Friday, March 18, 2011

Rehabilitating National Income Accounting

Troy Camplin has been busy doing a Hazlitt-job on Keynes here and here. He's focused mainly on the savings/investment issue. Now Keynes famously detested savings while simultaneously praising investment, even though Keynes himself defines them as the same thing in his GT. Now, after all my years of macro, I've discovered something that is missing from national income accounting that makes it abundantly clear investment and savings are not the same. So, I'm jumping on board this train (briefly) to make this correction, then it's back to micro and liberty!

First, let's do the "expenditure" side of national income (GDP or GNP) that we can call Y. I'm going to assume we are dealing with a large closed economy (i.e. the world). First we have households, then businesses, then government. So Y = H+B+G. H gets subdivided into consumption (C) and saving (S), but here I want to add a third element: change in cash balances (R). Before, S would have included R. But now, I want to be explicit in saying S are money flows, directly or through intermediaries, to borrowers. A finance person would call "S" a change to a person's investment portfolio (buying stocks, say). R now is the addition to cash balances that are not to be lent out. One could understand this as a bank's reserve requirement, if all S is held in the bank. R isn't small - it's 10% of bank deposits.

So now we have Y = C+S+R+B+G.

Let's subdivide B now. Business expenditure comes in the form of inventory purchases, wages, and capital expenditure. To avoid double counting, we focus on just the part we call investment (I), which (for Keynes) included fixed capital, working capital, and liquid capital. I'm going to subdivide I into capital expenditure (fixed + working, although working is a stretch) and money balances (liquid capital). Money balances aren't usually large for businesses, but they certainly are these days, and have been for a few years now. So call liquid capital L.

Now we have Y = C+S+R+I+L+G.

I don't have any plans to rehab G, so we can move to the income side. National income is still Y, but the right-hand-side changes. Household income is made up of wages (W) and returns on savings (Dh). Business income is made up of profit (P) and returns on savings (Db). Government income is taxes (T).

Y = W+Dh+P+Db+T

Equating the two sides gives: W+Dh+P+Db+T = C+S+R+I+L+G. Looks icky. Can this be cleaned up a bit? Why, yes it can! The way S&I have been defined, is that they are equal (now). Therefore, including both in the right-hand-side leads to double counting. So let's take away I.

W+Dh+P+Db+T = C+S+R+L+G.

Now let's group by by type.

Household: W+Dh = C+S+R
   Note that W and Dh are after taxes.
Business: P +Db = L
   Note that P for businesses is after taxes and payments to investors (Dh).
Government: T = G

It might seem strange that business doesn't have an investment expenditure anymore. Essentially what I am saying here is that the household ultimately makes the investment expenditure, but uses the business to do so on their behalf. Households, then, are the real capitalists.


  1. I really like your GDP reducto: households (aka me) are the real capitalists. Makes perfect sense.

    I'm trying hard to understand the notion of GDP, or perhaps more precisely, our national economy. Does the way in which we attempt to measure our economy, GDP, the best method to affix a measurement? The reason I ask this question is because of the way GDP captures G.

    People rightly protest that if we reduce government spending, GDP will decrease. But is this a valid argument? Simply increasing G for the sake of keeping GDP positive isn't necessarily a good thing. It creates malinvestment, can lead to inflation, and can create large deficits with debt service.

    So, is there a better way to think of our national economy than GDP? Or do we need to think of it at all (at such an aggregate level)?

  2. Brad,

    You ask good questions. The first, and most important, point to make is that national accounting is necessarily ex post, or after the fact. In other words, it does not describe an operational relationship. Thus, the response to decreasing G is the following: it may reduce GDP, or it may increase GDP. It may reduce it because no spending will come to take the place, or it may rise because government is getting out of the way of some other spending.

    I unfortunately don't think there's a better measure, right now, of national income than GDP. Nevertheless, I think GDP is bad, and becoming worse, because so much of peoples' pleasure now is available for free. Think of Facebook, online books, online TV (e.g. Hulu)- all kinds of stuff available for the price of monthly internet service.

    I also think thinking about this stuff on a national level is simply an arbitrary stopping point. I do not think it is sensible in an economic way - but it is sensible in a political way.

  3. My issue with GDP is that as an aggregate it masks what is really going on. For example, if you have two countries, A and B, that both produce 1 unit of X per year, both countries have a GDP of 1. However, if A destroys each unit of X, and B does not, after 5 years, B is 5 times wealther than A. This is beside the obvious problem that government, too, does not contribute to GDP in the way that matters most: wealth creation. We need a measure of that.

  4. I don't know how much this really means. You could have dropped S instead of I and concluded that businesses make savings decisions. Or you could have dropped half of both and concluded that they each make half the decision for the other. The income equation is just an accounting identity. You can't derive any statements like "X does Y from it".

  5. Daniel,

    Congratulations for getting the whole point of my post! They are just accounting identities. The reason I chose to retain S is that, temporally, savings must precede investment. Also, it's a standard neoclassical micro-economic assumption to say "households own the business."