In a post earlier this week, Michael Pettis was kind enough to refer to a passage from Ralph Hawtrey’s review of Keynes’s General Theory, which I had quoted in an earlier post, criticizing Keynes’s reliance on accounting identities to refute the neoclassical proposition that it is the rate of interest which equilibrates savings and investment. Here’s what Pettis wrote:
Keynes, who besides being one of the most intelligent people of the 20th century was also so ferociously logical (and these two qualities do not necessarily overlap) that he was almost certainly incapable of making a logical mistake or of forgetting accounting identities. Not everyone appreciated his logic. For example his also-brilliant contemporary (but perhaps less than absolutely logical), Ralph Hawtrey, was “sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships”, according to FTC economist David Glasner, whose gem of a blog, Uneasy Money, is dedicated to reviving interest in the work of Ralph Hawtrey. In a recent entry Glasner quotes Hawtrey:
[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment and saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary.
This is a very typical criticism of certain kinds of logical thinking in economics, and of course it misses the point because Keynes is not arguing from definition. It is certainly true that “identity so established cannot prove anything”, if by that we mean creating or supporting a hypothesis, but Keynes does not use identities to prove any creation. He uses them for at least two reasons. First, because accounting identities cannot be violated, any model or hypothesis whose logical corollaries or conclusions implicitly violate an accounting identity is automatically wrong, and the model can be safely ignored. Second, and much more usefully, even when accounting identities have not been explicitly violated, by identifying the relevant identities we can make explicit the sometimes very fuzzy assumptions that are implicit to the model an analyst is using, and focus the discussion, appropriately, on these assumptions.
I agree with Pettis that Keynes had an extraordinary mind, but even great minds are capable of making mistakes, and I don’t think Keynes was an exception. And on the specific topic of Keynes’s use of the accounting identity that expenditure must equal income and savings must equal investment, I think that the context of Keynes’s discussion of that identity makes it clear that Keynes was not simply invoking the identity to prevent some logical slipup, as Pettis suggests, but was using it to deny the neoclassical Fisherian theory of interest which says that the rate of interest represents the intertemporal rate of substitution between present and future goods in consumption and the rate of transformation between present and future goods in production. Or, in less rigorous terminology, the rate of interest reflects the marginal rate of time preference and the marginal rate of productivity of capital. In its place, Keynes wanted to substitute a pure monetary or liquidity-preference theory of the rate of interest.
Keynes tried to show that the neoclassical theory could not possibly be right, inasmuch as, according to the theory, the equilibrium rate of interest is the rate that equilibrates the supply of with the demand for loanable funds. Keynes argued that because investment and savings are identically equal, savings and investment could not determine the rate of interest. But Keynes then turned right around and said that actually the equality of savings and investment determines the level of income. Well, if savings and investment are identically equal, so that the rate of interest can’t be determined by equilibrating the market for loanable funds, it is equally impossible for savings and investment to determine the level of income.
Keynes was unable to distinguish the necessary accounting identity of savings and investment from the contingent equality of savings and investment as an equilibrium condition. For savings and investment to determine the level of income, there must be some alternative definition of savings and investment that allows them to be unequal except at equilibrium. But if there are alternative definitions of savings and investment that allow those magnitudes to be unequal out of equilibrium — and there must be such alternative definitions if the equality of savings and investment determines the level of income — there is no reason why the equality of savings and investment could not be an equilibrium condition for the rate of interest. So Keynes’s attempt to refute the neoclassical theory of interest failed. That was Hawtrey’s criticism of Keynes’s use of the savings-investment accounting identity.
Pettis goes on to cite Keynes’s criticism of the Versailles Treaty in The Economic Consequences of the Peace as another example of Keynes’s adroit use of accounting identities to expose fallacious thinking.
A case in point is The Economic Consequences of the Peace, the heart of whose argument rests on one of those accounting identities that are both obvious and easily ignored. When Keynes wrote the book, several members of the Entente – dominated by England, France, and the United States – were determined to force Germany to make reparations payments that were extraordinarily high relative to the economy’s productive capacity. They also demanded, especially France, conditions that would protect them from Germany’s export prowess (including the expropriation of coal mines, trains, rails, and capital equipment) while they rebuilt their shattered manufacturing capacity and infrastructure.
The argument Keynes made in objecting to these policies demands was based on a very simple accounting identity, namely that the balance of payments for any country must balance, i.e. it must always add to zero. The various demands made by France, Belgium, England and the other countries that had been ravaged by war were mutually contradictory when expressed in balance of payments terms, and if this wasn’t obvious to the former belligerents, it should be once they were reminded of the identity that required outflows to be perfectly matched by inflows.
In principle, I have no problem with such a use of accounting identities. There’s nothing wrong with pointing out the logical inconsistency between wanting Germany to pay reparations and being unwilling to accept payment in anything but gold. Using an accounting identity in this way is akin to using the law of conservation of energy to point out that perpetual motion is impossible. However, essentially the same argument could be made using an equilibrium condition for the balance of payments instead of an identity. The difference is that the accounting identity tells you nothing about how the system evolves over time. For that you need a behavioral theory that explains how the system adjusts when the equilibrium conditions are not satisfied. Accounting identities and conservation laws don’t give you any information about how the system adjusts when it is out of equilibrium. So as Pettis goes on to elaborate on Keynes’s analysis of the reparations issue, one or more behavioral theories must be tacitly called upon to explain how the international system would adjust to a balance-of-payments disequilibrium.
If Germany had to make substantial reparation payments, Keynes explained, Germany’s capital account would tend towards a massive deficit. The accounting identity made clear that there were only three possible ways that together could resolve the capital account imbalance. First, Germany could draw down against its gold supply, liquidate its foreign assets, and sell domestic assets to foreigners, including art, real estate, and factories. The problem here was that Germany simply did not have anywhere near enough gold or transferable assets left after it had paid for the war, and it was hard to imagine any sustainable way of liquidating real estate. This option was always a non-starter.
Second, Germany could run massive current account surpluses to match the reparations payments. The obvious problem here, of course, was that this was unacceptable to the belligerents, especially France, because it meant that German manufacturing would displace their own, both at home and among their export clients. Finally, Germany could borrow every year an amount equal to its annual capital and current account deficits. For a few years during the heyday of the 1920s bubble, Germany was able to do just this, borrowing more than half of its reparation payments from the US markets, but much of this borrowing occurred because the great hyperinflation of the early 1920s had wiped out the country’s debt burden. But as German debt grew once again after the hyperinflation, so did the reluctance to continue to fund reparations payments. It should have been obvious anyway that American banks would never accept funding the full amount of the reparations bill.
