In a very small world, Jimmy earned himself one dollar. It so happens that the very next day a sweet lady took a shine to young Jim, or maybe it was the way that solid silver dollar shined in his hand -- it was all the money either of them had seen, as it happens it was all the money in the world. I did warn you that this is a very small world.After 10 years drifting around thinking about their futures, Jimmy and his wife met the Old Man. The Old Man owned a farm, but lacked the strength to work hard so he offered to sell the farm for ten thousand dollars to Jimmy. No one had ever seen ten thousand dollars, there wasn't enough silver in the world to pay. Jimmy showed the silver dollar in his hand, "That's all I got."
"No problem," said the Old Man, "Pay me that one silver dollar today, and you can owe me for the rest of it. I'm going up to my hut on the hill. You bring me some food tomorrow and I'll buy food off you every day."
So they shook hands on the deal.
Jimmy and his wife worked the farm, they had more food than they needed and Jimmy was good to his word. Every day he took food up the hill to the Old Man, and the Old Man bought the food for one silver dollar. Jimmy gave back the silver dollar in payment on the loan and then went back to his farm. As the years went on, the Old Man grew older, Jimmy's wife had a baby and they called him Jack. Many years later came a day when Jimmy brought food to the Very Old Man and after he got the dollar in payment (it was a bit worn by now) Jim stood thoughtfully and waited. The Old Man spoke first.
"Yup, I been counting it too, you made your last payment yesterday, and I just handed you my last dollar."
"It's OK", Jimmy replied, "I don't mind bringing you food tomorrow, and you ain't been eating much these last years."
Well out of decency, Jimmy kept bringing food to the Very Old Man a few years longer, but one day he was gone and the hut was empty. Jimmy never knew exactly where he went but he did know he wasn't coming back. Some years went by and Jack had grown, he wanted to go out into the world and find himself a wife so Jimmy gave one silver dollar to his son, it was all the money he had, and as it happens, it was all the money in the world.
Some years later Jack came back with his own wife, and Jimmy saw that his son was strong and ready to work hard. Jim and his wife knew they were getting old themselves so they spoke to their son and said, "We can sell you this farm for ten thousand dollars, starting with that one dollar. We can live in the hut on the hill and you come up every day to pay back one dollar of the loan."
Jack thought about it and they shook hands on the deal.
OK, OK... it's a hokey story and ridiculously oversimplified. Let me tell you a different story (mercifully shorter).
A great sultan loved to race camels but he never knew which would win. The sultan hired: an economist, a chemist and a physicist.The (freshwater) economist told him the marketplace knows best, so just check the betting odds at the bazaar and always bet on the favourite.
The sultan was dissatisfied that the favourite didn't always win, so he asked the chemist. The chemist offered to make any camel win, and any camel lose merely by dosing them with drugs before the race. The sultan loved this idea until his strict religious adviser warned him that cheating would surely bring a curse upon their house.
So the sultan asked the physicist who quickly sketched up a mathematical formula to calculate the exact speed of every camel. The sultan was delighted. As he eagerly started plugging numbers into the formula, the physicist mentioned, "It works best with spherical camels traveling in a vacuum."
So getting back to the issue of debt... the ballad of Jimmy and the Old Man is a spherical camel -- oversimplified but it does teach some basic principles. Let's call these the take home points (THP).
Somewhere around here, it's worth pointing out that repayment of debt is one way for the loan to disappear, but there are other ways. Suppose the Old Man happens to open up his secret stash of Mountain Whiskey and goes a bit hard one night, then staggers around and accidentally steps on a rattlesnake. These thing happen, no one should be blamed for what is evidently a freak act of God (I know I'm skipping over the ethical side of this very quickly, although ethics and morality certainly are extremely important in economics, I just don't want to dwell on that question right now). To get on with the point, suppose that one way or another the remaining debt on the loan never actually gets paid... the Old Man has no heirs, and the debt is just written off and forgotten. In practice there are many ways a debt might get written off, typically involving bankruptcy or possibly just a refusal to pay and no workable method of debt recovery.
When the loan is written off, this is equivalent to one big final payment (from an accounting perspective), but regardless of how it happens, the debt is unwound and total debt in the system rapidly drops. Very important: repaying a debt happens slowly, writing off a debt happens quickly.
