Balance Mechanics 3.1: More on income

We had previously defined income and consumption as the transactions that change a unit’s net worth, i.e.:

y-c=\Delta nw \

Now I want to explain in more detail what income is because income can be different things that have to be kept apart. Also what income is is often not sufficiently well explained in normal textbooks.

First we should define income. Income is defined as a unit’s consumption plus its change in net worth:

y=c+\Delta nw \

Further, changes in net worth can be separated into changes in tangible assets (\Delta ta \) and changes in net financial assets (\Delta nfa=\Delta ofa -\Delta l \ ) so that:

y=c+\Delta ta +\Delta nfa \

The change in tangible assets is also called investment (\Delta ta \equiv=i \ ); and you can change your net financial assets (as we had defined in the previous post) by having an expenditure surplus or deficit (r-e=\Delta nfa \). Putting all that together we can write income thus:

y=c+i + r-e \

Using this definition we can distinguish between three kinds of income: production as income, revenues as income and capital gains as income.

Production as income

The things that you produce and then either consume or invest are also your income. For instance, if you have a garden where you grow potatoes, the potato is your production and as such your income. When you eat the potato, you consume your product and your income is equal to your consumption:

y=c \

When you do not eat the potato but just keep it, you increase your stock of tangible assets — because you can plant the potato and have more potatoes later on:

y=i\

You can also produce services: if you cook your dinner yourself (having found and not planted the potato) this service is also your income and your consumption. While this kind of service is not counted in the national accounts (whereas going out for dinner is), it still is income and consumption. There is no reason one should not count it in the national accounts because other strange but comparable things are.

Take the implicit rent of people who own their house and do not rent it. The housing service which in value is equivalent to the rent you would pay the landlady to live in the house is counted in the national accounts. Otherwise economies with a high rate of home owners would have a much lower GDP than economies where most people rent.

As far as investment as income is concerned, in the real world this is mostly important for companies. Companies which build their own machines and other tangible assets increase their income (which is their profit) one-by-one with their investment — if no expenditures are associated with the investment.

Income as revenue

For most of us, the main source of our income are our revenues, mostly from wages, but for some also from interest and dividends (capital income). Companies receive revenues from their sales (but this is not yet companies‘ income).

There are three things that you can do with those revenues: you can use them for consumption, investment or to increase your net financial assets if you do not spend as much as you receive in revenues.

If you receive some revenues (for instance wages) and consume part of its, the consumption occurs on two places in the income equation:

y=c+r_{wage}-e_{consumption} \

Consumption occurs both as c as a positive entry and as an expenditure e_{consumption} as a negative entry. This is different from the consumption goods that you produce and consume yourself and which directly increase your income. Here, consumption does not change your income because you buy your consumption good somewhere. Your income is thus equal to your wage. If we did not add the term c, income would be equal to the expenditure surplus only and not the full amount of your wage income. To the extent that you buy all your consumpion goods, c - e_{consumption} is always zero. When you also produce some of your consumption goods, consumption will be higher than consumption expenditures. This is why it is important to keep consumption and consumption expenditures apart.

The same principle applies if you buy tangible assets with your income:

y=i+r_{wage}-e_{investment} \

As long as you buy your tangible assets (houses, machines etc.) your expenditures are as high as your investment and your income is again equal to your wages as it should be.

Lastly, whatever you buy, you change your net financial assets by the amount of your revenue supluses / deficits so that:

y=c+i+r-e=c+i+\Delta nfa \

Income as capital gains

The third kind of income is if your net worth changes due to capital gains. Capital gains change the value of your assets. We can write:

y=\Delta nw=\Delta gfa_{capgains}+ \Delta ta_{capgains}-\Delta l \

Since we had defined income as consumption plus the change in capital gains, capital gains are also income. Normally liabilities do not change in value so that capital gains only apply to changes in the value of assets.

