February 19, 2016

Economists’ perennial trouble with accounting

Comment on Steve Keen on ‘Hey Joe, banks can’t lend out reserves’

Blog-Reference

Steve Keen says: “... the useful stuff accountants know is double-entry bookkeeping. Why don’t economists know this themselves? Today’s economists simply don’t study it .... Economists of Joe’s generation often did learn accounting as undergraduates ... but very few of them ever integrated accounting concepts with their economics.”

Accounting is elementary mathematics and, true, it is regularly beyond the capacities of economists (2012). Unfortunately, also of heterodox economists. This includes Steve Keen.

The matrix is not the best tool to present the accounting interrelationships so I present my refutation of Keen’s argument in an alternative format here.

1 In the beginning, there is only the central bank which creates overdrafts and deposits uno actu out of nothing. Overdrafts stand here for all forms of direct loans to the household or the business sector. The deposits of the central bank are money and used for transactions between the household and the business sector. Other forms of money are here kept out of the picture.

2 The banking sector is now split between the central bank and commercial banks. The central bank creates 10 monetary units (million, billion, trillion, Euro, Dollar, Yuan) of overdrafts and deposits for the commercial banks only.

3 The commercial banks start their lending business and create 100 monetary units overdrafts and deposits for the business sector. The deposits of the commercial banks are the transaction money used by the business sector to pay wages and by the household sector to buy consumption goods. The ratio of central bank deposits (= reserves) to business overdrafts is here 10 %, i.e. 10/100 units) and it is assumed that this is the maximal ratio. So, the commercial banks have here reached their limit of money creation. It is the central bank’s turn to act.

4 In the course of quantitative easing, the central bank takes over 5 monetary units of business sector overdrafts (= loans) from the commercial banks. The ratio of central bank deposits to business overdrafts is now 15.8 %, i.e. 15/95. So the commercial banks have excess reserves. With regard to the 10 % limit they need 9.5 units of central bank deposits but have 15.

5 The commercial banks now again take up their lending business and increase overdrafts to business by 55 units. Of course, the same increase takes place on the debit side (= business deposits +55). The ratio of central bank deposits to business overdrafts is now again 10 %, i.e. 15/150).

In the strict sense, it is misleading to say that commercial banks lend out reserves. In a pure credit economy the commercial banks create overdrafts and deposits uno actu out of nothing. The reserve ratio is not a practical but a legal limit.

So, literally, is is right to say that commercial banks do not lend out reserves. But it is obvious that between step 4 and step 5 the banks have excess reserves and therefore are in the position to create money in the form of bank deposits for the business and the household sector. Between step 4 and 5 the credit multiplier is indeed greater than 0. Steve Keen’s conclusion “Therefore, the $1.4 trillion of excess reserves that QE has created in the USA alone has added precisely $0 to the lending power of banks” is false.

The lending power is there but of no use, if the household and business sector prefer to deleverage (Koo, 2009).

The real problem of QE is that the central bank takes toxic loans off the commercial/ investment banks' balance sheets and thus protects them from losses.

Egmont Kakarot-Handtke


References
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
Koo, R. C. (2009). The Holy Grail of Macroeconomics. Lessons from Japan’s Great Recession. Singapore: Wiley.

Related 'Accounting for dummies'  and 'Accounting basics' and 'End of confusion' and 'Either stupid or duplicitous' and 'Unaccountable'

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COMMENT on Asad Zaman and John Hermann on Feb 21

The two criteria of science are formal and material consistency (Klant, 1994, p. 31). The latter is established by empirical testing. How important this is for genuine scientists one may glean from the fact that physicists have built ‘the world’s most expensive and complex experimental facilities to date’ (CERN, Wikipedia) in order to test a hypothesis that has been put forth around 1964 by six theoretical physicists.

This vividly contrasts to the silly methodological motto of most economists, i.e. “it is better to be roughly right than precisely wrong!” (Davidson, 1984, p. 574)

The analogon to the physicists’ fervor of measurement would be to install a giant facility which records every economic transaction in real time according to the principles of accounting. This facility then delivers the exact numbers (two digits) of total income per period, consumption expenditures, saving, and so on. And these numbers are the rock-solid foundation of empirical testing.

Curiously, economists have never shown any ambition to build such a facility. Worse, economic theory is not even built upon concepts that correspond with what could be actually produced with such a gigantic bookkeeping machine. Just the contrary, economic theory has been built upon concepts like utility or equilibrium and it should have been evident from the very start that there is no testable correspondence to these green cheese concepts in the real world. Thus, the scientific failure of economics has been methodologically pre-programmed 140 years ago.

What most economists have not realized to this day is that accounting is pivotal to their discipline. Their manifest incompetence consists in not understanding the elementary mathematics that underlies accounting (2012). This is the real mathiness problem.

“Somewhere between the Political Arithmetician, alias the National Income Accountant, and the Financial Analyst, alias the Accountant, lies the task of the quantitative economist’s analytical role, and none of the theoretical or applied tasks of these two pragmatic and paradigmatic figures requires anything more than arithmetic, statistics and the rules of compound interest. These, in turn, require nothing more than an understanding of the conditions under which systems of equations can and cannot be solved. But what kind of quantities do these equations encapsulate as parameters, constants and variables? Surely, the kind of quantities that enter the equations of the Political Arithmetician and the Accountant cannot be other than rational or natural numbers — negative and non-negative? Eminent theorists, working in core areas of economic theory — price theory and monetary theory — have made this point in interesting ways over the past half a century.” (Velupillai, 2005, pp. 866-867)

To be sure, accounting is not all of economics. But make no mistake, above the entrance to economics as science is inscribed the phrase: “Let None But Those Who Mastered The Elementary Mathematics of Accounting Enter Here.”


References
Davidson, P. (1984). Reviving Keynes’s Revolution. Journal of Post Keynesian Economics, 6(4): 561–575. URL
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
Klant, J. J. (1994). The Nature of Economic Thought. Aldershot, Brookfield, VT: Edward Elgar.
Velupillai, K. (2005). The Unreasonable Ineffectiveness of Mathematics in Economics. Cambridge Journal of Economics, 29: 849–872.