May 29, 2016

The tiny little problem with economics

Comment on Lars Syll on ‘The tiny little problem with Chicago economics’

Blog-Reference and Blog-Reference on Jun 2

The problem with economics is that BOTH orthodox and heterodox economists are scientifically incompetent. The proof is in the fact that they do not even get macroeconomic accounting right which is a rather elementary form of mathematics.

1. Locked-in for 80+ years
Lars Syll summarizes: “What Cochrane is reiterating here is nothing but Say’s law, basically saying that savings are equal to investments, and that if the state increases investments, then private investments have to come down (‘crowding out’). As an accounting identity there is, of course, nothing to say about the law, but as such it is also totally uninteresting from an economic point of view. As some of my Swedish forerunners — Gunnar Myrdal and Erik Lindahl — stressed more than 80 years ago, it’s really a question of ex-ante and ex-post adjustments.”

2. The logical blunder
(a) “Savings are equal to investments is an accounting identity,
(b) it’s really a question of ex-ante and ex-post adjustments.”
Both statements are provably false (2011a; 2011b; 2012).

3. How Keynes got I=S wrong
Keynes formulated the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income − consumption. Therefore saving = investment.” (1973, p. 63)
This elementary syllogism is conceptually defective because Keynes NEVER came to grips with profit (Tómasson et al., 2010, p. 12).

4. Rectification
The Keynesian premises have to be replaced by the axiomatically correct macrofoundations. This is achieved as follows.
(A0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(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.

For the graphical representation of this ABSOLUTE formal MINIMUM see Wikimedia AXEC31:

(A1) to (A3) asserts: At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of (i) budget balancing, i.e. C=Yw, and (ii), market clearing, i.e. X=O.

Under the conditions (i)|(ii) the price is derived in each period as P=W/R, i.e. the market-clearing price is in the most elementary case equal to unit wage costs which vary over successive periods. This is the macroeconomic Law of Supply and Demand.

In the next period, the households save, i.e. condition (i) is now lifted. The result is shown on Wikimedia AXEC33:

Consumption expenditures C fall below Yw and with it the market-clearing price P. The product market is cleared due to (ii) and there is no such thing as inventory investment, i.e. I=0. Monetary saving of the household sector is given by SmYw−C.

The business sector makes a monetary loss which is equal to the household sector’s saving, i.e. Qm≡−Sm. Therefore, loss is the exact counterpart of saving; by consequence, profit is the exact counterpart of dissaving. This is the most elementary form of the Profit Law. It follows directly from the profit definition Qm≡C−Ym and the definition of household sector saving.

The sector balances always add up to zero, and THIS is the correct accounting identity. Saving and investment are NEVER equal, neither ex-ante nor ex-post.

5. Generalization
The correct profit equation for the investment economy reads Qm≡Yd+I−Sm. Legend Qm: monetary profit, Yd distributed profit, Sm monetary saving, I investment expenditures.

The DIFFERENCE between investment and saving I−Sm, which exists at EVERY moment on the time axis, plus distributed profit Yd determine monetary profit Qm, which is measurable with two decimal places at EVERY moment with an appropriate accounting system.

6. Conclusions
(i) Neither is investment determined by saving (= orthodox error) nor is saving determined by investment (= Keynesian error). Both variables vary independently and are NEVER equal, neither in accounting nor in reality, neither ex-ante nor ex-post because there is NO such thing as an equilibrium of I and S.
(ii) All I=S/IS-LM models from Keynes/Hicks to Krugman are provably false (2014).
(iii) The investment multiplier is formally defective since Keynes.
(iv) Both, orthodox and heterodox profit theories are false. This is the tiny little problem of economics since Adam Smith.
(v) The representative economist has NOT realized (i) to (iv) until this day because of elementary logical/mathematical/accounting incompetence. The Swedish school from Myrdal/Lindahl to Syll is no exception.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011a). Keynes’s Missing Axioms. SSRN Working Paper Series, 1841408: 1–33. URL
Kakarot-Handtke, E. (2011b). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. 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
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
Keynes, J. M. (1973). The General Theory of Employment Interest and Money.  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

For more about the worst economic equation/equality/identity/equilibrium see cross-references Refutation of I=S.

For more about Myrdal see AXECquery.