What the Entente wanted, in other words, required an unrealistic resolution of the need to balance inflows and outflows. Keynes resorted to accounting identities not to generate a model of reparations, but rather to show that the existing model implicit in the negotiations was contradictory. The identity should have made it clear that because of assumptions about what Germany could and couldn’t do, the global economy in the 1920s was being built around a set of imbalances whose smooth resolution required a set of circumstances that were either logically inconsistent or unsustainable. For that reason they would necessarily be resolved in a very disruptive way, one that required out of arithmetical necessity a substantial number of sovereign defaults. Of course this is what happened.
Actually, if it had not been for the insane Bank of France and the misguided attempt by the Fed to burst the supposed stock-market bubble, the international system could have continued for a long time, perhaps indefinitely, with US banks lending enough to Germany to prevent default until rapid economic growth in the US and western Europe enabled the Germans to service their debt and persuaded the French to allow the Germans to do so via an export surplus. Instead, the insane Bank of France, with the unwitting cooperation of the clueless (following Benjamin Strong’s untimely demise) Federal Reserve precipitated a worldwide deflation that triggered that debt-deflationary downward spiral that we call the Great Depression.
Uneasy Money 
Re: “Keynes argued that because investment and savings are identically equal, savings and investment could not determine the rate of interest.”
I find this to be a rather odd statement for when I read Keynes I didn’t find anywhere that he argued this sort of thing. He often argued that “an act of saving” or “an act of investing” in itself could not have an direct effect on the rate of interest, and he said things like: “Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income”, but I don’t find him saying that savings and investment could not determine the rate of interest are identical.
A quote from Keynes in which he actually says something to this effect would be helpful here.
LikeLike
Keynes and the logical brilliance of Bedlam
Comment on ‘Keynes and Accounting Identities’
It is the very definition of a non-scientist to transform every objective problem into an ad-hominem story and thereby to make it definitively insoluble. This works because most people are fond of stories, which allow for good/bad moralizing or like/dislike blather, but not so much of scientifically valid theories, which allow only for clear cut true/false judgments.
Accordingly, David Glasner frames the issue of accounting identities thus: “Keynes, who besides being one of the most intelligent people of the 20th century was also so ferociously logical (and these two qualities do not necessarily overlap) that he was almost certainly incapable of making a logical mistake or of forgetting accounting identities.” (See intro)
This distraction works because now we are entangled in the question of whether Keynes or his opponent Hawtrey was more intelligent/brilliant. To be sure, the correct answer had been given long ago by Nobel laureate Allais but because it had been delivered in French it never came to the attention of the representative economist: “L’intuition de Keynes lui a fait sentir où se trouvaient les difficultés, mais son insuffisance logique ne lui a pas permis de résoudre les problèmes que son intuition lui avait fait entrevoir.” (1993, p. 70) Roughly: Keynes intuition led him to the real difficulties but his logical insufficiency prevented the solution.
This is a polite way of saying that logical consistency was not exactly one of Keynes’s strong points. But, in the final analysis, this does not matter much because Keynes was first and foremost a political economists and not a scientist. In politics the effectiveness of an argument counts and, as a rule, the intended audience could not care less about logical and material consistency.
In sum, Hahn’s characterization is more to the point: “I consider that Keynes had no real grasp of formal economic theorizing (and also disliked it), and that he consequently left many gaping holes in his theory. I none the less hold that his insights were several orders more profound and realistic than those of his recent critics.” (1982, pp. x-xi)
To characterize Keynes as ‘ferociously logical’ is plainly against what Keynes himself thought about the whole issue “… a remorseless logician can end up in Bedlam.” (quoted in Moggridge, 1976, p. 36)
The final proof of Keynes’s logical incapacity is that he messed up the most elementary accounting identities. As a centerpiece of the General Theory he formulated the foundational syllogism of macroeconomics. “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (1973, p. 63)
This elementary two-liner is conceptually and logically defective because Keynes did not come to grips with profit (Tómasson and Bezemer, 2010, pp. 12-13, 16). The fault is in the premise ‘income = value of output’. This equality holds initially only in the limiting case of zero profit in both the consumption and investment good industry. Hence, Keynes formally dealt with a zero profit economy without being aware of it (2011a; 2011b). This means in concrete terms that the multiplier formula is provably false.
The first logical blunder kicked off a chain reaction of mistakes because when profit is not correctly defined, income is not correctly defined, and then saving is not correctly defined. By consequence, all I=S models are logically defective. Krugman, for one, has not got the point until this very day and underpins his economic policy advice with a recent variant of IS-LM (2014). This does not matter either, because Krugman, too, is merely a political economist and not a scientist.
The root cause of all accounting errors/mistakes is a complete lack of understanding of what profit is. The conceptual error carries over to national accounting (2012).
Walras’s original model had also been a zero profit economy. Clearly, Walrasianism and Keynesianism is squarely at odds with reality. Yet, economists are busily occupied with shoptalk about the Bedlam models of their brilliant masterminds until this very day.
Egmont Kakarot-Handtke
References
Allais, M. (1993). Les Fondements Comptable de la Macro-Économie. Paris: Presses Universitaires de France, 2nd edition.
Hahn, F. H. (1982). Money and Inflation. Oxford: Blackwell.
Kakarot-Handtke, E. (2011a). Keynes’s Missing Axioms. SSRN Working Paper Series, 1841408: 1–33. URL http://ssrn.com/abstract=1841408
Kakarot-Handtke, E. (2011b). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. URL http://ssrn.com/abstract=1966438.
Kakarot-Handtke, E. (2012). The Common Error of Common Sense: An Essential Rectification of the Accounting Approach. SSRN Working Paper Series, 2124415: 1–23. URL http://ssrn.com/abstract=2124415
Kakarot-Handtke, E. (2014). Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It. SSRN Working Paper Series, 2392856: 1–19. URL
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2392856
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.
Moggridge, D. E. (1976). Keynes. London, Basingstoke: Macmillan.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and
Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL http://mpra.ub.uni-muenchen.de/20557/
LikeLike
if you think of all wealth as equal to all capital as equal to all savings
then putting the money in savings or bonds to collect the interest is just moving capital from one place to another, so doesn’t change the total savings
where as the part that goes into investment (attracted by the competitor to interest, the marginal efficiency of capital, the return to investment)
does follow the rule Y(income) = I(investment) + (C) Consumption
and that investment does get preserved, as savings, in someones pocket if you will
but this is just preservation of the original investment , not creation of new wealth
that is how I have found it useful to look at that
LikeLike
another concern I had regarding his concept of investment, was the idea of user cost
because I find that this is really a microeconomic concept involving a firm or firms or individuals
and what he basically says, is that before any other investment can get moved into income, it has to pay for all the expenses, raw materials etc, ……
before you can have any income from the investment……
this makes sense from the micro perspective but doesn’t make any sense from the macro perspective
because from a macro perspective what he is saying is that during the given time period
all the capital, in the total economy, that is lost (depleted, deteriorated, destroyed or depreciated)
would need to be replaced or made up for, before we could have any capital being shifted into income
(it is the capital that is moved into income that creates the spending that leads to he multiplier effect on income)
this would mean that the wealth of the world could never decrease over a given period or we could never have a viable economy!!!
