Sunday, December 6, 2009

The Fish Balance of Hobbiton

Like everyone else I've been trying to make sense of the arguments between the Keynesians, Austrians, etc. over the financial crisis. Lately I've been trying to puzzle out the National Financial Balance Accounting Identity:

Household FB + Business FB + Government FB + Foreign FB = 0

Described here. The importance of this equation is its use in justifying government deficits:

"We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus." Marshall Auerback

From the first linked article, some definitions:

Financial Balance FB = income - expenditures, or saving - investment
income = profits + wages = P + W
spending = investment + consumption = I + C
normally (when FB=0) total income = total spending, so P +W = I + C

In discussing households we simplify by assuming no profits, so P=0

savings = W - C
FB = (W - C) - I

The author of the first linked article criticized an earlier author who claimed it was possible for all sectors Financial Balance to be simultaneously positive, so the Accounting Identity would not have to sum to zero. He claimed this would only be true in a primitive barter-based "Hobbit Shire".

Let's build one. Assume our world economy only consists of Hobbit households. No businesses, no government, no foreigners, no money, no outside investment. One primary resource: deep sea fish. Household "Wages" are the daily catch of fish. "Consumption" is eating fish. "Savings" is storing fish in the snow (Eskimo Hobbits :-) for later. So in good times (summer?) the net FB "Fish Balance" of all the Hobbit households is positive, while in bad times (winter?) the FB can be negative. This doesn't match the original Accounting Identity, but we can make it sum to zero by adding a new often-negative "Natural Resources" term to the equation.

Hobbit Household FB + Natural Resource FB = 0

This forms an interesting analogy to arguments against evolution based on the Second Law of Thermodynamics. Life on earth is not a closed system. It depends on a constant supply of energy from an outside source -- the sun. Life on earth is also dependent on heavier elements produced in prior supernovas. Similarly human economics is dependent on many raw material inputs which are not initially generated by (or often even owned by) humans. For the above Hobbit example I chose deep sea fish as a renewable resource owned by no-one. Other renewable resources include timber, food crops, textile crops, livestock, etc. Non-renewable resources include oil and minerals. Think AH Civilization or Settlers of Catan. And note these raw materials also ultimately come from the sun or supernovas.

This introduces the question of why the real Accounting Identity doesn't include a Natural Resources term. Obviously the real one is about money, not about resources. But if gathering natural resources creates value within the system, shouldn't it be represented? It is also not clear how many other aspects of value creation (such as a household purchasing an income-generating asset, rather than investing in the business sector) are represented.

This also brings up how new money is injected into the system. If the currency were gold-backed, money would be a resource. But a fiat currency is created by central banks. I assume the government deficit spending advocated in the quote above is fiscal spending, and the Government FB is budgetary spending. Alternately could they be advocating monetary stimulus, and the Government FB is that of the Federal Reserve? Does inflation matter in the equation, or is it irrelevant?

I think some of these questions are at the heart of the debates between the Keynesians and the Austrians. The Austrians focus on productive versus wasteful uses of resources, like my Hobbiton Fish Balance (to the extent they recognize the Financial Balance version they see it as an argument for returning to the resource-based gold standard). The Austrians claim recessons are caused by misallocation of resources. Keynesians are more focused on the flow (especially velocity) of money inside the Financial Balance Accounting Identity. Some claim our current problems are due to government not carrying out its proper role: running deficits.


Paul Hubbard said...


You might like post on the tertiary economy. Many of the same ideas, even if he's damned grim in his forecasts.

Awesome blog, BTW.

Gemfinder said...

Fish are real, but do not have a fixed value, in that they are caught and consumed with varying efficiency. If you expended 2000 calories of physical effort to catch a 1000-calorie fish, you'd quickly run out of Hobbits. The less effort per fish, the greater their value.

This is a rudimentary illustration of return on investment, which is central to determining the economic value of natural resources. And of much else.

Gemfinder said...

It does look like natural resources are largely outside the financial balance equation. Another way to state it is that wealth creation in the traditional sense (especially where synonymous with "increased rate or efficiency of resource extraction") is at least partly outside the financial balance equation.

Far be it from me to defend the Keynesians, who I think are promoting a largely untested theory, but I think their idea is orthogonal to all that. It operates on a snapshot of the economy, in which wealth is fixed (some on the balance sheet, some not). When you increase the supply of fiat dollars, you dealing only with the explicit balance sheet. And you are robbing Peter to pay Paul. The pizza doesn't get bigger -- you just cut it into smaller slices, and hand out some free pizza.

So in the 1930s, you create new dollars to run anti-unemployment programs, and this fractionally decreases the value of existing bank savings and Treasury bonds held by investors.

In the case of the US, the total public and private domestic financial balance is negative (foreign dollar balance positive). Creating new dollars mainly serves to decrease the value of Treasury bonds held by east Asian central banks. This is consistent with the financial balance argument.

As you know, I think that if this works at all, it only works slightly and in the short run. I think the real value comes from maximizing transparency, which in turn maximizes return on investment, which in turn maximizes the efficiency of resource use.

I think this reconciles your thoughts with both theirs and mine.