that will reside on its balance sheet before it can be sold – whether sold successfully or not. In this sense, all consumption goods are initially investment goods. And the true residual is what is converted from investment to consumption.

    Regarding micro dissaving and valuation of financial claims that connect to micro dissaving – yes this is an issue, but it is not inconsistent with the book value flow of investment as the starting point in identifying the flow of saving. It becomes a valuation adjustment for accumulated stock savings. And that valuation adjustment includes the expected effective claims on future goods and services that may be synergistically complementary and incremental in value to any starting investment value and savings value proposition in respect of assets already produced and now on the books.

  30. Steve Roth writes:

    In equation 1:

    Y ≡ C + G + I

    I must mean private investment, right? Because G is separate. I’ve always wondered how this worked, because some decades ago the national accounts started splitting out government investment and consumption.

  31. reason writes:

    “But electricity produced and not consumed? It dissipates as heat. Bread produced and not consumed grows moldy.”

    Steve – I haven’t read the entire thread – if somebody said this already my bad – but this is not quite right. GDP basically isn’t a measure of production. It is basically a measure of exchange (except for the odd imputed rental exception).

    But in general you are right – some exchange is for goods counted as final consumption (which are actually often as far as a household is concerned actually investment goods – e.g. a private automobile), some is for intermediate goods, and the rest is considered investment goods. And yes it is rather arbitrary, and someday I might persue that thought much further.

  32. reason writes:

    Thinking about what I said above it is not quite right either. Yes GDP is basically a measure of exchange + imputed rental + calculated change in business inventories (not sure how stocks of intermediate goods are treated). But lots of production is not counted – not only intermediate goods, but all household production.

    GDP is a mess. But everybody knows that.

  33. JKH writes:

    30. Steve – yes, I is private sector investment in that equation

  34. [...] Steve Randy Waldman and Scott Sumner (plus many others, linked from Steve’s post) wade in on notions of saving and investment. [...]

  35. Peter N writes:

    How is this as a starting point:

    If you price added value at the cost of the labor that produced it, then the total added value of the goods produced must equal the total of the payments for their production.

  36. [...] As JKH has quite rightly pointed out, if Sectoral Saving means money saving, “one stumbles upon the unhelpful conclusion that global saving…is identically zero, which is not very productive.” Income = Expenditures, right? One person’s spending is another’s income. So for the world or any closed sector (no net flow in or out), Money Saving (Income – Expenditures) must equal zero. [...]

  37. [...] As JKH has quite rightly pointed out, if Sectoral Saving means money saving, “one stumbles upon the unhelpful conclusion that global saving…is identically zero, which is not very productive.” Income = Expenditures, right? One person’s spending is another’s income. So for the world or any closed sector (no net flow in or out), Money Saving (Income – Expenditures) must equal zero. [...]

  38. It is late to comment on this post, but I would like to offer a new twist on the aggregate demand equation. I have developed a new model for Aggregate supply & Effective demand. Then you can see how the traditional aggregate demand equation is extended into an Effective demand version.

  39. Here is the equation for effective demand that builds upon the equation you give above.

    Effective demand = (C + I + G + Xn) * effective labor share/(capacity utilization * (1-unemployment rate))

    You could have fun with this equation. els=effective labor share… cu=capacity utilization… u=unemployment rate
    Let’s just solve for the unemployment rate. We get this…

    u = 1 – els(C + I + G + Xn)/(ED*cu)

    We can see that if total spending, (C + I + G + Xn), increases… Unemployment would decrease too, if ED held constant. But ED (effective demand) increases too by the same percentage. For example, we increase spending by 20%, ED also increases by 20%… 1.2*ED = 1.2*(C + I + G + Xn)*els/(cu*(1-u)). So in effect, just an increase in spending does not change unemployment.

    In order for unemployment to truly decrease with a rise in spending, another variable has to change. but if effective labor share of income increases by 20%, ED also increases by 20%. And if capacity utilization increases by 20%, ED will decrease by 20%.
    Thus, no one factor alone can lower unemployment. So then how does unemployment decrease?
    The answer may surprise you…
    - by hiring more workers as capacity utilization increases.
    - By hiring more workers as effective labor share decreases.
    - By hiring more workers as spending is increased.

    Just by increasing spending, unemployment is not automatically lowered when there is spare capacity, whether done by the government or consumers. Labor and capital already employed may just be used more.
    The key is to just hire more workers. Thus the Germans had it right with their program to keep more workers working at part time.