(no income, no spending, unless we replaced all the lost wealth first!!!)
that is obviously an absurdity
————————–
so I prefer to keep total capital = total wealth = total savings on a different axis
than income, they are related but different
and I prefer to look at the effect on wealth as capital created minus capital depleted over the given time period
that would mean any wealth produced minus any wealth used up
is the real change in total capital = total wealth = total savings
————————
so savings would have two components, that which is just the investment preserved as savings “in someone’s pocket”
(if the investment was all in cash, then this would just be the preservation of the cash)
but this is not new wealth just preserved pre-existing wealth
and that NET capital production should be considered as new wealth and should be considered as part of SAVINGS
so
Savings equals investment is not entirely correct , that only accounts for the part of savings that is preservation of the income investment
in actuality
it should be savings = investment plus net capital production
in other words investment that goes into income gets preserved as savings
and any capital that is used up , perhaps as raw materials , or just depleted, is taken away from that produced to get net production which increases our total wealth
this also is savings
—————————————-
it is the second form of savings that determines the change in wealth of the society
in fact since the savings that equals income investment is only the preservation of preexisting capital, it does not lead to increased income
so if we accept savings always equals investment
then in the macro economy we could never have an increase in wealth, or a decrease in wealth
LikeLike
Yikes. Redux on this issue, and déjà vu all over again.
“But Keynes then turned right around and said that actually the equality of savings and investment determines the level of income. Well, if savings and investment are identically equal, so that the rate of interest can’t be determined by equilibrating the market for loanable funds, it is equally impossible for savings and investment to determine the level of income.”
I’m pretty sure I haven’t read the GT original as closely as you. But my assumption would be the following:
Based on the simplest interpretation of the multiplier, investment is equal to saving at all moments in the process (as I claimed/explained in our previous discussions on this). The simple multiplier process proceeds in discrete logical steps where the equivalence of investment and saving prevails at all times. But the process of iteration does not come to a stop and the point of equilibrium reached until the propensity to consume has been fully exhausted – based on the impetus of an original injection of investment and corresponding income – and the final level of the economic expansion has been reached according to the logic of that process. Therefore, there is nothing wrong in claiming that the equivalence of investment and saving is essential to the process of the multiplier – it exists at every step of process – but one must also say that the size of the original investment injection and the equivalent level of created saving is also essential to the size of the ensuing expansion according to the multiplier.
That context is not altogether inconsistent with claiming “equality of savings and investment determines the level of income” – because the multiplier process features that equivalence at all times. Moreover, it is the way in which the multiplier process actually frustrates any alternative realization in the form of a “using up” of savings though some imagined macroeconomic contraction of savings (which cannot be part of the process because saving remains equal to the original investment throughout the process) that causes it to be extended as a process so that agents attain micro and macro balance only by expanding their consumption relative to the initial endowment of macro saving. In that sense, the equivalence of saving and investment becomes a very real constraint on the ability of agents to attain their desired microeconomic mix of consumption and saving other than by expanding economic activity through consumption. And in that specific sense, it is the enduring equality of saving and investment throughout the process that indeed “determines the level of income”.
I’m working here on the basis of your interpretation of Keynes, but I don’t know how Keynes could have said something much different than the above unless the logic of the multiplier was in fact not something that he claimed at all and that all of the textbooks have it wrong. Because there is no question according to accounting logic that the equivalence of saving and investment holds all the way through the process as it is described in the textbooks – even though as we previously discussed, just about every textbook under the sun would fail to observe that in fact saving and investment must be equivalent throughout the process (as I described in your earlier posts), even though they get the arithmetic of consumption expansion itself right.
In addition to that, I note that you omitted reference to Pettis’ point on the difference between ex ante desires and ex post realization, which is another way of referring to the logical process of the multiplier. In the context of a process that has not reached its equilibrium completion point, ex ante disequilibrium of desired saving at the micro level is quite consistent with ex post macro equivalence of saving and investment all the way through that process.
Finally, for some reason I was unable to post a comment at Pettis’ post, so with your permission I’d like to set it out here, because it blends quite well with my comment above:
……
Excellent post on the subject of the relationship between accounting and economics. The section “Violating Identities” is very good, including:
“The important point about accounting identities – and this is so obvious to logical thinkers that they usually do not realize how little most people, even extremely intelligent and knowledgeable people, understand why it matters – is that they do not prove anything, nor do they create any knowledge or insight. Instead they frame reality by limiting the number of logically possible hypotheses. Statements that violate the identities are self-contradictory and can be safely rejected. Accounting identities are useful, in other words, in the same way that logic or arithmetic is useful. The relevant identities make it easier to recognize and identify assumptions that are explicitly or implicitly part of any model, and this is a far more useful quality than it might at first seem. Aside from false precision, my biggest criticism of the way economists use complex math models is that they too-often fail to identify the assumptions implicit in the models they are using, probably because they are confused by the math, and they would often be forced to do so if they weren’t so quick dismiss accounting identities on the grounds that these identities don’t tell you anything about the economy.”
Indeed, “even extremely intelligent and knowledgeable people” may have the blind spot that prevents them from seeing the full logic of the relationship.
I was interested to see the quote from Hawtrey via Glasner. Glasner is a tremendous writer of economics with a great blog. I had an exchange with him earlier this year about this subject of accounting identities. That discussion ran through comments over several posts, culminating with this:
(I had attempted to demonstrate the continuity of the saving/investment identity via accounting in the case of the Keynesian cross and the multiplier.)
As you note in the comments, “Keynes was a brilliant mathematician and a monster of logic.” I think JMK had a gigantic grasp of the sorts of things you note in this post about the relationship between accounting and economics. He employed national income and balance sheet accounting before they were subsequently invented in a more formal way.
…….
LikeLike
to George H. Blackford
October 21, 2015 at 1:08 am
I am pretty convinced that Keynes not only said it but he believed it
that savings equals investment in all situations and at all times
and further if that is literally true, then their is no possibility of increasing total wealth
because investment is just that wealth put into income, in Keynes definition
(remember he has to pay for all user cost prior to having some left over for income)
so if saving equals investment it is just preservation of the original income investment for the given short term time period
and does not account for new wealth
the new wealth comes from production
in the macro the user cost is just wealth depleted in the process, and in production is the new wealth created
savings equal investment plus net production
where total savings equal total wealth equals total capital
LikeLike
To djb October 21, 2015 at 10:37 am
Keynes definitely did accept the accepted definitions of savings and investment that made them equal, by definition, at all times. What he did not do is argue that this identity implied that savings and investment cannot determine the rate of interest.