Balance Mechanics 3: Flows that change the balance sheet

We had already defined the different items on a balance sheet that we are interested in here. Now the question is how one can change any of those items. In German standard accounting there are three kinds of flows that change the items on the balance sheet:

  • Incomey \, increases and consumptionc\, decreases an economic unit’s net worth: y-c=\Delta nw \ (Remember, net worth is the difference between assets (both tangible and financial) and liabilities: nw=ta+fa-l \,).
  • Revenues, r \, increase and expendituresr \, decrease net financial assets: r-e=\Delta nfa \ (Remember, net financial assets are the difference between financial assets and liabilities: nfa=fa-l \).
  • Receipts increase and payments decrease a unit’s means of payment (stock of money): , receipts-payments=\Delta m \,

Now, it is very important to keep those items clearly apart. Too often, receipts, income and revenues are mixed up with each other as are consumption, expenditures or payments. While there might sometimes be an overlap between those different flows (a revenue might also be income and come in the form of a receipt), they have to be kept strictly apart.

Here are some examples:

  • Income but no revenue: Here only tangible assets increase and net financial assets do not. The simplest example would be a non-monetary gift.But it also contains all production of tangible assets to which no expenditures correspond (this will be very important when we will talk about profit). Another example is the appreciation of an asset (financial or tangible) you already own. An important note: Although net financial assets can increase through an appreciation because after one they are worth more, this does not count as a revenue since revenues are transactions and a change in an asset’s value is not a transaction.
  • Consumption but no expenditure: Those are all transactions that leave your net financial assets unchanged. Imagine you cook for yourself and eat what you cooked. This is a consumption but not an expenditure. For companies, depreciation of your tangible assets (sometimes also called consumption of fixed assets) is a consumption that is no expenditure.
  • Revenue but no income: This is an increase in net financial assets that leaves your net worth unchanged. This then has to be a transaction in which an increase of your net financial assets is compensated for by a decrease in your tangible assets. This could be the sale of a machine — it increases your net financial assets (more money) and decreases your stock of tangible assets (less machines).
  • Receipt but no revenue: The stock of means of payments increase without an increase in net financial assets. This can be due to two things: a) liabilities increase by the same amount as your means of payment, i.e. you take out a loan. This is a balance sheet lengthening (more on that later). b) somebody pays you back money she owes you. Then your other financial assets decrease (your claim) and your stock of money incrases. This is an asset exchange.

And so on. You can make up other examples but the bottom line is: in order to understand what is going on in the economy, you have to keep those different transactions apart (and as an appetizer: I think much of academic economics does not properly keep those different transactions apart with grave consequences…).

Balance Mechanics 2.1: Assets and liabilities for groups and the aggregate economy

Having defined the balance sheet and its composition, we can now employ the framework of partial, relational and global statements to see what we can say about assets and liabilities in the aggregate and for groups of economic units. While basic and sometimes trivial, we can derive very important conclusions for economic policy from this exercise.

To recap, we had separated assets into tangible assets (machines, houses etc.) and financial assets (financial claims); liabilities are units’ debts and net worth is the difference between all assets and liabilities:

ta+fa-l=nw \

Net financial assets are financial assets minus liabilities, where financial assets can be separated into means of payment and other financial assets so that:

m+ofa-l=nfa \

Now it is essential to keep in mind that every financial assets is always someone’s liability; and every financial liability is someone else’s asset so that:

fa\equiv l \

Net financial assets – how much you can hold

With this insight we can make an important statement about the economy, namely that you can only hold a positive (negative) stock of net financial assets if the rest of the economy (what we had called the complementary group) has an negative (positive) stock of net financial assets of the same absolute amount. To see that, we can separate all holdings of financial assets and liabilities in an economy into those of some group, g \, and its complementary group, cg \:

fa_g+fa_{cg}= l_g+l_{cg} \

Bringing the group’s liabilities to the left and the complementary group’s liabilities to the right yields the net financial asset holdings of both the group and the complementary group:

fa_g-l_g=-(fa_{cg}-l_{cg}) \

That means that whatever amount of net financial assets you hold – the rest of the world will by necessity always hold the exact same amount but with the reverse sign. Expressed in terms of the three statements we can write:

  • Partial statement (valid for individuals or groups):  Individuals or groups of economic units can have a positive (or negative) stock of net financial assets.
  • Relational statement (which tells us under which conditions the partial statement is valid): Individuals or groups can only have a positive (negative) stock of net financial assets if its complementary group has the exact same amount of negative (positive) net financial assets.
  • Global statement (valid for all units): The aggregate economy’s (a closed economy or the world economy) net financial assets are zero.

