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.

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