What he argued was that an “act of saving” or an “act of investment” will affect income through a direct effect on effective demand rather than on the rate of interest, and that the only mechanism by which it could affect the rate of interest is if it was accompanied by a change in the supply or demand for liquidity. If an act of saving or investment is accompanied by an increase in the demand for liquidity interest rates will increase, and if it is accompanied by a decrease in the demand for liquidity interest rates will fall. Otherwise, there will be no effect of the rate of interest. It’s the supply and demand for liquidity that determines the rate of interest, not saving and investment.
This is a dynamic argument as to how the rate of interest is determined at each point in time as it changes over time, not a static argument as to how saving and investment affect the static equilibrium positions of the economic system, and it is just silly to treat Keynes’s arguments as if they are contradicted by a static analysis since in static analysis everything determines everything else and it makes no sense at all to try to isolate what determines what within this context. Does anyone really believe that Keynes didn’t understand this elementary fact of static equilibrium analysis?
Keynes argued, in effect, that the rate of interest is determined by the supply and demand for liquidity in the same way that the price of apples is determined by the supply and demand for apples. He argued that savings and investment does not determine the rate of interest because an act of saving or investment is not directly related to the willingness to lend or borrow money in the same way that a change in the demand or supply of apples is directly related to the willingness to buy or sell apples. He further argued, in effect, that a change in the demand or supply of liquidity is directly related to the willingness to borrow or lend money in the same way that a change in the demand or supply of apples is directly related to the willingness to buy or sell apples. Hence, his conclusion that the rate of interest is determined by the supply and demand for liquidity and not by savings and investment.
Keynes’s point is, it is possible to provide a logically consistent, rational ceteris paribus argument as to how a change in the demand or supply of liquidity will affect the rate of interest, just as you can provide such an argument as to how a change in the demand or supply of apples will affect the price of apples, but you cannot provide a logically consistent, rational ceteris paribus argument as to how a change in savings and investment will affect the rate of interest.
When viewed from this perspective, everything Keynes said about savings and investment and the rate of interest makes sense. The only way to contradict what Keynes said in this regard is to view his arguments in static terms, which is what the Keynesians did following Keynes death to their everlasting discredit, or to base your arguments on the savings-investment identity, which is what the followers of Robertson did, to their everlasting discredit as well. This sort of refutation of Keynes is pure obfuscation.
LikeLike
to George H. Blackford
to me the savings equals investment simply applies to that part of income supplied directly by the investment
it gets acted on by the multiplier to get total income
that part of the total income that is not used for consumption goes into someone’s savings
if total savings equals total wealth equals total capital
then that savings that equals investment is not the only savings (increase in wealth that occurs)
the other part of savings is net capital production that occurs in the given time period,
capital produced minus capital used up
savings equal investment plus net production
I don’t think Keynes accounted for that
LikeLike
so would agree that savings equals investment is not strictly correct
but that doesn’t disprove the hicks diagram
I-S is that portion of investment that goes into income and gets preserved as savings
or call it just the I line instead of the I-S line
and it intersect at the LM line to give employment and interest rate
if at less than full employment increased investment will increase employment , increase the marginal efficiency of capital ………. and for a given money supply give an increased interest rate
the chart itself is straight lines because it really represents a linear approximation around the given existing equilibrium point
so believing that savings equals investment from net production doesn’t change that really
it could affect the economy if some of that newly produced wealth (capital) (savings) caused an increase in investment
but the cross still applies
LikeLike
George H. Blackford
That sounds right enough that I would bet it’s what Keynes said.
The investment saving identity is an essential accounting tautology in a monetary economy. But it is silent on how liquidity actually channels the required financial intermediation. It is independent of that. That’s why in my mind it makes sense to say the equivalence of the amount of investment and saving has nothing to do with interest rates, but that the specific liquidity channel by which it works operationally may well have an effect on interest rates. From an accounting perspective, this possibility should be intuitive when one understands the difference between an income statement (the identity capture) and a flow of funds statement (the effect of liquidity on prices and interest rates).
Finally, it should be noted that in a monetary economy investment and saving are not the same thing – but that they are the same in measured quantity.
LikeLike
“The investment saving identity is an essential accounting tautology in a monetary economy.”
Money is a commodity with a stable store of value , low transaction costs, and low carrying costs
When added to the total wealth it is just another asset but because it has the above properties people prefer it as an intermediary in transaction and begin to value their others assets in terms of their trade value with money
Savings (increased wealth) that is produced in forms other than money is convertible into money and therefore net production needs to be included in the “identity”
Savings = Investment plus net production
LikeLike
To djb October 21, 2015 at 3:51 pm
My point is only that Keynes’s rejection of the LF theory was not based on an identity. Keynes’s objection to the LF theory was based on the fact that this theory does not make sense in terms of a basic supply and demand analysis of market behavior.
A rational argument can be made that the price of apples will respond to a difference between the willingness to buy or sell apples at a given price of apples, and a similar argument can be made that the rate of interest will respond to a difference between the willingness to sell or hold liquid assets at given rates of interest, but it is impossible to make a rational argument to the effect that the rate of interest will respond to a difference between the willingness to save and invest at given rates of interest.
The fundamental difference here is that Keynes saw the prices of currently produced goods, including capital goods, as being determined by the supply and demand for these goods, but the supply and demand for capital goods differ from the supply and demand for other good in that the markets for capital goods are dominated by existing stocks of capital goods. Hence, the prices of capital goods have to adjust in such a way as to induce people to hold the existing stocks of capital goods as these stocks change over time.
The willingness to hold existing stocks of capital goods involves more than just capital goods and their prices since individual wealth holders also have a choice between holding their wealth in the form of money or debt as well as in the form of capital goods. If we look at the markets for assets from this perspective we can see that, except for money, there is a price that is directly associated with each asset that is available to wealth holders that can be seen to equilibrate that market in a Marshallian, partial-equilibrium sense. Since the price of money is defined by the monetary unit, there is no problem in explaining how it is determined, but a question does arise with regard to the prices of debt, i.e., rates of interest.
The classical economists argued that the rate of interest was determined by the willingness to save and invest. But there is no reason to believe that changes in the willingness to save or invest will have a direct affect on the rate of interest in the same way that changes in the willingness to hold a particular kind of capital good will affect the price of that good. An increase in the willingness to invest can be associated with a decrease in the willingness to hold debt only if the increased willingness to invest is to be financed through borrowing.
Similarly, an increase in the willingness to save can be associated with an increase in the willingness to hold debt only if the increased willingness to save is for the purpose of lending money. If an increase in investment is financed through a drawdown of existing savings or an increase in savings takes the form of accumulating money there will be no effect on the willingness to hold existing debt or on the amount of existing debt, and, therefore, there will be no effect on the rate of interest that equilibrates the market for debt. What does it mean to say that the willingness to save and invest determine the rate of interest if changes in the willingness to save and invest may or may not have an effect on the rate of interest?