Why is that important? A first application would be pension systems based on the accumulation of financial assets. If households wanted to save in the form of financial assets, they could only do so if the rest of the economy (i.e. companies, the government, foreigners) issued the corresponding liabilities (among which we also count stocks). No liabilities, no financial assets.

But this is the risk of pension systems based on an accumulation of financial assets: somebody will have to increase liabilities by the same amount that pensioners increase their financial assets. And liabilities are payment commitments. The higher payment commitments are, the more likely – all else being equal – are defaults which in turn hurt pension savers etc. The problem is exacerbated if the government would not be allowed to issue debts. In most industrialised countries, government bonds are a safe asset, i.e. a default free assets because in the extreme case in which the private sector is not willing to refinance government debt, the central bank might step in an (more on that in a later post); also governments can coerce (at least to some degree) the population to pay more taxes in order to service its debts which private companies can (normally) not do. This ability of governments to get taxes gives holders of government debts the assurance that the government will keep its promise and pay. If you save for your pension or are already a pensioner you certainly want to receive your pension payouts and thus need some safe asset.

A second – and related – question is the one about whether government debts are a liability to “future generations”. They certainly are a liability of future governments which future tax payers will have to shoulder. For those tax payers, government debt then really will be a burden. But in those “future generations” are also those holding the corresponding net financial assets who will receive interest. There certainly is a problem (if you think it is a problem) of distribution between those who pay taxes in order that the governments pays interest and debt holders who receive this interest. But future generations can by definition not be burdened in their entirety by government debt.

A third application are net financial assets of entire countries. The US today is the world’s biggest net debtor – i.e. it has a huge stock of negative net financial assets. This means that the rest of the world holds the corresponding positive financial assets, among them claims vis-à-vis Americans. Some see that as a huge problem that needs to be corrected (one can have a debate about whether this is a problem for the US or even an advantage reflecting the fact that the US issues the world currency, i.e. the dollar. But we leave that to another post).

Assets in the aggregate

A final point I want to make is to ask what kind of assets the aggregate economy can hold? That is fairly easy if you keep in mind that the aggregate economy’s net financial assets are by definition zero because (gross) financial assets and liabilities sum to zero in the aggregate. Since tangible assets are also assets, this means that an aggregate economy’s only assets are tangible assets, i.e. the houses machines etc. This finding is important: National economies that are open to the world (which today are mostly all economies) have both positive and negative net financial assets, i.e. they are either net creditors or net debtors. But they mostly hold huge amounts of tangible assets.

Coming back to the US example: While the US is the world’s biggest net debtor, it also holds huge amounts of tangible assets that are by far worth more than their net debts (= negative net financial assets). It is in this sense that the US is probably the richest country in the world even with high net debts.

But that in the aggregate (which means in a closed economy or the world as a whole) there are only tangible assets has important implications for saving to which we will have to say more later on. Here is only a short teaser: Since saving is the change in net worth, and net worth consists of tangible assets and net financial assets, saving is both a change in machines and houses (=investment) and a change in net financial assets. Since the aggregate economy’s net financial assets are always zero, the change in net financial assets is also zero. This means that an aggregate economy can only save by increasing its tangible assets, i.e. invest. We’ll come to what that means later on in more detail.

Balance Mechanics 2: Balance Sheets

Now we come to one of the fundamental building blocks of balance mechanics, the balance sheet. A proper understanding of what a balance sheet is and the items it contains is the basis for all of balance mechanics (since balance mechanics has the word “balance” in it for a reason…).

Each economic unit has a balance sheet, be it individuals (you and me), households (your wife / husband, kids etc.), firms, governments, countries etc. This balance sheet contains assets, a \, liabilities, l \, and the difference between assets and liabilities: net worth, nw \.

