December 4, 2016

Economists still don’t get Econ 101 right

Comment on Peter Dorman on ‘The Identity-Equals-Causation Fallacy, Yet Again’


Peter Dorman criticizes Gregory Mankiw’s latest piece titled ‘Don’t Worry About the Trade Deficit’. He observes: “The flaws in Mankiw’s analysis do not come from inaccurate data or a faulty assumption here or there, but a basic misunderstanding of Econ 101. The guy needs to take an intro class. Of course, if the textbook isn’t very good it won’t help him much.” (See intro)

The discussion shows that economists still do not understand the elementary mathematics of accounting. And all this started 80 years ago with Keynes’s famous identity of saving and investment.#1, #2

The formal description of the economy is given by Dorman with two equations:
(1) Y ≡ C + I + G + NX
(2) Y ≡ C + S + T
Legend: Y is national income, C is consumption, I is private investment, G is government spending, NX is the trade balance X-M, S is savings and T is taxes.

This gives the interrelation of balances:
(3) NX ≡ (S-I) + (T-G)

When government is taken out of the picture, i.e. T=0, G=0, then (3) reduces to:
(4) NX ≡ S – I

Conclusion: “the trade balance (net exports) is identical to the sum of net savings (savings minus investment).” If the trade balance is zero one arrives at the good old I≡S of Keynes’s General Theory (p. 63). This identity is false since its inception but among all After-Keynesians only Allais has realized it.#3

The error/mistake/blunder of this approach is in the definition of total income and total saving and in the absence of total profit and distributed profit.

It is well known that Keynes had no idea of what profit is: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al.)

Keynes’s error/mistake/blunder carries over to the equations (1) and (2). It is pretty obvious that they do not contain profit. This blunder in turn carries over to trade balance accounting.

In order to see this one has to go back to the MOST ELEMENTARY configuration, that is, the pure consumption economy which consists only of the household and the business sector.#4

In this elementary economy three configurations are logically possible: (i) consumption expenditures are equal to wage income C=Yw, (ii) C is less than Yw, (iii) C is greater than Yw.
In case (i) the monetary saving of the household sector Sm≡Yw-C is zero and the monetary profit of the business sector Qm≡C-Yw, too, is zero.
In case (ii) monetary saving Sm is positive and the business sector makes a loss, i.e. Qm is negative.
In case (iii) monetary saving Sm is negative, i.e. the household sector dissaves, and the business sector makes a profit, i.e. Qm is positive.

It always holds Qm+Sm=0 or Qm=-Sm, in other words, at the heart of national income accounting is an identity — the business sector’s deficit (surplus) equals the household sector’s surplus (deficit). Put bluntly, loss is the counterpart of saving and profit is the counterpart of dissaving. This is the most elementary form of the Profit Law.

When foreign trade is added then it holds under the condition of zero investment of the business sector and zero saving of the household sector Qm≡X-M, that is, the overall monetary profit of the business sector is positive if the rest of the world runs a deficit and negative if the rest of the world runs a surplus.

The balances of the business sector, the household sector, the government sector and the rest of the world are interrelated as follows: Qm≡(I-Sm)+(G-T)+(X-M), and THIS is the correct accounting identity for an open economy without distributed profit.

Not only Mankiw’s economics is brain dead rubbish, the textbook misery started already with Samuelson.#5 Economics students swallow every junk hook, line and sinker since generations. It seems that scientific incompetence is hereditary in the dismal proto-science. Lucas once confessed that “... he was bewitched by the beauty and power of Samuelson’s Foundations of Economic Analysis.”#6 You cannot make this stuff up.

Egmont Kakarot-Handtke

#1 For details see cross-references Refutation of I=S
#2 See ‘The Common Error of Common Sense: An Essential Rectification of the Accounting Approach
#3 See ‘How Keynes got macro wrong and Allais got it right
#4 The elementary consumption economy is given by three systemic axioms: (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.
#5 See ‘The father of modern economics and his imbecile kids
#6 The correct foundations of economic analysis are shown on Wikimedia

Related 'How to end the Punch and Judy show about profit' and 'Wikipedia and the promotion of economists’ idiotism' and 'From false micro to true macro: the new economic paradigm' and 'The final implosion of MMT' and 'Econ 101 is dead ― and now?' and cross-references Accounting

Immedialtely following 'The false foundations of economics'