Keynes rejected this way of looking at the determination of the rate of interest in favor of a theory that argues the rate of interest is (strictly speaking, “own rates of interest” are) determined in the Marshallian sense by the supply and demand for liquidity, wherein an increase in the demand for liquidity, as defined by Keynes, will have the direct effect of increasing the willingness to hold money (increase in the willingness to hold liquid assets), thereby, causing the price of debt to fall (non-money asset prices to adjust) in such a way as to cause the rate of interest to increase (“own rates of interest” to adjust) so as to equate the supply and demand for liquidity.
Similarly, an increase in the supply of money (liquid assets) will have the direct effect of increasing the stock of money (the stock of illiquid assets relative to non-liquid assets) that need to be held and will, thereby, cause the price of debt (prices of assets) to increase (non-money assets to adjust) in such a way as to cause the rate of interest to decrease (“own rates of interest” to adjust) so as to equate the supply and demand for liquidity.
The LP theory is fundamentally different from the LF theory which is based on savings and investment, and the two theories have fundamentally different implications with regard to how the economy works: The LF theory tells us that an increase in saving will lower interest rates and, thereby, will lead to an increase investment. The LP theory tells us that an increase in saving will lower output rather than interest rates, and there is no reason to believe the resulting fall in output will lead to an increase in investment.
The fact that mainstream economists have refused to accept this difference between the two theories has provide a justification for the policies to increase savings in the US that ultimately led to the economic situation we face today. See: http://www.amazon.com/Where-Did-All-The-Money-ebook/dp/B00N9H75NG
LikeLike
To JKH October 21, 2015 at 5:34 pm
If I were to put this in accounting terms I would say that Keynes argued, in effect, that non-capital goods are income statement kinds of variables and capital goods, money, and debt are balance sheet kinds of variables, and that the prices and quantities of the two kinds of variables are determined in very different ways.
The rate of interest is the price of a balance sheet kind of variable. In assuming that that the rate of interest adjusts to equate saving and investment the LF theory ignores this fact, and attempts to explain this price as if it were an income sheet variable.
LikeLike
End of confusion
Comment on ‘Keynes and Accounting Identities’
Hicks was the first to come up with a smart solution of the saving-investment conundrum: “What a tricky business this all is! In his Treatise on Money, Mr. Keynes told the world that savings and investment are only equal in conditions of equilibrium; that an excess of investment over saving means rising prices, and vice versa. In his General Theory, he told us that saving and investment are always equal, and that this is a mere identity or truism, without significance for the determination of prices. As far as I can make out, there are relevant and important senses in which all these statements are each of them right and each of them wrong.” (1939, p. 184)
Indeed, in economics anything goes and at the end of every grand debate the confusion is roughly the same as at the beginning.
“Throughout the 1920s and 1930s the focus was increasingly on the role of the equality of saving and investment, but the semantic squabbles that dominated much of the debate (the distinctions between ‘ex ante,’ and ‘ex post,’ ‘planned’ and ‘realized’ saving and investment, the discussion of whether the equality of saving and investment was an identity or an equilibrium condition) reflected a deeper confusion.” (Blanchard, 2000, p. 1378)
The saving-equals-investment debate from Adam Smith onwards is a striking example of hereditary scientific incompetence.
Lest younger economists waste another eighty+ years in deeper confusion it should be mentioned that the whole issue has been settled: “Autrement dit l’investissement n’est pas égal à l’épargne spontanée, mais à l’épargne spontanée augmenté du revenue non distribué des entreprises ….” (Allais, 1993, p. 69) Or, summed up in a crisp formula (for details see 2014; 2013):
This formally consistent accounting identity makes it clear that saving and investment never were and never will be equal and that the familiar story of the interest rate mechanism has never been more than clueless verbiage.
The formal foundations of Keynesianism are defective. For Keynesians, though, inconsistency is not a fatal flaw but the sign of an extraordinary mind: “It is well known that John Maynard was born anew every morning; for this reason, his colleagues at Bretton Woods commented that he was too intelligent to be consistent.” (Valentino, 1988, p. 239)
Any questions why Keynesians messed the whole IS thing up and, more general, why economics is a failed science?
Egmont Kakarot-Handtke
References
Allais, M. (1993). Les Fondements Comptable de la Macro-Économie. Paris: Presses Universitaires de France, 2nd edition.
Blanchard, O. (2000). What Do We Know about Macroeconomics that Fisher and Wicksell Did Not? Quarterly Journal of Economics, 115(4): 1375–1409. URL http://www.jstor.org/stable/2586928.
Hicks, J. R. (1939). Value and Capital. Oxford: Clarendon Press, 2nd edition.
Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL http://ssrn.com/abstract=2220651
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792
Valentino, R. (1988). Discussion. In H. Hanusch (Ed.), Evolutionary Economics. Applications of Schumpeter’s Ideas, pages 238–249. Cambridge, New York, NY, etc.: Cambridge University Press.
LikeLike
George H. Blackford October 21, 2015 at 9:15 p.m.
I agree with the characterization of the interest rate as a “balance sheet kind of variable”. Balance sheets evolve over time. That evolution is captured in flow of funds accounting. The flow of funds depicts how funds settle in the form of balance sheet stock items, and such settlement includes the setting of the interest rate where required by the nature of the funds instrument created. In addition, some balance sheet funding items remain static in place over a full accounting period, and their interest rates are either fixed previously, or are reset according to some variable rate contract.
That said, income statements include the effect of newly produced consumer goods, newly produced capital goods, and monetary items such as wages, interest payments, and profit.
So both modes of accounting include interest payments within their scope.
But I agree with the characterization that the interest rate is determined at the balance sheet liquidity level. The income statement reflects that determination as period revenue or expense in the form of interest payments that are a function of the interest rate.
Conversely, the notion of equivalence in the measured quantity of investment and saving is at its core an income statement phenomenon. The necessary equivalence can be demonstrated very easily by actual operational events. Unfortunately, the economics profession tends not to appreciate how financial accounting corresponds in logic to actual operational steps in reality.
For example, if at the opening of an accounting period I pay somebody to cut down a tree, then the resulting timber becomes an investment. My payment to the tree cutter becomes his income – and simultaneously his 100 per cent saving from income (before he chooses to do anything with it otherwise – or not). The quantity of investment equals the quantity of saving. The tree cutter in the same accounting period may subsequently use that money to pay his barber. The two steps in combination expand GDP by more than the value of the investment. That is the multiplier. Meanwhile, the barber now has claim to the financial representation (a bank deposit for example) of the original investment, which means that intra-period saving has been transposed as saving from the income of the tree cutter to saving from the income of the barber. And with that transposition the quantity of period investment still equals the quantity of period saving.