Thus, it is necessary to carefully distinguish between hard assets and soft assets. In the story in question we have two hard assets only -- the farm and the one gold coin. These hard assets are never created, nor destroyed in this story (hard assets might quite sensibly be created and destroyed in other stories but this story is about debt), they do change hands at various times but the total tangible wealth in the entire system remains constant. Some people refer to this as equity and from a simplistic broad brush approach let's just treat equities exactly the same as wealth or hard assets.
Here is the chart of assets owned by the Old Man (red), and Jimmy and his wife (green) and Jack (blue).
There's no way Jimmy could but a whole farm for one dollar, and there's no way for him to build up sufficient savings in hard assets to exchange for the farm because suitable hard assets for this purpose simply don't exist in this small-world example. In practice, they would no doubt figure something out if left to their own devices (most people do). However, the debt instrument serves to facilitate gradual exchange of assets over many years where a simple barter transaction would imply an instantaneous exchange.
Needless to say, I'm lumping a whole lot of possible soft asset instruments together here (again, it's a simplified spherical camel explanation) so you might have the farm divided up into share certificates an Jimmy works for the Old Man as an employee, getting paid in shares of the business. That's an alternative soft asset (share certificates) that can be tradeable in a similar fashion to other assets. There are many other possibilities and some may be better or worse depending on circumstance, but they all serve one primary purpose: to facilitate trade where a simple instantaneous barter transaction is not convenient.
Debt written-off is indicative of a broken promise, something that either could not be fulfilled, or would not be fulfilled, depending on the circumstance.
Getting back to the issue of trust, and going one step further, suppose that neither Jimmy, not the Old Man could trust each other, but they do both trust their local hillbilly priest. Instead of making promises to each other, they exchange promises with their priest. Jimmy borrows from the priest instead of borrowing from the Old Man, and Jimmy promises to repay the priest, so it becomes a three-way transaction instead of a two-way transaction and the priest becomes the intermediary who makes sure both sides of the deal get fulfilled as expected. The priest may even make some small profit in the process.
The job doesn't have to be done by a priest, it could be a local lawman, or a banker, or even a powerful government. The only requirement is that both sides of the transaction are able to trust this third party will be both willing and able to ensure a stable and predictable outcome. Please note that this is in no way contradictory with THP #1 above, because government intervention is not required but there are some times where some outside power might be useful providing that the parties in question do really trust that outside power to be both authoritative and even handed.
Indeed, this perspective provides a way of evaluating possible candidates for the job; and government does not stand out as best option. In a democratic country, the executive and legislative government can change quickly and write new rules, it is not knows for consistency and even handedness. Most countries have a judicial side to government that changes only slowly, and is committed to delivering at least a predictable outcome, if not a perfectly fair one. There are many aspects to what makes people trust one another, and it goes well beyond the scope of this memo, but the key component of this particular Take Home Point is that trust is an essential element for any promise to be successful.
Understanding the simple example is essential before attempting to understand something more complex.
Let's see how this fits together with other people concepts of "Accounting Identities" and beliefs about what is possible, and what is not possible.
Peter Dorman comes up with the following:
Such "serious" people somehow think that public and private debt levels can be lowered simultaneously, without a substitution of foreign assets in domestic portfolios (a current account surplus). It does not occur to them that one person's debt is another's asset -- too confusing, I guess.
It is under the heading, "This Is What Accounting Identities Look Like". Dorman even has a go at trying to equate accounting with physics (and aren't there a lot of economists in love with the idea that they are doing something pretty darn close to physics). My first response is that if economists want to bring their discipline a bit closer to the physical sciences, the best place they can start is by understanding Dimensional Analysis. So anyhow, let's go back to the THP's from above and see how our micro-example fits Peter Dorman's view of the world.
Do we require government to get involved in order to reduce debt? Categorically no, as per THP #2 above. I accept that one possible transaction, is for private debt to get shunted across onto the public books -- that is indeed a possibility, but no "accounting identity" makes this necessary. After all, each and every accounting identity works perfectly well in both directions, and yet both public and private debt have grown extensively all over the world during the previous 50 years or so. The accounting identity never prevented the debt from growing, so why would it decide to preferentially stop the debt from shrinking? Very strange huh?