Thus, net worth is:

nw_t \equiv ta_t+fa_t-l_t \

Assets can be both tangible assets, ta \, and financial assets, fa \. Tangible assets are: machines, houses, cars etc. Financial assets are financial claims like money on the bank, a loan, a bond, a stock etc. The difference between those two kinds of assets will be very important in balance mechanics. A unit’s liabilities are the debt it owes and also the part of equity that are stocks. To include stocks as a liability is somewhat strange. We do it however anyway in order to be consistent (more on that later).

Now we can define another important concept that will be widely used later one, namely net financial assets. This is the difference between financial assets and liabilities:

nfa_t \equiv gfa_t-l_t \

It is very, very, very important to keep financial assets – more exactly: gross financial assets – and net financial assets apart. (Gross) financial assets are assets that can be traded on financial markets and are – more or less – concrete things. Net financial assets cannot be traded on any market but are just an accounting concept where you subtract two accounting items from each other. Many economists tend to confuse the two (which is a stark claim which will be substantiated in a later post).

The last important definition we will use is that financial assets contain two kind of financial assets: means of payment, m \ – i.e. money – and all other financial assets, ofa \ – i.e. financial claims that are not means of payment:

gfa_t\equiv m_t+ofa_t \

The latter distinction is crucial for all of economics, and especially if we want to analyze financial crises, monetary policy, what banks do etc. So what are other financial assets — $ofa$? Those are all financial claims except for money. They are are promises to receive means of payment, $m$, but tend to be no means of payment themselves. Since any unit’s financial asset is another unit’s liability, liabilities are promises to make payments. And here comes the important point: A payment is the act of servicing a contractual debt.

However, there is some difficulty to exactly define the financial assets that are means of payment and that are not. Why is that the case? Take a euro coin or a euro banknote. Those are obviously not accepted to service dollar debts. In the US, a euro banknote is generally not a means of payment. But since it is a financial asset, it then becomes an “other financial assets”. Also, a sight-deposit at a commercial bank is normally accepted by non-banks (us) as a means of payment. When we see a higher balance on our bank account, we accept this as payment. We do normally not go to our employer and demand our wages in cash (At least not not any longer. Our grand parents used to do exactly that). But commercial banks among each other do not accept their respective sight-deposits as means of payment. This is an important fact that determines much of what banks and monetary policy can and can’t do. We will come back to this later on (however not in this post).

While this context-dependence of what constitutes a means of payment makes it hard to exactly define money independent of context, the distinction between means of payment and other financial assets is at the heart of every financial crisis: in a crisis, debtors have difficulties to make good on their promises to deliver the contractually promised means of payment. Even if they held other financial assets they may well not be able to convert them into means of payment, or only at far lower prices than anticipated. They may therefore be forced into default owing to a lack of liquidity. This is why you should always keep apart other financial assets and means of payments – both for your personal financial health as well as analytically.

All balance sheet items are shown in the table below. All assets are listed on the left hand side, all liabilities and net worth are listed on the right hand side. As I already wrote: every economic unit (whether implicit or explicit) has such a balance sheet. However, what kinds of assets, liabilities and what amount of those assets and liabilities each unit holds is quite different: For instance, non-financial firms normally hold mainly tangible assets like machines and only relatively few financial assets. They often have a high net worth and low debt. Private households typically hold both tangible assets (mainly houses) and financial assets (deposits, bonds, stocks) and have high net worth. Banks’ tangible assets are mostly negligible. They mainly hold loans, bonds, derivatives and other financial assets, have very high debts and very low net worth.

So, this is basically what is there to know about balance sheets, at least for our purposes. In the next post I will show you how those different balance sheet items can be changed.

Balance Mechanics 1: Groups, the Aggregate Economy and Fallacies of Composition

This is the first official lecture on balance mechanics and it will be about a fundamental issue: the difference between what you can say about individual economic units, groups of economic units and the sum of all economic units, i.e. the aggregate economy.