LikeLike
“so believing that savings equals investment from net production doesn’t change that really”
should have said savings equals investment plus net production
and this doesn’t make the hicks diagram invalid
LikeLike
JKH:
“For example, if at the opening of an accounting period I pay somebody to cut down a tree, then the resulting timber becomes an investment. My payment to the tree cutter becomes his income – and simultaneously his 100 per cent saving from income (before he chooses to do anything with it otherwise – or not). The quantity of investment equals the quantity of saving. ”
now I would say that the tree is wealth depleted and that the timber is wealth created, and this would count as SAVINGS for you
what you pay the tree cutter certainly counts as income to him and is your investment
his spending (which will occur according to marginal propensity to consume) would then count as consumption
when you sell the timber (now pre-existing wealth) for cash and you spend that cash, that counts as investment too
(spending from pre-existing wealth, not from current income)
this spending will go into the income of the people or business you purchased something from
they will then consume part of that etc etc
LikeLike
Please could someone explain to this Keynesian how ex-post savings can ever differ from investment?
Starting with a closed economy with no government, the assertion that S=I is simply a restatement of the fact that income = expenditure. The introduction of foreign and government sectors don’t undermine Keynes’ insight.
LikeLike
ICYMI (comment on Anders of Oct 22)
The premise income=expenditure is false as I pointed out above (Oct 21) and the deeper reason is that the profit theory is false. For the rectification of Keynes’s approach see the working paper ‘The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment’
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792
LikeLike
Egmont,
From your paper …
“The household sector’s monetary saving has never been equal to the business sector’s investment and will never be – neither ex ante nor ex post nor otherwise.”
But I don’t think anyone writing carefully said so.
Let’s take a pure private economy for simplicity.
Household saving + Firms’ saving = Household investment + Firms’ investment.
S = I.
LikeLike
if we increase the money supply then that will make it less valuable compared to other assets that also make up the entirety of wealth, in the long run
in the short run, since we , through quantitative easing for example, are basically causing the liquid cash to be in the hands of rich people who may have little need or desire for a lot of those other assets
so its effect on direct demand will not be so much
on the other hand, since they will be looking for another place to give them a return, and since, given that the interest rates go down as the liquid cash supply goes up
they will hopefully will find a better return in investments that create jobs, increase employment and total income and hopefully lead to increased production of wealth
with wealth being defined as you like it
and this could increase end up with increased prices as demand will definitely go up then (unless production outstrips income)
so whereas, according to Keynes ricardo assumed that interest rates equilibrated with marginal efficiency of capital
Keynes thought the role of liquid money as an intermediary
——————————————————————–
its also interesting that Keynes stated the liquid money was only necessary because of uncertainty, because without uncertainty you could always direct your investment in such a way, that the cash was there exactly when you needed it
——————————–
next point again, is
but if savings is all the wealth in the world, and if you are going to invest some of that wealth, then for whole world you cannot have savings equals investment
you cannot even have the change in savings equals the change in investment
if by investment you mean that capital that was moved into income
because that money is preserved as savings in the process
capital moved out of savings is just capital moved
any capital moved into raw materials and expenses but does not contribute to income, that is used up, is best look at as capital depleted in the process,
and when subtracted from that capital produced gives net production
so savings equals investment plus net production
LikeLike
ICYMI (comment on Ramanan of Oct 22)
The mistake in your argument is that first household saving is denoted with S and then, in an additional step, the SUM of household saving and “Firm’s saving” is also denoted with S. With this inadmissible double notation one arrives indeed at the familiar result. I have clarified this case in Section 17 of the working paper ‘Keynes’s Missing Axioms’
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1841408
LikeLike
Egmont
I’m still unclear how you repudiate the basic “income=expenditure” identity.
Within an accounting period, if aggregate income isn’t equal to expenditure, where does the surplus (deficit) go (come from)?
You mention profit as a key reason to reject the identify; indeed, you claim that “Profit is the pivotal concept” for understanding the economy. This seems entirely incorrect.
I hope we can agree that certain contingent aspects of our modern economy can be stripped away without losing coherence:
1. assume a government account in balance, and a balanced current account
2. assume no bank lending
3. assume every household and business spends all of its income, running neither a deficit nor a surplus
4. assume balance sheet capitalisation hasn’t been invented yet for corporates; all businesses use cash accounting
In such an economy, all businesses would be break-even, with zero net profit or loss. (Note that this is no reason for the businesses to cease operating; they could all be owner-operated, as all businesses presumably once were.)
Now, let’s make one business start to run a profit. This can happen from another agent running a deficit (a business operating at a loss, a household running down its cash endowment, or a deficit from the government or the RoW). But how can profit appear without anyone else running a deficit – or more generally – how can you make a profit without relying on the rest of the economy, in aggregate, running a deficit towards you?
The answer lies in balance sheets. All it takes for a firm to run a profit is for the firm itself to capitalise some of its expenditure, eg as inventory, IP, plant or equipment. The recognition that some expenditure in the current accounting period may support income in future periods – or capitalisation – is surely the ultimate, and simplest, explanation of profit.
This insight – which, although trivial, I have never seen articulated elsewhere – doesn’t strike me as having any negative implications for Keynes’ work.
Anders
LikeLike
ICYMI (comment on Anders, Oct 23)
Indeed, you ask the pivotal question: “I’m still unclear how you repudiate the basic “income=expenditure” identity. Within an accounting period, if aggregate income isn’t equal to expenditure, where does the surplus (deficit) go (come from)?”
The shortest possible and graphics supported answer has been given in the 3 page working paper ‘Debunking Squared’
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2357902
The complete answer with the consistent inclusion of money has been derived in ‘The Emergence of Profit and Interest in the Monetary Circuit’
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1973952
In sum: Neither Classicals, nor Walrasians, nor Marshallians, nor Marxians, nor Keynesians, nor Institutionialists, nor Monetary Economists, nor MMTers, nor Austrians, nor Sraffaians, nor Evolutionists, nor Game theorists, nor EconoPhysicists, nor RBCers, nor New Keynesians, nor New Classicals ever came to grips with profit. Hence, they fail to capture the essence of the market economy.
LikeLike
Egmont – I have set out an argument for why profit does not constitute a problem for standard economics (even if it isn’t typically analysed in this way). If you would like to engage with it, I’d be glad to hear your views of where I have gone wrong.
I have tried to follow the thread of your papers but I’m afraid I am unable to.
Anders
LikeLike
ICYMI (comment on Anders, Oct 23)
The formally correct accounting relationship is given here:
Ignore for simplicity distributed/retained profit, i.e. Yd=0. Then the equation says: monetary profit Qm is equal to the difference between investment I and monetary saving Sm. All variables are measurable with a precision of two decimals and one will ALWAYS find that the business sector’s investment expenditures are different from the household sector’s saving/dissaving in a period of given length and that profit/loss for the business sector as a whole is different from zero.
