Accounting identities don't tell us how the economy actually works.
Whenever the public discourse turns to economics, the results tend to be painful. Economists are forever pulling their hair out over the politicization of the discipline. But recently, things have gotten even worse than usual. It’s no exaggeration to say today’s economic deliberations are vacuous, compared even to a few years ago. Appallingly, some assaults on sound economics come from economists themselves!
There’s one mistake that’s particularly common and damaging. Too many observers try to derive economic principles from accounting principles. This is flat-out wrong. The reason is simple: Economics is not accounting. Economists try to understand the causal relationships in commerce and government. Accountants document stocks and flows in an orderly fashion. Economics obviously makes use of accounting, and accounting can be improved through knowledge of economics, but they’re not the same thing.
The most egregious abuses of economics that we see today start with an accounting identity — a true statement or equation — but end with an absurd economic claim. Importantly, an identity is true by construction. Based on the definitions of the variables, the formulation must be so. But it doesn’t say anything about the real world. It certainly doesn’t capture the causal relationships among those variables.
Here’s an example: If you’ve taken an introductory economics course, this equation is probably familiar to you: Y=C+I+G+(X-IM). In plain English: Gross Domestic Product (GDP, in this equation ‘Y’) is the sum of consumption (C), investment (I), government spending (G), and net exports (X-IM). This is the foundation of national-income accounting, and it’s true by construction. GDP is defined as the sum of these things. Nothing in this equation tells us how the economy actually works.
But you wouldn’t know it, based on how often it’s misused. Here’s a case from the Left: Because government expenditures enter positively into GDP, increased government spending raises GDP. Simple, right? Not so fast. The output effect of a stimulus package, for example, depends on how the increase in government spending affects other GDP variables. If the economy is operating at full employment — if productive inputs are being used as effectively as possible, given existing tradeoffs and constraints — then Uncle Sam spending more doesn’t increase the size of the economic pie. It just redistributes existing slices to Uncle Sam, or to whomever Uncle Sam finances. More public-sector consumption means less private-sector consumption. So much for stimulus!
Here’s a case from the Right: It’s fashionable among today’s conservatives to be an international-trade skeptic. The “hollowing out” of our “manufacturing base” supposedly shows the evils of free trade. Fans of protectionism frequently point to the sign of imports in the GDP equation. “See?” they cry. “Imports get subtracted. Therefore imports reduce GDP!” Fact check: false. Buying an Italian sports car doesn’t reduce U.S. GDP by $100,000. We subtract imports from GDP to prevent double counting. The idea is to capture spending on domestic production only. For accounting reasons, not economic ones, we deduct imports. Buying from abroad doesn’t make us poorer. If anything, it makes us richer. There are exceptions, but in general, you’re going to make a fool of yourself if you ignore comparative advantage.
Accounting identities can be incredibly useful for economics, of course. Here’s another macro-accounting statement that’s been put to good use: MV=Py. This is the famous equation of exchange, the darling of monetarists. M is the money supply; V the velocity of money (its rate of turnover); P the price level; and y is real (inflation-adjusted) GDP. This equation is based on a tautology: the velocity of money is defined as the ratio of nominal GDP (real GDP times the price level) to the money supply.
The equation of exchange is the bedrock of an important economic theory, the quantity theory of money. But here’s the key: QTM introduces a specific premise, one that’s empirically testable. It assumes the velocity of money is stable over time. The implication of QTM is straightforward: a direct link between the money supply and the price level. Put simply, printing money causes inflation. This qualifies as a genuine economic theory because the assumption about velocity allows us to make a causal statement.
QTM was the basis for Milton Friedman’s famous monetary-growth rule, a proposal that the Fed increase the money supply by a certain percentage each year. Friedman thought this would promote economic stability. And this approach works . . . assuming velocity remains unchanged. If it doesn’t, constant money growth by the Fed won’t tame the business cycle. As it turns out, the velocity of money was pretty stable for a while, before destabilizing in the 1980s due to innovations in the financial sector. To their credit, Friedman and other monetarists backed away from their favored rule once it became clear that the theory behind it was based on an outdated premise.
Accounting is a useful tool. We couldn’t do economics without it. But accounting and economics have fundamentally different purposes. You can’t rely on the former to do the work of the latter. Reasoning from an accounting identity involves sneaking in an economic theory, and usually snuck-in theory is bad theory. And when the analysis is politically motivated, as is all too common, the whole thing is worthless. Don’t let partisan hacks get away with this trick. When they do this to economics, it cheapens public debate.
Editor’s note: This piece has been updated since its original publication.