One of the most interesting aspects of balance mechanics is that it teaches you to always keep different kinds of statements for different levels of analysis apart – and to both detect and avoid fallacies of composition, i.e. the application of statements valid for individual economic units or groups of economic units to the aggregate economy.

What do I mean by the term “economic unit”? I mean by that everyone and everything that is relevant in the economy, i.e. individuals, firms, governments, countries etc. Groups of economic units can be defined at will: It can be all individuals, all firms, or – if you want – some kinds of households, some kind of firms etc.

Also important is that to each group in the economy corresponds a complementary group which are all economic units in the economy that are not members of that group. This means that the group plus the complementary group are the sum of economic units in the economy:

group + \text{\textit{complementary group}}=\text{\textit{all economic units}}

We can also – depending on our interest and field of analysis – define groups and complementary groups for certain types of economic units. For instance, we might be interested in the relation of banks between each other. Then we might define the aggregate of all banks and divide this aggregate into a group of banks and all other banks which would then constitute the complementary group.

Standing up while watching a play

It is best to illustrate this with a little example. Imagine a theater filled with the audience. Now one man sits up to improve his view (I take a man. They tend to be ruder than women). However, he will only be successful in improving his view if all other members of the audience stay seated. Or, expressed with the terms defined above: the group (here a group with just one member) will be successful in improving its view if the complementary group (all other members of the audience) stay seated. If everybody stood up, nobody would be able to improve their view.

This means that the statement “one can improve one’s view in the theater by standing up” cannot be applied to all of the members in the audience. To do so would constitute a “fallacy of composition“.

Now we can use three kinds of statements to sort out what is valid for individuals and groups of units, under what conditions it is valid and what is valid for the sum of all economic units:

  1. Partial statement (valid for individuals or groups):  an individual or a group of members of the audience can stand up to improve its view.
  2. Relational statement (which tells us under which conditions the partial statement is valid): an individual or a group of members of the audience can only improve its view if the rest of the audience stays seated.
  3. Global statement (valid for all units): If all members of the audience stood up, nobody could improve their view.

Now, in this theater example the global statement might not be 100 % correct for each and every individual because some will certainly be able to improve their view while others won’t, depending on where you sit, the height of different audience members etc. It will most likely hold only on average. There will however be cases to be discussed later where the aggregate statement will hold for everybody and not only on average.

We can now define a fallacy of composition in terms of those statements: obviously, a fallacy of composition is when you apply a partial statement to the aggregate economy. There might be cases and conditions under which what is true for a single group is also valid for the aggregate. But those are normally special cases and not general cases. We will come to those cases later on.

You could of course also have the reverse, i.e. that you falsely apply a global statement to a group or an individual. I don’t know whether there is a term for that but that would evidently also be a problem.

Fallacy of composition vs. the rationality trap

The term “fallacy of composition” is used when you make an ex ante analytical statement about a certain situation. It does not depend on the concrete behavior of individuals. If behavior is concerned, i.e. if people actually tried to stand up to improve their view and found out that they could not actually improve their view because everybody did the same, it would constitute a “rationality trap”. Such a trap is that people individually behave rationally but their intention will be thwarted in the aggregate.

This is not to say that those people are dumb or do not understand that their standing up might be based on the fallacy of composition and might lead them into a rationality trap. Take the example of a fire breaking out in the theater. Everybody will be absolutely rational and right to stand up and run to the emergency exit. However, given that emergency exits are often very small compared to big audiences and fire tends to expand quickly, some will not get out, will be trampled down and burn. But it would hardly have been wise to stay seated and wait to be burnt alive. They had to take their chances.

Many economic situations (and other situations as well) are of this sort that one might know that some collective solution might be better but will have no chance of being realized so that people have to act rationally even if they get – on aggregate – into a rationality trap.

While balance mechanics is more about detecting fallacies of composition, one needs to find those fallacies to avoid rationality traps if possible. This is one of the appeals of balance mechanics.

While the above example is trivial, I will later show that quite a number of economics problems will be easier to analyze with the framework of groups, complementary groups and the three statements in your mind.