Again, all I=S models are false and the proof is in the national accounts, see ‘The Common Error of Common Sense: An Essential Rectification of the Accounting Approach’
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2124415
Your statement ‘profit does not constitute a problem for standard economics’ is a bit strange, to say the least. The profit theory is false since Adam Smith and this disqualifies the whole of economics. The fact of the matter is that the representative economist cannot, after more than 200 years, tell the difference between profit and income. You will not find many examples in the history of science that are more embarrassing.
LikeLike
read the paper from ekh
Comment
1 Keynes understood profit was included in total income
2 in his consumption only economy there is no explanation of where consumption>income comes from……it must therefore come from pre-existing wealth
Only way to get growth is net production, otherwise we are just moving pre-existing wealth around
Of course in a world where wealth deteriorates without maintenance then in such a situation we need to have production, just maintain what we got
LikeLike
ICYMI (comment on Anders of Oct 23)
The formally correct accounting relationship is given here:
Ignore for simplicity distributed/retained profit, i.e. Yd=0. Then the equation says: monetary profit Qm is equal to the difference between investment I and monetary saving Sm. All variables are measurable with a precision of two decimals and one will ALWAYS find that the business sector’s investment expenditures are different from the household sector’s saving/dissaving in a period of given length and that profit/loss for the business sector as a whole is different from zero.
Again, all I=S models are false and the proof is in the national accounts, see ‘The Common Error of Common Sense: An Essential Rectification of the Accounting Approach’
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2124415
Your statement ‘profit does not constitute a problem for standard economics’ is a bit strange, to say the least. The profit theory is false since Adam Smith and this disqualifies the whole of economics. The fact of the matter is that the representative economist cannot, after more than 200 years, tell the difference between profit and income. You will not find many examples in the history of science that are more embarrassing.
LikeLike
Comment on djb of Oct 23 and Anders of Oct 23
You say: “Keynes understood profit was included in total income.”
This is true, of course, but my argument is that exactly at this point Keynes made the fatal conceptual blunder which consists in not coming to grips with the two fundamental economic concepts profit and income. To miss the crucial difference is just as unpardonable as a physicist confounding force and energy.
I perfectly agree with Anders up to this point: “Now, let’s make one business start to run a profit. This can happen from another agent running a deficit …” This is a good example for begging the question. It is not demonstrated in detail how profit emerges from the monetary circuit but simply assumed with “let’s make one business start to run a profit …” Note well, if one business starts to make a profit and the other makes a complementary loss, the profit of the business sector as a whole is still zero just as in the initial case. Obviously, this does not explain how the business sector has managed to make overall positive profits over several centuries.
Here is again the formally correct accounting relationship:
For simplicity, distributed profit and investment is set to zero, i.e. Yd=0 and I=0. Then the equation says for the pure consumption economy: monetary profit for the business sector as a whole Qm is equal to dissaving; and monetary loss is equal to monetary saving Sm (under the condition of product market clearing, that is, no inventory investment/disinvestment).
Profit is a phenomenon that can only emerge in a monetary economy. As a matter of principle, real models cannot explain profit.
In sum: it is incorrect to say that total income is the sum of wage income and profit, but it is correct to say that total income is the sum of wage income and distributed profit. This is the all-dominant conceptual difference. Its oversight makes that economic theory from Adam Smith to Keynes and up to the present will not even make a footnote in the history of scientific thought.
LikeLike
investment needs to be considered as any capital added to the current income that comes from preexisting wealth (or newly printed money)
such as your households using their savings for consumption
Keynes consumption must only be that consumption that comes from current income
that’s the only way the multiplier makes sense since MPC, marginal propensity to consume, is how much of current income you spend
so there cannot be an investment-free economy, unless MPC = 1 or 100%
consumption from preexisting wealth makes it viable, but this has to count as investment
and I agree there is something missing
if savings equals investment at the end of the given period, that is just preservation of investment as savings in someone’s pocket
but this would not allow for any increase or decrease of wealth
what I think he is missing, that ultimately allows business to get a return on their investment is net production, which is the only thing that allows for increase in total wealth in the economy
anything that does not allow for capital production minus capital depletion, ie net production, does not allow for any increase in wealth
this production of wealth is the “profit”, the return on investment
otherwise you are just shifting wealth or capital or money around
I think the increased wealth, for the given time period, is best considered as the “savings ” which I consider equal to the increased “capital”
LikeLike
Comment on djb of Oct 25
Confusion is the default state of the representative economist (2013). Obviously, you cannot get out of Keynes’s accounting mess by nonstop introducing new concepts like wealth, capital, consumption function etc. The solution lies exactly in the opposite direction.
“There can be no doubt whatsoever that a problem which has not yet been solved in all its aspects under its simplest conditions will be still more difficult to tackle if other, ‘more realistic’ assumptions are being made.” (Morgenstern, 1941, p. 373)
In the most elementary case of the consumption economy the accounting identity says (i) Qm=-Sm.
After taking investment into account the accounting identity reads (ii) Qm=I-Sm (for the full investment cycle see 2011).
And so it goes consistently on to ever higher levels of complexity. Equations (i) and (ii) tell you that saving is never equal to investment. All equations are testable/refutable in principle. So there is absolutely no need for endless confused blather.
References
Kakarot-Handtke, E. (2011). Squaring the Investment Cycle. SSRN Working Paper Series, 1911796: 1–25. URL http://ssrn.com/abstract=1911796
Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL http://ssrn.com/abstract=2207598
Morgenstern, O. (1941). Professor Hicks on Value and Capital. Journal of Political Economy, 49(3): 361–393. URL http://www.jstor.org/stable/1824735
LikeLike
Sorry, but I just haven’t been able to keep up with all the comments on this post, and my responses are likely to be on the perfunctory side.
George, I have tried to respond to your request for a quote from Keynes in my most recent post, which I guessing you have already seen. In case not, here’s a link:
Egmont, I think you are misattributing Michael Pettis’s words which I quoted to me. I have great respect for Keynes’s intellect, but I have never asserted that he never committed any logical blunders. I am skeptical about your claim that a theory can be dismissed simply because of an incorrect definition. I am enough of a Popperian to be a philosophical nominalist, so I don’t believe that the validity of theories depends on how terms are defined. If there is a problem with the theory it must be because of something more basic than a definition. At least that’s my view.
djb, Sorry, but I’m unable to follow what you are sayingi
JKH, Yikes, indeed! I tried to formulate my position in a way that would skirt issues that we discussed at length previously and I have no desire to revisit just yet. One way to sort it out I think is to say that although savings equals investment according to one set of definitions, we can identify components of savings and investment that are equal only in equilibrium. So even the definitional equality of savings and investment always holds the various components of savings and investment aren’t necessarily always equal. Which components of savings and investment must be equal and which may not be equal will depend on the specific behavioral assumptions that one is making. Thanks for your kind words about this blog, and I’m sorry you couldn’t get it posted on Pettis’s blog. I also tried unsuccessfully to post a comment on his blog. Oh well.
