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.

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