Which accounting identity is Dorman referring to? Well, he says, "one person's debt is another's asset" so how does this identity line up with our example above? Well the debt is the loan, and Jimmy's debt is the Old Man's asset so the identity does hold true. What's more, the first derivative of the identity also holds true which is to say that time-change in Jimmy's debt (i.e. the repayments) is also equal and opposite to time-change in the Old Man's assets (see the red line falling while the green line rises in the graph above). No problem with the accounting identities, all neat and tidy. All accounted for.
Does this prevent the aggregate debt from shrinking? No!
Does this prevent the aggregate debt from growing? No!
It should occur to readers about now that exactly the same accounting identity also proves that we cannot possibly all be in debt to each other, such a thing doesn't make sense. Some people must be nett creditors, while others must be nett debtors. The whole objective of reducing debt is to reduce the total on both the creditor side and the debtor side, and thus reduce the total system leverage between soft assets (i.e. financial instruments) and hard assets (i.e. equity and physical wealth). It should also occur to readers that although all debt is balanced by a financial asset somewhere, not all assets are created out of debt. In particular the silver coin is an asset that does not link to debt in any way, shape of form, it is a hard asset that has intrinsic value unto itself. Putting this a different way, the set of all assets is larger than just the set of financial instruments.
I can explain this another way using THP #5 from above. Think of a Mother, and two children. One day, there is only one ice cream and Billy gets it, but Sally is sad because she is missing out.
Mum asks, "Hey Billy, can't you share with your sister?"
Billy replies, "Oh mum, I'll just have the ice cream for today, and I promise she can have tomorrow's ice cream and then I'll miss out."
Sally is a bit suspicious, but decides to agree. Tomorrow comes around and sure enough, Billy wants to take the ice cream for himself a second time.
Mum is angry, "Billy, you make a promise yesterday, and I intend to see that you learn to keep your word."
Billy tries it on, "Mum, the accounting identity made me do it. I can only give the ice cream if a new ice cream comes along for me."
Most six year olds would already understand that mum is highly unlikely to swallow this, but they might give it a run just to see what happens. It's sad to see adults behaving this way. I note that Warren Mosler gets a mention, pointing the way to the upside down world of Modern Monetary Theory. At least Paul Krugman keeps within some bounds; saying that the rules are reversed when you are in a "Liquidity Trap", but the MMTers seem to think the rules are reversed all the time, Keynes unchained! It will take me at least a whole nother page to explain all the things wrong with MMT, so I'm going to skip past Mosler and onto David Cameron.
From the Guardian, reporting on Cameron's speech in October we have this:
David Cameron has hastily rewritten his conference speech to remove any suggestion that he is either urging or instructing the public to pay off their credit card bills -- a move that could dampen consumer demand and worsen the recession.A pre-briefed version of the speech on Tuesday read: "The only way out of a debt crisis is to deal with your debts. That means households -- all of us -- paying off the credit card and store card bills."
The prime minister's aides said the speech would now read: "That is why households are paying down the credit card and store card bills."
Many people have pointed out elsewhere that David Cameron is a political lightweight, a man with no direction and no convictions whatsoever. It's sad, but it's also pretty normal for that sort of man to rise to the top. The problem is that, as leader, people look to him for leadership but he himself is led by the nose so easily that he positively radiates lack of leadership. Naturally, in a democratic nation, the leader must look to the will of the people, but the will of the people right now is they want to get out of debt.
Instead of looking to his own convictions, or looking to the will of the people, Cameron looks to a small self-chosen elite group of Keynesian economists who have no plan for what will happen as nation after nation is driven to default. Ultimately we are headed in a direction that will put the USA itself in default, but most likely they will use inflation as their tool to force a real devaluation of their debts (i.e. not a nominal default, but a default in real terms).
Paul Krugman came up with this comment:
Martin Wolf is shrill:
[W]ithout economic growth, it is almost impossible to deleverage an economy. The prime minister revels in his pre-Keynesian views. When weak demand is the immediate constraint on output, that is simply terrifying.He's reacting to Cameron's statement, semi-withdrawn but not really, that what Britain needs is for everyone to pay down debt, said in obvious obliviousness to the fact that if everyone cuts spending at the same time, income must fall.
Oh dear, straw-man alert! Did David Cameron ever suggest that it would be a good idea if "everyone cuts spending at the same time" (go back up and check the original above) ? I'll indulge myself in repetition here, the accounting identity mentioned by Peter Dorman also proves that we cannot possibly all be in debt to each other. Interpreted with even a modicum of common sense we must believe that David Cameron was attempting (in his wishy washy way) to suggest the people who are in debt (i.e. debtors) should pay back their loans and get out of debt. He was not attempting to suggest that creditors should should pay off their credit card and store bills, because they don't have any credit card and store bills to pay off -- err, duh!