An Easy Introduction to Balance Mechanics and its Inventor

Who was Wolfgang Stützel, the inventor of “balance mechanics”? Hardly known in the anglo-saxon world and largely forgotten in Germany today, he was an economics professor and published his landmark book “balance mechanics” (in German: “Volkswirtschaftliche Saldenmechanik“) in 1958.

In the 1960s and 1970s he was widely known beyond economics because he was a member of the famed German Council of Economic Experts which is still influential today. In his work, he shows that no abstract models and fantasy assumptions about human behavior are necessary to draw rigorous and logically necessary conclusions about the actual economy. Essentially, you only need a profound understanding of something as trivial as accounting. Thus Stützel wrote in his book:

Apart from things that depend on human behavior, […] there are many economic relations […] about which one can make strictly generalisable statements, relations that do not depend on human behavior but which would still be unchanged if people behaved in absolutely strange way.

[In German: [Es gibt] neben Zusammenhängen, die vom menschlichen Verhalten abhängen, […] viele Größenbeziehungen in der Wirtschaft […], über die sich streng Allgemeingültiges aussagen läßt, Zusammenhänge, die nicht vom menschlichen Verhalten abhängen, sondern auch dann unverändert bestehen bleiben würden, wenn die Menschen sich noch so ungewöhnlich verhielten.]

Those relations are very trivial things, like: Someone’s purchases are another one’s sales because nobody can sell something without someone else buying it; or that someone’s debts are someone else’s claims because nobody can have financial claims without someone who holds the corresponding liabilities.

One would have to assume that economists know those “trival arithmetic relationships” and their implications. However, this is mostly not so. Stützel always showed with great relish how his colleagues stubbornly held beliefs which one would never hold if one only knew the basics of accounting and balance mechanics.

Here are some examples: The trivial but always true statement that somebody’s claims are someone else’s debts is often ignored by economists and politicians alike if they claim that today’s government debt would burden future generations. The underlying assumptions of this statement is that in the future there are debts but no corresponding financial claims — a logical impossibility. If there are debts in the future, holders have to pay interest and somebody will earn this interest. People do not only inherit debts but also the corresponding claims.

Or another example: Savers increase their (net) financial claims. But this in only possible if others increase their (net) debts by the same amount. However, if nobody is willing to increase her net debts, nobody will be able to save. While this is trivial, it becomes politically salient if applied to the privatization of pensions. Those willing to increase privatization of pensions by logical necessity also have to be in favor of higher debts.

But who should increase their debts? In many parts of the world (Germany, for instance), companies do not increase their net debts at all but finance their investment out of their current earnings; all over the world the government is held not to increase or even to decrease its debts. But then only foreign countries could increase their debts – i.e. those countries like the European crisis countries that lived through a debt crisis… However, if nobody is willing to increase their debts, there cannot be higher private pension saving (and other saving as well) — and one cannot ask persons to do so anyway.

Austerity in Europe after 2010 can also be understood by the trivial accounting rules and balance mechanics: in order to pay back their debts, governments in the crisis countries had to radically reduce their expenditures. However, since someone’s expenditures are another one’s revenues, this cut in government spending also made life hard for the rest of Europe which had to deal with a drop of exports — its revenues — to the crisis countries.

All this very much sounds like simple Keynesianism — but Stützel shows that it is just the consequence of pure accounting: If everybody is asked to reduce their expenditures, it would be unreasonable to expect an increase in revenues; if everybody is expected to save more and increase financial assets, one can not demand that nobody is allowed to increase debts.

But Stützel himself was no left leaning Keynesian. In the introduction to the works of his teacher Wilhelm Lautenbach, he wrote:

The claim that deficit spending — the creation of money by the state through higher debts — could fulfill all economic needs, has not been made by serious employment theorists. It is an invention of demagogues who have taken money creation from modern credit theory and increasing debts from Keynesianism to make the masses believe illusions and to poison the atmosphere for sober thinking. Perhaps it is just a bugaboo which was invented by the enemies of employment theory in order not to think too much when arguing against employment theory.