George, I completely agree with your critique of the savings and investment theory of the rate of interest. The rate of interest is determined by the markets for capital goods and fixed income instruments, i.e. stock markets of existing assets and financial instruments, not flow markets. The problem with the liquidity preference theory is that it leaves unexplained the real rate of interest that is the prospective return yielded by all assets, net of storage costs, expected appreciation, and service flow, which all assets must be expected to provide in equilibrium. Keynes got it right in chapter 17, but for some reason, he seems to assume that the liquidity premium explains the expected return on real assets, but there is no reason why liquidity preference should imply that the real yield on physical assets would go to zero if there were no liquidity premium.
Anders, It is true that the savings-investment identity corresponds to the expenditure-income identity. However, there are choices available in defining income and expenditure that make it possible for expenditure not to equal income. E.g., are we talking about the income of households or of business business firms? Income may accrue to business firms before it accrues to households. If we accept that consumption expenditures are undertaken by households not businesses, and that desired savings as a function of income (marginal propensity to save is a function of household income) then savings (by households) and investment by business firms will be equal only in equilibrium. That is the straightforward understanding of how the simple Keynesian model works with savings equaling investment treated as an equilibrium condition rather than an identity. JKH prefers to work with the accounting identities holding at all times. That seems to me to be inconsistent with the straightforward understanding of how the Keynesian model actually works (e.g., I don’t understand how to interpret the marginal propensity to save in that framework), but he seems to be able to carry on nevertheless.
LikeLike
I am saying that investment should include pre-existing wealth that goes into the economy that becomes income
private spending from savings, government spending, government and private investment
all capital that is transfered into the economy that becomes income*
and the C in Keynes equation needs to equal consumption from current income
and that the savings that equals the original investment , S=I is preservation of wealth (or capital same thing) that was transferred into income originally
and that it doesn’t account for any new wealth created
and that savings should equal investment
plus capital appreciation
*I am saying that user cost in which Keynes accounts for expenses is a micro economic concept
whereby before he can put investment into income, he has to pay off all the expenses , which he calls disinvestment, and what is left over goes into income
meaning that investment is income
but in the macro we cannot pay off all the wealth lost before we invest anything
wealth is being lost and gained all the time
this does not preclude a functioning economy
so keeping in mind that after paying off user cost what is left is investment and it goes into income (Y = I + C right?)
and that wealth should be handled on a different axis than income
so that for example preexisting wealth that goes into raw materials, counts and capital depleted
and that produced counts as wealth created
so on the wealth axis, you got capital created minus capital destroyed
so preexisting wealth either goes into raw materials or it goes into income
the income part is the investment, and the wealth part is the net capital production
savings equals investment (preservation of old wealth) plus net production, (new wealth)
LikeLike
David,
“I have no desire to revisit just yet”
That’s probably a good idea for both of us – with “just yet” providing some hope for the future.
In case you hadn’t seen it, here is Roger Farmer just the other day on the equivalence of saving and investment.
http://rogerfarmerblog.blogspot.ca/2015/10/demand-creates-its-own-supply.html
I like his post. He does conclude with the idea of saving and investment being equal in equilibrium (I assume implying exclusively in equilibrium), similar to yourself.
LikeLike
David,
Sorry, but the challenge of trying to explain one’s views feels Sisyphean at times, if not masochistic. The task remains. So once more around it:
In your comment to Anders, you say “I don’t understand how to interpret the marginal propensity to save in that framework.”
Assume an accounting period of indefinite length.
We can examine what happens during that accounting period by looking at discrete events as they unfold.
I claim that the following analysis is entirely consistent with the usual construct of the multiplier and the measurement concepts of expenditure, income, investment, consumption, saving, marginal propensity to consume, marginal propensity to save, etc.
Suppose at the beginning there is an investment of 100.
Assume the real investor pays 100 to a single factor of production F.
(Maybe something simple like paying somebody to cut down a tree or mine a rock that is then put into inventory – a temporary investment before being processed into a finished product.)
F’s income is 100.
Freeze frame.
Investment is 100. Income is 100. And saving is 100.
Saving is 100 because F has not yet exercised his marginal propensity to consume. We are considering the effect of discrete events accumulating over an accounting period of indefinite length.
Suppose the marginal propensity to consume is 2/3.
F then spends 67.
F started out saving 100.
Now he has spent 67.
That means F has just marginally dis-saved 67 by spending it.
And F has cumulatively saved 100 – 67 = 33.
That result of 33 corresponds to F’s marginal propensity to save.
Thus, the standard concept of marginal propensity to save has been decomposed into 2 successive, discrete propensities – one at the point of F receiving income and one at the point of F spending.
The marginal propensity to save is thus the net result of an “instantaneous” propensity to save (identically equal to 1 at the point of receiving income) and a marginal propensity to dis-save (identically equal to the marginal propensity to consume at the point of spending).
That’s a complete story of F’s saving propensity from the time he receives income to the time he spends.
But at the point of F’s spending (and net saving result), it is an incomplete picture of the aggregate saving propensity and the aggregate saving of the macro economy.
Because aggregate saving at that point consists of the joint effect of F and somebody else with whom F has just transacted:
Suppose F has spent 67 in return for a service provided by F1.
So F1 receives income of 67.
In the same way that F had saved 100 prior to spending, F1 has now saved 67 prior to spending.
So total cumulative saving at the point of F’s spending is 33 (F) + 67 (F1) = 100.
And total cumulative saving has remained unchanged. Saving equals investment.
F1 then later spends 45 by paying F2 for a service provided.
Again, cumulative saving at this point remains at 100, because the net effect of this latest transaction is (45) (F1) + 45 (F2) = 0.
F2 goes on to spend/dis-save 30 …
Rinse and repeat F3, F4, F5… etc.
Cumulative saving = 100 at all times.
Returning to your comment: “I don’t understand how to interpret the marginal propensity to save in that framework.”
Maybe one way to think about it is that, as above, the marginal propensity to save is the net effect of two constituent sub-propensities:
a) The instantaneous marginal propensity to save income, which is identically 100 per cent, given the realistic assumption that transaction events are discrete in time, and spending takes place after income is received
b) The eventual marginal propensity to spend from income (dis-save from income already received), which is the standard MPC
So the cumulative saving flow is always equal to cumulative investment flow (i.e. within the same accounting period – which for purposes of illustration I have made indefinite here, without loss of generality).
In particular, the continuous equivalence of cumulative investment and saving within a given accounting period holds when propensity a) is exercised, and when propensity b) is exercised, and at all other points in time as well.
LikeLike
http://rogerfarmerblog.blogspot.ca/2015/10/demand-creates-its-own-supply.html?showComment=1445950538114#c5950524548487444335
LikeLike
ICYMI
David, for my summary see Moronomics
http://axecorg.blogspot.de/2015/10/moronomics.html
LikeLike