So putting this into the accounting context, what David Cameron was trying to say is that debtors should work hard and keep their promises to creditors, with the implied converse that creditors should attempt to employ debtors in order that they can make those payments. There is absolutely no accounting identity that prevents this from happening! In fact, if it did happen, the extra work done would be a good stimulus to the economy and would boost economic activity. There are however, some practical issues (unrelated to accounting identities) that can obstruct this process:
Rather than examining the issue with level headed common sense, Paul Krugman just wants to wring his hands and moan about politics. In particular he wants to constants assume he is right about everything, and then accuse whoever might disagree with him of not understanding basic arithmetic. Consider this quote from the same article as before:
But then, this kind of obliviousness is very widespread, and my experience is that if you try to point out problem the if you try to explain that my spending is your income and versa vice you get a belligerent response. Y=E is seen as a political statement, which in a way it is if one side of the political spectrum insists on believing things that can't be true.
In my opinion, this is one of the stupidest things I've ever heard from Krugman, and it belies a complete lack of understanding of accounting, and even a lack of understanding of economic modeling. I'll go through it in small steps. Let's look at the particulars of the key phrase "Y=E is seen as a political statement", so what exactly does Y = E represent?
Well from a purely mathematical point of view, it is a statement of equality, an equation if you will. So I can write a bunch of equations, x = y, alpha = beta, higgerty = schmiggerty and we can say every single one of these is absolutely and undeniably true with a rock solid mathematical basis. Arithmetic cannot be denied. What to they mean though? Well nothing at all, they are just abstract equations, and so is the equation Y = E an abstract equation. Only once both the terms and the context are defined do any equations take on meaning. We call this applied mathematics as opposed to pure mathematics.
Krugman is not quite so silly at to grab two random letters out of thin air and make a completely abstract equation out of them, the equation Y = E does come with an implied context, it just happens that Krugman is too lazy (or maybe too sneaky) to fully explain the context to his readers. I'll now go to the trouble of doing just that.
The relevant context comes from a Two-Sector Keynesian Model of the Economy from whence I get the following quote:
We often find it convenient to give this guide line the label of Y = AE, where Y is the common designation for aggregate production and AE is the abbreviation for aggregate expenditures. Such a label descriptively indicates that this is, in fact, the equilibrium guide line for the Keynesian model.
Here is another description known as the circular flow of income and I'll quote the bit about the "Two Sector Model":
Two Sector Model
In the simple two sector circular flow of income model the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:
Y = E = O
And to be fair, I should include the basic assumptions from the same source:
Assumptions
The basic circular flow of income model consists of six assumptions:
- The economy consists of two sectors: households and firms.
- Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).
- All output (O) produced by firms is purchased by households through their expenditure (E).
- There is no financial sector.
- There is no government sector.
- There is no overseas sector.
I have added emphasis to one particular assumption "There is no saving" which means this model is not interested in tracking inventory buildup, nor equity, nor debt. It's a simplified model that serves some purposes but not all purposes. You can say that the model is mathematically correct, within that set of assumptions, but you cannot say this model represents reality, because reality has no respect for those assumptions.
So let's get back to Krugman's sarcastic comment, "Y=E is seen as a political statement" and think about how this really works. The equation as a statement of equality is not seen as a political statement, but the assumptions and implied model that go along with the "Y = E" are seen as a political statement. Obviously, the "Two Sector Model" is a poor model is you want to study investment, equity and debt. The political statement that people react to is that somehow conclusions based on this model do apply to our current situation. Yes, that's very much a political statement, and no law of arithmetic is going to save the people making that political statement.
What's more, the two sectors in the "Two Sector Model" are households and business. These are arbitrarily chosen because it happens to be of interest to Keynesians. There are also other models with three sectors, four sectors, five sectors, etc. In every case, the exact dividing line between the sectors is poorly defined... so does a small home business selling goods online count as part of the "household" sector or part of the "business" sector? We don't really care because it's only a rough model anyhow.
Here's another Krugman quote:
So we're in a world in which Very Serious People demand that debtors spend less than their income, but that nobody else spend more than their income.
And there's that straw-man again, no one is making such a demand.