 [In German: „Die Behauptung, daß mit der Druckknopftherapie des deficit spending, der staatlichen Geldschöpfung durch Verschuldung, alle wirtschaftlichen Nöte gelindert werden könnten, stammt nicht von ernsthaften Beschäftigungstheoretikern. Sie ist eine Erfindung von Demagogen, die sich aus den modernen Kredittheorien das Geldschöpfen und aus dem Keynesianismus das Schuldenmachen geholt haben, um damit breiten Massen Illusionen vorzugaukeln und die Atmosphäre für nüchterne Überlegungen zu vergiften. Vielleicht ist es auch ein Popanz, den sich manche Gegner der Beschäftigungstheorie zusammengezimmert haben, damit sie in ihrer Argumentation gegen die Beschäftigungstheorie nicht so viel zu denken gezwungen sind.]

But while Stützel saw that much can go wrong if one relied too much on the market, he believed in capitalism and the market economy, was an active member of the economically (neo-)liberal free democratic party (FDP) and part of the neoliberal “Kronberger” circle which propagated an extension of markets in the 1970s and beyond.

Since the early 1970s Stützel was against the financing of the welfare state by contributions levied on wages and explained the increasing unemployment at the time not with the lack of aggregate demand but of too high wage costs. Also, when capital controls were still in place almost everywhere, he was a strong defender of the free movement of capital because he trusted market more than bureaucrats.

On the other hand, in his book “Market price and human dignity” (“Marktpreis und Menschenwürde”) he demanded a lower limit for wages (and favored a labour union that encompassed all workers to enforce this limit). By this he wanted to prevent a “wage paradoxon” according to which each individual, in order to save her job, had to accept wage reductions and a lengthening of working time which would — if applied to everybody — only result in wage reductions for all with at an unchanged overall employment level. He took that thought from Karl Marx. And while he rejected high social contributions on wages, he was not concerned to decrease the welfare state but to finance it by taxes in order not to disturb prices on the labour market.

Thus, Stützel was an economic liberal, even a neoliberal. However, he knew when the market reached its limits and when the pursuit of self interest by each individual could result in collective disaster.

This text is a translation (with slight changes) of an article originally published in  German on the Blog “Herdentrieb” of the German weekly “Die Zeit”.

Saving does not finance investment!

Why do neoclassical economists want the budget to be balanced and people to save more? Because they believe that “saving finances investment”. They believe that in order to finance investment, somebody has to have saved beforehand. This might sound intuitive, but it is one of the biggest (and unfortunately oldest) fallacies in economics. Saving never finances anything – money and credit do; and nobody has to save for anybody else to have credit and thus to invest.

According to the “saving-finances-investment”-theory (often called the loanable funds theory), households have to save first, bring their money to the bank so that firms can borrow and invest – as long as government deficits have not taken away the precious savings from firms. From this it follows that more household saving and lower government deficits are the best way to promote investment: More saving leads to a higher supply of credit and thus more investment. Zero government deficits avoid crowding out private investment. And so if investment is not high enough, both households and the government should save more by cutting their spending and thus allow banks to increase credit.

Credit in the real world – a simple booking procedure

At first sight, the theory seems to be intuitively appealing. But once you look how credit is actually created in the real world, the theory quickly becomes utter nonsense (find more on this in my recent working paper). Nobody has to save before a credit can be created. A bank (either a commercial bank or the central bank) creates credit and money out of thin air by a stroke on a computer keyboard: a bank creates a deposit for its debtor which the debtor can withdraw to pay for something. Later on, the debtor has to repay its debt – if he can’t, the bank has a problem. Giving credit is a simple booking procedure. No bank has ever denied a credit to a potential borrower because of a lack of prior saving.

But if banks can create money out of thin air, why do they need deposits? Banks create bank money, but not central bank money – which only the central bank can do. But central bank money – coins, banknotes, deposits at the central bank – is what people need to make payments. So banks somehow have to get hold of central bank money, either directly from the central bank, from other banks via the interbank market or via deposits.

