The relationship between accounting identity and economic models is often misunderstood. Accounting identity is, by definition, equality that must be true. It’s tautology. The purpose is to classify and organize relationships between variables. For example, assets = liabilities are identity. Rugardless Whats “Assets” must be equal, and “liabilities” must be the same amount. This is what I defined. There is no causality regarding this statement. It tells us that we have received information about the behavioral relationships between various factors.
Furthermore, identity is testable and not counterfeitable. It’s always true and troublesome. It cannot be tested to see if an increase in consumption increases GDP. It always does so everywhere. If GDP decreases as consumption increases, there is a mathematical mistake.
Conversation, economic models explain causal behavioral relationships. Rather than being defined in Celerin Way, the model simplifies assumptions and makes observed behaviors positive causes and effects. Use a simple model of demand: quantity of demand = 10-2p. This is a model of the behavioral relationship between quantity demand and price. As prices drop, the amount of demand increases by 2 (and vice versa). By definition, the quantity demand is not equal to 10-2p. This is based on observational behavior and changes in simplified assumptions. A quantity in demand can be secondary, and can slop upwards locally, and can take many different shapes! This is a discovered relationship and is limited to this use.
Additionally, the model is testable and counterfeitable. You can test whether price changes affect quantity demand.
Misunderstanding can come from the fact that we see identity and models. Both are mathematical equations. But in order to properly understand what they are saying to us, we have to understand the difference. The model explains theoretical causality. Identity is an explanation for a definition. Furthermore, accounting identity simply tells you what has happened in the past.
Michael Pettis, a Carnegie Fellow and finance professor at Beijing University in Beijing, is perhaps the most prominent (but only) criminal who will confuse the two, as he writes Oppen at a large international outlet. Brian Albrecht, chief economist at the Center for International Law and Economics, has an excellent post showing how he displays most of the weaknesses, contradictions and hidden assumptions in Pettis’ arguments on econ 101.[1] (My co-blogger Scott Sumner has a similar comment.)
Pettis frequently argues that the policies of other governments, particularly Chinese merchantists, will force the US to carry out the trade deficit. His argument falls out of accounting identity, which is saving = investment, in a closed economy. If planet Earth is a closed economy (and at least we are invincible to undo ventilated alien lives), then increasing savings for a nation like China must mean other countries invest more and lead to a trade deficit. Taking Pettis’ arguments with his own hair betrays a fundamental misconception about how accounting identity works. Accounting identity is not mind control. They are records of transactions. In other words, they tell us not what happened or what will happen. Only transactions that occur will be displayed in your account. Accounting is merely an explanation of what has occurred. Accounting for past events speaks of future transactions.
Get assets = liabilities with a simplified accounting ID. If a company purchases a butt with credit, the company’s assets will rise and the company’s liabilities will rise at the same amount. When a company pays its debt, its assets decrease and its fiance decreases for the same amount. It must be true to merely be the purpose of these categories. However, changes in the reflection of assets and liabilities that arise, not future transactions. Naturally, if a purchase occurs, the bush assets and liabilities are adjusted – an IPH transaction occurs. If the transaction is not an OSCUR, it will never appear in the ledger.
To bring this to the international stage, the accounting IDSTITY investment = savings – trade balances simply take into account the (officially) transactions that occurred in the previous previous journal. If a sub-investment was decided, it must have been funded by a sub-combination of domestic and international savings. But it doesn’t track rare investments (and savings) that they didn’t happen that tea made no sense at the gradual speed available. Beka did not happen, they can explain, so those deals don’t appear at all! Again, accounting identity tells you what happened, it tells you what happens.
In another example, let’s say you have an extra $200,000 and decide to save it. You run a certificate of deposit savings account at a local bank and deposit your money there. Bank assets are increasing. Deposited funds are now available for investment, but there is no way to say that investments must increase in deposits. I wake up the next day and say, “I have to buy a house now and borrow $200,000!” Banks try to seduce borrowers with interest rates, but there is no compulsion. Also, there is nothing about definitions that has to happen. Certainly, if the bank cannot lend money, it will remain in the bank’s reab and not appear in GDP at all. Savings accounts are on the rise, but without corresponding investments, transactions will not be displayed in GDP.
Accounting IDs of 11 understand that they have no power to record transactions that occur and force future transactions. Increased Chinee’s savings won’t force Americans to carry out the trade deficit. Of course, everything else is held equally, and the increase in savings (loanable funds) reduces interstitial rates, increases the amount of loan demand, and increases US GDP (increased consumption, investment, or government spending) and trade deficits. But it continues from the ECON 101 supply and demand framework, not from the accounting identity. If there are no apostates for borrowing, and there will be no mutually beneficial transactions, then an increase in savings will not make up for America.
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[1] As Brian points out, Pettis would argue that Econ 101 doesn’t apply. But that is another weakness in his argument. Your case isn’t very good if you have to throw away scientific laws to make your point.