Martin Wolf has a somewhat despairing-sounding column this morning, in effect pleading with the Cameron government to admit that the laws of arithmetic must apply. Good luck with that.Martin writes,
If the private sector is seeking to run down its debts, it is hard for the government to do so, too, because everybody cannot spend less than their income. That is the "paradox of thrift". No, it is not a novel idea.
Once again, up comes the straw-man. Krugman and Wolf have now switched to a different two sector model where one sector is government and the other sector is the private sector. They carefully ignore the foreign sector (because that might be a bit inconvenient) and don't bother distinguishing between debtors and creditors (because that might be too close to the heart of the problem).
We know that the US government is a debtor, so the good old "accounting identity" tells us that either the domestic private sector or the foreign sector must be a nett creditor (or both of course). But what does that mean, in real terms, that one sector is a "nett creditor"? Of course it means nothing at all, because the choice of sectoral division is itself an arbitrary assumption. The economy is not made of sectors, it is made of many individuals. Hundreds of millions of individuals, some of which are creditors, and some of which are debtors, and some of which are neutral. By carefully ignoring this fact, Krugman and Wolf are able to pretend to have the unstoppable power of arithmetic on their side, when what they are really using is the flimsy power of arbitrary sectoral divisions and conveniently selected assumptions.
Oh, and widespread debt forgiveness (or inflating away some of the debt) would solve the problem.
So wait a minute here. The laws of arithmetic supposedly make it impossible to pay down debt, but yet debt forgiveness is still possible? How can that work?
Paul Krugman is enthusiastic about inflation, but how exactly does an inflationary environment punch a hole in those laws of arithmetic that Krugman keeps talking about? Doesn't even make sense. If Paul Krugman can explain why certain "accounting identities" apply in a regular environment but suddenly stop applying in an inflationary environment then I'll take my hat off to him.
No it's not what Krugman, Wolf and Dorman are claiming, it's a bit different, but actually more important if only people would pay attention to what is really going on rather than the hand waving. In order for the system to de-leverage and for debtors to reduce their debt load, the creditors need to shift the composition of their savings away from financial instruments and towards hard assets. Note well, I did not say that the creditors need to reduce their actual savings, they can still have savings, they would need to seek out equity savings, or hard assets, rather than financial assets.
Let's consider a pension fund, it might have decided to put some of its money in a bank, and the bank in turn might be running credit cards for a bunch of individuals who are in debt. The pension fund is a creditor (more correctly, the members who bought into the pension fund are creditors, and they will need to spend this credit as they retire), and the individuals holding credit cards are debtors. While the individuals holding the credit cards are paying 25% interest, they are a source of income to the bank, and hence they represent a return on investment for the pension fund.
Suppose these individuals are inspired by David Cameron and they make the extra effort to pay back their credit cards, the bank can't refuse their payments, so the total credit card debt goes down. The bank can only lend the money to someone else, or else hang onto the money (and thus get lower interest). The bank signals to the pension fund, by lowering the interest that it pays on deposits. Maybe the pension fund goes looking for other places to invest.
One scenario amongst many is that the pension fund hears about the crumbling infrastructure and makes a deal with the local authorities that it will build a spanking new bridge (to replace the existing bridge that is falling down) and there will be a toll road. The pension fund collects tolls for 20 years after which the road and the bridge revert to public ownership. In the process, new jobs are created and new infrastructure is also created which in turn improves the efficiency of other industries.
What about the accounting in this scenario? No problem, the pension fund is drawing down their financial assets (because debt is being paid back) and they are transferring these financial assets into physical assets in the form of a bridge and a road (i.e. taking money out of the bank and investing it into a project). If done properly, their return would be better than what the bank was offering. It will also create jobs, which in turn helps people pay back their credit cards.
Alternatively, the pension fund could leave its money in the bank, but the bank could invest by buying shares in a startup company that was into road and bridge building. These shares represent equity in the venture, and if the company was managed properly then returns would be paid as dividends to the shareholders. It doesn't matter exactly how the investment is organised, all that matters is the creation of new and valuable physical assets. That does leave the problem of correct valuation of those physical assets, it's a very real problem, and far to big to get into right here. It also leaves the problem of why creditors are reluctant to take a risk putting investment into such physical infrastructure and building hard assets, I guess Krugman is going to have to have a chat with the confidence fairy about that little issue.
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