But if banks want to get money from depositors, this does not necessitate in any way that depositors save. Money does not disappear when it is spent and not saved – it is not “used up” by government deficits or investment. If everybody would always spend all of their income and not save at all, the money would not disappear but flow to firms and back to households: it is transferred from the customer’s bank account to the firm’s bank account; from the firm’s bank account in the form of wages and interest to the household’s bank account and so on. The money is not lost at all to the banking system whatever it is spent on and whatever amount people save. When people do not spend all of their income but save, this is money that the business sector does not get in the form of sales.

In general, as long as people keep their money at the banks – whatever their amount of saving – the banking system has no problem refinancing itself with deposits. And if people were less willing to keep their money at the bank (which today happens for instance in Europe’s crisis countries), banks can refinance themselves at the central bank. So, no saving has to take place either for deposits to be a source of bank credit or for credit to be created.

Financial saving is a zero-sum game

Anybody with sufficient collateral who wants to finance a physical investment (produce or buy a machine or a house) can get this credit, use the money so obtained and invest (with the caveat that banking regulation can of course restrict credit creation, but again, this has nothing to do with saving). Most adherents of the view that saving finances investment seem not to know that investment itself is saving. Normally, we tend to identify saving with financial saving – i.e. to have more money, more bonds or more equity. However, accountants have defined saving as increases in all kinds of wealth, both financial and non-financial.

While the production of new capital goods always increases saving in an economy, financial saving is a zero-sum game. One can only increase net financial assets (financial assets minus financial liabilities) by spending less than one earns. The problem is that your spending is my earning. So if anybody cuts his spending to increase his net financial assets, somebody else will see his earnings cut by the same amount – and thus his ability to save money. Since earning and spending are necessarily equal in the whole economy, the whole economy cannot save financially – net financial assets are zero in the aggregate.

On the other hand, investment creates spending – if a firm builds new machines and houses, it spends money on wages which are income for wage earners; firms that buy machines and households that buy houses spend money – which sellers earn. In contrast to financial saving, increasing production of physical capital goods – investment – is not a zero-sum game.

The paradox of thrift

So what would really happen if people save more money believing that this leads to a higher availability of credit and more investment? Since households mostly spend their money on goods sold by firms, cutting spending in order to increase saving automatically reduces firms’ revenues. Will that incite firms to build more machines?

This seems unlikely. Even if they take out more debts when they see their revenues fall, they would probably not use it to increase their investment. If they would like to continue spending the same amount of money on their employees which they did before households had cut their spending in order to save, they would have to borrow the money which they had earned before by their sales.

But is it even likely that they will take out more credit when they see their earnings fall? That depends on their expectations of future household spending. If households firmly believe in loanable funds theory, they will try to keep their saving up in the long-term – and in consequence firms’ revenues will be permanently reduced. If firms still kept up their former level of spending, their higher credits would lead to higher interest commitments in the future. Thus, rational businesspeople are more likely to cut spending themselves than to increase future spending by taking out new credits. What kind of spending are they likely to cut? Probably they will reduce the wage bill by either reducing wages or firing people. Unfortunately, those are the private households’ revenues, out of which households had planned to save.

Thus, if firms reduced their payrolls households would have shot themselves in the foot with their decision to save: they wanted to save but what they actually achieved is to cut their own revenues. If they would then again reduce their expenditures, firmly believing in the merits of thrift, firms would again face lower revenues etc.

This is the paradox of thrift: households’ plans to save more leads to a decrease in aggregate revenues and expenditures – and no financial saving has actually taken place. Since firms are also likely to cut back their investment, overall saving will have fallen. The government could of course counteract the whole process by spending more where households spend less – but if the government also believes in loanable funds theory, it will cut spending itself and consequently the private sector’s revenues – welcome in recession-land. Or rather: welcome in euro-land.

Those are the economic costs if people who firmly believe in “saving finances investment” rule or advise the rulers. This is not just theory, the fallacies of loanable funds theory are what makes millions of unemployed in the euro zone suffer every day. Economic theory has real world consequences – sometimes for the better, often for the worse.

The text was first published in 2012 on the Social Europe Blog.